Financial Sector Review - World Banksiteresources.worldbank.org/PSGLP/Resources/overview.pdf ·...

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Overview and Executive Summary 1 The SBs are often called development financial institutions (DFIs). The respective specialized aspects of these banks are described in Chapter 4. Financial Sector Review Volume 1, Number 1 May 2006 xiii A. Global and Domestic Macro-Financial Environment 1. The Financial Sector in Bangladesh: The financial sector in Bangladesh comprises of four categories of scheduled banks, non-bank financial institutions (NBFIs), microfinance institutions (MFIs), various co-operative banks, insurance companies and two stock exchanges. While Bangladesh Bank (BB, the Central Bank of Bangladesh) has regulatory and supervisory jurisdiction over the entire banking sector as well as the NBFIs, the Securities and Exchange Commission (SEC) exercises similar functions for the Stock Exchanges and the merchant banks. Most components of the financial sector are characterized by a mix of public and private ownership. For example in the banking sector, as of 31 December 2005, there are 4 nationalized commercial banks (NCBs), 5 government-owned specialized banks (SBs) dedicated to agricultural and industrial lending, 30 domestic private commercial banks (PCBs) and 9 foreign commercial banks (FCBs). 1 Of the 28 non-bank financial institutions (NBFIs), only one has significant government ownership, and the rest are in the private domain. The office of the Chief Controller of Insurance has supervision authority over the insurance industry, which currently has 62 firms, of which 44 are engaged in the general (i.e., non-life) line of business while the rest 18 underwrite “life” policies. Each line of the insurance business is characterized by one firm in the public domain. All the rest are private entities (including the lone foreign entity in the life sector). The microfinance institutions (MFIs) are still largely unregulated, while the co-operative banks are under the supervision of the Registrar of Cooperatives. However as reviewed later in this Review, the pace of activities in the cooperative system has of late slowed down markedly. To put the Bangladesh financial sector in a regional perspective, note that the combined share of banking and insurance in the country’s GDP has stayed in the range of 1.5 to 1.6 over FY02 to FY05, while in India this was the case in the late 60s/early 70s. The Indian share between FY99 to FY04 has averaged 6.7 percent, i.e., a multiple in excess of 4 vis-à-vis that of

Transcript of Financial Sector Review - World Banksiteresources.worldbank.org/PSGLP/Resources/overview.pdf ·...

Overview and Executive Summary

1 The SBs are often called development financial institutions (DFIs). The respective specialized aspects of these banksare described in Chapter 4.

Financial Sector ReviewVolume 1, Number 1

May 2006

xiii

A. Global and Domestic Macro-Financial Environment

1. The Financial Sector in Bangladesh: The financial sector in Bangladesh comprises of four categories of scheduled banks, non-bank financial institutions (NBFIs), microfinance institutions (MFIs), various co-operative banks, insurance companies and two stock exchanges. While Bangladesh Bank (BB, the Central Bank of Bangladesh) has regulatory and supervisory jurisdiction over the entire banking sector as well as the NBFIs, the Securities and Exchange Commission (SEC) exercises similar functions for the Stock Exchanges and the merchant banks. Most components of the financial sector are characterized by a mix of public and private ownership. For example in the banking sector, as of 31 December 2005, there are 4 nationalized commercial banks (NCBs), 5 government-owned specialized banks (SBs) dedicated to agricultural and industrial lending, 30 domestic private commercial banks (PCBs) and 9 foreign commercial banks (FCBs).1 Of the 28 non-bank financial institutions (NBFIs), only one has significant government ownership, and the rest are in the private domain.

The office of the Chief Controller of Insurance has supervision authority over the insurance industry, which currently has 62 firms, of which 44 are engaged in the general (i.e., non-life) line of business while the rest 18 underwrite “life” policies. Each line of the insurance business is characterized by one firm in the public domain. All the rest are private entities (including the lone foreign entity in the life sector). The microfinance institutions (MFIs) are still largely unregulated, while the co-operative banks are under the supervision of the Registrar of Cooperatives. However as reviewed later in this Review, the pace of activities in the cooperative system has of late slowed down markedly.

To put the Bangladesh financial sector in a regional perspective, note that the combined share of banking and insurance in the country’s GDP has stayed in the range of 1.5 to 1.6 over FY02 to FY05, while in India this was the case in the late 60s/early 70s. The Indian share between FY99 to FY04 has averaged 6.7 percent, i.e., a multiple in excess of 4 vis-à-vis that of

Overview and Executive Summary (Continued)

2 While the Indian figure actually relates to March 2005, the rest pertain to December 2005. In the Bangladesh case we have used the estimated GDP for December 2005. 3 Year over year change in CPI stands at 1.4 (May) and 5.0 (April), percent, respectively. Only Indonesia features double digit rate of 15.6 (May) percent.

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Bangladesh. On the level of financial deepening as measured by the rate of monetization of the economy, the broad money (M2) to GDP ratio in Bangladesh currently stands at 41 percent, while the M3/GDP ratio is substantially higher at 65 percent in India as of June 2005. In terms of the stock market capitalization, the comparability is even weaker; market capitalization in 2005 in the Dhaka Stock Exchange (DSE) stood at 5.8 percent of GDP against 54.7 percent for the Bombay Exchange, 42 and 23 percent for the Karachi and Colombo markets, respectively.2 The development of the insurance sector is comparable to that of Pakistan, but lags both Sri Lanka and India by a considerable margin. The total premium income to GDP reached a mere 0.62 percent in 2004 (against 0.67 percent in Pakistan). The relevant figures for India and Sri Lanka were 3.08 and 1.49, respectively. The issues holding back the financial development in Bangladesh vis-à-vis those of its neighbours are important to disentangle, and this Review offers a preliminary analysis in the appropriate chapters and sections that follow.

2. World Macroeconomic Outlook: While growth had slowed in calendar 2005 vis-à-vis 2004 in the major seven OECD countries, it still recorded a respectable figure of 2.6 percent. The US, which is the principal destination of most of Bangladesh exports, grew by 3.5 percent in 2005. Of course, growth has been even faster in Asian countries like China, India, Pakistan, and South Korea, all of which are indeed competitors in the market for Bangladesh exports, and in turn are among the major sources of national imports. Buoyed by robust performance of US and Japan, the major seven OECD countries have also maintained the growth momentum in the first quarter of 2006 (at 2.9 percent on year-over-year comparison). Regionally too, growth is likely to be robust in 2006. First quarter growth in China, India, Indonesia, Malaysia, and Thailand has been (again, year-over-year) 10.2, 9.3, 4.6, 5.3, 6.0 percent, respectively.

Inflation however is a potential risk to the OECD growth momentum. CPI inflation reached 4.2 percent in the US, although the core rate (i.e., CPI minus food and energy) remains at 2.4 percent as of May 2006 (year-over-year), which is being judged to be on the high side. Consequently, the federal funds rate appears poised to go even higher from the current level of 5.0 percent. Inflation elsewhere presents a mixed picture, with a slight uptrend in Japan and the EU region. Faster growing countries in Asia however, do not appear to indicate any cause for alarm with inflation remaining well contained in China and India.3

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4 The deficit in US current account has increased to 6.4 percent of GDP in 2005 from 5.7 percent in 2004.

While there has been a correction of stock prices of late, possibly on account to inflationary fears among other, many exchanges (notably China) have retained a large part of the gains since the end of 2005. Even though the faster growing country’s bourses have registered high growth over the past several quarters, the overall exuberance appears contained by historic standards. However, the large and persistent imbalances in the US and Chinese current accounts, large US budgetary deficit, and the sustained tension in the world oil market are among the primary sources of uncertainties over the immediate future.4 But there are signs that the central banks around the globe including those in emerging Asia are increasingly adopting responsible postures in dealing with the crisis. Currency alignments, though far muted than necessary, have been moving in the right direction. Overall financial markets in the East and South Asia region appear conducive to growth even though several countries appear to have a greater proportion of poorly functioning bank assets (e.g., in terms of high non-performing loans) than others. However such weakness of corporate governance is unlikely to destabilize regional financial markets as a whole.

3. Recent Bangladesh Macro-Financial Developments

(i) Background: Financial intermediaries essentially involve the transfer of funds in exchange of goods, services, or promises of future return. Development of the financial sector raises the overall efficiency of financial institutions. As argued by Levine (1997), a developed financial system reduces transaction costs, information asymmetries, market frictions and pools risk. Such a system can be a stimulant in accelerating economic growth by mobilizing savings and facilitating investment in an efficient manner. By reducing risk and vulnerability, it increases the ability of individuals and households to access basic services like health and education, thus having a more direct impact on poverty reduction. Launching an assessment of the overall financial sector in the form of the bi-annual Financial Sector Review (FSR) by the Bangladesh Bank (BB) can be seen as a significant step in guiding the future course of financial policy in the country.

Over the past decade and a half, the monetary authority of Bangladesh has pursued a series of legal, policy and institutional reforms to improve the process of financial intermediation and ensure efficient allocation of financial resources, which in turn is expected to improve the competitiveness of the private sector and promote investment and growth in the real sector. The thrust of the reform program has been to improve the environment for, and the ability of bank owners, bank management, bank regulators and the markets to provide better governance and regulation to achieve the above-

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5 While the 12-month moving average general consumer price index (CPI) has remained stable at about 7-precent of late (vis-à-vis 6.49 percent at the end of FY05), the low figure for the weighted average deposit rate is mainly due to a large amount of zero-rated deposits in the banking system. 6 However, data for FY98, FY00 and FY02 suggests that the growth of public and private sector credit have been in the opposite directions in these selected years, which need not be suggestive of crowding out, rather the limited capacity the private sector to utilize credit.

mentioned objectives. The reform program focuses on: (i) greater autonomy of BB, (ii) strengthening of BB's capabilities and technical skills to perform its enhanced responsibilities, (iii) strengthening prudential regulation and supervision, (iv) restructuring the management and internal processes of NCBs and ultimately the privatization of NCBs, (v) strengthening the legal and judicial processes, and (vi) improving the money and debt markets. All these elements have been reviewed in some detail in the Monetary Policy Review (MPR) released by BB on October 2005, and, as appropriate, are further analyzed in the present document (FSR).

(ii) The Interest Rate Structure: With a reversal of the declining trend in recent years, nominal lending and deposit rates in the economy have both started to increase since April 2005. However, (weighted average) real lending rates have continued to fall, and the real deposit rate became negative starting from June 2004 due to inflation.5 The high spread (i.e., typically between 5 and 6 percent in the private domestic banks) between average lending and deposit rates remains a matter of concern. At the same time, the most recent increase in interest rates in the commercial banking system (following an increase of 150 basis points offered by the government in December ’05 on its 3- and 5-year savings certificates) in the face of a stable inflation outlook, appears unsustainable. The consequent adjustment in the lending rates may affect the competitiveness of the industry, and discourage private investment and commercial operations. However available evidence points to continuing steady demand for private credit.

(iii) Government Borrowing and Private Sector Lending: In order to finance deficits the central government borrows from domestic and external sources. Historically net foreign financing of the national budget deficit has dominated domestic financing in Bangladesh (e.g., over FY92-05). Among the domestic sources, government borrowing from the non-bank public has been increasing over the last seven years while borrowing from scheduled banks and the Central Bank has followed an irregular path. While significant net public borrowing from domestic sources would in principle lead to an increase in the market interest rate, the evidence of the latter’s effect on economic activity, as well as the effect of public borrowing in displacing private sector credit, appear inconclusive in the Bangladesh context.6 In the face of a highly variable growth pattern of public borrowing, private sector credit has grown in a stable manner since FY 97.

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On the mix of domestic versus foreign financing of the budget deficit, data for FY06 to date (i.e., July-March) indicates a deviation from the trend; domestic financing has far exceeded foreign financing. This has presumably been caused by the high cost of energy imports and a concomitant decline in the realized level of official development assistance. While nominal credit growth thus far in this fiscal year has exceeded the target, it has been in line with rate experienced in the last fiscal year. In terms of foreign exchange (which is relevant for import demand) however, the currency depreciation implied that the effective growth of private credit has been slower than the previous year’s level. The most recent episode of enhanced public borrowing from the non-bank public has been accompanied by steep increase in the interest rates in the commercial banking system. It would be important to assess the consequences on aggregate demand both from the interest rate channel as well as from the perspective of the substitutability/complementarity of public and private spending.

(iv) Balance of Payments and the Foreign Exchange Market: Moderating import growth coupled with steady export growth narrowed down the trade deficit by 362 million USD at the end of July-March period of FY06 over the corresponding period of FY05. However a sharp rise in the services account deficit largely offset the improvement in the trade balance. It was worker’s remittances, which increased by 654 million USD during the nine months of FY06 over the matching period of the previous year that turned the current account deficit to a modest surplus. In spite of this surplus, overall balance fell into a small deficit of (-) 37 million USD, due to a large shift in the financial account, which turned into a deficit account of (-) 78 USD million in July-Mar period of FY06 from a surplus of 1297 million USD during the same period of the previous fiscal. This deficit in the financial account is attributable to maturing deferred payment on account of FY05 oil imports and a substantial reduction in the inflow of Medium and Long Term (MLT) loans coupled with sizeable net outflow of short term loans and trade credit. Thus despite considerable growth of remittances and exports, BDT underwent nominal depreciation against USD of 8.8 percent over the period in review, engendering some short-term instability in the foreign exchange market.

(v) Micro-Finance and SME access to Funds: Traditionally low-income families, small and medium size enterprises (SMEs), and rural entrepreneurs in a developing country like Bangladesh have difficulty obtaining financial services. Microfinance has proven to be a powerful weapon to reduce pervasive poverty. Bangladesh, a pioneer in the field, has witnessed a significant uptrend in microfinance activities over the last two decades. Development of this sector has been mainly driven by the NGO-MFIs. However, public initiatives to energize microfinance activities, especially through the creation of the apex organization Palli Karma Shahayak

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7 The name Palli Karma Shahayak Foundation may be translated as Rural Employment Facilitating Foundation.8 Cooperative Bank Statistics, Bangladesh Bank, 2001.

Foundation (PKSF) as an on-lender, mentor and coordinator, have been of considerable importance.7 In terms of issues such as outreach and gender empowerment, microfinance has met with outstanding success in Bangladesh as well as globally. Most recent data indicates that about 1000 NGO-MFIs are active in Bangladesh, of which over 90 percent are of local origin. Out of top 15 MFIs by number of borrowers among all developing countries (as of 2003), 10 come from Bangladesh with 5 of these being included in the top 6. These 10 MFIs serve 38.8 percent of the total number of borrowers of the developing world, i.e., about 12 million borrowers in Bangladesh of which over 90 percent are women.

The cooperative movement seems to have stalled, however. Available data from 107 banks report a total of about 68,000 account holders. However the average deposit is a mere 3 Taka while the amount of advance per account is also meagre at 35 Taka.8 The average advance figure is therefore insignificant compared to the average loan of several thousand Taka in microfinance even for new borrowers.

Access to Finance by SMEs: There is evidence that small and medium enterprises (SMEs) can play a vital role in attaining sustainable growth and reducing unemployment. However banks perceive lending to SMEs both costlier and riskier than those involved in processing larger credit sizes. While many MFIs cater to the micro enterprises, which often originate from prior micro lending, there are no dedicated institutions that specialize in SME finance. Recognizing this gap, BB has been coordinating a number of donor initiatives in the provision of loan guarantees to SMEs. Along with the government, private and foreign commercial banks, the non-bank financial institutions and selective MFIs are nurturing this sector through the provision of loans and counsel.

(vi) The Insurance Industry: Over the recent period insurance penetration in the life insurance sector shows an increasing trend, while the general insurance sector appears to be stagnant. Both state and private sector insurance companies are facing increasing competition over the years in underwriting new businesses. Public sector insurance companies (both life and general) have been losing businesses to the private sector companies mainly due to the formers’ business as usual approach and an apparent lack of motivation to flourish. The regulatory authority needs to implement an effective monitoring and supervision system, and thus guide the industry in sound management of businesses, thereby enhancing its role in the development of the financial system of the country.

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(vii) The Extent of Financial Development in Bangladesh: The degree of financial development and efficiency does not provide any meaningful signal to the policy researchers unless some sort of international comparison is made. In this Review, the extent of the development in the financial sector of Bangladesh has been analyzed with reference to some of the South Asian countries as well as other low income countries. It is seen that for indicators such as (a) domestic credit to the private sector as a ratio of GDP, (b) liquid liabilities to GDP, (c) ratio of bank deposits to GDP in Bangladesh are fairly close to the South Asian average and are significantly higher than the averages for low-income countries, though staying behind India in each of these categories. Per capita banking penetration as also below the South Asian average, though per unit area it is the highest (due to high population density). The net interest margin indicator performed significantly well which is the lowest in Bangladesh among the comparator group although it is due to high relative costs of intermediation. Also of note is that ATM penetration is significantly lower in Bangladesh due to its late start. Other segments of the financial system, such as the insurance sector and the stock market, as noted above, are substantially less developed than in major South Asian countries.

With a view to investigating the historical evolution of the above indicators of financial development and its association with investment activities (measured by fixed capital formation as a percent of GDP denoted by i_y) as well as per capita income (denoted by y_pcap) annual data during 1976-2005 are used. The scatter-plots of the three indicators of financial development vis-à-vis investment as well as per capita income strongly support the hypothesis of co-movement between financial development and economic activity (Figures 1.4.6 and 1.4.7). Besides, an almost linear relationship is observed in another scatter-plot diagram between investment-GDP ratio and per capita income (Figure 1.4.8).

B. Supply of and Demand for Financial Products

4. Background: In terms of development of the financial system, in particular the depth and breadth of various services, Bangladesh is not at an advanced level. After allowing private sector banking in the early 1980s, the government launched a comprehensive financial sector reform program (FSRP) in 1990. It is also in the 1990s that the central bank started issuing licence to non-bank financial institutions who are typically engaged in housing and lease finance. However already many innovative financial products have been launched.

5. Payment and Transaction Products: The chief innovation over the past five years in the payment and transaction modalities through the banking system has been the emergence of credit/debit card use. Survey data

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indicates that while the scope of wire transfer has remained stable (accounting for about half of all transactions in volume terms), the role of chequing accounts has fallen, and the room has been taken up by the credit /debit card transactions. From virtually nil (one fifth of one percent) at the end of 2001, its share has gone up to 8 percent of all transactions (again in volume) by December 2005. In the case of ATM use, it is the private sector banks (PCBs and FCBs) that account for 97 percent of all transactions.

6. Saving Products: Commercial banks in the Bangladesh financial system offer a good number of saving products for deposit mobilization. The major products are savings deposits, short term deposits, fixed deposits of various durations, pension scheme deposits and others including certificates of deposit. The growth of deposit mobilization by type of banks shows a mixed trend during the last five years. After a decelerating trend in deposit growth during the period of 2001-2003, total deposits increased by 17.09 percent in 2005 from 13.40 percent in 2003. Even in real terms, the typical industry growth has been in double digits over the last five years. Total deposit mobilization as a percentage of GDP by the banking system has been growing over time. The ratio was 29.61 percent in 1990 which grew to 39.27 percent in 2005. From the cross-country analysis, it is evident that deposit-GDP ratio of Bangladesh was higher than that of Pakistan during 2000-2003, and the ratio was about the same as that of Sri Lanka in the last three years. However these figures are well below the ratio for India (of close to 60 percent). However, the Bangladesh trend is indicative of growing monetization of the economy as well as the growing confidence of the public in the banking system.

7. Loan Products: In recent years, credit disbursement of scheduled banks in aggregate as well as for most individual bank groups has followed an increasing trend, though credit disbursement by NCBs has fallen off both in real terms and as industry share. The rise in the credit disbursement of scheduled banks is prompted by the growth in advances originating primarily from higher economic activities. Advances (in real terms) disbursed for major economic purposes follow a stable pattern with the growing importance of “working capital for the industrial sector”. Between FY04 and 05, the credit share of this sector to national GDP rose from 5.25 to 5.99 percent, i.e., the market share rising by 12.5 percent. The increasing participation of the household sector in accessing consumer credit (especially the use of credit card loans), while still modest, is indicative of greater financial intermediation in aggregate consumption.

8. Specialized Loan Products: Disbursement of term lending grew at an annual average rate of 38.2 percent over the last three fiscal years and

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9 Though in the case of loans for agriculture and export, and term loans to SMEs, some directives continue to apply to this day. 10 The two measures differ essentially in that in the first one the "weighted average deposit rate" is scaled by the total deposit in the system, while in figuring out NIM one uses "total bank assets" as the scaling variable both for "interest expenses" as well as for "interest income".

outstanding term lending to the industrial sector stood at 237.6 billion taka during the first quarter of FY06. Growth of term lending was mainly contributed by the PCBs which disbursed 55 and 13.3 billion taka respectively in FY05 and during the first quarter of FY06. Project and infrastructure financing has slowed down by FY05 showing a negative real growth rate of credit to the “transport and communication sector” as compared to FY02. Though outstanding credit to power and energy sector grew in real terms, its share in total term lending is small. Banks and NBFIs are increasingly being engaged in housing finance to meet the growing demand for urban housing. Housing finance by banks and NBFIs grew at an average real rate of 12.4 and 23.7 percent, respectively, over the last three fiscal years whereas the contribution of House Building Finance Corporation (HBFC), a public sector entity, decreased over the same period.

C. The Banking Sector

9. Background: The financial institutions taken over by the government after liberation turned out to be passive instruments of the governments' economic objectives. The directed lending policies required banks to expand fast into the rural sector and to channel credit into agriculture and other production oriented 'priority' pursuits at concessional lending rates; there were detailed sectoral credit restrictions, ceilings and curbs on lending for 'non-priority' purposes. In the urban sector, banks were directed to continue financing loss making public enterprises; and industrial term loans to the private sector by SBs were heavily influenced by external pressure. Eventually, loan default and loan delinquency became commonplace. To reverse the situation and in order to induce a market environment where financial institutions would compete to mobilise savings and seek its efficient allocation, major reforms were put in place starting from 1990. These related to interest rates liberalisation, abolition of sectorally directed lending and abolition of sectoral refinancing from the central bank.9

10. Interest Rate Spread: In the banking literature the concept of “spread” has been variously interpreted. First there is the difference between the weighted average lending and deposit rates. However, an alternative concept of net interest margin (NIM) is often more prevalent.10 NIM is typically defined as the difference between “interest expenses” and “interest income” per unit of “total bank assets”. This is believed to be an important

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indicator of intermediation efficiency. Ordinarily as the banking industry matures and competition prevails, NIM should gradually decline, especially in the industry segments that are not subject to pubic directives.

The weighted average spread for both PCBs and NCBs have followed a rather similar and stable path (i.e., between 5 and 6 percentage points) over the past six quarters or so. For SBs it declined during FY04, but stabilising at about 4 percentage points over the past 12 months or so, the lowest spread among all the major bank groups in the country. Conversely, the spread for FCBs has gradually increased from the fourth quarter of FY04 for the next 6 quarters before easing a bit (but still in the 8-percentage point range) in December 2005. Moreover, it is the highest among all bank groups over the same period.

While in Bangladesh NIM has declined in each of last three years for both PCBs and FCBs, the latter exhibit the highest spread. In contrast the NCBs experience low spread on account of various restrictions that are imposed on their priority borrowers as well as to the interest rates they can charge of these clients. Comparing the private sector banks internationally, the Bangladesh figure would appear high by Asian standards. Hence lowering of the spread would require substantial improvement in the current situation of limited competitive pressures, as well as overstaffing, high administrative costs, and burden of NPLs, which mostly affect the state sector banks.

11. Earnings and Profitability: An analysis of banks’ earnings and profitability shows that the NCBs’ share of the market was the highest in deposits collection and loan disbursements than PCBs, FCBs and SBs before 2002, but private banks have since matured and have taken a lead over the rest in these areas and also in earning interest income. In case of interest expenditure, NCBs also have higher expenditure than other scheduled banks. However, it is interesting to note here that in case of non interest income (bills, commission, brokerage fees) foreign banks raised the most revenue in spite of their low asset-liability base. In terms of ROA and ROE the foreign banks perform the best compared to their competitors. Of late (especially since calendar year 2004) the PCBs have started to close the gap with FCBs in earning profits. Though FCBs still boast of an ROA which is about three times that of their nearest rival, PCBs, in ROE, the PCBs are rather close (19.5 and 16.6 percent in 2004 and 2005 respectively as against 22.5 and 18.6 percent for FCBs). While between groups of banks, there is this sign of emergence of dynamism among the industry leaders in each group, the high sustained profit figures would support the claim that there is not a great degree of competition. Indeed a regime of tacit collusion may explain the maintenance of high level of fees and commissions, high interest rate spread and high profits.

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11 CIB was introduced in 1992, and started operation in 1993. Its database has been expanded to include outstanding loans of BDT 50, 000 and above, and for credit cards the amount is BDT 10, 000 and above. The CIB report is a first useful check on the credit standing of potential borrowers. BB is in the process of modernizing CIB to provide online information.

12. Non-Performing Loans (NPL): NPL has declined significantly from its highest level of 41 percent in FY99 to 14 percent in FY05 due to improvements of legal and regulatory framework initiated by BB. Updated provision for writing off bad loans and the services of BB’s Credit Information Bureau (CIB), for example, have contributed to this process.11 NCBs and SBs however still have significant non-performing loans due to past policies and the continuation of what remains of directed lending to SOEs and priority sectors. Indeed the high NPL ratio for NCBs and SBs especially for industrial term lending and agricultural and micro lending suggests that the underlying model for the delivery of such products is faulty and not meant to be a profitable activity. While the situation is likely to change once the on-going restructuring (and eventual privatization) of NCBs gains momentum, alternative measures require exploration in the interim. Only a major re-focus whereby the relevant agricultural and industrial lending (both short and long-term) is redirected to the private sector (possibly with NGO intermediation in agriculture) may hold the promise of sustainable lending to these important activities.

13. Divestiture of the Nationalized Commercial Banks: With respect to NCB reform, MOUs have been signed with all four of them relating to major issues such the rationalization of credit growth, branch network, classified loans, single-borrower exposure, operating expenditures and human resource development. Management support teams are now in place in Agrani, Janata, and Sonali banks. Given the unfortunate delays already experienced, intensified efforts are underway to ensure the successful divestment of Rupali Bank. All outstanding legal challenges to Rupali Bank’s divestment have been resolved, and the issue of its recapitalization has already been worked out. In addition, at the point of transaction, the government will remove from Rupali’s books and assume full responsibility for the liabilities of existing pensioners and for the accrued rights of current employees, with cash payments made from the government’s budgetary allocation as these payments become due. The eventual majority shareholder will have management control over all aspects of the bank’s operations, including human resource policies and pay scales. With respect to the other three NCBs, the government is committed to bringing Agrani to the point of divestment in the near term.

14. Default Risk, Write Off and Loss Provisions: This study shows that the provision shortfall in the banking sector between 1997 to 2005 fluctuated within the range of about BDT 33 billion to BDT 55 billion (i.e., about 3.5 to 8.4 percent of total lending as of appropriate dates). It reached the peak

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in 2003 (about BDT 55 billion) and then consistently decreased to BDT 45.75 billion in 2005. One of the main reasons behind the downward trend is due to the immediate response by the scheduled banks to the new BB write-off policy, which was introduced in January 2003. As bad loans were removed from the balance sheet by the accumulated provisions, both regulatory provision and actual provisions against classified loans went down sharply. Though actual provision declined by about BDT 23 billion in 2003, bad loans declined by about BDT 42 billion. It can be argued that the Money Loan Court Act, 2003, government’s remission of interest burden (about BDT 5.0 billion) on agricultural credit, relaxation of rescheduling criteria (without collateral) for agricultural loan and provision of incentives to officials of government-owned banks for the recovery of stuck-up overdue loans, among other, might plausibly contribute to reducing a significant part of the accumulated bad loans.

Further analysis excluding NCBs shows that the remainder of the banking sector's performance in terms of provision shortfall and provision maintenance ratio (PMR) improved significantly in the recent period. The PMR was 70.50 percent in 1997 which increased to 82.70 percent in 2005. However, compared to 2004, PMR moved downward in 2005, which was mainly due to one of the PCBs that suffered from acute provision shortfall.

In terms of different categories of banks, two notable features are observed. A significant part of loan portfolio of SBs was short-term agricultural and micro-credits. Since provisioning criteria for these categories of loans are much relaxed than other categories of loans, their provisioning requirement was much less onerous despite the high percentage of classified loans. It is also likely that loans of SBs were highly collateralized than those in the NCBs. Provision shortfall in NCBs remained significantly high since 2003 despite a decreasing trend in its share of classified loans. A significant percentage of bad loans supported by low collateral and their declining trend in profitability, which in turn retarded the build up of their actual provision, is a contributory factor.

It can be concluded that Write-off Policy supported by Provisioning Policy and the Money Loan Court Act 2003, among other, became indeed effective tools to clean up the impaired asset base from the banks’ balance sheets. Consequently, provision shortfall in the banking sector consistently declined since 2003. In terms of regulatory provision as a percentage of banks’ loan portfolios, banking sector in Bangladesh, notably the PCBs, experienced robust performance over the last 8 years. In 1998, the required provision as a percentage of total lending was about 17.6 percent, which came down to about 6.8 percent in 2005. This trend may further facilitate current efforts for restructuring and privatization of government-owned banks such as the NCBs.

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15. Maturity Profile of Assets and Liabilities: The overall increase in the mismatch between 2002 and 2004 is largely due to SBs. Secondly, while the number of banks experiencing mismatch has increased over time, the absolute size of the gap has decreased for PCBs and NCBs. Thus more banks in each of the latter two categories are sharing on average a smaller amount of the gap than two years ago. Hence one can conclude that systematic risk has moderated over time.

16. Capital Base Adequacy: The total capital position of the scheduled banks consistently increased in the last 7 years, except for a small decline in 2004. In fact, the total amount of capital rose from BDT 45.88 billion in 1999 to BDT 90.28 billion in 2005. This increase was caused by several factors such as rising standard of regulatory capital which led to issuing right shares, bonus shares and IPOs, entrance of new banks in the financial market, and the legal requirement to transfer a portion of bank's annual income to its statutory reserve fund. The downward movement in total capital in 2004 was mainly due to the fall of Agrani Bank’s capital that declined by BDT 21.59 billion from the previous year’s position.

Considering the minimum regulatory standards (fixed capital or risk-weighted asset whichever is higher) set by the Bangladesh Bank through different circulars and also by the Bank Company Act (BCA), 1991, it is found that since 1999, the total amount of capital in the banking sector has been consistently below the regulatory requirement. In fact, the gap between regulatory capital and actual capital increased significantly over the years. In 1999, capital shortage in the banking sector was BDT 6 billion which increased to more than BDT 27.99 billion by the end of 2005. They were the NCBs that substantially contributed to this cause. On the other hand, though some of the 3rd generation banks could easily meet the fixed capital requirement (BDT 1 billion) they are yet to approach the capital market. Once this is done, their own position as well as the overall capital position of the banking sector will improve significantly.

In terms of risk-based capital regulation, risk-weighted capital ratio (RCAR) during 1999 to 2005 remained within the range of 6.7 to 8.4 percent, i.e., marginally lower than the regulatory standard. Indeed, significant downward trend of risk-weighted capital ratios for government owned banks such as NCBs and SBs pulled down the aggregate risk-weighted capital ratios. Excluding NCBs, it can be seen that RCAR for the banking sector as a whole remained stable and above the regulatory requirement. Though capital requirement for the period 1999 to 2002 was 8 percent of RWA, actual capital varied between 8.5 to 9.7 percent. As Bangladesh Bank raised RCAR from 8 percent to 9 percent in 2003, actual capital in the banking sector (i.e., minus NCBs) moved up and remained 11.1 to

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11.5 percent of RWA between 2003 and 2005. It can therefore be concluded that except government owned banks, capital regulation was indeed able to guide the behaviour of the scheduled banks in Bangladesh.

The study shows that due to a lack of instruments suitable for inclusion in Tier II Capital, banks kept most capital in Tier-I. This fact points to the primacy of further financial and capital market development. On the other hand, implementation of Basel Accord II may require the banks, particularly the domestic ones, to raise their capital significantly. A gradual and orderly capital adjustment would appear desirable for the overall stability of the banking sector.

17. Banking Sector Outlook: The financial sector reforms were implemented in a generally stable overall macro-economic environment, and the post-reform financial system behaved in a manner that is consistent with broad macro-economic stability. The reforms have successfully put in place an operating environment and a regulatory structure appropriate for market based financial intermediation between savers and investors. Collectively the recent reform measures have started to produce results though with a delay.

The above review reveals that the industry still suffers from limited competition, weak adherence to the regulatory framework (e.g., provision and capital requirement), and a selective but unsustainable (i.e., particularly among NCBs and SBs) exposure to NPL. The latter is in part contributed by excessive borrowing by some loss-making SOEs from NCBs, a process often mediated by various government ministries with or without an explicit loan guarantee. Looking forward, it would appear that industrial term lending and general agricultural loans by NCBs and short-term agricultural and micro credit activities of NCBs require a major overhaul as to program design and delivery. The rising concentration ratio since 1999 among FCBs (with the top firm alone controlling over 50 percent of the sector assets) is also of concern. These indicators may be helpful in the decision to rationalise the structure of ownership of the banking sector as a whole.

D. The Capital Market and the Non-Bank Financial Sector

18. Background: The capital market is meant to play the important role of meeting the long term financing needs of an economy. While industrial financing and capital market institutions in Bangladesh were dominated by the public sector prior to 1971, development of the private sector got added importance given the growing long-term investment needs of the country. Consequently, a number of non-bank financial institutions in the private sector, primarily leasing and insurance companies have come into existence and the private commercial banks have also started to play a

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major role in industrial term financing. Recently, a new trend in non-bank financial sector has been the development of micro-financial institutions.

19. The Capital Market: Participation of the institutional investors is still very limited in Bangladesh. Recognizing the role of institutional investment in capital market development, the Government of Bangladesh (GOB) has amended a number of relevant laws. Securities and Exchange Commission (SEC) laws have been amended in order to encourage private sector-sponsored mutual funds to operate in the market. Further SEC’s Merchant Banker and Portfolio Manager Act of 1996 facilitated the operation of merchant bankers and portfolio managers. A total of 29 companies are now listed as merchant banks in Bangladesh. The first private mutual fund started operating in the market in May 2000. As of June 2005, twelve mutual funds are operating with a total market capitalization of BDT1247.00 million, which is rather low relative to the value of total market capitalization. Government owned Investment Corporation of Bangladesh (ICB) has recently formed three subsidiaries for active participation in the market.

After the 1996 crisis, the market index at Dhaka Stock Exchange (DSE), in fact, started to revive from the first quarter of 2004. However, the performance of DSE in 2005 has been dismal in comparison to 2004. The monthly closing value of the DSE General Index stood at 1843.95 in January '05, which went down to 1510.11 in July '05 before rising to 1677.35 in December '05. Market capitalization at DSE grew at a very slow pace (3.62 percent) in 2005 in comparison to 59.4 percent for the Karachi Stock Exchange (KSE) and 52.9 percent for the Colombo Exchange (CLSE) in local currency terms. Moreover, the present market capitalization of DSE is only 6 percent of GDP vis-à-vis 42 percent for KSE and 23 percent for CLSE at end-December '05. The figure is even higher for India (54.7 percent, in the Mumbai Stock Exchange, BSE).

A total of seventeen companies floated Initial Public Offerings amounting to BDT 3206.9 million of capital at DSE in 2005, of which BDT 1265.7 million were raised from initial public subscription. In recent years, one observes an overwhelming response for IPO shares, reflecting increased public confidence given recent reforms in the stock market and development of IPO distribution system by SEC. One important event for the capital market in Bangladesh in 2005 is that government securities began trading at DSE from January 01, 2005. A total of 18 treasury bonds and 8 debentures are listed at DSE that together comprise of 5.42 percent of total market capitalization. Initiatives should be taken to stimulate the secondary market trading of bonds and debentures that would provide alternative investment options for the public.

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20. Non Bank Financial Institutions: NBFIs are primarily expected to fill the gaps in the supply of financial services that are not in general provided by the banking sector and to complement the financing requirements of the evolving economy. The major business of most of the 28 NBFIs is leasing, though some are also engaged in merchant banking and housing finance. The Leasing Sector has witnessed a growth of 27.64 percent in 2005 (in terms of outstanding lease/loan) over the previous year. The share of classified lease/loans was a little above 6 percent in 2005 which has been decreasing since 2002. Total asset of the leasing industry is growing at an annual average rate of 33.9 percent over the last four years and growth in 2005 was over 45 percent at an annualized rate (data being available up to June). The current ratio (i.e., current assets/current liabilities) of the leasing industry hovered around a little below 2 over the last four years whereas the weighted average debt-equity ratio of the industry was 2.87 in 2005 (up to June). The leasing industry is mobilizing a greater amount of debt gradually as the industry is attaining maturity. Return on Equity (ROE) and Return on Investment (ROI) of the leasing industry had an increasing trend from 2002 to 2004. Up to June 2005 weighted average industry ROE and ROI stood at 7.91 and 2.08 respectively. ROE of PCBs showed a similar pattern. In June 2005 ROE of PCBs was 9.56 (19.12 on an annualized basis). Therefore in a market with considerable competitive pressures from banks and other financial institutions, the leasing industry has exhibited significant resilience.

21. Performance of SBs in Bangladesh (2002-2005): Although the GOB established some development financial institutions with the aim of providing special attention to the development of agriculture, industry and commerce, the overall performance of SBs as a group has been dismal. All of the SBs, as other government owned enterprises, suffer badly in terms of low capital base, low debt-equity ratio, low loan disbursement, poor recovery rate and consistent losses incurred mainly because of inefficiency, poor governance and lack of a competitive environment. Indeed the current state of the sector gives an impression that SBs were never designed with any workable business model in mind, and hence the salvation will lie in discovering a viable alternative.

22. Microfinance Institutions (MFIs): The origin of the microfinance industry in Bangladesh dates back to the mid 1970s. In the intervening period the prevailing cooperative system was replaced by the NGOs which were subsequently renamed NGO-MFIs due to the very nature of their activities. The sector, being led by the Grameen Bank and BRAC, began to significantly expand during the 1980s and the expansion process is still in progress. The notable growth of the microfinance industry in Bangladesh might be attributed to a number of factors such as the virtual absence of

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credit in the rural informal sector in the pre-MFI era (i.e., other than that at the usurial rates), availability of soft funds for on-lending especially in the early stages, high population density, availability of a good transportation-infrastructure network, presence of strong NGO-MFI leadership and management skills, non-prudential regulatory regime, and a supportive environment created by government (World Bank 2005).

The activities of MFIs can be classified into credit, savings, insurance, training/counselling, marketing and institution building. Although funds are sourced both internally and externally, the dependence on the latter has been falling over time. Bangladeshi MFIs are renowned for their outstanding performance and outreach. It is believed that the group based approach to lending has been a central element of success in the flagship element of its business. Of late, alternative credit delivery models of promise have also emerged.

To date the industry has functioned in the virtual absence of any regulatory framework from above. Recently, GOB has formed the Microfinance Research and Reference Unit (MRRU) in the Bangladesh Bank to coordinate the MFI activities in the country. A steering committee headed by the Governor of the Bangladesh Bank and with notable industry participation has been given the charge to monitor MRRU. The steering committee in collaboration with the MRRU has submitted a proposed MFI regulatory framework in the form of a draft law to the government which is in the process of enactment.

23. Insurance: Since the independence of the country, the insurance industry experienced a major structural transformation as it evolved from the dominance of state-owned enterprises (SOEs) to a more competitive market structure. Insurance penetration is still very low in Bangladesh in comparison to other South Asian countries; however, it has increased significantly over the last few years. Though the life insurance industry is growing over the years the major portion of the potential market remained unexplored due to lack of market oriented products and qualified insurance staff. Presence of a large number of general insurance companies in a relatively small market along with the absence of proper regulatory framework impeded the sound growth of the sector. Overall regulatory structure of the industry is underdeveloped and unable to guide the industry in fulfilling the growing demand of the clients. In the coming years the insurance industry is expected to go through a series of reform measures including upgrading its legislation and the regulatory process.

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E. Financial Market Governance Infrastructure

24. The Regulatory Framework: The financial system of Bangladesh is regulated by different agencies. The Bangladesh Bank (BB) regulates banks and financial institutions; Securities Exchange Commission (SEC) regulates the securities market, and the Ministry of Commerce (i.e., via the Office of the Controller of Insurance) regulates insurance companies under their respective legal mandates. To create an efficient environment in the financial system of the country, the respective authorities had already taken several initiatives in the legal, institutional and policy reforms areas since the 1990s.

In order to allow greater operational efficiency Bangladesh Bank Order 1972, the Banks (Nationalization) Order 1972 and the Bank Company Act, 1991 have been amended. The Bangladesh Bank Order as amended redefined the central bank’s functions in a more focused way, by giving it enhanced authority and make it accountable for its performance. The Banks (Nationalization) Order has been amended with a view to improving the governance of NCBs. Amendments to the Bank Company Act 1991 give Bangladesh Bank more authority and increased powers to regulate and supervise the banking sector. Besides, a new Financial (Money) Loan Court Act 2003 has been enacted to provide for speedy procedures for obtaining decrees and execution. Provision has been made for Alternative Dispute Resolution to ensure early settlement of disputes through settlement conference and negotiation. Money Laundering Prevention Act 2002 was enacted in April 2002, while a revamped draft Money Laundering Prevention Act 2006 has been submitted for approval.

In the backdrop of the emergence of a large volume of non-performing loans (NPL) since the nationalization of commercial banks in the country, a full-fledged Credit Information Bureau (CIB) was set up in August 18, 1992 within Bangladesh Bank itself under the Financial Sector Reform Project (FSRP). The performance of Credit Information Bureau (CIB) in fulfilling the objectives of bringing down the extent of default loan has been found remarkable. As reviewed in chapter 3, the volume of default loans has continued to decline steadily.

With a view to further strengthening the prudential supervision and regulation, Bangladesh Bank has also made additional institutional reforms. These include the revisions of capital adequacy ratios, deposit insurance, loan classification and provisioning modalities, Anti-Money Laundering Act, single-borrower exposure limit, appointment procedure of bank CEOs, introduction of a new loan ledger and International Accounting Standard (IAS-30) for scheduled banks and strengthening both off-and-onsite supervision by BB. Moreover, Bangladesh Bank has

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12 Note that the "Ease of Doing Business Indicator" is a survey based ranking produced by Deep Customer Connections, Inc.

undertaken a project named ‘Central Bank Strengthening Project (CBSP)’ with the financial assistance of International Development Association (IDA). The main purpose of this project is to strengthen the Bank’s operational capacity to formulate monetary policies and regulatory supervision for the financial sector.

25. The Contractual Framework: The contractual framework is one of the important building blocks for a stable, sound and effective financial system which in general deals with the rights of creditors, shareholders, contract enforcement, corporate governance as well as the informational framework. In spite of reforms and progress in macroeconomic stability, the financial sector has a long way to go in building an adequate contractual and informational framework in Bangladesh. By definition financial contracts consist of an exchange of money today for the promise of money tomorrow, which is sensitive to the uncertain future.

While some progress has been made with the recent introduction of the money loan courts that allow a faster and less bureaucratic enforcement of claims, it is still too early to say whether this reform has significantly impacted the availability and cost of loans. Further, appeals to the high court still pose a major bottleneck to the quick resolution of claim resolution as they are to wait in queue with other cases. The deficiencies in the contractual framework are reflected in cross-country benchmarking. Bangladesh is ranked 65th in the “ease of doing business indicator” (out of 155), a rank that is driven by deficiencies in the conditions for registering property where Bangladesh ranked 151st. However, Bangladesh is ranked in the median range in enforcing contracts and in closing a business (75th and 77th, respectively).12

26. Infrastructure Issues in Remittance Flows: During the last fifteen years the flow of worker’s remittances has increased steadily and contributed a major source of foreign exchange earnings of the country. However, the unofficial channels still play a significant role in transferring worker’s remittances Though over the last few years various steps have been taken to boost the flow of remittances through the official channels, these efforts have proven to be insufficient in reaching the recipients of remote areas with remittance services. Bringing the informal remittance-service providers into the formal structure under a proper regulatory environment can be an important tool to deal with the situation. The MFIs, which enjoy the economies of scale and, are characterized by a robust financial base and strong rural networks, can be utilized to channel remittances to the families of migrant workers. It is further observed that NCBs, which have a sizeable

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rural branch network, tend to offer lower exchange rate for inward remittances than their counterparts, namely PCBs and FCBs. Hence maintaining non-market exchange rates may also hamper NCBs’ efforts in attracting additional remittances. Growing awareness on the part of remitters of the available tax incentives, administrative simplicity and national priorities will induce them to resort to official means of transfer, and in this respect banks offering remittance services have a substantial promotional role to play.

27. Oversight of Payment and Securities Settlement: In order to reduce the systemic risk in the financial sector, BB and SEC oversee various payments settlement systems and securities settlement systems respectively. BB, deriving this power from the Bangladesh Bank Order-1972, keeps a sharp eye to cash, non-cash and foreign currency settlement systems. The important oversight actions recently taken by BB include on-going computerization of clearing houses, same day clearing of payments and cheques, upgrading of security features from time to time, making taka convertible in the current account (1994) and letting exchange rate be determined by the market (2003). On the other hand, SEC derives power from the Securities and Exchange Ordinance-1969, the Securities and Exchange Commission Act-1993 and the Depositories Act-1999. For strengthening oversight capacity, it established the Central Depository Bangladesh Limited (CDBL). The CDBL is responsible to operate and maintain central depository system under the Depositories Act, 1999. The oversight authorities will have to extend their attention towards electronic transactions which seem to be the potential area of future expansion of the settlement system.

28. Factors Affecting Sector Risk and Stability: Major macroeconomic indicators support further strengthening of financial sector stability. In particular the financial system has to better cope with both interest risks as well as exchange rate risks in an environment when both these rates are market determined. The former may be mitigated by a judicious alignment of the maturity structure of assets and liabilities as well as keeping a safe margin in the ratio of deposits lent out. Innovation of newer instruments especially in future contracts and secondary trading of government bonds will also help in reacting to the unfolding interest rate shocks. A vibrant deposit and inter-bank market in foreign currencies with corresponding portfolio adjustments of the foreign currency balances held abroad by the scheduled banks may also help in dealing with exchange rate risks. Of course avoidance of speculative behaviour would also help mitigate hardship in the face of unfavourable shocks.

Ownership approach suggests that the public sector’s fiscal involvement in the financial system risk has been falling due to the steady decline in its share since 2004 (which went below 50 percent) of the banking system’s

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total deposit. Conversely, risk of private banks’ depositors has, to a greater extent, been minimized due to the very low level of credit risk (only 5.62 percent classified loans in 2005) which, in turn, contributed to reducing the overall instability in the financial system.

Measurement of concentration of private banking assets indicate that both Hirschman-Herfindahl index (HHI) and the 4-firm concentration, (C4), indices have declined over the period 1999 to 2005. But the C4-Foreign index shows that concentration of assets among the foreign banks has increased steadily over this period to 89 percent vis-à-vis 30 percent for the private sector banks. Market-based higher net worth of listed banks shows that public's expectation about the prospect of the industry is steadily growing. The performance of Deposit Insurance Fund as a financial sector safety net, which increased to 4.25 billion BDT in 2005, i.e., by 21.43 percent from the year earlier, is noteworthy. While Bangladesh is a major compliant of Basel Core Principles, implementation of Basel Core Principles 6, 12 and 13 may require the banks to increase capital substantially from their current position. Considering the above arguments, the overall status of financial sector seems to be stable. Nevertheless further policy direction relating to a more balanced risk allocation in asset deployment (i.e., long vs. short maturity) among the various bank and non-bank groups, and a gradual and orderly adjustment to the higher capital requirement would appear desirable for sustaining stability of the banking sector.

29. Financial Market Outlook: While the banking system has come a long way since the immediate post-liberalization era, gradual phasing out of dictated lending (e.g., to SOEs, agriculture, and exports) would improve the profitability and hence the future sustainability of the NCB/SB sector. The scope of such interventions is reflected in the lower average lending rates experienced by NCBs vis-à-vis PCBs. Industrial term lending and general agricultural loans by NCBs and SBs and short-term agricultural and micro credit activities of NCBs are marred by high share of loan classification (e.g., in the 40-percent range for each of these categories as of end-2005). Efficiency would dictate that any funds the public sector wished to deploy in these market segments would be better served if administered by innovative private sector entities that would cater to the agricultural market. Such intermediaries may arise out of the expertise that has been accumulated over the recent past in the rural MFI sector. Industry leaders may find it relevant to initiate for-profit entities dealing with agricultural and (non-micro) rural credit.

F: Financial Sector Policy Stance

30. In order to accelerate output growth consistent with the MDG benchmarks, the degree of financial intermediation in Bangladesh has to soon reach standards for fast growing emerging economies. In particular,

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this would require a leaner and efficient NCBs (emerging out of restructuring and privatization as appropriate), discovering new modalities for delivering agricultural (typically short-term) and industrial term credit replacing the moribund SBs, boosting the access of SMEs to investment funds, adding depth to the insurance services, and further development of the market in public and private debt and risk capital. High tax rates on corporate income vis-à-vis tax deductibility of interest on debt have rendered debt issuance as the more attractive financing mode than equity issuance. On the demand side, insufficiency of disclosure of financial statements, weakness of corporate governance in most of the non-financial corporate bodies, frequent availability of non-market return on risk-free government debt (e.g., NSD certificates) are among major factors holding back the development of a vibrant equity market in the country.

In terms of specific behavioural weaknesses of the financial system, it will be necessary to better deal with the asset-liability mismatch in the banking system, enforce stricter adherence to regulatory guidelines regarding provisioning and capital adequacy, and above all, to put the NPL problems behind. However, it must be stressed that without an effective resolution of the SOE debt owed to NCBs, the financial stability of the affected banks will remain in jeopardy. Recapitalization of these entities on an ad-hoc basis as has frequently been the case, merely allows a breathing space within which hard decisions would have to be taken.

In a medium and longer term context, modalities of financing large projects would be an area requiring attention. Small capital bases of individual banks require syndication of small contribution for a large number of banks for any large project financing, which tends to be cumbersome and time consuming. Merger of small banks into larger and stronger entities would be the way forward as in other developed financial markets. Facilitating issuance of rated debt securities by the projects in the capital market will be the other mode of arranging large project financing. Although parallel development of consultancy expertise in third-party evaluation of the technical merits of the project and the management capacity of the borrowers will also be indispensable.

Reference

Levine, R. (1997), “Financial Development and Economic Growth: Views and Agenda,” Journal of Economic Literature, 35:2, 688-726.

World Bank (2005), The Economics and Governance of Non-Government Organizations (NGOs) in Bangladesh, available at

http://www.lcgbangladesh.org/NGOs/reports/NGO_Report_clientversion.pdf