INDUSTRIAL LOAN DEFAULT: THE CASE OF BANGLADESH MOHAMMAD ZIAUL HOQUE B,A. Hons (Dhaka). M.A. (Dhaka), M.B.A. (S.Aus.) A thesis submitted for the degree of Doctor of Philosophy Department of Accomiting and Finance Victoria University of Technology Melbourne, Australia June 1999 FTS THESIS 332.75095492 HOQ 30001005872090 Hoque, Mohammad Ziaul Industrial loan default the case of Bangladesh ABSTRACT Industrial development finance institutions (IDFIs) in developing countries have been experiencing serious financial distress since the early 1970s due to persistent loan defaults. Despite the application of a number of remedial measures, industrial loan default problems continued to haunt the IDFIs. The massive loan loss has not only impaired the viability of many financial institutions, but also made them dependent on government bail-outs. The problem of persistent industrial loan default has become a most important and serious issue that has attracted the attention of bankers, financial market operators, international lending institutions such as the World Bank and policy makers in developing countries. Bangladesh is chosen as a case study because it is an interesting example of the persistent industrial loan default problem. In the past, very few studies were carried out on industrial loan defaults. These studies have tended to concentrate on the attributes of the borrowers. How the inefficiency in the loan intermediation process and inadequate entrepreneurial guidance towards proper utilisation of credit, and inconsistent public policy regimes contributed to borrower's inability and unwiUingness to repay industrial loans have received scant attention from the authors of these studies. Moreover, these studies are neither comprehensive nor complete, since they have omitted a number of significant variables relating to industrial loan defaults. The main objective of this study is to identify the determinants of industrial loan defaults in developing countries. Especially, it endeavours to identify the factors that are responsible for borrower's inability and unwillingness to repay industrial loans. A comprehensive theoretical model incorporating 23 explanatory variables was developed and tested in the light of the experiences Bangladesh Shilpa (Industrial) Bank (BSB) has had over the last two decades. Ill In order to test the model, both the quantitative and qualitative research methods were used to arrive at a valid and convergent conclusion about the causes of industrial loan default in Bangladesh. Various data collection methods have been employed, such as administered questionnaires, interviews, inspecting loan files and processing customised data collected from the Head Office of the BSB. In addition, case study method was also used to increase the reliability and accuracy of the research findings. The findings of this study support the model that industrial loan default is the outcome of flawed financial role and flawed developmental roles of the IDFI, and flawed public policy regimes. This suggests that IDFIs should play a flaw-free financial role and industrial or entrepreneurial development role and the government should provide flawless public policies with a view to increasing borrower's ability and willingness to repay industrial loans. It is expected that such measures would help to achieve the goal of industrialisation through reducing, if not totally eliminating, incidence of industrial loan defaults in developing countries. 1\ DECLARATION I certify that this thesis does not include any written material previously submitted for a degree in any university; and to the best of my knowledge and belief it does not contain any material previously published or written by any other erson exce t those mentioned in the text. ACKNOWLEDGEMENT This thesis could not be completed without the encouragement, support and cooperation of many individuals stretching from my supervisors to my family members. I would remain ever grateful to Professor Bob Clifl who was instrumental in bringing this study into fiuition. Bob was generous in giving me much time while identifying the problem as the study progressed. Without his guidance and direction, I would never be able to tackle the problems associated with my study. I owe enormous debt of gratitude to Associate Professor Mary Sweeney for bringing the 'big picture" to my attention. Her encouragement and advice have bolstered my commitment to my study. This study involved a trip to Bangladesh where I got enormous support from a number of individuals and institutions. Particularly, the officials of the Ministry of Finance, Mr. Lutfor Rahman Sarker, former Governor of the Central Bank of Bangladesh, Managing Directors and senior bankers of several banks such as Sonali Bank, Bangladesh Shilpa Rin Sangstha, RupaU Bank and Janata Bank. I am indebted to the Chairman, Managing Director and a number of senior and junior officials of Bangladesh Shilpa Bank who extended all sorts of cooperation while eliciting and processing data from a large number of loan files and v^thout their cooperation, I would have come back to AustraUa empty-handed. I am thankful to Mr. Md. Mahbubul Hoque, Mr. Mizanur Rahman, Miss. Kazi Baynna Ahmed, Mr. M. Gaffar and Mr. Mahmudul Hassan who worked tirelessly as my research assistants in collecting, collating and processing data for about three months. I got tremendous moral support and encouragement from my fiiends such as Dr. Morshed Uddin Chowdhury, Dr, Quamrul Alam, Mr. Md. Abdus Sattar Bhuiyan and Dr. Raisul Awal Mahmood and numerous persons. My twin brother Mohammad Rezaul M Hoque Bhuiyan and my elder brothers Mohammad Mozammel Hoque Bhuiyan and Maulana Mohammad Mominul Hoque were constant sources of encouragement and support. My uncle General Wajhi Ullah and aunt Mrs. Rowshan Ara Wajhi always encouraged me to overcome the hurdles in the doctoral program. They are above simple thank you. My wife Khaleda has been my constant source of support and encouragement. I salute her for her patience and for captaining our family ship with my son Tanzil and daughter Nuha on board. This thesis is dedicated to my late dad and mum and my late father and mother in-laws who always encouraged me to go for higher studies. vu TABLE OF CONTENTS Chapter One : Introduction 1.1 Loan default at development finance institutions 1 1.2 Statement of the problem 2 1.2.1 Loan default problems in developing countries 2 1.2.2 Theoretical underpinning of development banking 3 1.2.3 Need for a study of industrial loan default problem 9 1.2.4 Loan default problems in Bangladesh 10 1.2.5 Bangladesh Shilpa Bank - a case study 11 1.3 Objective of the study 14 1.4 Hypotheses 14 1.5 Research methodology 15 1.6 Limitation of the study 16 1.7 Organisation 16 Chapter Two : Review of Literature on Industrial Loan Default 2.1 Introduction 17 2.2 Review of theoretical studies on industrial loan default 18 2.3 Review of empirical studies on industrial loan default 29 2.4 Summary 38 vm Chapter Three : Overview of Industrial Finance Market and Loan Default Problems in Bangladesh 3.1 Introduction 40 3.2 Bangladesh economy 41 3.3 Financial markets in Bangladesh 44 3.3.1 Bangladesh Bank 45 3.3.2 Commercial banks and industrial loan defauh in Bangladesh.. 49 3.3.3 DFIs and industrial loan default 54 3.4 Bangladesh Shilpa Bank - a case study 58 3.4.1 Debt-finance 59 3.4.2 Equity and stock investment 65 3.4.3 Existing conditions of the BSB 66 3.5 Summary 66 Chapter Four : Theory of Industrial Loan Default 4.1 Introduction 68 4.2 Role of industrial development finance institutions (IDFIs) 69 4.21 Meaning of development bank 69 4.2.2 Types of development bank 71 4.4.3 Objectives of public IDFIs 73 4.2.4 Functions of pubhc IDFIs 73 4.2.4.1 Financial functions of public IDFIs 75 4.4.4.2 Developmental functions of pubUc IDFIs 78 4.3 Determinants of industrial loan defaults 83 IX 4.4 Model of industrial loan defauhs 86 4.4.1 Industrial loan defauh and flawed financial role 88 4.4.2 Industrial loan defauh and flawed development role 91 4.4.3 Industrial loan defauh and flawed pubUc poUcy 95 4.5 Summary 99 Chapter Five : Research Methodology 5.1 Introduction 102 5.2 The model and variables 103 5.3 Research design 104 5.4 Quantitative research 105 5.4.1 Secondary data collection 105 5.4.1.1 Audit and inspection of loan files 107 5.4.1.2 Visit to departments of BSB 109 5.4.2 Data from primary sources Ill 5.5 Qualitative research 115 5.5.1 Interview 116 5.5.2 Case study method 117 5.6 Validity and reUability of survey instruments and data 118 5.7 Statistical tools and analysis 118 5.8 Summary 119 Chapter Six : Results of Field Survey and Loan Files Investigations 6.1 Introduction 121 6.2 Financial role variables 122 6.3 Developmental role variables 127 6.4 Summary 141 Chapter Seven : Testing the Model - Parti: Flawed Financial role and Industrial Loan Default 7.1 Introduction 143 7.2 Credit control mechanism 145 7.2.1 Officer-appHcafion ratio 145 7.2.2 Borrowers' credit worthiness 148 7.2.3 Credit need assessment 156 7.2.4 Government intervention 161 7.3 Credit disbursement 162 7.4 Debt-equity ratio 167 7.5 Term and variable loan ratio 170 7.6 Loan repayment period 177 7.7 Summary 182 Chapter Eight: Testing the Model - Part II: Flawed Developmental Role and Industrial Loan Default 8.1 Introduction 184 8.2 Project selection 187 8.2.1 Export orientated industry 188 8.2.2 Import substituting industry 190 8.2.3 Excess capacity 191 8.2.4 Firm size 199 8.3 Project implementation 200 8.4 Supervision and follow-up 205 8.5 Monitoring 208