Regulations, Governance, and Resolution of Non-Performing Loan: Evidence from an Emerging Economy

Abstract

How do banks resolve a severe bad loan problem in a capital-constrained, low-income economy when a government bailout is not an option? We address this question by examining new evidence from a sharp decline in bad loan ratios in a panel of conventional commercial banks in Bangladesh. On the aggregate level, the bad loan ratio in this market has dropped from 41% in 1999 to only 10% in 2012. We find that at a micro level, this dramatic improvement is associated with bank management quality and internal governance that were substantially enhanced during a decade of large-scale regulatory reforms. The bank-level findings persist even after controlling for market monitoring, bank- and industry-level factors, and macroeconomic variables. Both economic growth and financial development paved the way for banks operating in this macroeconomic environment to reduce non-performing loans over time.