SECTION 6 - THE BANKING SECTOR AND LENDING PRACTICES IN THE RETA ECONOMIES

6.1 General financial control and regulation

It is desirable to commence with a brief examination of the issue of general financial control and regulation in the RETA economies. This is important for at least two reasons.

The first is that lending and recovery practices may be dictated, to varying degrees, from central bank or finance ministry level. This control can have an effect on the availability of funds for lending and on policies of debt recovery and enforcement. The Banking Act of Pakistan provides, for example, that a domestic bank cannot lend on an unsecured basis.

Secondly, central bank or finance ministry intervention in a time of general economic and financial difficulty or crisis, may not only be directed at the banking sector itself (as, for example, is presently the case in Indonesia, Malaysia, Thailand, Korea and Japan) but also (and more relevantly for the purposes of this study) at the methodology to be applied by banks in an endeavour to rationalise problems of bad debt and non performing loans.

There are some wide differences within the RETA economies in this area. Central financial control ranges from a policy of heavy regulation to a comparatively free and "laissez faire" policy.

At one end of the scale is Pakistan which appears as the most heavily regulated of the RETA economies. In Pakistan, the control of government, despite the existence of a theoretically independent central bank, is most evident. To some degree, this is a product of history. Domestic banks in Pakistan were nationalised in the 1970's and remain government controlled. That control has also produced a history of bank lending according to government, executive or political directions or dictates. Much of this lending has been made without any adequate or any proper assessment of the assets of the corporate borrower or of the capacity of the corporate borrower to repay. Often, also, there has been no control over the disposition of the loan funds. There have been many instances in which the loan funds have not been applied to the business of the corporate borrower but have been used for private purposes. Because of the political links or association of the borrower, recovery of the loan is difficult, if not impossible. In such circumstances, the employment of debt recovery, security enforcement or the insolvency law regime processes offers little prospect of recovery.

In Korea there has been considerable control of the commercial banking sector through the Ministry of Finance and the Economy. The banks in Korea are mainly government owned or, certainly, government controlled. Although there may have been far less "directed" lending in Korea than in Pakistan, the overall control exercised by the government of Korea appears to have been such that much of the bank lending has been state controlled or directed. A report by The Economist (November 14, 1998) touched upon this. The report suggested that the corporate conglomerates of Korea (the "chaibol"): "....were deliberately fattened by successive governments with favours and state directed credit....and grew big ....by recklessly loading up with debt" (emphasis added). The same report maintained that a present consequence of this "directed" lending is that ".... the pain of restructuring is falling on small and medium sized firms, ten of thousands of which have gone bust, often because they are unable to get bank loans".

In Malaysia the balance of control was recently tipped toward greater government intervention by banking and monetary policy measures announced in September 1998. One of those measures, which is relevant to this study, was that the repatriation of the proceeds of the sale of secured property to an overseas lender could be delayed by up to one year.

The involvement of a central bank or government ministry in relationships between corporate debtors and bank creditors can, however, produce positive results. For example, in Malaysia, the central bank, Bank Negara, has been primarily responsible for the formation of the informal Corporate Debt Restructuring Committee. In Thailand, the Ministry of Finance and the Bank of Thailand will monitor the progress of debt restructuring under the recently proposed informal Framework for Corporate Debt Restructuring in Thailand. In Hong Kong, China, the Hong Kong Monetary Authority expressed its support for the informal Guidelines on Corporate Difficulties which were issued by the Hong Kong Association of Banks in April 1998.

6.2 Secured lending

Secured or collateral lending, as it is popularly known, by which property of a corporation is used as security for the eventual repayment of a loan, depends on a number of factors if it is to be considered reasonably safe, predictable and commercially risk free. The most important of these factors relates to the development of an efficient and stable property ownership and property rights system. This requires an adequate legal regime through which precise and reliable information concerning ownership and other interests in property may be conveniently accessed.

All of the RETA economies possess a reasonably well developed land ownership and property rights regime and in most of the RETA economies it is a reasonably simple and commercially efficient process to take security over land.

It is not surprising, therefore, that asset based secured lending (particularly over land) is by far the most widely practised financing technique throughout the RETA economies. Security over shares, by way of a pledge, is also quite widely practised and, in most cases, is simple and expedient.

However, the taking of security over property other than land or shares is not as popular and, in some cases, presents some difficulties. The practice of taking security over chattels (by way of a chattel mortgage) varies in the RETA economies. In Hong Kong, China, Malaysia and Singapore, it is a popular form of secured financing mainly because each of those countries inherited the concept known as the "floating charge" from England. It is a reasonably safe and predictable form of security. It is also popular for lenders because it covers all the assets of a corporation and may be enforced by appointing receivers and managers to take control of the corporation. In most of the other RETA economies, however, the concept of the chattel mortgage, although practised, can be more difficult and less safe because of the absence of a developed or any system of registration or recording of a chattel mortgage.

Lease financing does not appear to be widely practised in some of the RETA economies, nor is the taking of security over receivables (debts) a common or popular form of secured lending.

In summary, there is a heavy concentration and emphasis on secured lending over land and, to a lesser extent, shares. Secured lending over other forms of property is not as concentrated nor popular.

Issues regarding enforcement of security and the inter-relationship between enforcement and the application of the insolvency law regimes are discussed later in this report.

6.3 Income (cash flow/profitability) based lending

Cash flow or profitability based lending (which is largely based upon an assessment of the ability of a corporation to derive income and deploy part of the income to meet recurring debt on a regular cycle) is not so apparent on an examination of lending practices in the RETA economies.

A number of aspects arise from this of which two are relevant to this study. The first is that dependence on collateral based lending often means that a lender may not make any sufficient or any assessment of the ability of the corporation to service a loan and ultimately repay it (otherwise than from the proceeds of sale of the collateral). This is because attention is focused primarily on the value of the collateral. There may be little or no measurement nor assessment of income, cash flow and profitability. When this occurs not only is there little or no understanding or assessment of the overall financial position of the borrower at the time of the borrowing proposal, it almost inevitably follows that there may only be cursory monitoring of the borrower's financial position after the making of the loan.

When the corporate borrower experiences financial difficulty, the lender may know very little about and have a poor understanding of the business and financial position of the corporate borrower. This makes it difficult for the lender to react in a positive, objective and considered manner when the loan becomes a non performing loan. It must make it a more difficult task to objectively assess the causes of the financial difficulty and consider how, if at all, the financial difficulty might be arrested and improved. The local study of Hong Kong, China expressed it this way: "....there (is) agreement that banks are often provided with much more information at the time they try to collect an overdue debt than at the time a loan is made. There was also agreement that many medium-sized local banks continue to emphasise asset protection rather than cash flow analysis".

Another side effect may result. The comfort which comes from asset based lending, coupled with the lack of continuing monitoring, information and enquiry into the overall business and financial position of the borrower, presents the obvious possibility that the borrower may become overcommitted to debt from a variety of other sources (many of whom may have committed similar errors or omissions of judgment in the lending process).

The point that may be made from these observations is that, for a variety of reasons, the lending practices of domestic banks in some of the RETA economies may lack a degree of commercial responsibility and experience. Most of the RETA local consultants agreed in their respective reports that the lending and associated practices of foreign banks, particularly those from more fully developed countries, were decidedly more intense, strict and responsible compared with some domestic lending practices.

Much of this may be traced to "pre-economic crisis" practices and it might, of course, be suggested that no amount of diligent initial assessment and continued monitoring of corporate accounts and the like could have altered or lessened the effects of the consequence of the regional economic crisis. This caused the value of collateral to fall dramatically. It resulted in corporate insolvency, non performing loans and bad debt. That may be so, but it can not overcome the fact that asset based secured lending without more does little to encourage or foster collaboration between lender and borrower in times of financial difficulty, no matter what the cause of the difficulty. When cash flow and liquidity becomes of vital importance, a thorough knowledge and understanding of the borrower's business and financial position on the part of a bank creditor can be of critical importance.

The other point that arises from the economic crisis is that in many RETA economies the commercial banks were discovered to have breached their own liquidity requirements and to have also exceeded lending limits to corporate customers. So at least part of the problem may be the responsibility of the lending and other practices of the banks.

6.4 Conclusion

It does not seem appropriate for this study to make proposals in this area.

The main purpose of the above observations is to draw attention to elements of background or influence which need to be considered in framing insolvency law and related policies. Quite clearly, policies of central banks and finance ministries will have considerable impact on the relationship between the banking and corporate sectors. Governments should carefully consider this impact. Governments can also assist by promoting both formal and informal corporate insolvency practices (see, in particular, the promotion of informal practices presented in Section 10 of this report). But a careful balancing of general banking and financial sector policies and those practices is required.

As to actual banking practices, some might argue that irresponsible or imprudent lending practices might be reduced by the imposition of some type of "penalty" within the framework of an insolvency law (for example, in a case of liquidation by deferring payment of claims resulting from such practices to a position below all other creditors). However, such a policy has never found its way into an insolvency law regime.

What is more important, however, is that if banks and other financial institutions fail to exercise reasonably prudent lending practices they should expect to suffer loss. That is something which is highly relevant to rescue proposals, both formal and informal. It needs to be brought to and recognised at the negotiation table.