Why are banks drowning under Non-Performing Advances?

Of late, banks and other financial institutions are engulfed in a massive quagmire due to increasing Non-Performing Advances (NPAs). The situation is not only alarming but also leads to many questions, such as those pertaining to the fundamentals of credit evaluation, credit administration, the role and level of supervision of regulators, the role of auditors and the way the Boards of Directors instruct their respective organisations. The answers to these questions reveal the underlying causes of this alarming rise in Non-Performing Advances. 

Negative paradigm shift

Long ago, credit was granted by purely assessing repayment capacity. The ability to repay the loan was the key criteria in addition to many others. Even in the leasing industry, what mattered was the repayment capacity and a minimum number of rentals as the borrower’s contribution were of paramount importance. Today, however, this fundamental criterion of assessing repayment capacity has dramatically shifted to ‘target-oriented credit’. While acknowledging that all financial institutions like other companies are competing in the Volatile, Uncertain, Chaotic and Ambiguous (VUCA) world and the world is moving towards a performance-oriented culture, it does not mean that every invoice that the marketing officer brings in should be greeted with a lease, or every apartment that is being constructed can be granted a loan. ‘Paya deken leasing’ (Lease within two hours) is a classic example to prove that the repayment and credit worthiness of the borrower are not at all assessed. This negative paradigm shift from the assessment of repayment capacity to target-oriented credit has created ripples within the industry. This is one of the causes for high NPAs within the industry.   

General Motors was facing many issues since the early 2000s purely due to its inability to gauge the pulse of the consumer and to be congruent with the evolving world. While facing these issues, the 2009/2010 recession in the US aggravated its commercial death. In a similar manner, banks and finance companies have had enough NPAs up to December 2018, but kept them under the carpet due to an unending desire to ‘beat’ competitors and become ‘number one’ in the industry. However, similar to GM’s story, the 21 April attacks in Sri Lanka aggravated NPAs beyond control. 

Most leasing customers at finance companies cannot even meet the premium of the insurance renewal after one year. Either the finance company has to grant another loan to be repaid over a period of one year or they move towards third party insurance. Moving towards third party insurance poses the threat of losing the asset for the company despite having absolute ownership in case of theft, fire or a major accident. 

Despite these setbacks, most banks and finance companies still boast that their NPAs are below 10%, not realising that this 10% actually translates to billions of rupees. Many are of the view that it is not the percentage that matters but the ultimate total quantum of NPAs, and rightly so. Financial controllers and auditors have to be aware of this fact. Hence, if the Central Bank of Sri Lanka (CBSL), being the bankers’ banker, and the financial regulator, imposes a rule to disclose the actual ultimate value of NPAs in the annual report, financial institutions will be exposed in ineffable terms and at great reputational risk. 

Ultimately, how can auditors confirm that the economic sustainability of the firm is sound? Such aspects are evident when one observes conspicuous gaps in the rosy stories written on economic sustainability and the actual level of NPAs of the financial institution. 

Ignoring strategic plans

All financial institutions have their strategic plans designed for three to five years. Some banks even pay billions, sometimes unnecessarily, to design their strategic plans. Paying a higher amount to design a strategic plan does not ensure the envisaged degree of effectiveness and the level of competitiveness in the market. Besides that, the reality in Sri Lanka for the last three to four years has been that the banks attempt to ‘beat’ each other, with greater focus on surpassing the competition than any emphasis on organisational wellbeing. This is similar to a Matara bus plying Galle Road attempting to overtake a Tangalle bus at any cost to earn an additional Rs. 500 and risking the lives of all the passengers, pedestrians and other vehicles using the same roads. 

Ultimately, all financial institutes are in trouble. The strategic plan, if designed well, provides a direction to achieve predetermined multidimensional objectives in realistic terms as well as to overcome envisaged (scenario-based) geopolitical issues. Ignoring the strategic plan in this VUCA world not only leads nowhere but also creates totally unexpected consequences.  

Despite these setbacks, most banks and finance companies still boast that their NPAs are below 10%, not realising that this 10% actually translates to billions of rupees. Many are of the view that it is not the percentage that matters but the ultimate total quantum of NPAs, and rightly so. Financial controllers and auditors have to be aware of this fact. Hence, if the Central Bank of Sri Lanka (CBSL), being the bankers’ banker, and the financial regulator, imposes a rule to disclose the actual ultimate value of NPAs in the annual report, financial institutions will be exposed in ineffable terms and at great reputational ris

Such a focus on beating the competition, ignoring any strategic plans and corporate objectives, results in many banks ‘loading’ their so-called prime customers with more credit merely to achieve their targets and to beat others. Due to this fact, there is a strong possibility that every prime customer will become the ‘worst customer’ after seven to eight years when they reach the declining stage of the product lifecycle. 

There is no rule to say that every financial institute should record a growth in profit, credit portfolio and market share each year. Similar to the security forces making a strategic withdrawal in one or two battles, financial institutions can record a decline in profit or credit portfolio to periodically consolidate their position. The envisaged position this year is that all financial institutions will record a significant negative growth. This is good for consolidation.   

Narrow product portfolio

Most finance companies only focus on leases which are about 75% of their portfolio and pawning and a few personal loans for the balance. This narrow portfolio, coupled with an unending desire to be a market leader, has led to the ‘leasing and seizing’ scenario. 

These companies have to expand their portfolio into at least two more lending arenas not only to mitigate the risk by reducing the leasing portfolio to about 50%, but also to contribute to the economy and society. What would happen if the Government curtailed the importation of vehicles? Importing a vehicle naturally erodes foreign exchange reserves. Importing fuel as a nation for such leased vehicles creates a further negative impact on already constrained foreign exchange reserves. Hence, finance companies’ economic and ecological sustainability are negative and societal sustainability has to be ascertained through econometrics. Do we make such calculations?  

Another alarming factor is that even microfinance companies are providing leases instead of focusing on cottage industries. The concept of microfinance is to aid and support cottage industries, however, these companies too are more focused on making profits through ‘leasing’ rather than actually fulfilling their purpose. Hence, it is the duty of the financial regulator to instruct finance companies to have a sound and well diversified portfolio based on globally accepted quantitative and qualitative terms.                          

Centralisation and cost management

Most banks have centralised the credit evaluation process with two objectives: one is to enjoy a sound credit portfolio and another is to reduce their costs. Have they achieved these two objectives? Most of the evaluations are made by young CIMA- or ACCA-qualified accountants based on the customers’ balance sheets and other financial documents. While highlighting the fact that one cannot purely depend on balance sheets in Sri Lanka, credit evaluation goes well beyond financials. 

For instance, carrying out an inspection to ascertain the business level, nature of the property offered as collateral and relationship with the customer is important. Since most banks in the Sri Lankan banking industry enjoy a large branch network, having branch experience and a relationship with the branch and customer are of paramount importance. Credit evaluators and approving authorities in a centralised environment should not only have adequate branch exposure but should also be congruent with invisible cultural characteristics in branch lending. Personnel who parachute in at the top with little to no ground level experience should understand this requirement.   

Secondly, most banks and finance companies are involved in ‘cost-cutting’ exercises. ‘Cost-cutting’ in itself is a misnomer; organisations should engage in cost management or cost efficiencies rather than blindly ‘cutting’ costs. In this endeavour, cost management should be carried out without compromising quality in lending, the reputation of the bank, ambience and other services offered. 

In this VUCA world, mere cost reduction on trivial aspects is grossly inadequate. How many financial institutes have carried out a comprehensive value chain analysis during the last three years, not only to reduce costs but also to identify activities in the value chain where value can be added or to strengthen backward or forward integration? Have financial institutions during the last three years or so improved their productivity and efficiency above industry norms and included them in their Performance Management Systems (PMS)? Do they understand that NPAs, like excess capacity, are costs? How many financial institutes have ‘killed’ unproductive products during the last three years upon ascertaining the poor contribution of that unproductive product to the overall profitability of the bank? Do they award the best branch or the division that has the highest cost reduction based on some accepted criteria? Banks still focusing on CASA should understand that this VUCA world has moved away from simply canvassing current and savings accounts, and a more sophisticated approach is required to survive. Considering the quantum of NPAs and interest in suspense as costs is important, although it naturally poses challenges from an audit perspective.   

Credit cards

Credit cards have become another hidden headache for NPAs. A credit card allows the consumer to purchase beyond his or her purchasing power. However, in Sri Lanka, banks are involved in unethical practices where credit cards are issued even to take over the card liability of another bank. This needs to be restricted. In certain instances, when the loan or overdraft is declined, the bank issues a credit card to the same customer. 

Most of the credit card portfolio is run on a separate computer system which is not linked to the core banking system. Under these circumstances, in a target-oriented culture, credit cards are issued to customers to use them lavishly in order to maximise their interest revenue at a higher rate. The repercussions are assessed later. 

From the merchant’s perspective, the consumer is encouraged to use the card lavishly to strengthen their business. This would undoubtedly lead to ‘personal bankruptcy’ like in the US. Currently, banks, while competing in turbulent market conditions, envisage the card business as the only option to maximise their profits at a higher rate. Hence, latecomers (banks) to the market with credit cards have to be more cautious of this.  

The author’s experience is that in other financially disciplined countries, the customer first meets the bank’s commitments and with the remaining funds, they manage their domestic requirements. But in Sri Lanka, the customer first spends lavishly and only if they have any remaining funds do they remember their bank commitments. Businesses are no exceptions. Hence, the impact of issuing credit cards under such circumstances without proper assessment can be detrimental.    

Directors’ professionalism

Ironically, almost all banks and finance companies are owned by powerful business tycoons who are fundamentally ‘achievement oriented’. This is where Non-Executive Directors and corporate management members have to be vigilant and learn to refuse without saying no to the pressures exerted by such tycoons. This is where professionalism matters.

Directors should direct the company to greater heights, not only identifying available opportunities but also envisaging possible threats and formulating strategies to overcome them. Corporate governance explains that directors should be a set of professionals with business acumen, knowledge and competencies in their given fields. Therefore, assigning work to consultancy firms even to design a strategic plan is a reflection of a lack of professionalism and knowledge on the part of the directors. 

It is accepted that if the investment or the project is of an uncommon nature or a significant investment or turnkey operation, assigning it to a consultancy firm for advice or for a feasibility report can be an astute move. But definitely not for routine or simple assignments. 

No board in the financial sector has demonstrated the need to record declining profits during the last three years as a proactive measure or as a prudent board that does not go with the herd as they were going all out to beat the others. When you drive a car fast, the car has to have a better Automatic Brake System (ABS). 

When a bank goes fast to beat others, the bank should have a sound braking system, a back-up system and a meticulously designed contingency plan. Have the directors instructed corporate management to redesign the PMS giving more weightage for recoveries to be congruent with the need of the hour?

Another dimension is that directors were encouraging lending to dying industries such as the apartment industry for instance.  Although the apartment industry had high demand, supply subsequently exceeded demand. While agreeing that the Sri Lankan economy has been performing under a saturated and subsequently turbulent market, with the economy growing only around 3-4% during the last few years, this does not mean that due to a lack of lending opportunities, all banks should lend only to one industry. 

“Former Central Bank Governor Dr. Indrajit Coomaraswamy stated that the apartment construction industry appeared to be overheating, was using credit lines meant for small and medium enterprises (SMEs) and provided a safe haven for black money,” according to an article by Lanka Business Online which appeared on 25 May 2017. 

In this context, the author totally endorses the statement made by the former CBSL Governor about the apartment industry. Today banks face repercussions. 

Banks pay undue pressure to improve the bottom line. The bottom line has only about one-third and the balance should be on the top line and the topmost line. But the irony is that directors or CEOs do not pay attention to the latter two.      

Hence, all financial institutions have to make every effort to reduce their NPAs with a well-planned program within the next two to three years. By 2022, NPA ratios should be at global standards. If not, this will have a negative impact on the ratings of Sri Lankan banks, as well as the country as a whole in terms of credit worthiness and business attractiveness. 

On the other hand, regulators have to be more vigilant with tough measures to control the situation. If not, there is a possibility that the entire finance industry, especially finance companies, will soon crash.

(The writer is the Head of Academic Affairs at PIM. He is a strategist, consultant, banker and academic with a wealth of corporate exposure across many spheres).