Irina Guruli is Program Manager at the Economic Policy Research Center.

TBILISI, DFWatch–The problem of bad loans gets huge attention nowadays. It has become a headache for all from bank managers to government authorities. Bad loans were basically the driver of the recent world economic downturn. The situation is no different in Georgia.

The practice of selling off the collateral property by the banks and other finance or non-finance institutions has become commonplace since the war in 2008 and the world economic crisis. Almost 10% of all bank loans are non-performing loans (NPLs), i.e. payments are not made in the predetermined time frame; more than 100 thousand natural and legal entities are in the list of the Debtor Register; hundreds of people have lost their property and require loan restructuring; and the government is discussing restrictions on the issuing, enforcement, and execution of risky loans.

In August 2013, a moratorium on enforcing the auction sales of the collateral property was passed by the Parliament of Georgia at the first hearing in August 2013. It immediately created exaggerated expectations in society, giving them hope that their loans would be written off, or paid by the state. At the same time, a fear of uncertainty and possible loss arose in financial circles. It should be seen as a positive sign that the draft law was canceled, since it could have been a blow to the stability of the country’s financial sector.

Among the 124 countries listed in the World Bank database about the share of the NPLs in total loans, Georgia stands 52nd which is slightly better than the average. Notwithstanding the fact that the total bank loans to NPL is not very high in Georgia compared to some other countries, the problem of defaults and NPLs remain a significant issue in the country. One of the most painful consequences of the NPL problem is when people lose their houses and become homeless. With this regard it is important to state that the share of the real estate secured loans had been growing for the last 6-7 years, which indicates more people being exposed to this risk.

According to information from the Public Registry and the NBE, enforced sale of property has been on the rise since 2010. Moreover, almost half of the sold real estate was residential flats. The fact that execution can be done very quickly creates additional incentives for asset based lending, and collateral in many cases becomes a primary source of loan repayment. At the same time, complicated and prolonged procedures could make the conditions and interest rates/commissions even higher for compensating difficult execution process.

In the past years, the government of Georgia (GoG) has simplified the execution and property repossession or sale by the auction procedures. Some important changes include simplified execution and creation of private execution offices and creation of debtor registry. After the enforcement is complete, if the amount retrieved from the property sale is enough to fully cover the debt, the debtor is removed from the debt registry. Otherwise, the debtor remains on the list, unless the following occurs: a change of the fine mode, suspension of the enforcement or retrieve of enforcement paper to creditor, withdrawal of enforcement sheet, or a court decision.

According to the Civil Code of Georgia article 301(1) “An asset secured loan is closed after the asset is sold even if the amount retrieved from the sale is not enough to fully cover the debt, unless otherwise stated in the agreement.” This exception from the law, that if the agreement states otherwise, a debtor’s liability is not limited to the secured asset only, gave an opportunity to financial and non-financial institutions to have a claim on other currently existing or future assets. This gives a possibility no to limit the loan dispute settlement to the collateral property only and makes a debtor a lifetime hostage of a creditor. This amendment was due to the 2008 crisis (that resulted in price decrease on real estate); however it transferred the entire burden to the borrower. It is desirable to review this amendment.

According to the draft law passed by the Parliament, amendments are being made to the law on Enforcement Procedures of Georgia starting from 2014. According to the amendments, unlike the current edition, that envisages a possibility of holding the first and one additional auction on the repossessed property, an opportunity of holding the first and two additional auctions emerges. The latter makes it possible to sell an asset at a price closer to the true market value.

The government of Georgia has already tried to resolve the problem in order to help out the affected, so that they could maintain their housing. In 2008 a three year government subsidized municipal loan has been distributed. However, a major shortcoming of this initiative was that it was planned independently, without having preliminary negotiations with the banks, and was offered only in December 2008, when the majority of these families had already signed new contracts of loan restructuring on worsened terms with the banks. Therefore, assessing the effect of the initiative was quite hard. We believe that the initiatives like the municipal loan must be implemented with caution so that they do not create further incentives for individuals to take a loan irresponsibly, thinking that the government or other private institutions will support them later. Simply stated, the government should carefully reconsider the problem of moral hazard.

Generally, growth of NPL share in Georgia is driven by the following important macroeconomic factors: high levels of unemployment and poverty, poor risk management especially by the borrowers that leads to their overindeptedness (taking additional loan to cover existing problem loan), low awareness and access to information, unbalanced enforcement legislation and inadequate fines. The research conducted by Economic Policy Research Center (EPRC) clearly highlited the problem of financial iliteracy among the borrowers. Major problems are overestimating borrowing capacities of oneselves, thus resulting in overindeptedness, and difficulty in grasping and understanding the obligations and responsibilities imposed by the contract terms. In this regard, we believe that a public awareness campaigns, particularly the ones targeting youth groups, should be a focus of both non-governmental and governmental entities.

It should be noted that the current interest rates on the private lenders’ market is the result of supply-demand. Direct intervention and artificial correction of the interest rate will not bring desired results. This type of intervention is envisaged by the amendment to be made to the Civil Code of Georgia, entering into force from 2014. According to the amendment, a loan agreement with a private lender has to be approved by a public notary. A public notary will be obliged to duly explain to the parties their rights and responsibilities, as per the agreement, and the legal proceedings that will be followed in case the agreement is breached. At the same time, an interest rate ceiling will be imposed (except for loans below 1000 GEL), the rate shall be no higher than one twelfth of 2.5 times the annual average of monthly annual base interest rates set by the NBG for commercial banks. The latter will enter into force from March 1, 2014.

We believe that strict regulation of microfinance organizations and private lenders, such as licensing, or interest ceiling, as planned by the legislative amendments passed by the Parliament of Georgia, will not be effective. These initiatives shall artificially interfere into the market equilibrium and increase the risks of shadow economy activities.

Due to the fact that Georgia’s private lender market is unofficial, there is no statistical data on how many people are affected by the NPLs. The most crucial recommendation directed to the GoG will be a clear investigation of the problem in order to determine its scale and measure it, especially in monetary terms.

Moreover, it is important that the insolvency/bankruptcy laws also protect natural persons and not just legal entities. The ability to claim and file for insolvency will defend the borrowing party from the extra material loss, which sometimes can reach beyond the repossessed collateral property and does not give a debtor a chance to have a fresh start.