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Default Culture.

Its impact and measures for Reduction


Origin of default culture
A default is the failure to pay back a loan. Default may occur if the debtor is either unwilling or unable to pay their debt. This can occur with all debt obligations including bonds, mortgages, loans, and promissory notes. The legacy of corruption and malpractice in the banking sector can be traced back to the pre-liberation (pre-1971) days. The Pakistan government, bent on rapid industrialization and modernization of agriculture, provided liberal refinance facilities to specialized development finance institutions, who were encouraged to dole out large amounts of money to budding industrialists and large agriculturists. There were reports of borrowers bribing bank officials in cash or kind for getting loans. Large industrial loans required political patronage, some of which was thought to have had a price tag attached to it. Insider lending was common in private banks, as was the use of bribes to mobilize scarce deposit funds from owners or controllers of government and military funds. The incidence of fraud and forgery was however very limited and/or not made public.

Growth and Spread of default culture


After independence, all private banks, except foreign banks, were nationalized and brought under the direct control of the bureaucrats. The government allowed the remission of interest and, in some cases, even the principal for borrowers who could claim that they had been adversely affected by the war of liberation. The acute shortage of manpower in the banking sector forced the government to go for hasty, quota-based recruitment drives. The prolonged government ban on new recruitment of officers (forced upon by trade union pressure) even when the branch network was expanding rapidly created pressure for promotion from the clerical ranks. This resulted in a decline in the average quality of the work force. The government's policy of mandated credit for agriculture, to be disbursed through local level government officials and rural power brokers, practically institutionalized corruption in agricultural lending. Dishonest bank officials took a 10 to 20 percent cut of the loan amount, as a matter of routine.

The new government inherited from its predecessor an enthusiasm for rapid industrialization. Government-owned development finance institutions (DFIs), using soft donor loans, financed numerous projects. However, a large proportion of such loans represented political patronage to party supporters, former and serving civil / military bureaucrats, and their relatives. In such cases, the lending decisions were obviously not based on sound banking principles. At the same time, commercial banks offered lines of credit indiscriminately without reference to the customers' bankability, safe in the knowledge that the bank's lending risk would be covered by Bangladesh Bank's credit guarantee. The free-wheeling banking operations came to a shuddering halt in the early eighties, following the hardly unexpected revelation that the DFIs were burdened with large non-performing loan portfolios. The flow of donor credit dried up soon afterwards. Large borrowers willfully defaulted on the loan repayments to the DFIs and nationalized commercial banks (NCBs), emboldened by their close links with the corrupt civil-military bureaucracy. Subsequently, the defaulters extracted concessions in the form of interest waivers, segregation of loans into "blocked accounts", and repeated rescheduling. Some defaulters are alleged to have used the defaulted funds to start private banks and insurance companies. This gave them a further opportunity for insider lending and for diverting yet more funds to various pet ventures. Herein lies the origins of the 'default culture'.

The Situation Today


A recent study on the bank loan default problem found that in the sample group of 125 defaulters, 78% utilized political connections, including ministers' influence, to get loans sanctioned. Of the 37% directly involved with the ruling party, a large proportion had changed their political affiliation at least once. Successive governments have made half-hearted attempts to tackle corruption in the banking sector. Recommendations made by various committees set up to investigate corruption never received the priority that they deserved. In some cases, the final report was not even published. The attitude of major donors was ambivalent. The Financial Sector Adjustment Credit programme (World Bank) and the Financial Sector Reform Program (USAID), two major aid projects focusing on the financial sector, neglected the issue of combating corruption in banks. The political patronage enjoyed by the defaulters and dishonest senior bankers was sufficiently strong to prevent the Anti-Corruption Bureau (ACB) from investigating suspected bank officials without the clearance of the Prime Minister's Office (PMO). Defaulters were allowed to contest the 1991 general

election. In the 1996 elections, the caretaker government initially took a strong stance against the participation of defaulters. The government later reversed its position and allowed defaulters to contest, provided they got their default loans rescheduled on payment of only a single installment of 10% of the defaulted amount. After getting elected a Members of Parliament, their default status no longer mattered. Recently, the government, with some sustained prodding from the donors, has brought in new laws to fight defaulters in spite of the powerful defaulter's lobby in the parliament. But these reform measures have not reversed the poor trend; the banking sector remains fragile and capital deficient. The proportion of total bad loans has increased (67% for DFIs, 40% overall) despite the fall in the proportion of classified loans disbursed during 1996-98. Today, the NCBs and many private banks of Bangladesh would be considered insolvent by international standards.

Magnitude of default culture


Reliable estimates of the monetary involvement in cases of bribery, fraud and forgery in the banking are hard to come by because of the high degree of secrecy maintained by the concerned parties. Good borrowers who are active abettors in the game prefer to conceal their involvement whereas defaulters are prone to exaggerate their costs of doing business with banks. The cumulative losses through frauds and forgeries are estimated to be Tk 1 billion at the end of November 1998, at 0.2% of total bank deposits. Bribes related to agricultural loans are said to range between 10 to 20% of the loan amount; but a lower rate (2-10%) applies in the case of larger loans which are usually taken out by relatively influential borrowers. In the case of project loans for agriculture, fisheries, and dairy, bribes collected by the bank officials are sometimes shared with the local government project development officers. In the case of commercial loans, the banker not only collects outright bribes (1-5% of the loan limit), but often receives occasional gifts and regular hospitality or entertainment from the client. For term loans, the bribes range from 1 to 5 %, depending on the (a ) type and size of the projects, (b) special services, if any, to be rendered by the bank staff in preparation of the project feasibility report and processing the loan proposal as a "package deal", and (c) the status of the person influencing the loan sanctioning decision. The successful borrower has to pay a further sum at the time of disbursement. Working capital loans involve a separate payment of 1 to 5% to the bank's managers, employees and trade union leaders.

Nature of default culture


The diversity of bank services and the numerous steps involved in loan processing, disbursement, and monitoring provide corrupt bank officials with a wide range of opportunities for extracting bribes. The more common and significant of these include:

Sanctioning of loans not on the basis of prudent banking principles but for some other considerations, such as outright bribes in the form of cash, valuable gifts, allotment of land, house construction, acquisition of apartments, share in business (usually in the name of dependants), appointment of dependants in good jobs, scholarships and admissions in educational institutions political pressure and patronage for posting, promotion, and extension of job tenure future lucrative employment in the borrower's company Over valuation of properties and assets of the borrower which are offered as collateral Cash credit without actual physical pledge of goods, contrary to documentary evidence Allowing withdrawal of funds in excess of or after expiry of the loan limit Loans sanctioned to the banks directors in driblets over a period, each sanctioned amount being within by the managing director's authorization limit.

Institutional malpractice includes:

Payment of substantial contribution to ruling party political funds and to key middlemen who have an effective say in the granting of licences for opening a new bank or a new branch of existing bank Entertaining or bribing bureaucrats who have regulatory control over large potential deposit funds. An increase in the incidence of such practices is very likely given the increase in the number of private banks and the formulation of a new government policy which allows 40% of government funds to be deposited in private banks.

Default culture related to Working Capital Financing


The Principal Office of a bank extended loan facilities to a private steel mill owned by one of the richest families in Bangladesh by extending the loan limits and repayment period without the required authorization, collateral and loan

margin. The company subsequently defaulted on the repayment of the loan principal and unpaid interest. The company's factory ceased operations in 1993. This case involved collusive arrangements between the borrower on the one side, and the Branch Manager and his superiors in the Head Office on the other, taking advantage of a government directive to extend term loans and working capital facilities to the industrial sector. Subsequent investigation revealed several irregularities, including:

The borrower's cash credit (CC) limit was extended but the bank did not ask for repayment within the original stipulated period. The company, with active connivance of the branch manager, failed to deposit the proceeds from the sale of pledged goods. The manager also failed to monitor the end-use of the loans. The borrower received illegal banking facilities without providing the required collateral or margin. The interest rate on the CC amount was only 6.5%, half the the original borrowing rate of 13%. The branch manager inflated the valuation of collateral securities without taking any advice from a professional surveyor. The branch manager sanctioned loans against imported merchandise without having the authority to do so. The branch manager did not take legal advice about the status of immovable property which was taken as the primary security. The branch manager did not verify the stocks of goods pledged.

No legal action was taken against the defaulting borrower up to June 1997. There is no evidence of any concerted effort by the bank's management to recover the loans from the borrower or of any administrative action against the officers involved. Therefore, it can be assumed that the chain of corruption reached up to the highest executive level of the bank. Some justice was dispensed with the subsequent removal of the managing director from service for "his general reputation as a corrupt person".

Trade Union Activities in Banks


Trade union activists, particularly the Collective Bargaining Agents (CBAs), are often involved in pressurizing the authorities to sanction loans to themselves, as well as to outside borrowers. CBAs in banks are not averse to using strong-arm tactics to influence the management in decisions relating to recruitment, postings and transfer, officer promotion, award of construction contracts, and even loan applications.

CBAs have fairly strong links with the ruling political parties and receive their protection. Such support has allowed the CBAs to successfully resist government moves towards an outright ban or a 3-year suspension or a curtailment of union activities in banks.

Causes of default culture in the Banking Sector


The findings of the diagnostic study indicate that the following factors played a significant role in the growth and continuation of corruption in the banking sector in general, and the nationalized commercial banks in particular:

The government's rapid drive towards industrialization during the first decade following independence whereby large amounts of industrial loans financed from soft donor sources were liberally doled out to favored persons. The government's policy of mandated credit for agriculture, disbursed through local level officials. Interference by senior government officials in lending decisions, directing the bankers to lend to dubious projects owned by political or business allies of the ruling party, in violation of sound banking principles. Leniency of successive governments towards known loan defaulters, most of who belong to the highest social and political classes in the society. The poor caliber of bank officers, many of whom lack the requisite background and training needed to carry out proper banking functions. The ambivalent attitude of the major donors with regard to the issue of combating corruption in the banking sector. The growing power of politically backed trade unions. Low compensation package for bank officers and staff.

Reasons for the Continuation of default culture


As a general proposition, grand corruption in the banking sector, manifested in the form of large loan defaults, has continued to fester because governments of the day either did not have the required level of commitment to combat this disease or did not consider it politically expedient to take action against the defaulters who had strong business or political links with the ruling clich. In many cases, the influential ruling party members or the lawmakers themselves have been the direct or indirect beneficiaries of bank corruption. However, there are other deficiencies in the system which have allowed and encouraged the maintenance and growth of corruption. These include:

Inadequate and ineffective internal controls within banks Weak supervision and monitoring by the Bangladesh Bank Reluctance of management to take appropriate disciplinary actions against recalcitrant and delinquent elements Archaic institutional procedures to deal with the delinquents Jurisdiction of Administrative Tribunals over the NCB personnel Pressures from politicians and trade unions An inefficient and corrupt Anti-Corruption Bureau

Impact of Default Culture


Large scale loan default has made the country's economy even more fragile . Effects of this default culture is mentioned here: Putting adverse impact on profitability and liquidity. Raising the cost of lending substantially. Huge default is forcing the banker to lend on their own. With the erosion of capital base international banking operations of the domestic banks are at stake It has increased the money interest rate excessively as banks forced to cover the loss with that. Hampering the concept of micro credit business. Demotivating the good borrowers. Spreading corruption vigorously in the financial sectors. Even the bank officials are become corrupted Creating money inflation in the economy etc.

Suggested Remedial Measures


Serious and committed efforts towards reducing corruption in the banking sector could consider the following remedial measures:

Appoint an Ombudsman exclusively for the banking sector. Set up special tribunals to facilitate expeditious trial of defaulters. File test cases against some delinquent large borrowers to send a strong signal to others. Retrench surplus manpower through "golden handshakes". Curtail trade union activities. Allow only one registered union per bank, and prohibit the installation of the trade union office within the bank premises.

Restore the ACB's professionalism, expertise and credibility by drastic revamping it. High Courts could play a non-discriminatory and proactive role by issuing suo moto rules on the government why incidences of glaring corruption committed by ministers and other high level officials should not be properly investigated. Corruption should not pay and a corrupt person should not be allowed to enjoy his / her ill-gotten assets. The Penal Code should be amended to allow confiscation of such assets. Conduct both 'off-site' and 'on-site' inspections of banks. Look into the feasibility of mandatory audit of each branch by external auditors every alternate year at the cost of the inspected bank. Make external auditors more accountable for their failure to report gross irregularities. Delegate further the powers for sanctioning an disbursement of loans, without jeopardising prudent banking and security considerations. Bangladesh Bank should have complete and effective autonomy. The Governor and Deputy Governors should have fixed tenures. No civil servant should be appointed as Deputy Governor. The Governor and Deputy Governor should not be allowed to take up employment in private banks / non banking financial institutions within three years of retirement. Bank directors should not be allowed to borrow from the bank in which s/he is a director, to eliminate "insider lending" and reduce default culture. (This rule has recently been implemented by Bangladesh Bank). Greater transparency in political party funding sources will make it more difficult for political parties to receive major contribution from bank defaulters.

Conclusion
As for the default loan scenario, the entire focus has been on the borrowers. Bank officials have been very fortunate to escape blame for their role in many corrupt, or at best ill-judged, lending decisions. There appears to be a lack of awareness in the government and the banking community that bank officials can be penalized by the law for willful or negligent conduct in disbursing loans.