Bank loan default: Prevention and cure

Zia Uddin Mahmud

The words 'Loan Default' have become common in the banking sector of
Bangladesh these days. Because, commercial banks as well as non-banking
financial institutions (NBFIs) have been experiencing frequent loan default cases
which have resulted in huge profit cut and low return on their investment. This is an
unpleasant and undesirable situation for a banker in the life-cycle of a loan but still
bankers have to meet the situation when a loan seems to be unrecoverable within
the stipulated time period or as per agreed terms of the loan contract.

It may not be realistic to expect that one hundred per cent of the loan disbursed will
be recovered. Some of these may remain unrecoverable. Internationally-accepted
rate of loan classification in a bank is not higher than 2.0 per cent. But in
Bangladesh, the rate of loan classification is on average 8-11 per cent. The rate is
around 17 per cent in case of state-owned commercial banks. This is an alarming
situation for our banking sector which ultimately affects smooth growth of the
economy. When a loan becomes default, the bank has to face multifarious problems.
Cost of fund of a classified loan is much higher than that of an unclassified loan. A
classified loan does not yield to any income however it bears cost. On the other
hand, the bank has to keep provision against classified loan ranging from 20-100
per cent on the basis of different stages of classification which shrink investment
scope of the bank as well as income. Due to provision against the classified loan,
the bank loses opportunity to use the fund for further investment. Besides,
reputation of the bank is also hampered due to high rate of classification which may
affect the stock price of the bank in the capital market. So, we should immediately
come out from this situation and should develop a strong culture in the banking
sector so that this situation can never recur. But how will it be possible? To find the
answer, this writer, from his banking experience and knowledge, can outline some
solutions.
There is a very famous proverb: "Prevention is better than cure". This proverb is also
very true in case of bank loan default. It is always better to take preventive
measures than to cure so that a loan cannot be default in its life cycle. So, at first
we will look how to prevent loan from being default and then will look as to how to
combat the situation if a loan becomes default despite its prevention.

The following measures should be taken to prevent a loan from being default:

1. Preventive measure to arrest a loan from being default should start from the very
day of processing of loan i.e. when a loan proposal is submitted by a customer. The
genuine loan requirement of the client has to be scrutinised very judiciously. There
should be an analysis whether the loan amount is sufficient or not and if the loan
amount applied for by the client is insufficient to run his proposed business or the
project may finally face problem in future to pay off the loan due to capital
shortage. On the other hand, if the loan amount is more than actual requirement,
then there has a chance to divert the fund which is one of the main causes of loan
default.

2. Purpose of the loan has to be carefully examined. Loan fund to be used in any
unproductive sector like purchase of land or luxurious goods has to be strictly
prohibited. On the other hand, loan sanctioned for a particular purpose and used in
another area is also a great cause for loan default. This should be monitored before
and after disbursement of the fund. The 5 Cs of a loan applicant must be considered
while sanctioning a loan. The 5 Cs are Character, Capital, Collateral, Capacity, and
Condition. Loan sanctioned to a dishonest person has a great chance to be default.
Generation of income of the client's business should be examined. Consistent
income of the client increases the chance to recover the loan in time. Credit history
of the client has to be collected from the market or from other sources. Experience
is an effective tool. Experience of the borrower to run the business should be taken
into consideration.
Bank loan default: Prevention and cure

3. Standard leverage should be maintained while giving loan to an individual or a

business entity. Ratio between net worth of the borrower and total loan amount
including proposed loan should not exceed 2:1. It is observed with great concern
that bankers often do not accurately examine the leverage which is also a reason
for loan default. A borrower, who uses most of the fund through loan to run a
business or project may not give coverage in times of any operating loss which
results in failure to repay the loan.

4. Relationship Manager (RM) should prepare the loan proposal without any
interference of any third party, top management of the bank or the client. He will
follow all the banking norms and rules as well as CRM (Credit Risk Management)
guideline while preparing a loan proposal for the best interest of the bank. In our
country, this is common that sometime the loan proposal has to be prepared with
bias of any interested group which ultimately may cause a loan to be default.

5. Security against the loan should be adequate. Both value and quality of security
should be taken into consideration. In case of collateral security like land, stress
value should cover the loan amount plus 10 per cent interest amount. Besides
correct sale value of the land must be considered. Moreover, genuineness of
property documents should be examined from the respective Sub-registry office, AC
Land Office, Tehsil Office by RM to avoid any hassle in future. Because, now-a-days
residual risk of documentary error of property has increased. In case of
hypothecation or pledge, date of expiry, condition of the goods and age of
receivables should be considered. In case of guarantee from an individual, credit
worthiness as well as net worth of the guarantor should be examined and in case of
corporate guarantee of a limited company, the company's financial position as well
as its Memorandum of Association should be examined to see whether the company
has any such power to provide corporate guarantee. A good coverage loan (secured
loan) cannot be default in the long run. If so, it can be recovered easily by releasing
the security.

6. Monitoring process has to be proper after disbursement of the loan till full
recovery. It is proved that most of the loan has become default due to lack of proper
monitoring after disbursement. Bankers should ensure that loan amount is being
used properly and the borrower is repaying the loan regularly. Loan provided to a
business entity should be monitored regularly. The banker shall ensure that the
business is running well and generating sufficient income for servicing the debt. On
the other hand, loan provided to an individual should also be monitored regularly.
The banker has to ensure that both the financial position of the borrower as well as
Income are in good condition to service the debt.

7. Say 'hello' to borrower on every working day. Keep good banker-customer

relationship with the borrower so that the banker can closely monitor the borrower.
To know the weakness of the client, there is no alternative to keep good relationship
with the client. This will also help a banker to get early alert before a loan becoming
bad.

8. Visit the borrower's business house on a regular interval. Monitor the operations
of the business of the client closely. Ensure that the loan fund is used only for the
purpose for which it is disbursed. Any deviation must be noticed in a proper way to
call back the loan.

9. Documentation should be carefully and properly completed as per sanction terms

of a loan. This will also increase the chance to recover the loan in time and prevent
it from being default.
10. It has been observed that in recent past, most of the default cases happened as
loan was taken in the form of local LC (Inland Letter of Credit) and LTR (Loan against
Trust Receipt) facilities. So, while granting such loan, actual transfer of goods under
local LC must be ensured and the RM must ensure that this is not an
accommodation bill. In case of LTR facilities, stock of goods under LC must be
monitored on a regular basis so that all the sale proceeds of the goods under LTR
facility are deposited towards adjustment of outstanding liabilities, not diverted
elsewhere.

The preventive measures described here may not absolutely prevent the loan to
become default but it will help recover the loan if it becomes default.

The following are the steps that can help recover a default loan:

1. When a loan becomes default or seems to be unrecoverable, then our first job is
to find out the main causes of the default. Because, it will help us find out our
projected course of action to recover the loan. A loan can be default due to
different reasons despite taking various preventive measures. The reasons are
shortage of adequate capital in business, lack of knowledge to handle the business,
operational loss in business due to adverse external economic factors like unstable
political situation, deflation, stagnant economy, diversion of fund from key business,
investment in unproductive sectors, wilful default etc. So, if we can find out the real
causes of default of a loan, we will easily find ways to recover the loan.

2. When a loan becomes default, a banker has to keep in touch with the borrower
on a regular basis and to convince him to repay the loan in a gentle way. Never
behave rudely with the borrower to recover the loan. This may aggravate the future
chance to recover the loan. Try to find out different sources of borrower from where
he can repay the loan. Counsel the client by which he can repay the loan from his
different alternative sources.
3. If the business of the borrower is running or if the borrower has other sources to
repay the loan gradually, then the banker can motivate the borrower to reschedule
the loan as per the Bangladesh Bank rules so that borrower can repay the loan
gradually. If there is any chance to reinstate the business of the client by further
investment, the bank may provide finance further the client. In that case bank has
to be ensured that further finance will generate sufficient income to recover the
dues.

4. Where there is no scope to recover the loan from any sources of the borrower,
then the bank can take steps to sell the mortgaged property through public auction
under section 12 of Artha Rin Adalat Ain-2003 for adjustment of the liabilities.

5. If sale proceeds of the mortgaged property through public auction does not cover
repayment of the loan, then the bank can take legal action against the borrower as
per Artha Rin Adalat Ain-2003 before it becomes time-barred as per Limitation Act
or under section 138 or 140 of Negotiable Instrument Act-1881.

6. Filing of a suit in the court against the client does not give relief to a banker from
his/her responsibility to recover the default loan. Proper monitoring of the court
cases has to be ensured for early settlement so that decree of the case comes in
favour of the bank. Recovery of the default loan through legal action is a lengthy
process. So different alternative actions may be taken under the provision of law
like settlement through mediation under section 22 of Artha Rin Adalat Ain, 2003.

7. Besides legal ways, a banker may continuously pursue the client to repay the
loan keeping good banker-customer relationship.
All the above are not the standards for preventing or recovering the default loan.
Rather these are different alternative ways. Style of recovery of the loan may be
different from borrower to borrower or prevention of loan from being default may
differ due to different natures of loans. But a banker should be hihgly judicious in
selecting borrowers, should be honest and careful while disbursing a loan and
should be responsible to recover it in time. These will ultimately reduce the risk of
loan default. If we can learn from the recent scams in the banking sector and
become more aware, we can surely bring back the banking sector to a good shape
which will ultimately improve the financial health of a bank.

The writer is Senior Executive Officer, National Bank Ltd., Anderkilla

Branch, Chittagong.