To make a bad loan worse

Bangladesh Bank -- the central bank -- has decided to make one of the economy’s banking problems worse. What makes this slightly more awful is that it’s an attempt to solve this very same problem. This isn’t, perhaps, how we’d like the authorities to be working.

The change itself sounds terribly technical, even trivial. There’s an international standard to decide when a loan a bank has made out to a borrower is sub-standard, doubtful, and bad. 

If the repayments haven’t been made for three months, it’s sub-standard, for six, it’s doubtful, and nine, bad. Bangladesh Bank has decided to extend all these classifications by three months. So, it now will take 12 months of no repayments for a loan to be described as bad. 

The point of all of this is so that it’s possible for a bank to work out how much capital it must have. Sure, some loans will go bad, some won’t be repaid. That’s just the nature of the activity being undertaken here. 

But we don’t want the people who have deposited their money in the banks to be the people taking those losses. We want the bank and its shareholders to be doing so. Thus, they must provide capital to cover likely losses.

Such loan losses are, as above, just a part of doing business. So, everyone gets charged interest which will cover some number of loans that aren’t repaid. What shareholders get as their profit and dividend is what’s left after the costs of running the bank, including paying off those bad debts. They get that profit because they’ve provided that capital.

But ah, how much capital should they provide? Which is what those international rules are for. A loan that hasn’t been repaid for three months is obviously more likely to not be repaid in full. 

One that’s paid nothing for nine months is even more likely. 

That means, the bank must allocate more of that capital to those loans – they’re more likely not to be repaid, there will be higher losses, they must put aside more of the shareholders’ money to be ready for those losses.

Do note that all loans have some capital put against them. A brand new loan, not even due for its first interest payment as yet, must have some capital put by just in case it turns bad over time.

So, banks must provide capital against loans. We insist they put more capital aside against what are, or are turning into, bad loans. So, why might we change the definitions of bad loans against which banks must allocate more capital? 

Well, capital is scarce and expensive. The availability of capital is the determinant of how much the banks can lend. And people tend to think that banks lending more is a good thing, that it expands the economy.

Which is the reason for what Bangladesh Bank has done. Loosen the rules on what is a bad debt, and therefore, banks must assign less capital, leaving them with more capital to put against new loans. More loans will be made, and the economy expands.

The logic is impeccable; it just misses what happens elsewhere in the economy. Because we don’t, in fact, want more loans to be made. What we want is better loans to be made. 

Lending to someone who can’t pay it back isn’t just a loss to the bank, it’s a loss to all of society. We’ve just sent economic assets -- those savings plus what they can buy -- off to a project which cannot pay it back. Cannot pay it all back because it isn’t adding value. It’s making a loss, also known as subtracting value.

So, we don’t in fact want more loans to people who might not pay them back. We want more loans to people who will pay them back, because they are adding value and they are making a profit.

We’ve not just made it less costly for banks to lend to those people who aren’t adding value. What do we know about human beings? They do more of whatever it is that costs less. 

Bangladesh Bank has, by relaxing these rules, just made more bad loans in the future more likely. This isn’t, to put it mildly, what we want in the economy.

To an extent, this is highly technical and it’s also close to being trivial. A three-month change isn’t going to make all that much difference, although the direction will definitely be as above -- in a bad direction.

There is though a larger point -- these international standards. On banking capital ratios and loan reserves here, but on all sorts of other things too. They’re not there to be played around with in this manner. 

They’re there because they are the distilled wisdom of history, in how to deal with these varied problems. The international standards on cement tell us how to make cement well, the international standards on children’s nightwear detail the trade-offs between costs and, say, flammability.

The international standards on banking are as they are not to annoy Bangladeshi bankers, but because they’re the best distillation of human knowledge about how to run a banking system properly.

Another way to put this is that it’s worth learning from those people who have made this mistake before. That being exactly what catch-up development, the type of economic growth we’re having in Bangladesh today, actually is. 

Seeing what other people have done that works, and doing that, trying not to make the same mistakes they did along the way. It works in telecoms standards, it works in cement-making, and yes, it works in banking too.
Source: https://www.dhakatribune.com

Tags :

Share this news on:

Previous Story

Trending Topics

Archive