Loan defaults … Threats to financial systems and growth

T + T – normal size

When Russian tanks invaded Ukraine, private debt crises could already be brewing in many parts of the world – albeit hidden – due to the economic disruption caused by the coronavirus pandemic. Now the war is pushing more countries into similar crises.

The recovery from the pandemic has always been unequal. According to an analysis based on the International Monetary Fund’s latest WEO, per capita income reached a new high in almost 37% of advanced economies in 2021. This share drops to about 27% in middle-income countries and below 21% in low-income countries. income countries. Perhaps these differences are about to deepen.

Early in the pandemic, many countries issued debt moratoriums to defer families and businesses, at a time when many were facing a sharp drop in income that made them simply struggle to meet their obligations. Debt suspensions were usually accompanied by policies that gave banks the regulatory flexibility that allowed them not to classify affected loans into a higher risk category, as was the practice, and helped enable banks to increase their capital reserves. avoid what would necessitate reclassification. Policymakers hoped banks would use the available cash to continue lending.

But while the suspension of debt payments has already provided temporary relief to private debtors, and possibly mitigated the effects of the disruption caused by the early pandemic, it was not without its flaws. Tolerance policies, in particular, have made it harder for bank supervisors to spot early warning signs of rising defaults, and this has given rise to the potentially disastrous backdoor problem.

With emergency debt moratoriums now in place in many countries, at-risk households and businesses, especially small and medium-sized businesses, are facing repayments on loans they can no longer afford. It threatens to unleash a wave of default, with far-reaching consequences for economic recovery, especially in low- and middle-income countries that are already struggling to revive growth.

More time to limit damage. But it requires public and private sector actors to recognize the problem before it degenerates into a comprehensive crisis, and to manage it effectively and efficiently. So far, there seems to be little appetite for the kind of transparency it would require. In fact, according to data provided by financial institutions to the International Monetary Fund, there is no problem, non-performing loan rates remained flat in 2019-2020 in a large sample of advanced and emerging economies that have adopted tolerance policies.

Data from the MasterCard Institute of Economics, which covers 165 countries, tells a very different story, with permanent business failures rising by almost 60% in 2020 compared to their baseline level before the pandemic (2019). Although the situation has improved in 2021, almost 15% of countries, most of which are low- and middle-income, are still reporting increases in permanent business failures.

The World Bank’s Pulse Survey, which covers 24 low- and middle-income countries, provides a similarly turbulent picture. As the graph shows, from January 2021, 40% of the firms surveyed expected to build up arrears within six months, including more than 70% of firms in Nepal and the Philippines and more than 60% of firms in Turkey and South -Africa.

As more governments end their debt moratorium, interests will increase. If we are led by the past, higher levels of non-performing loans will lead to fewer new loans, as financial institutions will try to exceed the limits of capital reserves, making them more risk averse. Not only will the credit crunch hamper economic recovery; It will also exacerbate inequality by affecting loans to low-income communities and smaller firms disproportionately.

Where one or more systemically important lenders do not have the capital to cover their losses, governments may have to step in to recapitalize those losses. It can simply mean that the solvency problem is shifted to the public sector at a time when governments are already facing heavy debt burdens and stretched budgets.

The war in Ukraine exacerbates the dangers by intensifying inflationary pressures and undermining the recovery in many emerging economies. The impact of the war is becoming particularly acute in Central Asia, where banks are highly vulnerable to Russian financial institutions and are interconnected by massive cross-border overflow flows. New capital and foreign exchange controls also create risks for financial institutions.

It is time to acknowledge and address this hidden crisis. The World Bank’s World Development Report 2022 identifies concrete steps that policymakers can take. First, countries need to increase the transparency of financial sector budgets. Clear and consistent practices in disclosure of asset quality, enforced through effective oversight, are essential. Financial institutions should also develop their capacity to manage non-performing loans so that no increase in default prevents further loans.

Countries must also establish or strengthen legal insolvency mechanisms, including out-of-court hybrid options involving conciliation and mediation arrangements. Such systems – which are currently lacking in many emerging markets and developing economies – could accelerate the resolution of debt and limit the damage to the financial sector. Cheap and affordable debt resolution procedures that limit court involvement in restructuring are especially important for micro, small and medium-sized businesses, as well as entrepreneurs and individuals.

Finally, regulators and lenders need to work to ensure that households and businesses retain access to credit. The extremely uncertain economic environment, combined with a lack of transparency about the financial position of lenders, has increased risks and reduced the effectiveness of traditional methods of measuring these risks. Lenders need to explore new, technology-enabled approaches to risk management and lending, made possible by revised government regulations that support innovation and ensure consumer and market protection in an easily enforceable way.

Experience has shown that issues of loan quality do not correct themselves; Unless it is tackled for a moment, problems will continue to grow, implying higher costs for the financial system and the real economy. If we do not heed this lesson, it will soon become impossible to ignore the problem of hidden bad loans.

* Chief Economist at the World Bank Group

** Senior Economist in the Financial and Private Sector Research Team of the World Bank Development Research Group


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