Asia's bad loans: It's time for a reality check

Asia's bad loans: It's time for a reality check

Jack Rodman, Ernst & Young, The Asahi Shimbun, Tokyo

A recent report from Ernst and Young's Asia Pacific Financial
Solutions Group suggesting that Asia's nonperforming loan (NPL)
problem is much worse than generally perceived has triggered a
wave of objections from the region's central banks, national
asset management agencies and other institutions.

Our Nonperforming Loan Report Asia 2002 said that NPLs on the
books of Asia's financial institutions currently total more than
US$2 trillion, equal to almost 30 percent of the region's gross
domestic product, and up 33 percent in the past two years. Our
estimate is double the official estimates of central banks and
other government institutions. It apparently has resurrected a
long-simmering debate over the depth and extent of Asia's NPL
problem.

Asia's banks and governments are under tremendous political
pressures to understate the magnitude of the NPL problem, keep
NPLs off their books, and minimize the amount of NPL loan loss
reserves. Banks continue to extend payment terms when loans come
due and to provide money to large borrowers to keep their
interest payments current.

Their hope is that troubled borrowers or Asia's troubled
economy will recover and make them "whole again." The problem is
getting worse, not better. Borrowers don't want to put good money
into troubled assets. Banks don't want to foreclose on the
assets; consequently, they have no legal authority to act as
custodians to protect the value of their collateral.

And the value of the asset continues to deteriorate, which
reduces the amount that the bank could recover when it is
eventually forced to dispose of the loan. It migrates down the
classification ladder from substandard, to doubtful or loss.

Government agencies such as the Korean Asset Management Co. in
Korea or the Financial Sector Restructuring Authority in Thailand
got off to a great start by gathering the NPLs from failed
financial institutions in their countries and offering them to
foreign investors at market-clearing prices.

However, some borrowers and banks demanded higher prices,
which investors refused to pay. This impasse led to the formation
of asset management companies (AMCs) to take the bad loans from
banks and "warehouse" them for future resolution through
disposal, restructuring, joint ventures or securitization.

We considered all loans, other than normal loans, as NPLs in
our computation. This included "impaired loans." An "impaired
loan" is one in which the lender must assess the borrower's
ability to repay the loan when it comes due. If the loan cannot
be refinanced, then the lender must look to the borrower's
balance sheet to determine if the borrower has sufficient liquid
assets to repay the loan. If the borrower's assets are all tied-
up in the business, and the borrower has insufficient resources
to repay the loan in full when it becomes due, the loan is
impaired.

This requires banks and regulators to classify it according to
loan classification standards in each country and to set aside
appropriate loan loss reserves. However, the process of
identifying "impaired loans" is extremely complex, time-consuming
and requires the financial institution and bank regulators to
make a series of complex judgments about the borrowers business
prospects, estimates of cash flow, valuation of the market value
of collateral, assess the strength of the guarantor (if there is
one) and weigh many interrelated facts to arrive at an
appropriate loan classification and loan loss reserve.

Unfortunately in Asia, there are few people within the banks
and government agencies with the experience and expertise to
assess and evaluate all of these complex factors. Furthermore,
banks are often skeptical that troubled borrowers are providing
them with reliable information on which to make these judgments.

We went to great lengths to accurately assess the real
estimate of NPLs in the financial markets in Asia by applying our
own assessment of international best practices comprised from
several international agency regulations, including International
Accounting Standards, BIS, Basle and others, for loan assessment.

Resolving Asia's NPL problem will require more diligent
efforts by governments and financial institutions. It is the role
of government to safeguard the financial system. If that means
additional capital injections in the banking system, so be it. If
it means changes in bank management, then such action is long
overdue. Furthermore, banking regulators and accounting firms
will have to be more diligent to ensure that bank financial
statements identify the extent of nonperforming loans and that
appropriate loan provisioning has been recorded.

Instead of focusing on our estimates, I suggest that
governments, central banks and financial institutions focus on
the problem itself. Whether NPLs are nearly 30 percent of GDP or
15 percent, they constitute a serious issue that has not been
adequately addressed. But the region's central banks may not be
able to address it on their own. We believe it would be
appropriate role for the World Bank, Asian Development Bank and
the IMF to provide logistical, technical and financial support to
reform-minded governments who are committed to resolving this
longstanding problem and returning Asia to the growth and
prosperity. The future of Asia and the global economy depends on
it.