Problem loans management practices : Ecobank Ghana Limited as a case study

CHAPTER ONE: GENERAL INTRODUCTION

I. Background of the study

Since the information between banks (as lenders) and borrowers is asymmetric¹, lending is a

risky activity. Banks need to monitor their borrowers to ensure the credit extended will be reimbursed in accordance with the pre-agreed terms and conditions.

The issue of problem loan remains crucial for economies of the world countries.

For instance, according to the Koizumi Cabinet², «One of the underlying causes of Japan's prolonged economic stagnation is the non-performing or bad loan problem». Professor Park (2002), states in a study³ that according to the Financial Agency Services, the total sum of bad loans extinguished from the book for the entire banking industry of Japan since 1992 amounted to nearly 69 trillion yen, but the new bad loans cropped up faster than the ones retired. According to the same study, 13 large city banks of the country had written off 8 trillion yen of bad loans at the end of March 2002. However, their combined bad loans outstanding actually increased by 8.7 trillion yen over the previous year due to a faster accumulation of new bad loans. These figures show that problem loans have become a serious concern and finding a solution is becoming an emergency. The problem is not restricted to only Japan; it concerns the whole world.

According to the McKinsey Quarterly, in 2002, European banks were owed $900 billion of non-performing credits. The daily also noted that dealing with bad loans has become so worrying for banks that some of them have discerned the seeds for a new business. Some banks and other companies are now specializing in debt recovery. If banks, which are supposed to be debt specialists, start outsourcing the recovery of their bad debt, depositors may be frightened and doubtful about the safety of their deposits. In 2000, the weighted average cost of bad debt as share of total profits in Europe was 48%.

West Africa is also facing the problem of bad loans. There are three identifiable reasons that make the situation more critical than before: (1) the growing number of lending institutions,

(2) the development of financial markets and stock exchanges and (3) the weaknesses in the

Banking Supervision roles of Central Banks in the region.

¹ For literature on asymmetric information refer to Akerlof (1970), Spence (1973), Stiglitz and Weiss (1981), Mishkin

(2000).

² «The Disposal of Non-Performing Loans and Its Potential Influence», Study Project on the Potential Influence of Balance- Sheet Adjustments, June 28, 2001.

³ «Bad loans and their impact on Japanese economy», See-Hark Park (2002).

5 MBA in Banking and Finance

The number of banks in West Africa has grown steadily the recent years. From 64 banks in

2000, the number of banks in the West African Economic and Monetary Union was 66 in

2002 and 74 in July 2004⁴. There is evidence that the growing number of banks will lead them

to a competitive environment that will raise credit extension. In a heightened competition, more money will be lent with a moderate effect on banks credit policies. This occurrence will include the creation of problem loans.

The growth of lending activities to non-bank financial institutions, whose number is also significant (24 in 2004) will heighten competition in the lending sector and then make the credit conditions more flexible. Since the number of borrowers will increase due to probable decrease of credit requirements, the likelihood for banks to lend to bad borrowers will also increase. In that situation, prudent credit risk management systems and ability to manage problem loans will become critical successful factors.

Second, the deepening of the West African markets through the creation of the stock exchanges in West Africa⁵ has given investors an alterative means for investment. Bank shareholders will therefore now require higher returns on their equity or shift their investments to the stock exchanges. This will constitute a fresh pressure on banks to, among others, grow their loan books for higher profitability, and hopefully increased shareholders' value.

Third, the weaknesses and inefficiencies of the Central Banks reflect in the relatively poor quality of the performance of the Banking Supervision function. In 2001, 15 of the 64 banks (being 23.4%) in West African Monetary Union did not comply with the risk coverage ratio,

23 banks (being 36 %) exceeded the limits of loans to managers and personnel of the bank and 29 banks were not complying with the ratio limiting the transactions with related groups

or organizations⁶.

Apart from the above-mentioned factors, which are common to most West African countries, there are note-worthy characteristics that are peculiar to the Ghanaian banking environment.

A survey by the IMF showed that Ghanaian banks were uncompetitive⁷. The institution

highlighted that banks in Ghana were making «super profits» largely from treasury bills with little need to compete for lending business in private sector so far that a decline in interest rates yields involved a decline in banks profitability. Statistics from the Bank of Ghana

⁴ Central Bank of West African States (www.bceao.int).

⁵ Ghana Stock Exchange (in Ghana), Nigeria Stock Exchange (in Nigeria), BRVM for the 8 WAEMU countries with an agency in each capital.

⁶ Rapport Annuel, Commission Bancaire, 2002.

⁷ «Why Ghanaian banks behave uncompetitively?», The Ghanaian Times August 22^nd and 24^th, 2005.

6 MBA in Banking and Finance

confirm that the banking industry advances represented 28.6% and 32.5% of total assets respectively in December 2002 and December 2003 (being a rise of 35%). The rise in lending

in 2003 was partially due to the decline in the T-bill yields and a fall in lending rates (lending rates declined from 34% in January 2003 to 32.5% in December 2003). If these trends continue banks will reduce their dependency on T-bills and increase lending, and most likely record increases in their bad loan portfolio, since, future non-performing loans is positively correlated with credit growth (Jiménez and Saurina, 2005).

The issue of problem loans is not new for Ghanaian banks. The Bank of Ghana shows that the percentage of non-performing loans to total loans amounted 12.8% and 11.9% in 1999 and

2000 respectively. After this marginal fall, non-performing loans ratio increased to 19.6% in

2001 and further to 22.7 by December 2002. In December 2003, it dropped to 17.9%. The

«up-and-down» movement described by these figures is indicative that Ghanaian banks were yet to get a firm grasp of the bad loan menace.

Compared to the average of the Ghanaian banking industry, the non-performing loans ratio of Ecobank Ghana is relatively low. From 3.4% in 2002, the ratio rose to 4.2% in 2003 and dropped again to 3.9% in 2004.