Fighting against potential financial risks

Reading through the 7/2017 directive by the Central Bank of Myanmar (CBM) on the implementation of the Asset Classification and Provisioning Regulation, the words and phrases that captured my attention were: “cash flow pattern of the borrower”, “credit risk analysis” and “term loans with up to a maximum maturity of three years.”

These technical terms are essential ingredients for effective financing of business establishments, especially small and medium enterprises (SMEs). By issuing the directive, the monetary authority is allowing local banks to make medium-term loans based on the business cycle and cash flow patterns of the SME. This represents a shift from a collateral-based to risk-based lending system, which is a significant development in the banking sector.

Collateral-based weaknesses

Under the old collateral-based system, banks accepted land and landed property as collateral and loan tenures were restricted to one year. After assessing the market value of the collateral, the bank estimates the forced-sale value of the collateral. To keep themselves on the safe side, banks usually grant credit of up to just 50 percent of the forced-sale value of the collateral.

That system has been accepted as normal banking practice since 2008, when the central bank, fearing a recurrence of the 2003 banking crisis in Myanmar, started imposing various restrictions on the banking sector. The most severe of these restrictions were imposed on the granting of credit. These include strict collateral-based lending, routine rolling over of loans, large volumes of overdraft loans and the lack of proper credit risk management.

Currently, local commercial banks accept all types of deposit, including fixed deposits, based on the short term. Since 2008, the banks have not been allowed to make long term loans from these short term deposits. While enforced so that banks will avoid any mismatches between the maturities of short term deposits and long term loans, the move failed to consider local SMEs, which require medium to long term loans to operate.

Instead, it led to borrowers spending money for business development to instead acquire immovable assets in the hopes of using those assets as collateral for future loans. As a result, few were able to repay their loans within the one year term. The loan repayments were thus rolled over from one year to the next. The banks allowed this practice as long as interest on the loans was serviced regularly.

Mounting overdrafts

In so doing, borrowers soon learned that overdrafts were the most convenient facility for rolling over their loans and many used it as an open-ended facility. In that manner, both the banks and their clients found a way to overcome the one-year maturity restriction set by the central bank.

However, this large outstanding amount of overdrafts carries potential risks, such as loan default. According to financial experts, total outstanding overdrafts are estimated at about 75 percent of total bank loans, which could lead to instability in the banking sector. One reason is the large stock of overdrafts undermines the level non-performing loan (NPL) on the banks’ books. Because the loans are rolled over indefinitely, NPL ratios are always under-reported. That is the central bank’s main concern.

In its effort to wipe out the risks associated with overdrafts, the monetary authority wants all banks to clear their overdraft loans at the end of each financial year, which is a requirement banks with large outstanding overdrafts will find hard to meet.

The CBM realises this and has since allowed banks to restructure their outstanding overdrafts into term loans with up to a maximum maturity of three years under its 7/2017 directive. The move indicates that the central bank wants all banks to establish an asset-liability risk management framework and to manage credit risks on a timely basis.

To avoid the concentration of risks in banks, it now restricts banks’ exposure to single counterparties or groups of connected counterparties and monitors transactions between related parties. The potential risks associated with outstanding overdrafts and the banks’ large financial exposure to them are serious, given that the monetary authority, at the request of some local banks, has relaxed its requirements with the issue directives 1/2018 and 2/2018 on January 8.

Towards risk-based lending

The allowing of medium term loans based on business plans and cash flows is a complete change in the lending system from collateral-based to risk-based. In the 7/2017 directive, the maximum maturity of a bank loan was extended to three years. The repayment terms should be flexible so that borrowers can fulfill their loan obligations.

Now, medium to long-term credit can be extended from the more stable portion or core amount of a bank’s deposits. Over the longer term though, banks should also develop new savings products that enable them to reduce risks associated with mismatches in the maturity terms of loans and deposits. When banks are more familiar with risk-based lending, longer term loans could be allowed to more effectively support the country’s SMEs.

While the CBM’s urging of local banks to develop new products with repayment terms that consider the business cycle and cash flows of the borrower is a complete change from collateral-based to risk-based lending, the new system does not mean a relaxation of collateral requirements when applying for loans. Banks can still take land, buildings and other immovable properties as collateral under their risk assessment processes. However, owning collateral will be less important than before.

Under the collateral-based lending system, banks were risk averse. The attitude was to seize the collateral when a borrower defaulted on loan. A bank under that system is more like a pawn shop than a bank. In contrast, under the risk-based, or cash-flow based system of lending, banks can take a more holistic approach when judging the weaknesses, strengths, viability, credit amount and particularly the repayment capacity of each business.

For the successful implementation of cash-flow based lending, banks should be familiar with asset-liability management (ALM), a useful tool for managing present and future balance sheet- related risks. By adopting a proper ALM system, banks would be able to maintain credit exposure within acceptable parameters. They would also be able to monitor and control their credit risk and make necessary provisioning against potential risks.

U San Thein is a former central banker in Myanmar and is currently a senior adviser for the German development agency GIZ.

Source: Myanmar Times

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