No faith on banking system
Industry Desk: Amid a slew of reports emerging in different sections of the media on poor corporate governance at various banks leading to highly suspicious loan disbursement practices, Finance Minister A.H.M. Mustafa Kamal struck a highly defensive tone this week.
Understandably questioned on the state of the banking sector recently, the finance minister told journalists: “How is the state of the banking sector bad? Let us know in writing and we will look into it.”
Despite largely being absent from the public eye in the last few months while the country navigated some choppy economic waters, the businessman-turned-politician seemed fed up with reporters asking questions on a legitimate issue of national interest.
By choosing to throw the question back at the gaggle of reporters, Kamal has opened up his competence for the position he holds to questioning. When times are tough, finance ministers are supposed to provide reassurance, to inspire confidence. To have some answers. Yet this callous, almost dismissive attitude on the part of one who holds the most important post in the cabinet is bound to reflect poorly on the government. Never mind the fact that this defensive posture may well be an attempt to paper over cracks that developed long before he took office, but have also clearly gotten worse, not better as promised, under his stewardship. And if he does need something in writing to realise this, we can only assume he has neglected to go over the World Bank’s latest Financial Development Index, where Bangladesh was ranked 95th of 184 countries in terms of financial development (2021 ranking based on 2019 country data), scoring only 0.24 points out of 1, slightly lower than its 2019 score of 0.25 points. The score tells us the sector is regressing, if anything. And the ranking is clearly out of sync with the country’s ambitions, indicative of poor performance and underachievement.
Financial development is defined in the study as a combination of depth (size and liquidity of markets), access (ability of individuals and companies to access financial services), and efficiency (ability of institutions to provide financial services at low cost and with sustainable revenues, and the level of activity of capital markets). Financial institutions include banks, insurance companies, mutual funds, and pension funds. Financial markets include stock and bond markets.
The way to think about it is this: for one of the world’s 40 biggest economies, one that aspires to be knocking on the doors of the top 25 at some point of the 2030s (projections vary from 2031 to 2036), Bangladesh’s poor record in terms of financial development, only barely making it to the top 100, can be expected to act as a drag on expectations, more of a hindrance than the facilitator of economic verve the financial sector is supposed to be.
“Comprehensive reforms are required to enhance financial sector intermediation capacity to support economic growth while preserving financial sector stability,” notes the report accompanying the index.
It also expands upon the systemic ills that have become seemingly entrenched in the financial sector, of which banks of course are such important stakeholders. The latest index was published in September, and the Bangladesh office of the World Bank arranged a programme to release it as part of the “The Country Economic Memorandum – Change of Fabric identifies,” with Planning Minister Abdul Mannan in attendance as the chief guest. There is really no excuse for the finance minister to be in such denial about the state of banks in Bangladesh, given what we learn from the report.
Bangladesh’s ratio of private credit to GDP is one of the lowest among its structural and aspirational peers, according to the report. The weaknesses of banks, and especially the high load of non-performing loans, reduced the ability to supply credit for the private sector, which dumped the credit-to-GDP ratio below 45% in Bangladesh, above only Indonesia. The rate is above 100% in China, Vietnam, Cambodia, and Thailand.
Even with default loans being underestimated, Bangladeshi banks have the highest levels of official default loans among the country’s peers (comparable only to India), coupled with very low profitability.
A mere 1 percentage point increase in private sector credit raises the per capita GDP in Bangladesh by 3.8 percentage points – the most among the variables tested by the World Bank model. But Bangladeshi banks do not have the capacity to supply credit to the private sector in the volume that it needs due to ‘inherent weaknesses’, on top of the high load of default loans. The Washington-based multilateral lender’s analysis found that banks with higher default loan ratios supply fewer loans and attract fewer deposits.
The World Bank identified that the board of directors of several banks were appointed from non-financial firms, political leaders and owners of business groups. It said although some restrictions on related-party transactions exist on paper, the regulations are not consistent with international best practices and, in practice, there are few barriers to self-dealing.
For example, the report said, to circumvent the Bangladesh Bank’s prior approval of loans to directors exceeding a certain amount, directors can borrow from banks other than the one for which they are directors, so as not to be classified as related parties.
At least 20 percent of the total loans in the banking system are being granted to directors, the World Bank estimates. When facing financial difficulties, directors are incentivised to borrow from other banks, directly or through family members, to regularise their position, to avoid termination of office, causing ‘evergreening’ of loans.
“Various fraudulent schemes reported in the public domain provide anecdotal evidence of this practice,” the report states. In just the last decade, the report notes, large losses occurred due to fraudulent schemes with the involvement of members of the board of directors in Sonali Bank (more than Tk 3,000 crore in losses, 2010-12), BASIC Bank (Tk 4,500 crore, 2009-13), and Padma Bank, formerly Farmers Bank (Tk 3,070 crore, 2017-18).
Weak corporate governance, poor regulatory enforcement and lack of transparency expose banks in Bangladesh to significant risks and abuse. The reports that have sprung up this week on Islami Bank, Social Islami Bank and First Security Islami Bank speak firmly to these underlying realities. While independently damning on their own, especially the revelations concerning Islami Bank, there is a common thread running through them that reveals even greater weaknesses in the system: they are all controlled by Chittagong-based a group, which is also known to control four other private commercial banks.
You don’t need the World Bank to tell you that 7 banks being controlled by a single business house can never be good news for an economy catering to 170 million people. The corporate governance and risk management frameworks do not provide necessary safeguards, the World Bank said.
“First, the common practice of having large, overpopulated boards does not facilitate effective oversight of business lines and control functions. The number of independent directors is not sufficient, and often independent directors are selected purely for compliance requirements and they do not exert meaningful influence,” the report states.
Second, the application of “fit and proper” criteria for boards does not ensure that skills and experience in relevant financial operations are commensurate with the activities of the bank.
Third, internal auditors do not always have sufficient technical skills and impact, leaving gaps in banks’ risk management. Lastly, weak regulatory enforcement on the BB side related to related-party lending and continuous default loan restructuring creates a culture of tolerance of regulatory breaches, the World Bank said.
Due to the limited powers of the central bank, the regulatory playing field for public and private banks is uneven, creating barriers to fair competition in the banking sector and posing further risks to financial stability.
“Operational independence of Bangladesh Bank is not prescribed in the law, and it is compromised by interference stemming from the ministry of finance’s broad mandate for financial sector issues.”
Subsequently, banks in Bangladesh have the lowest regulatory capital among the country’s peers, driven by the undercapitalisation of state banks. It said that Bangladeshi banks had a capital-to-risk-weighted assets ratio (CAR) of 11.6%, substantially below all the peers. The CAR in China is 14.64% and in India is 15.42%. The rate in Cambodia, Thailand and Indonesia is 21.77%, 19.35% and 23.31% respectively.
State owned banks, both specialised development banks and state-owned commercial banks, are severely undercapitalised, according to the report. The rate for state-owned commercial banks was 4.3% in 2020, below the regulatory minimum requirement of 10%.
Lower quality of assets and high operating costs have also led to bank profitability decreasing in Bangladesh, which leads to the lowest rate of return on assets at only 0.68%.
The report goes on to call for the operational independence of the central bank to be enhanced, so that it has adequate powers for dealing with potential ‘bank distress’ in a timely and cost-effective manner.
It also confirms what numerous economists from Bangladesh have been saying for a long time, even as new banking licences continued to be doled out by the government to its favoured parties. The banking sector is already overcrowded, and there is now an urgent need to strengthen the licensing framework so that fewer get handed out, and encourage consolidation.
In terms of financial depth and access, all of Bangladesh’s structural and aspirational peers have better developed financial institutions.
Will they listen?
Before asking journalists to present the problems in writing, the finance minister would actually do well to perhaps ask his fellow member of the cabinet, someone who had a reputation for brilliance as a career civil servant, before stepping into politics – Planning Minister MA Mannan. A rational thinker, Mannan is recognised for being receptive to data and facts, and knowing how to deal with large troves of information in an organised way.
Given that he was first inducted into the cabinet as the state minister for finance, under the late A.M.A. Muhith, and followed it up by taking over the Planning Ministry from Mustafa Kamal once he got the Finance portfolio, you cannot help but wonder if he would have been a wiser choice as finance minister for Sheikh Hasina. Given Kamal’s non-performance over the last four years, it is difficult to see him get an extension, provided the Awami League return to power in the next elections. There are also strong suggestions that his non-performance is down to health reasons, although no further detail is available on this. What we do know is that Kamal suffered a health scare around the time of his very first budget, i.e. June 2019. And ever since, he has never been as visible and on-the-job as people may expect, from what they have seen with previous finance ministers.
In his remarks as chief guest at the launch of the World Bank’s report last September, the planning minister acknowledged the pressing need for banking sector reforms, instead of getting overly defensive and clamming up.
“I can see lots of failure in this sector,” Mannan said. He went on to express his disappointment in the private sector banks. “I had a hope that the private sector would be so big and aggressive and nimble that the state banks would quietly dissolve and die. But the private sector banks have not done so well.”
A chequered history of reform
Financial sector reforms in the country started in the mid-1980s through the work of the Money, Banking and Credit Commission, including the denationalisation of banks, licensing of private commercial banks, use of back-to-back letters of credit, and introduction of micro-credit for the poor, said the World Bank report.
The reforms accelerated in the early 1990s with interest rate deregulation, restructuring of the banks’ operational procedures, and introduction of a loan classification system and provisioning framework as well as capital adequacy standards, it notes.
According to the World Bank, in the late 1990s, the reforms continued with improvements in the regulatory and supervisory framework of banks, assigning greater powers to the Bangladesh Bank. Bangladesh also progressed in adopting the Basel regulations, with the introduction of risk-weighted capital adequacy minimum requirements in 2007 as well as other prudential norms.
Further, to improve financial inclusion, the Credit Information Bureau (CIB), established in 1992, was automated in 2009. More recently, transformational advances have been made in the areas of digitisation and payment system infrastructure. But then comes the kicker:
“Despite this remarkable progress, in the development of financial institutions and financial markets, Bangladesh still lags behind its structural and aspirational peers,” the report adds.
As a starting point, the World Bank went on to call for an overhaul of primary legislation such as the Bank Company Act (1991) and the Financial Institutions Act (1993) to bring it in line with international best practices, including the provisions for resolution of problem institutions with minimum cost to the budget. It has also suggested clearer definitions of terms such as “controlling interest” and “ultimate beneficial ownership”. It also took issue with the deficient definition of “related parties”, that allows the real size of related-party lending to be masked.
But is the political will there to push through these changes? We’ll have to wait and see.
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