Loan review: How banks make NPLs look healthy

TANZANIA: BANKS publish financial results to demonstrate their financial strength, but headline indicators do not always tell the whole story. One important example is the Non-Performing Loan (NPL) ratio, which can decline even when a bank continues to carry significant credit risks.

Having reviewed publicly available audited financial statements over the past 15 years, I believe investors and other users of financial information should look beyond headline NPL ratios and examine restructured, refinanced and repeatedly extended loans. Loan restructuring is a legitimate banking tool.

It can help viable businesses overcome temporary financial difficulties, protect jobs and improve lenders’ chances of recovering their money. Problems arise when restructuring becomes a means of postponing loss recognition or disguising borrowers’ continuing inability to repay.

A declining NPL ratio may indicate genuine improvement in loan quality. However, it may also reflect changes in repayment terms that make distressed loans appear healthier without improving borrowers’ financial positions. Consider a Tanzanian manufacturing company that borrows 10bn/- to establish a factory.

Construction delays postpone production by two years, preventing the company from meeting its original repayment schedule. If the business remains viable and future cash flows can support repayment, extending the loan’s maturity and granting a temporary grace period could benefit both the borrower and the bank.

The situation differs when a borrower has no credible repayment capacity. Repeated restructuring may then postpone recognition of a deteriorating loan rather than resolve the underlying problem.

One warning sign is evergreening, whereby new lending or refinancing is used to keep a distressed exposure appearing current. For example, a borrower with a 5bn/- loan and 600m/- in arrears may receive a new 700m/- facility, part of which clears the overdue amount.

The original loan may appear to have improved, although the borrower has not generated sufficient cash from business operations to repay the debt. If this process continues, the bank may report apparent improvements while the borrower’s financial position remains fragile.

Regulators should therefore examine not only how much NPLs have declined, but also how many distressed borrowers have been refinanced and whether those loans subsequently perform. Another concern is capitalising unpaid interest.

A borrower owing 10bn/- with 800m/- in unpaid interest may have the arrears added to the principal, increasing the balance to 10.8bn/-. The bank may then calculate interest on the enlarged balance. Although this arrangement can be justified when a credible recovery plan exists, it can increase exposure without improving the borrower’s ability to repay. Repeated restructuring also warrants closer scrutiny.

A loan restructured because of temporary liquidity problems may be viable, but further extensions caused by missed projections and continuing repayment difficulties should trigger a deeper assessment.

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Three or more restructurings of the same exposure would be a significant warning sign, although the number alone does not prove that a loan is impaired. Banks should assess whether borrowers generate enough cash to meet revised repayment schedules. Projections should be independently verified, and collateral should not substitute for repayment capacity.

Even property valued above a loan balance may not prevent losses if the borrower cannot service the debt and the collateral cannot be sold efficiently at an adequate price. Weak post-restructuring monitoring, insufficient independent credit reviews and management incentives to minimise provisions can compound these risks.

If the same officers who approved an original loan also approve repeated restructurings without independent challenge, poor lending decisions may remain unaddressed. Disclosure is equally important.

Investors and regulators need information on the volume and age of restructured loans, repeat restructurings, capitalised interest, distressed refinancing and subsequent repayment performance. Without these details, a falling NPL ratio may provide an incomplete picture of credit risk.

The consequences can extend beyond accounting. If banks underestimate expected losses, they may understate impairment provisions and report stronger profits, asset quality and capital positions than their underlying financial condition warrants.

When losses eventually have to be recognised, provisions may rise sharply, weakening profitability and capital. As private-sector credit expands in Tanzania, effective oversight of restructuring practices becomes increasingly important.

Boards, shareholders and regulators should distinguish between viable borrowers recovering from temporary difficulties and distressed borrowers whose repayment depends on further borrowing.

The objective is not to classify every restructured loan as non-performing. Rather, banks must demonstrate that restructuring produces sustainable repayment, not simply a better-looking account. Ultimately, falling NPL ratios should be welcomed when they reflect genuine recoveries.

Before celebrating improvements, however, bank boards and investors should establish whether troubled borrowers are generating sufficient cash to honour their revised obligations. A healthier-looking loan is not necessarily a healthier loan.