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Internal Bank Factors Giving Rise to NPLs in Iranian Banks

Digging into the effect of the ‘internal factors’ on the NPLs, the study explores five hypotheses in regards to the banks, namely good management, parsimony, moral hazard, size and good management
Total NPLs in the banking sector have increased at an average rate of 19.4% between 2007-2015. Total NPLs in the banking sector have increased at an average rate of 19.4% between 2007-2015.

A study under the aegis of the vice governor of the Central Bank of Iran has found that discreet internal workings of Iranian banks have largely contributed to their high rate of non-performing loans (NPLs).

According to the research overseen by Ali Akbar Komijani, the remaining NPLs of banks have more than quadrupled from 204.87 trillion rials ($6.4 billion) in 2007 to 863.42 trillion rials ($27.1 billion) in 2015, reports banker.ir.

Furthermore, total NPLs in the banking sector have increased at an average rate of 19.4%. This is while the average on the global scale was less than 4% between 2005- 2014.

The study refers to statistics provided by the International Monetary Fund, which identifies countries in the Middle East and North Africa region as those with the highest ratio of NPLs to total loans. MENA's ratio for 2005 -2014, however, was 5.2% which is still a far cry from figures in Iran and is a testament to the high credit risk situation in the struggling banking industry.

Factors that have an effect on bad loans under the two categories 'external factors' relating to macro-economic conditions, and 'internal factors' having to do with the inner workings of the banks is mentioned in the study.

External factors mean that during an economic slowdown there are large layoffs while the efficiency of investments is far short of expectations. That is when the capability of households and businesses to repay the original amount and interest on loans is weakened, leading to a hike in the banks' credit risk.

The Five Factors

Digging into the effect of the 'internal factors' on the NPLs, the study explores five hypotheses in regards to the banks, namely good management, parsimony, moral hazard, size and good management.

The first hypothesis states that bad management, which can be described as 'poor cost-effectiveness" is coupled with low aptitude in credit risk management, resulting in a decrease in the quality of allocated loans or in other words an increase in sour loans.

The parsimony hypothesis says that overly high cost effectiveness can lead to higher bad debts: banks face a choice between allocating resources to manage credit risk and enhancing their cost effectiveness. Banks that put minimum effort and money into supervising and controlling the process of loan allocation have higher cost efficiency, the study found.

A low ratio of the share of a bank's capital from its total assets leads to more NPLs under the moral hazard hypothesis. The study suggests that CEOs of such banks have a higher incentive to engage in risky ventures which could potentially lead to higher counts of NPLs.

The 'size' hypothesis says the size of the bank has an inverse relationship with NPLs. When the size of a bank increases, it can reap the benefits and manage the process of credit validation and loan allocation with a clearer focus. This in turn helps in curbing bad debt.

According to the 'good management' hypothesis, there is a negative relationship between the banks' profitability and NPLs, meaning that if ratios of return of investment (ROI) and return of asset (ROA) are held as criteria for the banks' performance, it will be telling of the banking system's good performance which eventually translates into a decrease in NPLs.

The vice-governor's study concludes that internal factors in the banks play a significant role in the rise of the NPL ratio to total loans given by the banking system.

The empirical evidence in the study further verified good management, moral hazard and size hypotheses as valid.  In other words, these three factors will discourage bank CEOs to partake in risky endeavors and improve their conduct which would result in lower distressed debt.

 

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