Impact of Macroeconomic Forces on Nonperforming Loans

Lending and borrowing is the core business of any commercial bank. It works on the principal of accepting deposits of money for the purpose of lending or investment (Banking companies ordinance 1962).

The role of banking industry is versatile, Banks utilize the depositor’s funds in an efficient manner, share risk, play a significant role in growth of economy, are always critical to the whole financial system and remain at the centre of financial crisis (Franklin and Elena 2008).

Financial institutions are responsible to operate the whole economy because they play an important role to transform deposits into productive investments (Podder and Mamun 2004).

The main cause of financial instability or crisis is the percentage of nonperforming loans to the total assets of the banks both in developing and developed countries. Such as, financial crisis in sub Saharan African countries and east Asia is witnessed.

Similarly, the current crisis in US by virtue of default in subprime loans or mortgages (Sorge 2004). It means low level of Nonperforming Loans (NPLs) suggests a better and sound financial system while high level of NPLs is a trouble for banks management and regulators.

NPLs are a disease directly affects two main components of the banks responsible for overall efficiency i.e. the liquidity and profitability. As increasing NPLs demands provisioning which diminishes income efficiency.

Whereas, mismatch of maturities in assets and liabilities causes liquidity problems for the banks deteriorate the overall credit ratings and long run deterioration of bank image. A loan is considered as nonperforming if default or closed to being in default.

In other words, if principal and payment of interest overdue by 90 days the loans may be considered as non performing loan (International Monetary Fund). There is no exact time lapse of NPLs as it varies among different kinds of financial institutions and under different nature of loans.

A loan is considered as performing if paid for principal and interest as per the terms decided at the time of loan grant. Specifically in Pakistan NPLs are classified under four categories on the basis of their default period as; Other Assets Especially Mentioned (OAEM), Substandard, Doubtful and Loss.

The minimum time period for considering a loan as nonperforming is 30 days for Micro Finance banks (prudential regulation no 12 for MFBs). Unlikely, MFBs the minimum period for any consumer financing conceded by commercial Banks to earmark a loan as nonperforming is 90 days.

(Prudential Regulations for Consumer / Financings, BPRD SBP 2011). Expense provisioning kept on account of above classification of these loans are 25 % for substandard, 50% for doubtful and 100 % for loss of the difference resulting from the outstanding balance of principal less the amount of liquid assets realizable without recourse to a court of law and 40% of the forced sale value of pledged stock and mortgage properties. (Prudential Regulations for Small and Medium enterprises Financing, BPRD SBP 2011).

Objectives of the study

To examine the long run relationship between macro economic variables and nonperforming loans.
To examine the short run impact of macro economic forces on nonperforming loans.
To facilitate monetary and fiscal regulators to cover up the gaps and to make right decisions with sharing empirical results of the study.

Significance of the study

Profitability of commercial banks is consistently stagnant for the last 5 years even in this time banks deposits grew considerably from 3.2 trillion in 2006 to 5.4 trillion Rupees till 2010.

The profitability of all banking sectors was recorded at its lower growth due to provision of NPL and written of bad debts on expense side of income statement.

If we look at the first phase from 2002 till 2006 the overall profitability of commercial banks increased from 25 billion to 121 billion from 2002 to 2006 where profitability figures were almost doubled from 51 billion to 93 billion in just one year from 2004 to 2005.

The main reason of profitability was a prosperous economic scenario when all the macro economic indicators specifically inflation and interest rate were under control. A hunky dory GDP growth was prevailing.

Thereafter, a dark episode of macroeconomic instability i.e. sky rocketing inflation, interest rate almost double digit for the last 5 years, slow GDP growth and rapid depreciation of Rupee in international market faced by country.

Profitability of all commercial banks reduced to almost one halve from 121 billion to 69 and 67 billion in 2008 and 2009 respectively. Expense of NPLs became too high as increased from 21 billion in 2006 to 60 billion in 2007,105 billion in 2008 and reached at 115 billion in 2009.

Overall volume of NPLs belongs to commercial banks almost doubled within three years from 285 billion at start of 2009 and recorded as 572 billion till the end of 2011.

On the other side banking industry employing a big labor force and stability and sustainability of commercial banks also affects their total volume as no of employees were reduced from 149,432 to 140,181 in two years from 2008 till 2010.(State bank publication overall financial position of all schedule banks).

Nonperforming loans further brings mismatch in maturities liability and assets further reduced liquidity of banks and distorts credit ratings which is a requirement of central bank that every commercial bank being rated for asset quality after a specific period usually six month to 1 year by an authorized credit rating agency that determine likelihood of default for the debt issuers.

The study of nonperforming loans and to delve the scope of precarious macro economic indicators posses greater significance for all policy makers within the commercial banks and regulators responsible for economic instability of country to take appropriate actions to get rid of this status quo as early as possible.

Location: Indonesia