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.