By Tarek Kamal, Managing Partner
Not many people, not even many bankers, have heard the term hardcore overdraft but it is a thing. The purpose of an overdraft account is to help the account owner to smooth out cash shortfalls and excesses. Technically, when an overdraft facility is used too often or for extended periods, the bank considers this to be hardcore debt and therefore risky and increases the interest rate on the account. The logic behind this is that if the account is going to be overdrawn for an extended period, a longer tenure loan should be used.
This is the case in developed economies but in developing economies like Bangladesh, this is not how an overdraft account is used, particularly when it comes to business accounts. Most users of overdraft accounts use them as a means of flexible financing, i.e. they draw down on the limit when the cash situation is tight and pay it back when the situation reverses. Unfortunately, sometimes it does not work out this way, i.e. the business does not generate the expected revenue and the borrower has to wait a little longer or worse, they are able to get their credit limit increased. Slowly the debt increases, as do financing costs.
Higher limits on an overdraft account can be dangerous if the borrower is not careful. With an overdraft facility, funds are available for just about anything that the borrower wishes to use it for. The outstanding amount of an overdraft can rise quickly and without adequate funds coming in, the outstanding can become permanent. This is what happens in most cases where the business needs are not understood by the borrower or considered closely by the bankers when providing the limit. Since the outstanding amount does not come down below a certain point, the borrower pays interest on a permanent outstanding portion along with the remain fluctuating balance month after month and often year after year.Technically, an overdraft account has a cleanup period that is supposed to be at a time when the business has more cash coming in and does not, in fact, need to borrow. This requirement could be monthly, quarterly, semi-annual or annual depending on the business cash cycle. During the cleanup period, the overdraft account must be fully repaid for a specific period of time depending on the business cash cycle.
In super competitive financial sector borne of an ever-increasing number of banks and a fairly limited number of customers that can qualify for loans, these requirements are often overlooked. Some banks require an annual cleanup of only one day while others look at the volume of deposits made into the account throughout the year. For example, if there is a condition that the customer must deposit at least 1.5 times the overdraft limit throughout the year, then it is considered acceptable if the summation of deposits into the account meets that condition – even though the limit is fully utilized throughout the year. In the case of annual cleanup requirements, the customer could be borrowing the amount from somewhere else to pay down the overdraft outstanding for a day and then redrawing the full amount again to repay the person, business or bank they borrowed the funds from. Needless to say, these are risky for both the financial institutions and the borrowers.
A hardcore overdraft is more profitable for a bank than a term loan even if the interest rates are the same because the outstanding amount never declines. Bankers usually don’t offer overdraft facilities without collateral, generally mortgage of property. The user can’t get out because they don’t have sufficient cash flow to pay down the overdraft permanently and the bank, secure in the knowledge that their interest is well protected, happily earn additional interest.
The risk to both parties is real. There may come a time when the borrower is unable to service even the interest. The bank will have no choice but to foreclose on the property mortgaged but this can take years. To avoid finding themselves in this type of predicament, there is no other way, for borrowers or banks, than to restructure the loans while there is still time.
This is why a hardcore overdraft is like a debt addiction. Both parties are addicted and often are each others’ enablers. Increases in overdraft limits as the borrowers’ account approach full utilization is not uncommon. This can continue until the borrower is unable to service the interest on the debt. The bank is happy receiving the interest income but can get hurt if that interest is not paid and the account goes into default. The borrower is in too deep, they have borrowed too much and are not being able to pay down the debt while a large chunk of their income is being sucked by this debt habit.
The borrower and the bank, both, need to be weaned off this kind of unhealthy relationship with debt. The way this is done is by taking the hardcore portion of the overdraft facility and converting it into a term loan. There is hardship all around. The concession that the borrower has to make is that they have to begin paying down the loan in installments – this is in addition to the interest payments. The banks have to work with the borrower to agree on the term loan tenure even if it means an extended-term loan. There is no point pushing an unmanageable tenure on the borrower – if they had the necessary funds, this predicament would not exist. Pushing too hard will push the borrower into a default situation and possibly out of business. Needless to say that the overdraft limit will have to be either reduced down to a level that the business cash flow can justify or entirely closed (in which case, the entire outstanding will need to be termed out).
A recommendation for borrowers and banks in this situation would be to admit that there is a problem and make the changes. As they say, it is better late than never. It is even better earlier than later. Actually, the time to act is now.