NAIROBI, KENYA: Moody’s Investors Service - a global reputable provider of credit ratings, research and risk analysis is considering downgrading credit standing of some local banks. We need to address the weaknesses in the balance sheets of our banks.
The levels of non-performing loans among commercial banks are a concern and impact badly on the economy. Banks must come up with a solution for bad loans on their balance sheets.
Non-performing loans (NPLs) are bad assets. When bank assets decline in value, financial institutions become reluctant in extending credit to worthy borrowers, even when they should.
One only needs to look at the daily newspapers to acknowledge the magnitude of the bad debt problem.
In the dailies, we find advertisements by banks auctioning assets that they financed because the borrower is unable to meet their debt obligations.
By auctioning these assets, the signal from the bank is that they consider these debts toxic - the loans are unlikely to be paid.
Bad loans mean the lending capacity of the bank is eroded, and part of deposits is lost.
This is harmful to the economy. Our textbook understanding of commercial banks is that they accept deposits from savers, and from these deposits, they create assets in terms of loans to borrowers.
One would imagine that large amount of NPLs would substantially drain deposits, but does not appear the case given that our banks appear to still have a lot of money to lend.
The question then and this need to be researched on because it touches on the stability of our financial system is: Where are banks getting this money?
The circular argument is that the interest rate is high because the demand for money is high. This means that the saving rate by households is low, which begs another question: Who deposits the money at the banks?
The Bank of England’s publication titled Money Creation in the Modern Economy, asserts that banks are no longer mere intermediaries between depositors and borrowers but are digitally involved in the business of creating money.
Perhaps this might explain why NPLs are piling up, yet banks keep on advancing money.
There could be large amounts of deposits out there created by banks, which are then lent to the borrowers. Banks, however, need not worry about bad loans arising from such deposits!
It would be interesting to know how the Central Bank limits this money-making machine.
Back to bad loans, Joe Weisenthal commented that there is no market for the mountains of crap the big banks have piled on their balance sheets.
Bad assets earn no returns to the bank and are worthless to the shareholders.
The question that is rarely asked is: To what extent does a bank credit management practice contribute to non-performing loans?
The usual explanation is that the economy down, therefore, borrowers cannot service their loans; the other story is that interests are too high.
The untold story is the weakness of the banks’ capacity to screen borrowers. Banks must have the competence to evaluate information and to control and monitor borrowers.
Banks should accept credit risk only if the returns from loans sufficiently cover the cost of funding, such as risk costs.
Financial institutions must take acceptable risks or else depositors will lose their savings while bank owners will lose their investment in the bank.
Incompetent credit managers are prone to misadvising potential borrowers.
Care risk in any bank is credit risk that is such risk that the promised cash flows from loans made by commercial banks may not be paid in full. All banks face this risk, and successful ones are always on top of this risk.
Bank managers must ensure that they fund most creditworthy loans, that there are large amounts of non-performing loans tell us that banks are extending loans to bad borrowers. Banks which lack capacity required to estimate expected default risk end up extending loans to those unlikely to repay.
The source of this failure could be loan officers who are not either competent because they are not qualified or are qualified but corrupt.
Competency enables credit managers to monitor and to collect relevant information about borrowers and to price risk correctly, no wonder Sounders argues “managerial monitoring efficiency and credit risk management directly affect the return and risk of a loan portfolio.”
Corrupt credit managers will approve credit to bad borrowers for a pay. Corruption makes what is supposed to be a secured loan become unsecured.
Incompetent credit managers must be trained or sacked. In addition, banks will benefit by training their staff on ethics.
It appears our banks must re-design their credit rating models as a step to reducing the chances of loaning money to a bad borrower. Their models must be able to discriminate between bad and good borrowers, and there are a number of such models out there.
The traditional models used to control credit risk of lending include requiring risk borrowers to pay higher interest rates, restricting loans to riskier borrowers, requiring enhanced collection from the riskborrower, effective use of covenants and diversification.
However, bad training and corruption on the part of credit managers ground risk-management approaches. Good credit management practices push a bank away from insolvency.
The writer teaches at the University of Nairobi