Crosscurrent

Based on research by Brian Akins, Yiwei Dou and Jeffery Ng

• Timely loan-loss recognition can work as a powerful tool in fighting corruption in the banking sector.
• The faster a bank recognizes a problem, the easier it is to address the issue. 
• Recognizing losses quickly, however, only really matters in places without government ownership of banks. 

The loans should have been sure things. Two high-profile lenders — Russia’s VTB Bank and Credit Suisse — provided $2 billion to two government-backed companies in Mozambique. What happened next was a corruption case of epic proportions.

The funding, approved five years ago, was meant to support a tuna fishing fleet and naval protection for vessels operating out of the southern African nation’s territorial waters. Credit Suisse and VTB pocketed $200 million in loan fees.

The only problem: The two companies were woefully mismanaged and never generated any meaningful revenue. And to this day, at least a quarter of the money remains unaccounted for. It’s not even clear that it ever arrived in Mozambique: The banks sent the funds to offshore companies in Abu Dhabi. Meanwhile, Mozambique’s parliament was never informed of these government-backed loan applications — nor was the public.

How can banking institutions avoid entering into corrupt deals like this? And how does corruption on this scale happen in the first place? Rice Business professor Brian Akins, along with Yiwei Dou of New York University’s Stern School of Business and Jeffrey Ng of the Hong Kong Polytechnic University’s School of Accounting and Finance, delved into these questions in a recent study.

What they found is that banks can better address corruption if they quickly recognize when they’ve made bad loans. It’s an important finding because loan-loss recognition is a relatively simple way to stem corruption, and little research has been done on the effects of quickly spotting bad deals.

The researchers examined the records of 3,600 firms across 44 countries and found that timely loan-loss recognition decreased the likelihood of corrupt lending practices. The quicker banks recognize a problem, the easier it is to address the issue quickly.

Loan-loss recognition matters because it provides investors and depositors information they can act on, according to Akins and his colleagues. Investors who see that banks are making corrupt loans are likely to correct the issue quickly. Depositors won’t stay with a bank very long if they know it is wasting the money in their accounts on bad loans.

But the study notes that in countries where banks were largely owned by the government, there was a greater chance that the lending institution would be bailed out in the event of loan failure. That is to say, there was less in the way of incentives for speedy loan-loss recognition.

The greater the government involvement in a banking institution, the less likely it was that outside stakeholders would monitor the banks very closely, the study shows. “Government ownership of banks leads everyone else who is supposed to be monitoring the bank to just let it go because they expect the government to back their claims on the bank if it fails,” Akins explains.

Deposit insurance, too, works as a disincentive for outside stakeholders to monitor banks closely. Loan-loss recognition doesn’t work as a disciplining mechanism in this case because depositors have the security of knowing that their claims are backed by insurance. And banks have a greater incentive to take risks. After all, if the loans fail, the burden will fall to taxpayers.

The Mozambique case was hardly unique. In 2014, the Indian government fired the chairman of the state-run Syndicate Bank for taking bribes in exchange for loans, while in 2012, the head of one of China’s largest banks, The Postal Savings Bank of China, was arrested on charges of bribery and illegal lending. 

In developing countries especially, corruption plays a big part in the way wealth is distributed. A $2 billion dollar loan anywhere is a large sum, but in a country like Mozambique, it amounts to a sizable portion of the nation’s wealth. That is to say, protecting against corrupt lending practices through timely loan-loss recognition amounts to yet another tool to ensure that economic resources are more likely to go to those who need them instead of a corrupt few.

Brian Akins is an assistant professor of accounting at the Jesse H. Jones Graduate School of Business at Rice University.

To learn more, please see: Akins, B., Dou, Y., & Ng, J. (2017). Corruption in Bank Lending: The Role of Timely Loan Loss Recognition. Journal of Accounting & Economics, 63, 454–478.