Financial systems and development

Box 5.3
How good bankers become bad bankers
The quality of management is an important difference measures that increase net profits on paper, even if
between sound and unsound banks, and in most coun- more taxes must be paid as a result. By rescheduling
tries the better-managed financial institutions have loans, a banker can classify bad loans as good and so
succeeded in remaining solvent. Four types of misman- avoid making provisions. The capitalization of unpaid
agement commonly occur in the absence of effective interest raises profits by increasing apparent income.
regulation and supervision.
The reporting of income can be advanced and the re-
* Technical mismanagement. Poor lending policies are cording of expenditure postponed.
the most common form of technical mismanagement
* Desperate management. When losses are too large to
and are usually a consequence of deficient internal con- be concealed by accounting ginmmicks, bankers may
trols, inadequate credit analysis, or political pressures. adopt more desperate strategies. The most common of
Poor lending policies often lead to excessive risk con- these include lending to risky projects at higher loan
centration, the result of making a high proportion of rates and speculating in stock and real estate markets.
loans to a single borrower or to a specific region or Such strategies, however, involve greater risk and may
industry. Banks sometimes lend excessively to related well lead to further losses. The problem then becomes
companies or to their own managers. Mismatching as- one of cash flow: it gets harder to pay dividends, cover
sets and liabilities in terms of currencies, interest rates, operating costs, and meet depositors' withdrawal deor
maturities is another common form of technical mis- mands with the income earned on the remaining good
management.
assets. To avoid a liquidity crisis a bank may offer high
* Cosmetic mismanagement. A crossroads for manage- deposit rates to attract new deposits, but the higher
ment is reached when a bank experiences losses. cost of funds eventually compounds the problems.
Strong supervision or a good board of directors would
* Fraud. Fraudulent behavior sometimes causes the
ensure that the losses are reported and corrective mea- initial losses, but once illiquidity appears inevitable,
sures taken. Without these, bankers may engage in fraud becomes common. As the end approaches, bank-
"cosmetic" mismanagement and try to hide past and ers are tempted to grant themselves loans that they are
current losses. There are many ways to do this. To unlikely to repay. Another common fraud is the
avoid alerting shareholders to the difficulties, bankers "swinging ownership" of companies partly owned by
often keep dividends constant despite poorer earnings. the bank or banker: if a company is profitable, the
And to keep dividends up, bankers may retain a banker will arrange to buy it from the bank at a low
smaller share of income for provisions against loss, price, and if the company is unprofitable, the banker
thereby sacrificing capital adequacy. If a dividend tar- will sell it to the bank at a high price.
get exceeds profits, bankers may resort to accounting
several developing countries that liberalized their reluctant to let lenders foreclose. The default rate
financial sectors.
among small farmers in Ghana and India, for ex-
The lack of clear legal procedures for dealing ample, has been particularly high.
with insolvent banks has been another obstacle to In sum, poor prudential regulation and superviprompt
action. In Argentina, for example, the sion, together with inadequate legal systems, let
Central Banking Act did not empower the central lenders and borrowers in many countries behave
bank to take over banks, replace managers and in ways that have added to banks' losses.
directors, or order owners to provide new capital.
As a result, intervention led to numerous lawsuits. Lessons of financial restructuring
The difficulty of foreclosing on defaulting borrowers
has caused losses for many banks. In some As the 1980s proceeded, the distress of financial
countries willful default is encouraged by the fact institutions in some countries precipitated crises
that bankruptcy and foreclosure procedures are and so forced the authorities to take action. As Box
slow and cumbersome. In Egypt, Pakistan, Portu- 5.1 indicates, intervention ranged from the closing
gal, and Turkey, for example, loan recovery pro- of a few intermediaries with a small fraction of
ceedings frequently drag on for several years (see total assets, as in Malaysia, to the closing and re-
Box 6.4 in Chapter 6). In others, willful default has placement of nearly every bank, as in Guinea.
a more political cause: borrowers in priority sectors During the next few years many more countriessuch
as agriculture realize that governments are especially those contemplating broader programs
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