Bracing for NPL growth as loan restructuring extends into 2022

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Small traders, like this second-hand clothes seller in Boeung Keng Kang district, depend on micro loans to support their business. Hong Menea

The central bank is imposing strict provisioning measures on loan restructuring to stave off a looming credit risk. A pertinent move, but also one that could inadvertently dampen profitability and reserves

With only a few days left to the new year, National Bank of Cambodia (NBC) came through with an update on the extension for the loan restructuring exercise that will run for another six months ending June 30, 2022.

The internal prakas was well received by the banking and finance community, seeing that they were the ones who pushed for the extension with NBC.

“The extension would allow financial institutions to continue supporting its customers,” explained In Channy, chairman of the Association of Banks in Cambodia.

In the prakas, seen by The Post, the central bank urged the sector to continue adhering to specific instructions to classify and make provisions for restructured loans, as of December 31, 2021.

What is interesting though, is the underscoring of its definition for loans that require “more restructuring”, whereby NBC instructed that these loans be deemed as “non-performing loans”, a move that could inevitably push up the NPL ratio.

The instructions are also indicative of the defaults resulting from the strain of servicing loans in the pandemic, particularly in the second and third quarter this year as zoning restrictions and curfews in the country brought business activities to a halt.

This has inadvertently led to an increase in loan restructurings, as observed by the International Monetary Fund (IMF), which found that $2.5 billion worth of loans were reviewed and adjusted as of first half of 2021, a slight increase from nearly $2 billion in 2020.

But, when compared to 2019, the value of restructured loans for 2020 and 2021 is phenomenal, given that only $30 million worth of loans were restructured that year.

Up to November 30, 2021, a total of $5.2 billion worth of loans had been restructured.

The IMF felt that losses on restructured loans could “weaken capital positions” and “potentially undermine the ability of the financial sector to finance the recovery”.

“Results from bank stress tests and the extra reporting will allow the NBC to implement a carefully calibrated sequence of steps to gradually return to standard prudential requirements,” IMF said in its final consultation report this year.

This perhaps explains the extra restrictions on NPLs in the recent prakas.

The current loan classification and provisioning has been issued as part NBC’s accommodative policies to ensure liquidity in the banking system, as well as relieve the burden on borrowers.

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Source: National Bank of Cambodia

Therefore, the new instructions are unique to the present circumstances, and are crucial in order to “reduce credit risk” with the aim of “preserving financial stability and supporting the restoration of economic activities”.

However, this Covid-19 loan provisioning policy expires on December 31, 2021.

For new restructured loans beginning January 1, 2022, NBC said a new “forbearance period” would be opened till June 30, 2022.

“Therefore, restructured loans starting from January 1, 2022 would benefit from existing concessions and would not be subject to the [current] obligations on classification and provisioning,” it added.

It is not certain which loan provisioning policy the banking sector would use in the new forbearance period, but suffice to say that debtors who applied for loan restructuring since March 2020 will not “benefit” from the period next year.

Lower net profit

The banking and finance sector has observed loan provisioning for a decade now, but in 2017, NBC called for stricter credit risk monitoring and grading in its Credit Risk Grading and Impairment Provisioning Prakas.

In line with International Financial Reporting Standards 9, the upgraded prakas required banking and finance institutions to make specific provisions (or allowance) to cover “any shortfall in cash flows contractually due to be received”.

This sent the banking sector into a frenzy to meet a standardised reporting on loans and impairments, which resulted in lower earnings the following financial year.

The reason being, financial institutions were required to assess not just the impaired loan but for other facilities that would “give rise to credit risk exposure” to the customer.

In essence, when one loan is problematic, other loans taken by the same client would be affected.

This meant that the amortised cost of single or collective loans would have to be recognised as “expected credit loss” at all times.

To avoid a build up of NPLs on their balance sheets, financial institutions were required to make a provision on such loans, which inadvertently saw the usage of their reserves to make up for the shortfall, resulting in a dip in earnings.

For example, owing to the pandemic, lower net profit was recorded in 2020, as provision expenses by banks rose 79 per cent year-on-year, NBC noted in its 2020 Financial Stability Review.

Higher provisioning and slower credit growth saw return on asset dip to 1.7 per cent while return on equity fell 8.7 per cent in 2020 compared to 1.9 per cent and 9.8 per cent, respectively, a year earlier.

Impact on bank reserves

Current circumstances and the potential risk of rising NPL which can affect the solvency and liquidity of the banking sector obviously prompted the new directive that is benchmarked on the 2017 prakas.

Concerns in relation to the NPL ratio and if it “correctly reflects the level of debt distress facing the banking and microfinance system” amid the loan restructuring exercise was raised by the World Bank in its latest economic update.

Although, it did take note of the overall low NPL ratio for the banking and microfinance sectors in the first half of 2021 which stood at 2.5 per cent and two per cent, respectively.

Asked to comment on World Bank’s observation, Channy, who is also president and group managing director of Acleda Bank Plc, the largest bank in terms of total assets in Cambodia, remarked that the banking sector has “done enough”.

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Source: National Bank of Cambodia

He pointed out that as of November 30, 2021, some 600,000 loans valued at $5.2 billion had been restructured, which is about 13 per cent of total loan outstanding.

“[In addition] the portfolio at risk [PAR 30] + days past due [which indicates NPL ratio] was 1.95 per cent. So, financial institutions have done enough,” Channy said.

Echoing him, KaingTongngy, head of communications for Cambodia Microfinance Association (CMA) asserted that the overall NPL ratio has “fallen from almost three per cent in the middle of 2020”.

He offered that “five per cent NPL or below is considered healthy by global standards” even without Covid-19.

“Such low NPL can be attributed to NBC’s prudent rules, financial institutions’ strong loan disbursement and loan restructure policy,” said Tongngy, adding that CMA’s 115 members restructured loans for over 360,000 clients with a total value of $1.7 billion.

That said, Channy did not dismiss the fact that while stricter conditions imposed in the circular were necessary to help mitigate risk, it would affect the NPL ratio.

At the same time, the additional loan provision “will impact the bank’s reserves” (which is part of the calculation of the solvency ratio) and “capital adequacy ratio may decrease”, he said.

Possibly owing to this, NBC permitted financial institutions to “draw down in full (100 per cent) of the conservation capital buffers for additional provisioning on restructured loans”.

However, it should be noted that many banks have yet to fulfill the capital buffer requirement, as it was deferred by NBC as a result of the pandemic.

Could this be a red flag? Not sure, but the IMF did mention that the stress on loans could run the risk of “potentially inadequate provisioning and weak capital buffers”.

Nevertheless, Channy opined that the prakas contained “good preventive measures to protect all stakeholders and the financial industry on the whole”.

Doubtful, non-viable

Looking at the circular, financial institutions are expected to make loan provisions of between three per cent and 100 per cent of the gross carrying amount (the amortised value of the loan without depreciation), based on their classification.

It said financial institutions should consider the refinanced loans for the purpose of “conversion from bad loan to good loan as restructured loans”, using the classification and provisioning that is provided for in the 2017 Prakas.

For instance, restructured loans that are “viable” are viewed as “performing” and prescribed a “special mention” classification with “three per cent provisioning of gross amount”, regardless of the “number of restructurings”.

Restructured loans that require “more restructuring” would be deemed as “non-performing” and classified as “substandard” for loans under the first restructuring and provisioning of 20 per cent of the gross amount.

Those that are classified as “doubtful” under the second restructuring will require a provisioning of 50 per cent of the gross amount.

While restructured loans that are “non-viable” are be deemed as “non-performing” and classified as “loss”. These would require a provisioning 100 per cent of the gross amount.

In the meantime, financial institutions will need to conduct stress tests in restructured loan portfolios using three scenarios - base, moderate and severe - and report the results periodically next year.

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Source: National Bank of Cambodia

This exercise would help NBC assess the extent of the provisioning shortfall in relation to pre-Covid-19 regulatory environment, and review existing capital buffers, the IMF said.

Time to phase out

Experts including the World Bank have often commended NBC for its macroprudential regulations in the past decades and intervention measures that helped to strengthen capital.

Last year, despite the pandemic, the sector recorded high capital adequacy and liquidity coverage ratios (measures that indicate stability in the sector) that were way above the global average.

Added to that, expansionary measures such as interest rate cuts for the Negotiable Certificate of Deposits (NCD) and Liquidity Providing Collateral Operation (LPCO), the reduction of reserve requirements and deferment of the increase in capital conservation buffer ensured increased liquidity in the system.

(NCD is a short-term interest debt issued by NBC, while LPCO is a tool that enables NBC to lend to financial institutions in the local currency.)

Despite all of these, risks abound in the financial sector, ASEAN+3 Macroeconomic Research Office (AMRO) said, noting that it could stem from a “deterioration in credit quality and asset price inflation”.

Given active loan restructuring by financial institutions, AMRO said the differentiated recovery in economic sectors could lead to a further deterioration in credit quality.

“The difficulty in assessing the credit worthiness of restructured loans, combined with the possibility of inadequate provisioning ahead of an eventual unwinding of regulatory forbearance, could lead to a build-up of risks,” its 2021 annual consultation report showed.

Channy disagreed. “I think all financial institutions have carefully assessed the credit worthiness of the restructured loans and made provisioning based on NBC Prakas, especially NBC’s instruction on reassessment on loan restructuring.”

In addition to those safeguards, he shared that the classification of loans as “normal”, “more restructuring”, and “non-viable”, enabled financial institutions to “downgrade and add more provisions accordingly”.

Going forward, what can be expected once NBC lifts its forbearance policy? CMA’s Tongngy is somewhat concerned.

He acknowledged that with the recent prakas, new affected clients would be able to restructure their loans, while more restriction has been placed on those who have already conducted loan restructuring once.

But the time has come to start “phasing out” existing restructured loans, and that would mean a “slight increase” in NPL early next year.

While he does not think it would hit a “high risk level”, CMA will definitely keep a close watch on the situation.