Abstract
This Selected Issues paper reviews Bangladesh’s recent growth experience and per capita income. The paper identifies several key impediments to growth, namely: poor governance; restrictive trade and regulatory regimes; and inadequate investment in human capital and physical infrastructure. The paper makes the case that the medium-term fiscal strategy should be centered on boosting the revenue performance of the National Board of Revenue (NBR) by reorganizing it along functional lines, adopting a system of self-assessment, establishing a risk-based auditing system, and introducing a unique taxpayer identification number.
V. Banking Reform in Bangladesh—A South Asian Perspective28
87. This chapter examines bank reform in Bangladesh in comparison to India, Pakistan, and Sri Lanka. Section A provides an overview of the banking systems in all four countries. Section B examines the progress achieved in the areas of financial liberalization, prudential control and supervision, bank restructuring, and divestment of NCBs. Section C considers additional areas of reform that will be needed to further modernize banking systems in South Asia.
A. Overview
88. The banking systems of Bangladesh, India, Pakistan, and Sri Lanka have historically been characterized by low levels of intermediation, weak competitive environments, and tight state control over banking activities, often manifested by government ownership of the largest banks. These banks maintained extensive branch networks that accepted deposits from individuals, firms, and various levels of government, as well as remittances from abroad. The deposits were then converted into loans to large commercial firms and SOEs, import advances, or used to purchase government securities. Consumer credit, housing and auto finance, and lending to small- and medium-sized enterprises, key staples of activity for many banks in advanced economies, were insignificant, though efforts to promote these market segments have gained good traction in recent years.
89. The early emphasis on state-led banking reflected the need for governments to actively pursue industrial policies to engender growth. State-owned banks were regarded as the appropriate vehicles by which to channel savings to sectors of the economy with the best growth prospects. Moreover, it was frequently presumed that state-owned banks were necessary to provide banking services to rural areas, both by mobilizing rural deposits, and by providing credit to risky sectors like agriculture.
90. On balance, however, the historically dominant role of state-owned banks undermined financial sector development and impeded economic growth. In general, state-owned banks, or NCBs as they are called in Bangladesh, suffered from poor management, political interference, and an apathetic business culture that stressed protocol over innovation and customer service. Loans were frequently doled out to politically connected firms and individuals, with little subsequent oversight. Moreover, NCBs often made loans to unprofitable SOEs on noncommercial terms and with little expectation of repayment.
91. Consequently, the equity of NCBs was often deficient, forcing governments to provide periodic capital injections and their respective central banks to provide regulatory forbearance for capital adequacy. Additionally, the implicit government guarantee on deposits in NCBs created an uneven playing field for private banks, which made it difficult for them to attract savings on favorable terms. As a result, private banks had to offer a premium over state-owned banks on deposit rates, which impaired profitability and at times forced private banks to lend to risky customers to generate a sufficiently high return to cover their cost of funds.
92. However, the past decade has seen momentous changes in banking systems across South Asia. The general trend has been towards liberalization and privatization, driven by growing disillusionment with the performance of NCBs, and burgeoning cross-country evidence that financial liberalization leads to higher economic growth and lower financial sector vulnerabilities (La Porta, 2002). This has created more vibrant banking systems and increased bank intermediation, as evidenced by the pronounced upward trend in monetization in all four countries. Furthermore, with the growth of microcredit institutions, vulnerable groups have increasingly been able to gain access to finance without recourse to NCBs.
M2 as Percent of GDP
Citation: IMF Staff Country Reports 2005, 242; 10.5089/9781451804157.002.A005
Source: Fund Staff estimates.M2 as Percent of GDP
Citation: IMF Staff Country Reports 2005, 242; 10.5089/9781451804157.002.A005
Source: Fund Staff estimates.M2 as Percent of GDP
Citation: IMF Staff Country Reports 2005, 242; 10.5089/9781451804157.002.A005
Source: Fund Staff estimates.B. Recent Areas of Reform
93. The reform agendas pursued by Bangladesh, India, Pakistan, and Sri Lanka have all differed in important ways, especially with regards to the pace and scope of efforts to restructure and divest state-owned banks. However, a common set of elements can be identified:
Financial liberalization
94. All four countries have to varying degrees taken steps to liberalize their banking systems. This has entailed:
Reducing interest rate controls on lending and deposit rates. Interest rate ceilings often have the perverse effect of reducing lending to the targeted sector, especially to the smaller and riskier companies within that sector. All four countries have made significant headway in liberalizing interest rates. India, for example, has largely deregulated interest rates except for savings deposit accounts, nonresident Indian deposits, small loans up to Rs 2 lakh ($4,500), and export credit. However, banks in South Asia continue to be subject to occasional moral suasion by governments and central banks. This is particularly true with regards to lending rates to priority sectors, such as agriculture.
Curtailing directed credit to favored sectors or industries. Though explicit targets for lending to priority sectors have become less common, they continue to exert an influence over bank decision making. The Reserve Bank of India (RBI), for example, requires that domestic Indian banks make 40 percent of their loans to priority sectors selected by the government. NCBs in Bangladesh are also expected to lend aggressively to the agriculture and export sectors.
Lowering barriers to entry in the banking sector, especially to foreign banks. On balance, the market share of foreign banks in South Asia continues to be small, with much of their activities confined to providing banking services to multinational clients. However, recent policy initiatives have striven to create a more favorable environment for foreign banks. The State Bank of Pakistan, for example, has eased branch licensing policy and eliminated absolute restrictions on the number of foreign banks. India has increased the limit on foreign ownership from 49 percent to 74 percent of bank equity and now allows foreign banks to set up local subsidiaries. However, foreign banks are not permitted to acquire local banks unless the bank in question has been designated as a weak bank by the RBI. In Bangladesh, foreign banks are permitted to operate freely, although their market share remains low, and no foreign bank has endeavored to build a large branch network.
Reducing operational restrictions on staffing and branching. While restrictions are generally minimal for private banks, most staff at NCBs in South Asia continue to be governed by public sector pay scales and employment practices. Pakistan and India, as part of their efforts to modernize the public banks, have allowed for greater management discretion in human resource practices, including the ability to retrench excess staff, close unprofitable branches, and offer pay packages commensurate with those in private banks. In Sri Lanka, the two state-owned banks have been able to partially overcome strict government rules by hiring qualified staff on a contract basis.
Lowering the cost of doing business. All four countries have pursued reforms to create a business climate more conducive to entrepreneurship and investment. This has entailed tackling corruption, reducing red tape, securing property rights, and improving the tax regime. Statutory tax rates in the banking sector remain high, however. In Bangladesh, the top corporate tax rate is 50 percent. In Pakistan, banks are taxed at a rate of 47 percent, as opposed to a top corporate tax rate of 43 percent for private firms and 35 percent for public firms. However, to boost private banking, the Pakistani government has committed to a timetable to bring down the top corporate tax rate to 35 percent by 2007.
Improving government debt management. Every country has taken steps to make government borrowing from the banking system more market based, including having regular auctions for government securities, and fostering the development of primary and secondary debt markets. Additionally, Pakistan and Bangladesh have substantially reduced the interest rates on national savings certificates, which has allowed banks to compete for funds on more favorable terms while offering long-dated term deposits. This has spurred deposit growth and reduced maturity mismatches in bank balance sheets.
Removing restrictions on international financial transactions. While all four countries have largely removed restrictions on current account transactions, capital account restrictions continue to be more tightly regulated. This stems from concerns that reducing restrictions could fuel capital outflows and facilitate money laundering. More recently, as external reserves in several of the countries have risen to more comfortable levels, capital account restrictions have been selectively eased. For example, India amended its External Commercial Borrowing guidelines in early 2004 to facilitate external corporate investment in infrastructure. In Pakistan, significant easing of capital account restrictions and the formation of exchange companies have accelerated capital account movements. The investment regime, particularly for FDI, has also been dramatically liberalized in South Asia. Bangladesh, for instance, now allows FDI in the RMG sector, both inside and outside its EPZs.
Foreign Commercial Bank Share of Banking System Assets
(Percent)
Citation: IMF Staff Country Reports 2005, 242; 10.5089/9781451804157.002.A005
Source: National authorities.Foreign Commercial Bank Share of Banking System Assets
(Percent)
Citation: IMF Staff Country Reports 2005, 242; 10.5089/9781451804157.002.A005
Source: National authorities.Foreign Commercial Bank Share of Banking System Assets
(Percent)
Citation: IMF Staff Country Reports 2005, 242; 10.5089/9781451804157.002.A005
Source: National authorities.Prudential control and supervision
95. The liberalization of banking in South Asia has necessitated a vigorous focus on improving supervision and enforcement. This has entailed stepping up on-site and off-site supervision, enforcing stricter accounting and auditing standards, and imposing tighter rules on loan provisioning. In Bangladesh, an early warning system for problem banks has been introduced. Additionally, risk management and prudential guidelines for consumer credit and small business lending have been enacted. In Sri Lanka, the central bank now prepares a Financial Stability Report every six months and requires that all banks receive a credit rating. In India, the Board for Financial Supervision (BFS) meets once a month to provide guidance on regulatory policies and supervisory practices, which has resulted in numerous reforms that have helped bring banking standards closer in line with international best practices.
96. Measures have also been taken by all four countries to boost capital adequacy. In Bangladesh, the minimum capital requirement on a risk-weighted basis was raised from 8 to 9 percent and the minimum capital level raised from Tk 40 crores to Tk 100 crores ($17 million). The capital adequacy ratio in Sri Lanka was raised to 10 percent beginning January 2003. Similar measures have been adopted in the rest of the region.
97. Corporate governance has been a problem throughout South Asia, and steps have been taken to redress some of the more serious weaknesses. In Bangladesh, for example, the fit and proper test for CEOs of banks has been tightened and a similar test introduced for bank directors. Independent directors are also required to represent minority shareholder and depositors’ interests. Furthermore, no board can have more than one member from each family and limits have been placed on tenure and the maximum number of directors. To enhance transparency, banks are required to publish annual financial statements in newspapers.
98. Regulators in the region have also encouraged banks to list shares on the stock market to provide public signals about the banks’ financial health and to enable banks to raise additional capital. In Bangladesh, a directive is being considered to require all private banks to have publicly listed shares. However, the low level of liquidity in South Asia stock markets, deficiencies in security laws and regulations, and considerable constraints to short-selling overpriced securities have hampered the ability of stock markets to generate clear signals about the health of financial institutions.
Bank restructuring
99. With regard to bank restructuring, Pakistan has pursued a comprehensive and far-reaching program. Professional management teams from the private sector have been contracted to run state-owned banks on commercial terms. This has helped give the banks much more autonomy in their day to day operations and over medium-term strategic planning, which has led to more prudent lending practices, increased capital, and improved profitability. As part of the restructuring exercise, over 11,000 staff at NCBs in Pakistan have been retrenched through voluntary separation programs, and nearly 800 loss-making branches closed. India has also accelerated its efforts to restructure state-owned banks. In early 2005, the government granted state-owned banks greater operational and managerial freedom, including the ability to set human resource policies, establish overseas branches or subsidiaries, exit unprofitable lines of business, and acquire domestic and foreign banks.
100. Bangladesh’s government has awarded contracts to internationally recognized firms to strengthen NCB operations. A management support team has been appointed at Agrani Bank while management consultants have been procured for Sonali Bank, and most recently, Janata Bank. While it is still too early to gauge the impact that these teams have had on NCB performance, it is clear that this undertaking will be valuable only if a fruitful dialogue is established among bank management, the banks’ board of directors, Bangladesh Bank, and the teams themselves.
101. To ring fence and resuscitate problem banks, regulators in South Asia have made heavy use of Memoranda of Understanding (MOUs). These agreements signed with troubled banks typically spell out targets for increasing capital, enhancing profitability, and reducing operating costs. For instance, Bangladesh Bank has signed MOUs with all four NCBs, which among other things, set a ceiling on the growth in each bank’s lending portfolio of between 5–8 percent, restrict single party exposure to only 5 percent of paid-up capital of each bank, and set targets on cash recoveries from defaulters, with a special focus on recovery from the top 20 largest defaulters.
Divestment of NCBs
102. Pakistan has made significant strides in divesting NCBs. While the government still retains majority equity control of the country’s largest bank, National Bank of Pakistan, the other major NCBs have been divested.29 As a result, the market share of NCBs has declined to 22 percent in 2004, the lowest share of any country in the region. In general, Pakistan’s government has pursued a variety of models for divesting its NCBs. Some banks have been sold to strategic investors with majority ownership, while others have been sold with minority ownership. Others still have been divested through management buyouts, as well as initial public offerings. The growth of market share of private banks has also been strong in the other three countries, reflecting robust economic growth and ambitious policy reforms. While the assets of state-owned banks in India continue to account for about 75 percent of banking system assets (down from 90 percent in 1991), the share of assets in wholly owned government banks has declined to 10 percent, reflecting partial divestment of equity in many of the state-owned banks.
NCB Share of Banking System Assets
(Percent)
Citation: IMF Staff Country Reports 2005, 242; 10.5089/9781451804157.002.A005
Sources: National authorities; and Fund staff estimates.NCB Share of Banking System Assets
(Percent)
Citation: IMF Staff Country Reports 2005, 242; 10.5089/9781451804157.002.A005
Sources: National authorities; and Fund staff estimates.NCB Share of Banking System Assets
(Percent)
Citation: IMF Staff Country Reports 2005, 242; 10.5089/9781451804157.002.A005
Sources: National authorities; and Fund staff estimates.103. In general, governments in South Asia have endeavored to follow international best practices in the divestment of NCBs. This requires that: a “fit and proper” test be applied to potential bidders, the new owners be given full autonomy over human resource decisions and branch closures, the bank be recapitalized prior to divestment, and that safeguard measures be introduced, especially to prevent asset stripping in the lead up to divestment.
104. Experience from other countries suggests that there are significant risks associated with divesting insolvent banks. A deeply insolvent bank has a clear incentive to take undue risks since a conservative lending and investment strategy, even if well implemented, is unlikely to generate sufficient cash flow from operations to offset the bank’s expenses. This could induce the bank to increase deposit rates to attract liquidity. Thus, the government runs the risk that the insolvent bank, once divested, will grow in size and potentially become even more insolvent, thereby destabilizing the banking system and possibly forcing the government to shoulder the burden of a depositor bailout. Recapitalizing the bank prior to divestment helps to reduce this risk. Moreover, as long as the divestment process is transparent and open to many qualified bidders, it will likely be the case that the funds spent to recapitalize the bank will be largely offset by a higher sales price. In South Asia, governments have prudently avoided divesting insolvent banks. As a result, while the process of resuscitating former NCBs to health has often been a long one, no divested state-owned bank has gone on to fail.
105. An important issue is whether to move bad loans off the balance sheets of banks that are slated for divestment. The main advantage of cleansing banks of nonperforming assets is that the resulting bank will be, for the most part, a “clean bank.” This will greatly facilitate the due diligence of prospective buyers as it is much easier to assess the value of an entity whose assets are well defined and generating a predictable stream of income. The chief drawback of moving the nonperforming loans (NPLs) from the books of the NCBs is that it is not clear where they should go. The value added in banking stems in part from the ability of lenders to develop relationships with borrowers that reveal the ability and inclination of the borrower to repay a loan. In this regard, valuable information may be lost if the loans are transferred to an outside agency.
106. While there is little debate about the need to recapitalize banks prior to divestment, there is no accepted standard about the degree to which the bank’s operations ought to be restructured prior to sale. Pakistan has generally subjected its NCBs to a rigorous cost restructuring prior to divestment in order to bring their cost/income ratios in line with private banks. However, such a strategy was greatly facilitated by the ability of the State Bank of Pakistan to directly supervise and coordinate the restructuring efforts. In countries like Bangladesh where the central bank’s authority over the NCBs is not clearly defined, it may be more appropriate to allow the strategic investor to undertake the bulk of the restructuring efforts. While this will lead to a lower price for the bank, it will likely expedite the restructuring process, since a strategic investor will be able to install new management and undertake reforms, especially those pertaining to human resource management that would be difficult to achieve while the bank is under state control.
C. Conclusion
107. The reform efforts undertaken by governments in South Asia have already yielded tangible results. In all four countries, NPLs have decreased significantly and capital adequacy improved (Figures 1 and 2). In Bangladesh, for instance, gross NPLs in the banking system declined from 36 percent to 22 percent of total loans and advances during 1999–2004, while the net NPL ratio declined from 33 percent to less than 16 percent. At the same time, the capital adequacy ratio has increased from 7 percent in 1998 to 9 percent in 2004. This has led to a healthy increase in bank share prices, with the market weight of banking stocks rising from 10 percent of total capitalization in June 1998 to 47 percent in December 2004 on the Dhaka and Chittagong stock exchanges. At the same time, the spread between deposit and lending rates has narrowed, indicating increased competition in the banking sector and better risk management.
Net NPLs
(Percent of net loans and advances)
Citation: IMF Staff Country Reports 2005, 242; 10.5089/9781451804157.002.A005
Sources: National authorities; and Fund staff estimates.Net NPLs
(Percent of net loans and advances)
Citation: IMF Staff Country Reports 2005, 242; 10.5089/9781451804157.002.A005
Sources: National authorities; and Fund staff estimates.Net NPLs
(Percent of net loans and advances)
Citation: IMF Staff Country Reports 2005, 242; 10.5089/9781451804157.002.A005
Sources: National authorities; and Fund staff estimates.
Capital
(Percent of risk-weighted assets)
Citation: IMF Staff Country Reports 2005, 242; 10.5089/9781451804157.002.A005
Sources: National authorities; and Fund staff estimates.Capital
(Percent of risk-weighted assets)
Citation: IMF Staff Country Reports 2005, 242; 10.5089/9781451804157.002.A005
Sources: National authorities; and Fund staff estimates.Capital
(Percent of risk-weighted assets)
Citation: IMF Staff Country Reports 2005, 242; 10.5089/9781451804157.002.A005
Sources: National authorities; and Fund staff estimates.108. Looking forward, the main challenge will be to reform and divest NCBs while strengthening private banks so that they are more resilient to external and domestic shocks. As in any industry, there will be entrenched interests that will stand to lose from increased competition in the banking system and a more vigorous effort to allocate financial resources based on commercial merit. Thus, banking reform will require a strong public consensus and resolute political will. Concerted action will be necessary to collect loans from major defaulters, improve labor policy, and wean SOEs from their reliance on easy credit from the NCBs. In Bangladesh, the central bank should be given more regulatory power over the banking system and greater jurisdiction over the pace and scope of the reform agenda.
109. Bangladesh has adopted an ambitious program for divestment of its NCBs. The government intends to divest three of the four NCBs sequentially over the next three years. The information memorandum for Rupali Bank was issued in May 2005 and the bank is expected to be sold by the end of the year. The government also intends to corporatize Agrani Bank by end-2005 and to divest it by mid-2006. In the case of Janata, the government intends to corporatize it by end-2006 and bring it to the point of divestment by mid-2007. Given Sonali’s size and strong rural presence, the government has determined that the best course of action is to restructure the bank with the intent of bringing it to the point of divestment over the medium term.
110. Strengthening private banks will require a competitive market environment, continued vigilance in supervision, enhanced efforts to recover bad loans, and a stable macroeconomic climate. In order to strengthen internal controls and improve customer service, private banks in the region must move quickly to introduce information technology. Furthermore, the legislative frameworks in South Asia for loan recovery should be modernized, particularly by streamlining the legal procedures for banks to collect collateral on default loans. Bangladesh has recently moved forward in this regard by establishing specialized Money Loan Courts that provide dedicated judges and expedited procedures to resolve problem loans.
111. While there has been some consolidation in the banking systems of South Asia, many private banks continue to operate on a small scale, which has prevented them from building well diversified lending portfolios. Pakistan has sought to redress this problem by amending tax laws to facilitate merger and acquisition of banks and financial institutions by allowing group tax loss relief. In early 2005, India issued new guidelines for the merger of private sector banks to complement the guidelines already in place for nonbanking financial companies.
112. In the years to come, banks in the region will need to develop new markets and product offerings. This will necessitate a stronger focus on lending to medium-sized enterprises and to retail clients. Additionally, there exists significant potential in expanding the markets for consumer credit, mortgage and auto finance, and insurance. Infrastructure finance has also become a priority in the region. While infrastructure investment has been traditionally financed almost exclusively through the public budget, there has recently been a push to expand the use of public-private partnerships to mobilize private financing for infrastructure and to expand the role of the private sector in infrastructure development.
References
La Porta, R., F. López-de-Silanes, and A. Shleifer, 2000, “Government Ownership of Banks,” Journal of Finance (February).
