Banks should clean up their balance sheets

While banks can rightly say that they survived the liquidity crunch that hit the sector in early 2009. In 2010 the banks should be working on improving the quality of their balance sheets, specifically by reducing the unacceptable numbers of people defaulting on their loans. According to statistics from the industry’s watchdog, the National Bank of Rwanda (NBR), currently the rate of non-performing loans (as bad debts are technically referred to) generally stand at 12.8 percent within the banking industry. This is far above the required minimum threshold of 7 percent for each bank. The economic and financial costs of these impaired loans are significant. Potentially these loans may negatively affect the level of private investment and increase deposit liabilities. Bad debt also constrains the scope of bank credit to the private sector through a reduction of bank’s capital. When left unsolved, ”bad loans” can also lead into financial crisis the moment the loans exceed the bank’s capital. The high number of nonperforming loans also had a role to play in liquidity crunch that almost paralyzed the banking sector at the beginning of last year. To facilitate payments and avoid credit stagnation, the last resort lender, NBR, stepped in to rescue the banks by injecting sizable amounts of liquidity into the system. In cautious effort to clean their balance sheets, most banks tightened their lending standards, raising the risk of a prolonged credit slump. And as a matter of fact some banks completely put to halt issuing new loans. Already some banks were feeling the pitch from insufficient deposits resulting from a mismatch between their assets and liabilities. However, the initiatives to lower these ‘bad loans’ have been successful; they declined from a high of 30.7 percent in 2000 to 12.8 percent last year - sign of a relative improvement of banks position. In retrospect, the high ratio of non-performing loans, which is closely related to the liquidity crisis experienced last year, exposes the weaknesses in banking sector. It shows weaknesses in risk management and governance in commercial banks. Weaknesses in risk management make banks vulnerable to losses arising from bad debt as credit is extended to people who cannot manage it. Risk management in bank operations includes risk identification, measurement and assessment, and its objective is to minimize negative effects risks can have on the financial result and capital of a bank. Therefore, if banks had functioning risk management departments, it is most likely that there would be fewer defaulters. The structure and composition of these “bad loans” often comprise of speculative projects and short term loans which were meant to finance projects that could not generate enough income to service them. Until recently most banks did not have strong risk management departments. Conversely, there other several explanations for the high figures of non-performing loans due to the existence of a correlation between non-performing loans and a subset of economic variables: Per Capita, Gross Domestic Product, inflation, interest rates and changes in the exchange rate among others. This explains why the NBR also has a key role to play in reducing nonperforming loans. However it is worth noting that in the recent past, the Central Bank together with commercial banks have pledged to step up their operations, to address these issues. It remains to be seen whether there will be a real change though. bernanamata@gmail.com Berna Namata is a journalist with The New Times