Penalise banks for risky loans?

Each week Arabian Business invites you to have your say on a popular issue. This week: Penalise banks for risky loans?
Yes | No

Salah Attar, Dubai, UAE: YES

Banks should be penalised when they overstuff their books with risky loans. Of course, any bank that is exposed to a lot of risk will pay a penalty in the form of decreased profits or bankruptcy, but this is not enough of a deterrent to curb predatory lending practices.

Lenders have been very generous, handing out cash to anyone who desires it. If you want to buy a multi-billion dollar company with debt, or if you feel you need 99% financing on a new home, someone is willing to stake you for the right price.

In the UAE, the price is high interest payments coupled with prepayment penalties. This way, banks price their risk according to their standards, but UAE law gives them an extra advantage. Banks force debtors to write postdated checks; if these checks bounce, debtors get to spend some time in prison. Most governments help out banks because they are anchors of the economy. Economists call this a ‘moral hazard'. Companies rely on governments to ensure their risk, while individuals get the slammer.

Some relief is around the corner. Politicians in America are drafting legislation to constrain lenders' ability to issue sub-prime mortgages, which are similar to the loans issues in the region. Local banks commonly give out US$25,000 in unsecured loans (personal, credit cards) to employees making a US$1500. Sure the banks price their risk appropriately - average interest exceeds 25% per year. The practice is no longer prudent banking. It has become a loan-sharking racket.

Penalties should be imposed on banks in a number of ways. First, prepayment penalties must be lifted. Second, given the new credit rating system, debtors should be able to claim bankruptcy and forfeit their rating. Third, banks should pay a low grade loan tax to a relief fund that can be tapped if a bank goes under. This lightens the government's responsibility as a lender of last resort (easing the moral hazard) and increases the cost of offering risky loans. When a bank extends a loan, both the lender and debtor need to be on equal footing, or else someone will be taken advantage of.

Jan Nigel Bladen, Chief Operating Officer at the Dubai Financial Services Authority: NO

Nothing ventured nothing gained ... or in other words, no risks no return.

Banks in the Middle East have lots of liquidity to lend, and their target profit (read ‘return for shareholders') drives them to seek an optimised return on their capital and deposits. When the market for lower risk loans is satisfied and the banking community still has large amounts of liquidity to lend in a rapidly growing economy, it would be natural to expect banks to start lending to higher risk segments of the market in an effort to optimise that return for shareholders.

With improved credit risk management concepts, processes and systems to assess and differentiate credit risks, banks are developing the ability to enter new and/or riskier segments while lowering the fear of failure.

The new Basel II Accord and any credible bank's credit risk department should ensure that loans are appropriately priced. In other words, the higher the risk of default then the higher the interest rate charges should be. Simply spoken, banks should make their profits from pricing risks appropriately in the loan market. Basel will also ensure that sufficient capital is kept at hand by the bank.

Banks who regularly miss-price their loan portfolio, in an attempt to ‘win' market share, will find themselves with a larger portfolio of non-performing loans. In the longer term, these banks will be self penalised due to their lack of risk-based pricing. On the other hand, they might be tempted to avoid risks altogether to protect themselves, another costly mistake, since higher (managed) risk ultimately creates higher shareholder value. Good risk management not only helps protect banks from adverse risk but also confers a longer term competitive advantage, enabling them to be more entrepreneurial and make larger profits.

Should banks be penalised for giving risky loans? The answer is no, because any bank engaged in high risk loans and not pricing the associated risks appropriately is shooting itself in the foot and won't be standing for long.

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