CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF THE STUDY

Just as a healthy financial system promotes economic growth, a weak financial system grappling with non-performing loans (NPLs) and insufficient capital could undermine growth (Schumpeter (1969).

In modelling credit, Zeng (2012) views loans to the economy as boosting total consumption and hence yielding a positive social utility, while NPLs are viewed as a source of financial pollution (Minsky, 1964, 1995; Stiglitz & Weiss, 1981) that negates social utility. Zeng identifies two economic implications of NPLs. Firstly, economic growth could decline if NPLs grow, causing resource allocation inefficiency. Secondly, capital requirements will increase as a result of the growth of NPLs as erosion of capital occurs due to funds being trapped in such entities, making it impossible for the banks to fund new, economically viable ventures. While the definition of non-performing loans (NPLs) is not uniform across countries, in the global financial stability report of the International Monetary Fund (IMF (2004) a general definition encompasses several formulations. A loan is deemed to be non-performing if payments (principal and/or interest) due have not been paid for at least 90 days. The Bank of International Settlement (BIS) five-tier system of classification categorizes loans into five grades, namely, pass, special mention, substandard, doubtful and virtually lost, with the last three classified as NPLs. While the first category refers to a healthy loan, there may currently be no outstanding payments on a special mention loan, but a collections problem may be foreseen. However, the term impairment is used