Will External Audit Ensure End-use of Loans?

As learnt from media reports, Bangladesh Bank (BB) is going to introduce a new rule requiring an external audit report to ensure end-use of the loans of Tk500 crore and above. As per the report, the new policy outlining the requirement is almost ready and waiting for final approval. According to the proposed policy, three-tier verification will be required for disbursing large loans by the banks. In the first tier, loans amounting to Tk500 crore and above will require verification or an audit report by a BB-endorsed third-party audit firm. In the second tier, any loan amounting between Tk100 crore and Tk500 crore will require an end-use verification report by the bank’s internal audit and Risk Management department. In the third tier, any loan below Tk100 crore will require a written statement from the borrower declaring and explaining the loan utilisation, based on which the bank itself will conduct a risk-based evaluation depending on the factors, particularly the borrower’s risk profile, account activity and other relevant factors.

Large loans amounting to Tk500 crore and above will require stringent verification, as the lending bank will be required to conduct their own verification in addition to assigning a third-party audit firm. The process apparently seems to be very effective with ensuring end-use of loans, which is mostly blamed for causing non-performing loans (NPL). To what extent this additional verification process will ensure end-use of the loan and thus prevent NPL must remain to be seen. However, these measures may be inconsistent with the modern risk management approach, which emphasises easy and smooth disbursement entirely relying on the borrower's integrity and trustworthiness. This extra verification process may add more layers and make the disbursement process cumbersome, which will not only delay the project implementation but also cause unnecessary additional expenses for the borrowers and the banks as well.

Moreover, this additional verification process may raise some relevant questions. Firstly, a large loan is usually required for project finance, where a lion's share of the fund is used for development and building, but the audit firm works on the account and financial information. The audit firm may not have that level of expertise to assess the cost involved with development work. If a proper implementation report is required, then a reputed consulting or engineering firm may be assigned. Secondly, a lending bank usually should maintain a separate team with specialised personnel, who will periodically monitor, assess and submit a progress report to customer relationship management (CRM) for evaluation and assessment. The bank's internal audit and CRM members may not be well equipped to properly conduct this additional task, which, in question, is technical in nature. Thirdly, there will be substantial cost involvement for paying fees to the audit firm and employing additional people in the bank’s internal audit team and CRM for conducting this assignment. Fourthly, there is a possibility that a dispute or disagreement may arise between the borrower and the bank or audit firm over the verification report, which may cause unnecessary delay to implementation, resulting in time and cost overruns and even turning the loans NPL in some cases.

Most importantly, there will be situations where lending banks may seem to be compromising with the borrower’s integrity and creditworthiness. What is the topmost criterion the borrower must possess to qualify for the loans from the bank? In principle, the borrower needs funds for investment in the business project. So, why will the borrower not utilise the borrowed money for their investment purpose unless there is a situation beyond their control? No genuine businessman will divert their fund. How come the bank can select a borrower for lending Tk500 crore and above with the doubt that the loan may not be utilised for the purpose and thus can be diverted? The borrower with minimum doubt of not utilising the loan should fall under the red flag and must be rejected under the normal screening process of CRM.

Now the question arises: how can end-use of the loan be ensured and fund diversion prevented, reducing NPL? There is no straightforward answer to this question. The country's banking sector is required to be gone through complete overhauling to address this situation. Even the entire financial market, including both the money market and the capital market, will require drastic improvement, establish an effective secondary bond market and strengthen the capital market. Because project finance and the requirement of large funding for long-term projects should not be financed through bank loans but rather from either the bond market or the capital market. CRM must be fully automated and digitalised so that everything from loan application to the disbursement, recovery and reconciliation can be automatically done without any scope of manual work or human manipulation. Instead of a flat overdraft facility and term loan, a revolving time loan can be introduced with the option of borrowing a time loan sequentially, matching with the requirement / progress of work within the approved revolving amount. 

It is obvious that a bank can easily identify the good borrowers and bad borrowers if they are allowed to perform professionally and without any interference. We all know that good borrowers will not misuse or divert loans. Good borrowers do not require any additional verification or auditing certification for ensuring the end-use of the loan, because they themselves apply that due diligence for the sake of their own interest. On the other hand, a bad borrower at any cost will divert the fund, because they obtain a loan with ill motive. Neither internal nor external audit will be able to prevent it unless approval of this type of potential bad loan can be stopped at the approval level of CRM. Therefore, the new approach may not prevent fund diversion causing NPL but rather will cause unnecessary trouble and hassle to the good borrowers. We hope BB will reconsider and reassess the situation prior to proceeding with this new measure.