Banking Sector: Turbulence in Disguise

Bangladesh is one of the fastest growing economies in Asia-Pacific. The country is aspiring to gain the status of a middle income country very soon and has been making great strides in terms of social, economic and technological transformation. It recorded a commendable GDP growth rate of 7.86% in 2018.^[1] All these being said, a growing economy like Bangladesh is expected to to have high private sector credit growth, high investments, a vibrant stock market and a dynamic financial system; however, the financial system has been on a downward trend since the first quarter of 2018.

The financial sector of Bangladesh is undergoing liquidity crunch owing to a number of demand and supply side factors. Alongside, governance issues within the banking system have contributed to high levels of non-performing loans (NPLs), resulting in lack of trust for the banking industry.

A look into the structure of the financial system of the country^[2]

The financial system of Bangladesh is comprised of three broad fragments: formal sector, semi-formal sector and informal sector. The formal sector includes all regulated financial institutions. The semi-formal sector includes institutions which are regulated otherwise but do not fall under the jurisdiction of Central Bank. The informal sector includes private intermediaries which are completely unregulated. The following diagram delineates the broad structure of the country’s financial system:

Dissecting the Commercial Banking Industry

The basic principle of how commercial banks make money is by providing loans and earning interest income from those loans. The loans that they are providing come from the deposits they are taking from people in return of interest and from their own reserves. Their share is the difference between the lending and deposit interest rate. The current weighted average deposit rate and lending rate of the country are 5.56% and 9.59% respectively.^[3] Commercial banks also earn revenue from commission based incomes from trade and treasury services.

The three main reasons for the current predicament of the banking sector are deposit shortage, declining asset quality due to governance issues and enormous competition within the industry. One of the most alarming symptoms to these causes is the rising level of non-performing loan. The amount of NPL stood at BDT 893.4 billion in 2018, which is more than 10% of the total loan disbursed. Along with these, some other factors also played a role behind the liquidity crunch. The next section puts a deeper look into it.

Reasons for decline in the deposit reserve amount of banks:

• Fluctuating deposit rates: The deposit rates of commercial banks have shown a declining trend over the past few years. In 2018, Bangladesh Association of Banks (BAB) decided on an interest cap of 6% on deposits. This has restricted deposit flow within the banking system as the risk-adjusted return was perceived to be low among depositors.
  

  Figure: Deposit Rates Trend / Source: Bangladesh Bank

Lucrative and risk free saving certificate: In the past 5 years, the sales of National Saving Certificates have been soaring. The return rates of different saving certificates range from 11.8% to 12.2%, which is much higher than the bank deposit rates of around 6%. ^[5] Recently, to control government debt, the government has levied a 10% tax on the proceeds from NSCs, which previously was 5%.^[6] And they are stringently tracking the sale of NSCs with introduction of new rules. This has contributed to a fall in sales of NSCs from July 2019 onwards.

• Loss of faith due to recent turbulence: The total money lost due to major scams, irregularities and heists in the financial sector, as of 2018, stood at Tk. 22,501 crore (~USD 2.68 billion)^[8]. Due to poor regulations and political influence within the banking industry, scams have increased, which caused people to lose faith on financial institutions and thus impacted the deposit level. The Chinese government has blacklisted five local private banks as they failed to meet payment and other obligations.^[9] Moreover, there has also been a loss of faith in the inter-bank money market. Most banks are hesitant to lend to other banks with questionable financial conditions.
• Capital flight: There has been a huge amount of legal and illegal capital flight from Bangladesh. According to Global Financial Integrity (GFI), Bangladesh is second in South Asia in terms of illegal outflows of money. The 2017 annual report of Swiss National Bank shows that money parked by Bangladeshis in Swiss Banks totaled around USD 481 million. The implication of such huge amounts of capital flight on the money reserve of the country is undoubtedly alarming.
• Large part of the economy not being financially included: The banking industry of Bangladesh is highly competitive. . There are 62 commercial banks, 40+ NBFIs and more than 60 insurance companies operating in Bangladesh. In 2016 Bangladesh had 75 branches of commercial banks per 1000 square kilometres of land, which was the highest in the South Asian region.^[10] In spite of all these stats, only 47% of the population is financially included. ^[11]Among them, only 25% have full-service bank accounts.^[12] The reason for a large part of the economy not being under the financial umbrella is because of the concentration of commercial banks in urban areas. So a large portion of the money being circulated in the rural areas is untapped by commercial banks. This problem is now being addressed through the introduction of Mobile financial services (MFS) and agent banking operations predominantly for rural population.
• Foreign liquidity crisis: The high import expenditures and low export earnings has caused a demand-supply gap of US dollars. As a result, the foreign exchange market has been volatile with rising dollar exchange rates against taka. The devaluing of local currency compelled local banks to use money from their reserves for settlements of letters of credit (L/Cs) and thus put pressure on banks’ overall liquidity.

In the interbank market, the nominal exchange rate for taka-US dollar depreciated by 3.9% and the Real Effective Exchange Rate (REER) declined by 2.7%. Government injected USD 2.3 billion into the economy to adjust the exchange rate and to help banks make import payments. This has contributed to the outflow of funding from the banking system.^[13]

Reasons for the impeded asset quality growth of the banking sector:

• Non-performing loans: As the capital market is underdeveloped in Bangladesh, the private sector highly depends on commercial banks for mobilizing internal savings and for providing capital to companies and investors. However, the financial sector is heavily burdened by high percentage of NPLs. If we look at the trend of NPL as a percentage of total loans, we can see that the percentage of NPLs had an incessant annual uptrend since 2015 onwards.
  

  FIGURE: Increasing trend of NPLs / Source: Bangladesh Bank

  The uptrend in the percentage of NPL is an indication of the declining asset recovery rates of banks. This has caused an overall negative impact on the liquidity and the money supply of the economy. The prime reason for the rising NPL trend is poor governance at both private and government level.

Asset Structure: According to Bangladesh Bank’s guidelines on Risk Based Capital Adequacy (2014), banks must maintain a minimum total capital ratio of 10% plus a Capital Conservation Buffer of 2.5%. The rising NPL trend, poor corporate governance by banks and increased difficulties in recovering bad loans has led to the weakening of the asset quality of the banking sector. This is well depicted on the figure below where most state-owned commercial banks have failed to maintain minimum capital adequacy since 2013 and development finance institutions (DFIs) seem to be massively under-capitalized.

• Point cut in CRR and SLR: CRR stands for Cash Reserve Ratio and SLR is Statutory Liquidity ratio. These are tools in the economy which manages inflation and flow of money. The central bank controls banks’ capacity of lending through CRR and SLR. One of the prime reasons for aggressive lending trend noticed over the past few years is due to 2018 Bangladesh Bank has given a point cut of 1% for Cash Reserve Requirement. The current CRR for banks is 5.5%. This measure was primarily taken to address the liquidity management issue but it encouraged banks to lend out more aggressively, thus resulting in growth of weak assets.
  

  FIGURE: Trend of ADR of the Banking sector

  A fluctuating Advance Deposit Ratio (ADR) indicates inefficiency in liquidity management by banks. It also indicates fluctuating Statutory Liquidity Ratio. Moreover, we can see an uptrend in AD ratio since 2017 which can be credited to the new CRR policy by the central Bank.

• Margin compression: As a new policy putting a ceiling on both deposit and interest rates were introduced, overall margin for banks were compressed. According to new policies set by the authority, interest rate for loans are to be kept to single digit, i.e, have to be less than 10% and the deposit rates are to be less than 6%. This margin compression resulted to banks having less money in their reserve, thus leaving an adverse effect on the Advance- Deposit (AD) ratio.
• Crowding out effect: Crowding out effect is the concept of increasing government spending and deficit financing sucking up available financial resources. Government lending from private sector has increased radically due to various on-going development projects like power plants, construction of ports, bridges etc. This has in turn caused a fund crisis in the reserves of mainly state owned commercial banks (SOBs).

Recognizing these problems from both state and private level

For various reasons, the capital market hasn’t grown enough to counteract the liquidity crunch coming from the banking sector. Moreover, alternative forms of financing like private equity firms, venture capitalists, angel investors, crowdfunding etc. haven’t grown as much as they should have, which caused the financial system of the country to be heavily reliant on the banking industry.

From a remedial point of view, the first step would be to recognize each of these problems from both state and private level. The next step would be to bring a few changes in the overall functioning of the banking industry. Some other steps that might enhance the overall functioning of the banking system are:

• The culture of giving licenses to new banks should be stopped. India has an economy much greater to ours but the total number of Private Sector Banks (PSB) in India is 27, on the other hand, we have 64 scheduled and non-scheduled banks.^[17] Last year, giving into pressure from government high-ups, Bangladesh Bank has set in motion the process of giving licenses to four proposed commercial banks^[18]. So given the size of the economy, the banking industry is already saturated and there is no need for new banks
• The practice of recapitalization of banks year after year, especially SCBs, should be stopped. These banks are bailed out on the basis of public money, which is economically uncalled for and morally improper.
• Overall governance of the banking sector should be enhanced. For example, one of the reasons for the increasing number of bad loans is due to the preferential treatment from banks to certain companies or institutions. Due to personal relationships with borrowers, some banks tend to compromise on the credit approval process at the expense of asset quality.
• Loan classification norms should be redesigned to better identify defaulters and internal control departments of banks should be strengthened to address these issues.
• Financial inclusion is the key to growth. Agent banking can pave the way for a more financially included banking system. bKash has commendably contributed to the increased access to financial services in the rural market.

The article is authored by Marzina Akhter Prottasha, Trainee Consultant at LightCastle Partners.