also have the skills needed to challenge common practices that banks often use to underrepresent NPLs, such as overvalued collateral, “extend and pretend” loan restructuring, and transfers of losses to unconsolidated but de facto affiliated entities. Moreover, supervisors will need to understand the broader business interests of the bank’s owners. Rigorous application of high-quality corporate governance standards and constraints on lending to related parties are essential steps. In the most challenged countries, reforms along these lines will take time and must be sustained over several years. Although the task can seem daunting, the rewards will be plentiful. Indeed, in recent years some countries have made remarkable progress in a comparatively short period of time. For example, with extensive World Bank support Uzbekistan introduced a new banking law in 2019 to prepare authorities for the transition to a banking sector with a more prominent role for private capital. The law established a “gatekeeper function” aimed at giving the central bank expanded powers to ensure that private investors seeking to enter the banking sector met common fit and proper standards, de facto ownership structures are well understood and monitored continually, and related party lending would be contained. Another priority was to allow the central bank to legally exercise supervisory judgment in fulfilling its mandate in the face of dynamically evolving banking risks. This change was a drastic and sometimes controversial one because the former legal framework prioritized compliance checks with administrative requirements over the mitigation of risks. The new banking law has had a galvanizing effect on financial sector reform in Uzbekistan. Building on the momentum for financial sector reform, the World Bank has continued to support the central bank in overhauling the corpus of prudential regulations and undertaking extensive capacity building to upgrade super visory practices.52
Building capacity to manage rising volumes of bad debts In normal times, banks routinely manage NPLs. They know their clients and their capacity to repay and thus are in the best position to restructure, collect, and sell NPLs. Bank capacity to manage NPLs may be insufficient when the volume of NPLs increases significantly across the board, which is very likely in response to the pandemic. Strengthening the capacity of banks to deal with NPLs is critical because of the urgency of addressing bad debts. The recovery prospects for bad loans diminish quickly, and delays in the initial policy response will allow the underlying problems to build, with the risk of overwhelming banks once pressures on asset quality begin to increase.
Methods to manage, recover, and resolve NPLs Banks can reduce NPLs through a combination of loan restructuring, legal action, write-off, and sale to third parties (see table 2.2).53 Bank decisions about how they manage NPLs and when to escalate from one method to another should be guided by the expected asset recovery for each method using net present value (NPV) calculations.54 These calculations should be based on conservative estimates for recovery, discount rates, and carrying costs. Poorly functioning insolvency regimes, for example, translate into lower recovery rates that banks must reflect in their calculations.
Challenges in addressing NPLs in practice The ease with which banks can work out, collect, write off, or sell bad loans depends on the strength of the enabling environment, particularly the strength of creditor rights, enforcement mechanisms, and
RESOLVING BANK ASSE T DISTRESS | 93
