Resolution of Bad Loan Problem: Bank-level Evidence from a Low-income Country
This paper was presented at the Eastern Finance Association annual meeting held April 9 - 12, 2014 in Pittsburgh, Pennsylvania.
Version posted is the July 2014 draft.
How do banks resolve a severe bad loan problem in a capital-constrained, low income country when a government bailout is not an option? We address this question by examining new evidence of a sharp decline in bad loan ratios in a panel of domestic banks in Bangladesh. On the aggregate level, the share of nonperforming loans in this market has dropped six fold, from above 41% in 1999 to below 7% in 2010. Notably, this dramatic improvement did not involve the creation of any centralized asset management facilities but relied on the bank management and governance reforms. We find that the gradual reduction of the bad loan ratio is primarily driven by bank-level management quality improvements and macro-level economic and financial development factors. Contrary to common belief, our results do not a support strong role of the corporate governance and the market monitoring channels in this process. Collectively, the evidence suggests the possibility of a gradual resolution of a severe bad debt problem at a bank level in a growing economy without direct government intervention.