The prerequisites to creating sustainable banking system in Bangladesh

A bank traditionally performs the function of financial intermediation: collecting deposits for lending. To do that, it faces the challenge of electing good borrowers for lending. Similarly, depositors face the challenge of finding good banks, where their deposits will be safe. To attain viability, banks must manage the various risks they encounter in this process of intermediation.

In the banking business, both banks and depositors face the problem of asymmetric information—a situation in a transaction where one party has more information than the other. This may lead to adverse selection where banks fail to distinguish between good and bad borrowers. Depositors also bear the risk of selecting bad banks, as they may not have complete information about their bank's financial condition. Therefore, banks need to select creditworthy borrowers and depositors need to recognise strong banks.

Depositors' savings are at risk when they select a poor-performing bank, being oblivious about its financial condition. For example, once in 2023, Union Bank reported its non-performing loan (NPL) standing at only four percent; later, Bangladesh Bank's audit found it to be 95 percent. Similarly, AB Bank reported its NPL rate to be only 31 percent of its lending portfolio in 2024. Recently, it was unearthed that the rate is as high as 84 percent. The high NPL rate means that depositors of these banks are at serious risk and cannot withdraw their deposits.

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Underreporting NPLs can distort the true picture of a bank's asset quality, capital adequacy, and provisioning levels. Since a lower NPL ratio suggests healthier assets, it reduces the apparent need for capital and loan-loss provisions. Once the actual NPLs are revealed, the capital and provisions are found to be significantly lower than what is required. However, in AB Bank's case, the massive discrepancy in NPL rate did not arise from asymmetric information. Most of these loans were sanctioned, and it was known ex ante that they would default ex post.

Banks collect short-term deposits and make long-term loans, which creates a gap between the terms of deposits and loans. Subsequently, deposits mature earlier than the loans. So, banks have to maintain liquidity—the ease with which an asset can be converted into cash—all the time to meet the demands of withdrawals by depositors. A sudden surge in deposit withdrawals may leave banks in a position to liquidate assets at very short notice and low prices.

Imprudent liquidity management is generally followed by a bank run, where many depositors rush to withdraw their funds. Therefore, it is imperative to reduce the maturity mismatch between deposits and loans by focusing more on short-term loans that are less risky and contribute to the economy. Moreover, their individual impact on the total loan portfolio is minimal.

Banks generally collect small deposits while they grant large loans. Borrowers need large loans because their large-scale businesses require huge capital. However, this process puts depositors at risk if a large loan is defaulted. The larger the loan size, the higher the magnitude of risk.

Large loans are always a threat to bank sustainability. A large loan is often equal to at least 10 percent of a bank's capital and the default of five such loans can eat up half of the bank's capital. Now think about a single borrower exposure where a bank is permitted to grant a maximum of 25 percent of its capital. The failure of four such borrowers can deplete the total capital of the bank.

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Banks should open their doors to the urban poor

A paradox in this country is that, despite the existence of a large number of banks, only 47 percent of people have bank accounts. The rural poor are less interested in maintaining bank accounts, while the urban poor keep their money in informal and semi-formal repositories. It is impossible to have a stable banking system by keeping these people out of the banking network. Just as several banks offer priority banking to large depositors, they must also provide priority banking for the marginalised, since most unbanked people perceive conventional banking unfit for them.

For financial inclusion, banking services should be established in various locations. Banks should offer affordable services to low-income and unbanked individuals. They have to ensure fair banking for all customers, regardless of their background. Another important task is to reinvest deposits from disadvantaged communities back into those communities.

Another area that requires attention is state-owned banks, which have been operating almost without accountability. Their boards are mainly politically appointed; they often apply their power to approve loans, but rarely bear the consequences when those loans go bad. The performance of these state-owned banks is miserable. For instance, Janata Bank's non-performing loans soared to 72 percent and five other state-owned banks averaged 48 percent bad loans. Between 2009 and 2024, the government had to inject more than Tk 25,000 crore as capital to make up for the state-owned banks' capital shortfall, but recapitalisation did not improve their operations.

A culture of accountability and punishment must be established in the banking sector. All parties involved in lending decisions should be held liable for the loans that go into default. Not only the wilful defaulters, the unscrupulous bankers must also be penalised. The salaries and benefits of bankers should be made proportional to their default rates.

Banks must operate in diverse geographic locations with various products to reduce risk. Their service delivery should be innovative, using cheaper technology. They have to avoid credit concentration in a few sectors, such as ready-made garments and megacities like Dhaka and Chattogram, where 78 percent of all bank loans are concentrated. Merger, acquisition and restructuring of banks should be a continuous process so that poor-performing banks bear the threat of being acquired or merged. For transparency, a bank must disclose all the components of lending interest rates to its borrowers. These must be carried out to establish a sustainable banking system that will protect depositors' savings and promote public confidence. If public confidence in the banking system is lost for any reason, its economic and social costs will be enormous and restoring the confidence will be extremely difficult.

Dr Md Main Uddin is professor and former chairman of the Department of Banking and Insurance at the University of Dhaka. He can be reached at [email protected].

Views expressed in this article are the author's own. 

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