Non Performing loan free essay sample

Non Performing Loans: Comparative Analysis of India and Pakistan Name Department Course Title Course Instructor Date Table of Contents Sr. No Topic Page No. 1. Executive Summary 2 2. Introduction 3 3. Non performing Loans: An Overview 5 3. 1 Definition 5 3. 2 Effects of Non performing loans 6 3. 3 Relationship between NPL and Bank’s profitability 7 4. NPL: India Vs Pakistan 7 4. 1 Background 7 4. 2 Structure and Ownership of banking structure 8 4. 3 Analysis 11 5. Conclusion 12 6. References 13 Table of Tables Graphs Sr. No Topic Page No. 1. Banking structure 8 2. Percentage figures: Table 9 3. Percentage figures: Graph 9 4. Tabular Comparison 10 5. Graphical comparison 10 Pakistan 10 India 11 Pakistan Vs India 11 Executive Summary This project titled Non Performing Loans: Comparative Analysis of India and Pakistan has been carried out in order to study the situation of non performing loans in two emerging economies of South Asia. The project starts with the introduction of financial institutions and move on to the discussion of commercial banks, being the major financial institution. Then the project hints on the concept of non performing loans by briefly documenting the definition, effects and relationship between NPL and profitability of a banking structure. We will write a custom essay sample on Non Performing loan or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page The last segment of the project deals with the comparative analysis of both the countries. Despite of the fact that both the countries almost enjoy similar type of patterns, it is interesting to note that the figures of non performing loans for India are on a gradual decrease for the last 13 years. The data for the concerned variable is obtained from the reliable source of World data indicators for the last 13 years from 2000 to 2012. The project at the end registers certain important policy implications for Pakistan to improve the existing situation. INTRODUCTION In any economic structure of a country, financial institutions play an utmost important role. In financial economics, a financial institution is an institution that provides financial services for its clients or members. Probably, the most important financial service provided by financial institutions is acting as financial intermediaries. It is important to note that many of the financial institutions are regulated by the government. Strictly categorizing the institutions, there are three main types of financial institutions. These are: Depositary Institutions: Depositary institutions are those institutions which accept deposits and manage them while they are also in the business of advancing loans. These institutions include banks, building societies, credit unions, trust companies, and mortgage loan companies. Contractual Institutions: These are savings institutions that obtain their funds through long-term contractual arrangements and invest these funds on the capital markets. These include insurance companies and pension funds. Investment Institutions: An investment institution is defined as an investment company or an investment fund. These include investment banks, brokerage firms, etc. Commercial banks happen to be the apex of these financial institutions. The pillars of any economy rest on the operations of banking system. Hence, among all the other financial institutions, commercial banks, single handedly; contribute more than half to the economy of any country. Here, it is important to document that what are commercial banks, what role do they perform and what are the factors that significantly affect the profitability of a banking structure. In a simple layman language, commercial banks are the banks that offer services to general public and to companies. However, the term encompasses many ideas and concepts that move far beyond offering services to public and companies. Technically speaking, a commercial bank is an institution that accepts deposits, makes business loans and offer related services. These institutions are governed to make a profit. Commercial banks offer a number of other related services but their main aim is to receive deposits and advance them to businesses. Here, it is important to document the profit mechanism of the banks, that is, how banks earn a profit. Banks accept deposits and make loans and derive a profit from the difference in the interest rates paid and charged to depositors and borrowers respectively. The process performed by banks of taking in funds from a depositor and then lending them out to a borrower is known as financial intermediation. Through the process of financial intermediation, certain assets are transformed into different assets or liabilities. As such, financial intermediaries channel funds from people who have extra money or surplus savings (savers) to those who do not have enough money to carry out a desired activity (borrowers). Banking thrives on the financial intermediation abilities of financial institutions that allow them to lend out money and receiving money on deposit. The bank is the most important financial intermediary in the economy as it connects surplus and deficit economic agents. Perhaps, one of the important indicators that reflect the possible profitability of a banking structure includes the measure of non performing loans. A gigantic figure of non performing loans for any bank indicates poor profitability and vice versa. In order to fully comprehend this relationship between the non performing loans and the profitability of a bank, understanding the concept is utmost important. NON PERFORMING LOANS: AN OVERVIEW There is no global standard to define non-performing loans at the practical level. Variations exist in terms of the classification system, the scope, and contents. Such problem potentially adds to disorder and uncertainty in the NPL issues. DEFINITION A simple definition of non-performing is a loan that is not earning income and: full payment of principal and interest is no longer anticipated principal or interest is 90 days or more delinquent, or the maturity date has passed and payment in full has not been made. According to the Bank for International Settlement (BIS), the standard loan classifications are defined as follows: Passed: Solvent loans; Special Mention: Loans to enterprises which may pose some collection difficulties, for instance, because of continuing business losses; Substandard: Loans whose interest or principal payments are longer than three months in arrears of lending conditions are eased. The banks make 10% provision for the unsecured portion of the loans classified as substandard; Doubtful: Full liquidation of outstanding debts appears doubtful and the accounts suggest that there will be a loss, the exact amount of which cannot be determined as yet. Banks make 50% provision for doubtful loans; Virtual Loss and Loss (Unrecoverable): Outstanding debts are regarded as not collectable, usually loans to firms which applied for legal resolution and protection under bankruptcy laws. Banks make 100% provision for loss loans. Non-performing loans comprise the loans in the latter three categories, and are further differentiated according to the degree of collection difficulties. EFFECTS OF NON PERFORMING LOANS Non-performing loans can lead to efficiency problem for banking sector. It is found by a number of economists that failing banks tend to be located far from the most-efficient frontier. The issue of non-performing loans (NPLs) has gained increasing attentions in the last few decades. The immediate consequence of large amount of NPLs in the banking system is bank failure. Many researches on the cause of bank failures find that asset quality is a statistically significant predictor of insolvency and that failing banking institutions always have high level of non-performing loans prior to failure. It is argued that the non-performing loans are one of the major causes of the economic stagnation problems. Each non-performing loan in the financial sector is viewed as an obverse mirror image of an ailing unprofitable enterprise. From this point of view, the eradication of non-performing loans is a necessary condition to improve the economic status. If the non-performing loans are kept existing and continuously rolled over, the resources are locked up in unprofitable sectors; thus, hindering the economic growth and impairing the economic efficiency. RELATIONSHIP BETWEEN NON PERFORMING LOANS AND BANK’S PROFITABILITY The profit earned by the commercial banks is the difference between the deposit rate and the lending rate, called the spread. Non performing loans erode a bank’s profitability. The relationship between non performing loans and profitability runs in a unidirectional dimension where the relationship moves from non performing loans to profitability. A bank’s net profits (before adjustment for tax) is obtained by subtracting the amount of disposal of non-performing loans from net business profits, the profits that are attained from core banking business, that is to say, profits from lending and bond transactions minus fund procurement costs and other expenses, adding stock-related profits/losses, realized from stock profits, and other profits/losses. Hence, it is simple to register that more of non performing loans will result in leaving less of profit at the end. Consequently, a huge figure of non performing loans results in sweeping the profitability of a banking sector. CASE STUDY: NPL INDIA VS PAKISTAN This project has been designed to study the situation of non performing loans in two important regions of the South Asian territory that is, Pakistan and India and then assessing the effect of this indicator on the financial health of the two economies. Before proceeding ahead, it is important to have a look at the banking sector paradigm prevailing in this part of the world. BACKGROUND The banking sector in South Asia is dominated by the public sector commercial banks that account for more than 50 % of the total banking assets. As a result, the performance of the public sector commercial banks reflects the overall performance of the banking sector in South Asia, which has been poor when compared to that of private commercial banks and foreign owned commercial banks. There are number of reasons for the poor performance of the public sector commercial banks, some of which include: Poor governance and management; Weak supervision and monitoring mechanisms; Lack of focus; Ineffective human resource management policies; Limited computerization and automation; Excessive politicized Trade Unions. These factors have resulted in weak, inefficient and unproductive public sector commercial banks with large levels of non-performing assets and high operating costs, of which personnel costs alone amounts to about 20-30 % of the total expenditure in public sector commercial banks as compared to about 10-15 % in the private banks and foreign commercial banks. The high operating costs and the large levels of non-performing assets have resulted in increased cost of borrowings thereby constraining investments, economic growth and employment generation. STRUCTURE OWNERSHIP OF BANKING SYSTEM The banking sector in South Asia consists of the Central Bank, Public Sector Commercial Banks, also known as Nationalized Commercial Banks, Private Sector Banks, Foreign Commercial Banks and specialized banks providing mainly agriculture and industrial credits. The public sector banks account for more than 50 % of the total banking assets, in spite of private and foreign commercial banks dominating the market in terms of number of banks. Banking Structure STRUCTURE COUNTRY PAKISTAN INDIA Central Bank State bank of Pakistan Reserve Bank of India Public Commercial Banks 2 27 Private Commercial Banks 13 32 Foreign Commercial Banks 21 42 Percentage Figures India Pakistan Public Sector Banks 72% 54% Private Sector Banks 21% 30. 20% Foreign Banks 7% 15. 80% NPL: Pakistan vs India Below, a comparative analysis of non performing loans has been presented by reviewing the data for the last thirteen years that is from 2000 to 2012. The data have been extracted from the reliable source of World Data Indicators. Tabular Comparison YEARS INDICATOR COUNTRY PAKISTAN INDIA 2000 Bank NPL to TGL1 19. 5 12. 8 2001 Bank NPL to TGL 23. 4 11. 4 2002 Bank NPL to TGL 21. 8 10. 4 2003 Bank NPL to TGL 17 8. 8 2004 Bank NPL to TGL 11. 6 7. 2 2005 Bank NPL to TGL 8. 3 5. 2 2006 Bank NPL to TGL 6. 9 3. 3 2007 Bank NPL to TGL 7. 6 2. 7 2008 Bank NPL to TGL 10. 5 2. 4 2009 Bank NPL to TGL 12. 6 2. 4 2010 Bank NPL to TGL 14. 7 2. 5 2011 Bank NPL to TGL 16. 2 2. 3 2012 Bank NPL to TGL 15. 432 3 Source: World Data Indicators Graphical Comparison Analysis As has already been mentioned in afore said discussion that non performing loans are the loans that the bank is unable to recover. However, there are many reasons that contribute to this lack of recovery system. The most important reason is the inefficient evaluation and monitoring system applied in the banking sector. Comparing India and Pakistan’s statistics of non performing loans, reveals a really interesting picture. This statistic has been on a gradual decrease for India where as the case is reverse for Pakistan. One of the interesting factors that needs to be documented here is fact that although India, has a larger number of publically owned commercial banks as compared to Pakistan but the figure is on a decrease for India, which is a good enough indicative of the reality that India is having a strong collection and recovery mechanism for commercial banking as opposed to Pakistan. Indian banking structure appears to be a good example and role model for Pakistani system where they can capitalize from the improvements made in the former system. Rising non-performing loans are hampering the profitability of Pakistan’s banking sector. Many reasons are causing this alarming rise but, primarily high interest rate, economic slowdown and poor law and order situation in the country are the main factors. Non-payments are increasing in all fields but mostly from the agriculture and government sector. The non-Performing Loans (NPLs) of the Nationalised Commercial Banks (NCBs) have become a major problem because of political interference and directed credits to individuals and companies. Indian banking system has been successful in improving upon certain factors that resulted in speedy recovery in public commercial banks. For example, the banking system moved from inefficient to efficient human resource policies, computerization of banking structure and cutting down the influence of government in lending and recovery of the lended loans. This could act as a sample for the Pakistani banking system to improve the situation at their end. CONCLUSION Non Performing loans are a major determinant of assessing the financial health of any economy, having an inverse relationship with the profitability of the banking structure. As the emerging economies of the South Asian region, India and Pakistan present an interesting case study for the analysis of the situation. It is important for both the countries to take advantage from the strengths of each other’s system, while minimizing on the weaknesses of the others. REFERENCES Beck, R. , Jakubik, P. and Piloiu, A. (2013). ‘Non performing Loans: What matters in addition to economic cycle. ’ Working paper No. 1515, Macro prudential Research Network. Bloem, A. , Gorter, C. (2001). The Treatment of Nonperforming Loans in Macroeconomic Statistics, Issues 2001-2209. New York: International Monetary Fund. Farhan, M. , Sattar, A. (2012). Economic Determinants of Non-Performing Loans: Perception of Pakistani Bankers. European Journal of Business and Management, 4(19), 87-99. International Monetary Fund. (2013). ‘India: Financial Sector Assessment Program—Detailed Assessments Report on Basel Core Principles for Effective Banking Supervision. ’ IMF Report No. 13/267, Washington, D. C.