Most of the financial institutions have the problem of non-performing loans. Basically, the non-performing loans (NPLs) mean that the loans in default, or is close to being in default according to Investopedia. In the contract terms, NPLs indicates the failure to promptly pay interest or principal when due. When the borrowers are unable to meet the legal obligation on making the required payment or are unwilling to honor the debt, the default will be taken place.
With the increase of NPLs, the level of market confidence will be affected. The effect of the banks’ bad-loan problems can be seen at the East Asian crisis which occurred in July 1997. During the crisis, banks’ balance sheets were deterioration due to the increasing of NPLs which showed in the Figure 1 below (Detragiache & Gupta). The problem was started as the deregulation was exercised in the financial markets. A lot of loan borrowings from the private nonfinancial business sector were easily being approved. But, the bank regulators failed to supervise the borrowers as there was a lack of expertise in screening and monitoring the borrowers at banking institutions. Hence, the default loans started to increase and the banks’ net worth (capital) became lesser. The bank would have lesser fund to lend. Then, the economic activity would be reduced due to the lack of funds (Mishkin and Eakins, 2000).
Figure 1: Changes of Non-performing Loans
( Source: Van Dijk and Fitch IBCA database)
In additions, the increase in uncertainty and a decrease in net worth caused a stock market declines. Then, the asymmetric information problems increased. It would become difficult to screen out good borrowers. The adverse selection and moral hazard problems increased seriously. With the increase of these problems, lenders were unlikely to lend out money and led to the decline of investment and the decrease of aggregate economic activity.
Due to the poor business situations and uncertainty about their bank’s health which the bank could go broke, depositors began to withdraw their funds from banks. The massive withdrawal of depositors would bring the bank failures. If they snowballed, bank panic would take place. The number of banks could decline. It was able to raise the interest rate even further and decreased the financial intermediation by banks. Deterioration of problems created by adverse selection and moral hazard could lead to the further economic contraction (Mishkin and Eakins, 2000). Ultimately, market would have a stroke which was hardly recovered. Thus, market confidence wouldn’t be optimistic. The stability of financial system in Malaysia could affect as well.
After the Asian crisis, governments in South-East Asian countries have taken action on solving the problems. Many rescue activities such as insertion of huge amount of government capital into problematic banks, moving non-performing loans out of banks, and setting up special government organisations to deal with non-performing loans, etc. (Hou, n.d.). To deal with the impact of the Asian financial crisis in 1997-98, Pengurusan Danaharta Nasional Berhad has been set up by Bank Negara Malaysia to buy bad loans from financial institutions. Meanwhile, Danamodal Nasional Berhad has also been set up to recapitalize banking institutions. And the Corporate Debt Restructuring Committee was set up to reorganize large corporate debts. Other than that, Bank Negara Malaysia was also instrumental in designing and applying the selective exchange control measures introduced in September 1998 (Bank Negara Malaysia, 2003).
To sustain full stability in the financial sector during the recent crisis, strong government commitment and support are important. It has contributed to the strength and thus returns of confidence in the industry. The support includes the timely government intervention to re-capitalise weak banks and remove non-performing loans from the banking system as well as the...
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