Loan Classification

Loan Classification For a long period after liberation, the banking system of Bangladesh operated in an environment of directed lending, particularly to priority sectors determined by the government, at administered rates of interest. The system of classifying non-performing loans was extremely lax in absence of a standardised loan classification procedure and specific time limits for loans to be classified. Generally, a long time was required for a loan to be identified as classified, and as such the provisioning requirement was less important. This resulted in huge non-performing loans and banks had to operate with inadequate capital bases. Gradually, the country's banking system reached a chronic state of insolvency and became virtually non-viable.

The National Commission on Money, Banking, and Credit conducted a study with the help of the World Bank and on the basis of its report, the government introduced a comprehensive financial sector reform programme in the country. As part of this programme, a new system of loan classification and provisioning against potential loan losses for advances as of 31 December 1989 was introduced in November 1989. The initial classification and provision calculations were completed by 31 August 1990. A new phase of classification and provision calculation began on 1 December 1990 and was conducted on advances as of 31 December 1991. The calculation of provisions and interest suspense was based on the balance outstanding on 31 December 1990 and the calculation was completed on 31 March 1991. Subsequently, the classification, provision estimates, and treatment of unrealised interest were carried out on advances as of 31 December each year and completed within three months.

The loans were usually classified by the lending bank whenever the bank had reasons to believe that the borrower would not be able to repay the loan. This judgement was made regardless of whether the loan was overdue or not. Banks by themselves formulated specific conditions for classification on a qualitative basis. Loans extended by a bank were classified into the following three categories: substandard-if an advance or any portion of an advance or interest thereon remained overdue for one year or more but less than three years; doubtful-if the advance or any portion of the advance or interest thereon remained overdue for three years or more but less than five years, or if legal action for recovery of the loan had been initiated; and bad-if the advance or any portion of an advance or interest thereon remained overdue for five years or more, or if legal action had been initiated and no court decision had been obtained within five years of initiation of action. The base for provisions on substandard loans was the balance outstanding in the loan ledger for the loan, less any interest taken in an interest suspense account. The base for provisions for doubtful and bad loans was the balance outstanding, less any interest included in the balance outstanding but offset in an interest suspense account. A 1% provision was taken for all non-classified outstanding loans while the rates of provision for loans classified as substandard was 10%, for those classified as doubtful 50%, and for bad loans 100%.

In December 1994, an amended and revised loan classification and provisioning procedure was introduced by the bangladesh bank to bring it in line with the international standards. This was implemented in five phases, the last of which ended in December 1998. In the revised policy, the duration for loans to be classified under various categories was drastically reduced, while the frequency of classifications was increased. In December 1998, to simplify the classification procedure, guidelines were issued to banks to categorise loans into four groups viz., continuous credit, demand loan, fixed-term loan, and short-term agricultural loans and microcredit. For classification and provisioning under the revised procedure, banks were instructed to classify loans overdue for more than 3 months but less than 6 months as substandard; those overdue for more than 6 months but less than 1 year as doubtful; and those overdue for more than 1 year as bad. The revised rate of provisioning for substandard loans was 20%, for doubtful loans 50%, and for bad loans 100%. Banks were instructed to classify loans annually in the first phase, half-yearly in the second and third phases, and quarterly from the fourth phase. The loan sanctioned, renewed, or rescheduled from first January 1995 are to be treated as new loans for classification and provisioning from the 4th phase of the revised procedure.

The new loan classification procedure has unmasked the extent and gravity of the loan default problem. It exposed the extremely weak quality of loan portfolios and forced banks, particularly, nationalised commercial ones to embark upon remedial action. It also forbade banks to pay interest on non-performing loans to show artificial profits. The net effect of new loan classification and provisioning is that it rescued the country's banking sector from the verge of collapse and enable it to stand on a new footing and to grow as a vibrant sector for facing the challenges of the new millennium.

Since FY 2000 Bangladesh Bank has from time to time revised its prudential norms for loan classification and provisioning to make it consistent with international standard. As a part of this process, in FY 2005 Bangladesh Bank introduced 'Special Mention Account' wherein the overdue loan for a period of 90 days or more will be put into and the interest accrued on such loan will be credited to Interest Suspense Account, instead of crediting to Income Account. However, loans in the 'Special Mention Account' will not be treated as defaulted loan but, it will provide early warning signals of weakness of a loan. Banks will be required to make general provision @ 5% on the outstanding amount of such loans. As a result, loan classification status increased to five instead of four introduced earlier. In FY 2007, Bangladesh Bank also introduced requirements of 1% provision against OFF Balance Sheet Exposures of the banks.

These steps in restoring credit discipline brought about a remarkable improvement in the asset quality of the banks. From the reports of the banks it is revealed that the ratio of non-performing loan (NPL) to total loans declined substantially from 41.1 per cent in December, 1999 to 10.8 percent in December, 2008. Although this is a very encouraging trend, still it is very high as compared to some of our neighbour countries. The high level of non-performing loans of the State Owned Commercial Banks (SCBs) and the Development Financial Institutions (DFIs) are responsible for this. The SCBs and the DFIs continue to have substantial level of such loans due mainly to disbursement of loans without economic considerations and under influence of the pressure groups particularly in the 70s and 80s. Poor appraisal and inadequate follow up and supervision of the loans disbursed by the SCBs and the DFIs in the past eventually resulted in massive booking of poor quality assets which still continue to remain significant in the portfolio of these banks. Furthermore, these banks were reluctant to write-off the historically bad loans because of poor quality of underlying collaterals. Recovery of NPLs however witnessed some signs of improvement mainly because of the steps taken with regard to internal restructuring of these banks to strengthen loan recovery mechanism and recovery drive and write off measures initiated in recent years. [Md Abdus Samad Sarker and Sayed Ahmed Khan]