Financial inclusivity and the banking sector

Financial reforms have been on a reverse gear in Bangladesh. The latest being the announcement to return to a regime of interest rate repression. Following the easing of loan classification and write-off standards and announcing generous rescheduling facility to the defaulters last year, this is yet another attempt to return to a financial regulation regime that we successfully got out of several decades ago.

A story of reforms

The financial sector turned around following a series of reform programmes in the 1990s. Legal, policy, and institutional reforms improved the regulatory and governance environment and enhanced the ability of bank owners, management and regulators, and the markets themselves to provide for better governance and regulation. The domination of the banking system by the State-owned Commercial Banks (SCB) declined while Private Commercial Banks (PCB) and Foreign Commercial Banks (FCB) gained market share, increasing competition in the banking industry. The private sector banks have consistently outperformed specialised banks and SCBs in terms of growth in deposits, bank advances and other banking services.

Banks were heavily burdened by high levels of nonperforming loans (NPLs) accumulated over many years due to weak management of the SCBs. Priority lending to loss-making state-owned enterprises, a deficient legal and debt recovery framework, weaknesses in loan screening and supervision, lack of accountability of bank officials, and a weak credit culture undermined good management. The share of NPLs rose steadily from 1972 onwards with the gross NPL ratio to total loans in the banking system peaking at 41.1 percent in 1999. The SCBs and Development Financial Institutions (DFI) recorded the highest NPL ratios. Directed lending programmes led to a massive build-up of poor-quality loans in the 70s and the 80s. Banks were reluctant to write off the long-lasting bad loans mainly due to sub-standard underlying collateral and fear of probable legal complications.

The government adopted several measures, dating back to the 1980s, to ensure better policy framework for managing NPLs. Administrative and judicial measures for solving problem loans of SCBs and DFIs suggested by the National Commission on Money Exchange and Credit, formed in 1986, were heeded to. The Financial Sector Reform Project in 1990 supported enactment of different laws and regulations to expedite settlement processes. A concrete loan recovery policy for SCBs was put in place based on recommendations from the Banking Reform Commission in 1996. The Structural Adjustment Performance Review Initiative in 2000 concentrated on better loan screening and monitoring standards of individual banks while the Credit Risk Grading Manual in 2005 made the Credit Risk Grading system mandatory for analysing credit risk. SCBs were corporatised in 2007 and the minimum capital adequacy ratio was increased from 9 to 10.  Measures were adopted for tightening loan classification and establishing provisions more in line with international practices. Key provisions in the Bank Companies Act were amended in 2013 to provide the BB full regulatory and supervisory control over the SCBs. The financial reporting of bank branches was automated in 2014. Banks implemented Risk Based Capital Adequacy guideline formulated in line with Basel-II and started adopting Basel-III.

NPL reduction was achieved through provisioning and write-offs and by a sharp reduction in new NPLs. Enhanced legal powers of the banks to collect problem loans and better screening of new loans improved the NPL ratio. NPL recoveries improved significantly after 1999, leading to steady decrease in the NPL ratio to 6.1 percent in 2011. Greater legal powers of the banks to recover problem loans through the money loan courts and better screening of new loans by the Credit Information Bureau contributed.

The slide back

Bangladesh's financial system deepened notably in the past decade, with private sector credit increased from 30.9 percent of GDP in 2009 to 39.8 percent of GDP in 2019. The improvements came mainly from banks, driven by better access and improved operating efficiency. Good access reflects a relatively wide network of ATMs and bank branches per 100,000 adults. Bangladesh's strong economic performance has been historically supported by rapid private sector credit growth. However, the correlation between the change in the private credit to GDP ratio and real activity is diminishing. The degree of co-movement of financial and real variables has weakened while the credit intensity of growth is on the rise. NPLs rebounded to 10 percent in 2012 and further to 12 percent in September 2019. This indicates growing resource misallocation. The deterioration of credit quality, with NPLs significantly increasing in recent years in the context of weakly capitalised banks, raises concerns about the capacity of the financial sector to continue supporting economic growth.

Increased regulatory forbearance of the kind seen recently in Bangladesh compounded the problem of NPLs. The fundamental causes of resurgence of NPLs include weak corporate governance practices, risk management systems and regulatory failures. Country experiences have shown that moral hazard thrive where the owners of undercapitalised banks have little shareholder capital to lose from risky investments. Weakening asset quality has undermined the intermediary role of banks. So far, the regulator's strategy for resolving the NPLs problem has been to allow the defaulters an exit route by relaxing the application of regulatory codes and repeated rounds of re-capitalisation of public sector banks. Neither strategy has paid any dividend yet. Almost all of the loans rescheduled in 2015 defaulted one year after they were rescheduled. Similarly, indiscriminate re-capitalisation of public sector banks without a credible commitment to improve governance and disinvest over time, created a vicious cycle of moral hazard and weak micro-prudential regulation. Although re-capitalisation plans have been linked to performance targets of the state-owned banks in theory, the links have not been enforced due to various intervening forces.

Two amendments of a dubious nature were made to the Banking Company Act in 2018 undermining the cause of good governance. The tenure of banks' board of directors increased from six years to nine years, while up to four family members were allowed to be on the board, instead of two. Repeated violations of bank policies have led to their current dilapidated state.

In the context of a remarkable history of reform success, how do we make sense of the reform reversals seen in recent years? These reversals demonstrated the key vulnerabilities of the financial sector and the regulatory architecture governing it with the government invoking both formal and informal mechanisms to issue directions to the BB. We know that elites have a disproportionate influence on any reform process and associated outcomes. The elites are also not a homogenous group. The functioning of the financial sector affects different elites differently. Some benefit directly from blocking financial sector inclusion. However, the elites controlling financial institutions have a direct interest in expanding their activities.

Similarly, large manufacturing firms need significant external finance and thus a developed financial sector. When the banking system is in part controlled by the State, elites can use it as a powerful economic lever in their political competition. The bureaucracy plays their part in determining who gives and receives credit, and at what price, offering various rationales for maintaining such a system. What is in the interest of one class of elites is not necessarily in the interest of others.

What determines which group wins the battle of the elites? Raghuram G Rajan and Luigi Zingales (2005) observe from their extensive research that in intermediate regimes of partial democracy, the balance of power tilts towards some economic elites who are able to "capture" the government with greater ease and adopt policies that simply maximise the interests of the same elites. Acemoglu and Robinson (2008) defined these regimes as "captured democracy". Such privileged elites may block reforms in specific areas, while reforms can still proceed in areas where they have no strong vested interests or where they in fact gain from reforms.

What makes elite control a problem?

If accountability of institutions is weak, elite capture can happen even under limited government where the authority of public officials is constrained. Such institutions can be subject to elite capture and favour connected interests. Connected individuals inevitably use it to obtain preferential access to capital, in particular from, but not limited to, the state-owned banks. The consequent weak financial regulation and enforcement limit access to finance for less established competitors.

The financial sector contains a number of very large institutions organised into powerful banking associations. They can afford lobbying through well-prepared participation in public debate on regulatory measures. Finance is necessarily characterised by asymmetric information between banks and their clients, and by systemic effects. Risk is an inherent feature of the industry. Confidence effects among banks and between banks and their creditors create various forms of externality. Other externalities arise because of competition. The competitive behaviour of banks varies depending upon their financial condition. Sound banks have lower funding costs and weak banks compete more aggressively. The regulations favoured by the key players may promote financial stability and largely coincide with what would promote overall efficiency if they perceive such regulation is in their self-interest. Often, they are not so perceived.

Politicisation of entry and excessive forbearance of risky lending lead to inefficiency and stability risks. Political influence led to allowing new banks without extensive scrutiny in recent years. Several of these fourth-generation banks suffered a severe liquidity and capital adequacy crisis. These had to be bailed out by the government. The costs are borne largely by a subset of institutions whose interests diverge from the users of financial services and those seeking financing who have less ability to exercise influence over regulators. The ability of just a few business interests to capture the regulator may be enough to undermine the public's confidence in the competence of the banking regulator.

When people lose trust in formal financial systems, they keep their savings in un-regulated or under-regulated investment avenues, making them more vulnerable to fraud. Anecdotal evidence suggests a number of weak PCBs are plagued by insider lending and other owner abuses.

The political capture of the regulatory entity prevents proper resolution of failing banks. While there is an explicit deposit insurance scheme, it has never been used. BB has de facto extended an implicit guarantee to all banks. Over the past years, no domestic bank has been allowed to fail. Weak banks are referred to the Problem Bank Monitoring Department within BB where they are subject to special supervisory oversight, certain regulatory restrictions and regulatory forbearance. These produce systemic inefficiencies. Larger loan loss provisions of weak banks drive up the spread between lending and deposit rates, allowing other healthy banks to enjoy rents in the form of higher profits.

The drift towards extractive institutions

In their "Why Nations Fail: The Origins of Power, Prosperity and Poverty", Daron Acemoglu and James Robinson, suggest that countries can be bedevilled by economic institutions "structured to extract resources from the many by the few and that fail to protect property rights or provide incentives for economic activity." The banking sector has historically been a target for extractive elites in many economies. The wealth of the financial industry gives them enormous lobbying power, including as contributors to political campaigns or to ruling parties. A narrow elite seizes control of bank regulation to prevent broad based financial inclusion. 

Sustained economic reform requires a framework of long-term policy to which the government can credibly commit itself. But the backsliding in the reform process is eroding most of the structures of institutional insulation of long-run economic management decisions against the wheeling-dealing of day-to-day politics. There are very few assurances that commitments made by the government will be kept even by itself under pressure. The pressure comes from insiders who have a strong incentive to block or reverse financial reform as financial development improves the conditions for entry of new players, thus challenging rents of the insiders through increased competition.

Can we still hope?

Bangladesh's financial sector development lags those of peer economies. Dealing with symptoms of a financial crisis before the crisis becomes full blown requires swift action to maintain stability and confidence in the banking system. Within Bangladesh's political elites, the leadership at the top plays a decisive role in shaping the policy. A leadership committed to reforms faces resistance from three quarters: opponents within and among the supporters of the government, those in the opposition, and the vested interests that expect to lose from the policy change. A determined leadership can often overcome resistance from all three sources.

The focus on regulation and corporate governance of banks is important given the prevailing dominant role of banking institutions as a source of finance for the corporate sector and the SMEs. Improved board structures, administrative procedures and disclosure requirements could result in better governed banks, which are more likely to allocate capital efficiently. The evolving discourse on financial regulatory reforms recognises that the motivation for state intervention in finance must be guided by an understanding of the sources of market and regulatory failures. The government has been taking on a very active role in the financial system to enhance savings mobilisation, direct credit to priority sectors, and make financial services affordable to larger parts of the population. Through interest rate controls the government is hoping to reduce lending costs for borrowers, while credit quotas are reportedly under consideration to guarantee that financial resources flow to priority and underserved sectors.

Government solutions to overcome market failures have not worked. Bureaucrats have limited expertise to run financial institutions and they are subject to political and regulatory capture. Bureaucrats as bankers have failed almost everywhere, but especially in developing countries. Being owner, borrower and regulator of an institution at the same time, the Financial Institutions Division under the Ministry of Finance face obvious conflicts of interest.

Experience in Bangladesh has shown once again that government-owned banks are often used by politicians to finance commercially unviable government projects or state-owned enterprises. Present approach to financial regulatory reform has been limited to addressing the symptoms. This approach relies on the government to enable and develop markets. 

The role of government has to be redefined to make Bangladesh's financial system more efficient and investment friendly. Beyond ensuring macroeconomic stability and providing an effective and reliable contractual and informational framework, the government should move from the role of an operator and arbiter in the financial system to the role of enabling and creating markets.

Yes, the financial sector suffers from the general governance problems in the economy and the society at large. This actually strengthens the case for putting financial sector reform at the centre of governance reform, since it is here that the money and thus the temptation is. The depoliticisation of financial sector regulation and supervision can send an important signal to the rest of the economy and society and be an important catalyst for governance reforms in other areas.

Zahid Hussein is an economist.