Though Bangladesh has made notable advancements in certain banking indicators, such as access and the depth of the banking system, poor governance, political meddling, and corruption in this sector has created increasing concern in recent years as for the past two decades, corruption, mismanagement and lack of accountability have seriously affected the sector. There is no denying that the culture of nepotism and favoritism in the banking sector has been perpetuated by political appointments to key positions in both the central bank as well as commercial banks. Such practices have enabled influential individuals and powerful companies to secure large loans with minimal oversight and accountability.
Bangladesh’s banking sector is grappling with a governance crisis and while bank failures are infrequent, with only one collapse recorded in recent decades, the true challenge lies in the persistent insolvency plaguing several institutions. Insolvent banks in Bangladesh are shielded from market forces and the threat of bankruptcy while the government protected struggling banks from competition and recapitalizing them through taxpayer-funded subsidies. This protective stance by the government has far-reaching consequences for banking sector governance. The lack of market pressure reduces incentives for banks to improve their governance structures, while government bailouts create a safety net that may encourage risky behavior by bank management. Moreover, with the implicit guarantee of government support, depositors have less motivation to demand better governance from their banks. The continued operation of insolvent banks also poses a long-term threat to the overall financial stability of the country.
In the context of the banking sector, the most serious issue is the high volume of non-performing loans (NPLs). Such high NPLs coupled with deteriorating law and order, and pervasive political interference have damaged the financial stability of the banking sector. To address these critical issues, experts have advocated for substantial reforms, including the establishment of a dedicated banking commission. Recently, the interim government has positively responded to it by announcing the formation of such a commission and committing to releasing a comprehensive report on the financial sector’s health and a detailed reform roadmap within the first 100 days of its administration. This is certainly a move towards the right direction and with effective implementation it can help in restoring stability in the financial sector.
The high levels of NPLs and the impact of political factors highlight the need for a strong political commitment to reform the banking sector. Often, this commitment results in extensive recapitalization efforts funded by taxpayers. The Bangladesh Bank (BB) has faced criticism for providing liquidity support to nearly bankrupt banks without adequate collateral, which has worsened the scenario further. Preliminary estimates suggest that the total amount of embezzled and laundered funds from the banking sector could reach Tk 100,000 crore. In response to these issues, efforts have been made to restructure the boards of major banks such as Islami Bank, Social Islami Bank, National Bank, and others. However, a comprehensive framework for managing NPLs and ensuring effective bank resolution is still needed. This includes establishing clear guidelines for mergers and acquisitions, assessing the asset quality of weaker banks, and protecting sound institutions from the fallout.
Another inherent problem of the banking sector is that the Bangladesh Bank, the central bank of Bangladesh, faces significant challenges in exercising its authority and independence. Despite its official status, the institution is constrained by various formal and informal constraints, resulting in only marginal policy and operational autonomy. In practice, it is often controlled by the Ministry of Finance (MOF), even in core central banking functions like regular banking supervision. This lack of independence stems not only from formal power structures but also from governmental overreach beyond legal mandates. The Such actions have marginalized the role of the Bangladesh Bank in decision-making processes related to operational matters and banking sector governance. While the Bank Companies Act of 1991 empowered the Bangladesh Bank to regulate the banking sector as an autonomous body, this independence was eroded when the MOF established its own banking division. A stark example of this marginalization occurred in November 2017 when the central bank’s decision to reject proposals for two new private commercial banks was overridden by the ministry, and proceeded with granting licenses. This incident raises serious questions about the central bank’s ability to operate independently.
State-owned commercial banks, specialized banks, and some statutory banks are controlled by the Bank and Financial Institution Division of the MOF, while private commercial banks, foreign banks, and non-bank financial institutions are regulated by the Bangladesh Bank. This duality has led to uncoordinated and often weak policy measures for government-regulated banks, with the Bangladesh Bank facing serious limitations in enforcing prudential and management norms. Consequently, this has rendered the entire banking sector weak and vulnerable to a potential domino effect. The government’s tendency to bypass the formal approval process of the central bank extends to critical policy issues such as monetary policy, lending to the government, and governance matters like special monitoring of insolvent banks or addressing non-performing loans in commercial banks. In fact, the government appears more inclined to limit the central bank’s authority when it comes to governance issues.
Additionally, Private Commercial Banks (PCBs) suffer from inadequate corporate governance. These banks often operate as closely held entities controlled by a small number of influential shareholders. This structure leads to a lack of transparency and accountability, making it easier for widespread theft and corporate fraud to occur. Insider lending and cross-lending, driven by personal or political connections, are common issues that further exacerbate the governance problems within the PCBs.
Reforms in the banking sector must address governance issues and ensure that changes to the Banking Companies Act (BCA) are based on economic rather than political motivations. The BCA needs to be revised to correct institutional flaws related to loan approvals, director selection, fines for defaulters, and the establishment of new banks. Effective policies should be developed to address various wrongdoings by commercial banks and ensure better oversight and accountability.
To stabilize the foreign exchange market, the interim government has decided to raise the band of the crawling peg from 1 percent to 2.5 percent. This adjustment aims to reduce excessive volatility in currency exchange rates, allowing businesses and investors to plan more effectively and supporting overall economic stability. Pegging currencies to major currencies like the US dollar or euro is a common practice among developing and emerging nations. However, this approach can also lead to problems if not managed properly. Historical experiences, such as the 1997 East Asian financial crisis, demonstrate the risks associated with rigid currency pegs. Hence, it is ideal that Bangladesh adopts this measure as only a transition period toward a floating exchange rate.
Bangladesh is currently facing significant challenges related to rising inflation and declining foreign exchange reserves. Recent economic turmoil has weakened the taka against the dollar, and there has been a noticeable decline in international remittances and export inflows. The foreign currency reserve has decreased from $48 billion in August 2021 to $19.3 billion as of November 2023. This decline has widened the gap between the supply and demand for dollars, putting upward pressure on the dollar’s price. Official exchange rates for imports, exports, and remittances have varied, with remitters receiving an incentive rate, but discrepancies with unofficial rates persist.
To address these issues, cautious and well-targeted monetary policies are crucial. Historically, Bangladesh’s monetary policy has not been able to manage inflation effectively. However, recent measures, such as a 0.75 percentage point increase in the policy rate to 7.25 percent, aim to control inflation by making borrowing more expensive and encouraging deposits. While this move represents progress, it may not be sufficient to fully combat inflationary pressures.
The central bank’s recent shift from a “6/9” interest policy to a variable interest rate policy linked to Treasury bill averages is intended to reduce liquidity and encourage savings. The increase in deposit rates from 7.5% to 9.6% aims to enhance savings and reduce domestic liquidity. However, this policy adjustment alone may not be enough to prevent inflation. Support for Cottage, Small, and Medium-Sized Enterprises (CSMEs) is essential, and additional measures may be required to mitigate any disproportionate impacts on these businesses.
In addition to monetary measures, improving the exchange rate and foreign reserves requires a more flexible currency system and diversification of foreign currency reserves. Non-monetary incentives may also be necessary to boost formal remittance channels and address issues related to money laundering. The shift away from a fixed interest rate policy in favor of a variable rate approach is a positive development, but further actions are needed to ensure that inflation is effectively controlled and that CSMEs receive adequate support.
The successful implementation of reforms of the banking sector, especially in terms of the NPLs and insolvency of certain banks, and effective management of the banking sector led by the proposed Banking Commission can pave the way towards a stable and solvent banking sector of Bangladesh.
This Article was first published in the September, 2024 edition of the Thinking Aloud.
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