This Selected Issues paper on Bangladesh underlies the export performance of readymade garment industry and inflation dynamics. Bangladesh has demonstrated that it is highly competitive in the world’s major garment markets. Inflation inertia, monetary factors, and exchange rate fluctuations are the main determinants of inflation in Bangladesh. Despite adoption of numerous tax policy measures during the past few years, policies implemented by the Bangladesh authorities have not been fully successful in lifting the revenue ratio to a level warranted by developmental objectives.

Abstract

This Selected Issues paper on Bangladesh underlies the export performance of readymade garment industry and inflation dynamics. Bangladesh has demonstrated that it is highly competitive in the world’s major garment markets. Inflation inertia, monetary factors, and exchange rate fluctuations are the main determinants of inflation in Bangladesh. Despite adoption of numerous tax policy measures during the past few years, policies implemented by the Bangladesh authorities have not been fully successful in lifting the revenue ratio to a level warranted by developmental objectives.

III. Banking Soundness and Financial Intermediation 1

A. Introduction

1. As financial deepening advances, high financial intermediation costs are holding back the sector’s contribution to sustained growth. Macroeconomic stability, liberalization measures, and regulatory reforms have helped strengthen the financial sector since the mid-1990s and encouraged the entry of private and foreign banks and of nonbank financial entities. However, the predominance of weak, large state banks, even though their market shares are diminishing, has prevented high intermediation costs from declining following increased competition.

2. This paper reviews recent performance of the financial sector, focusing on the soundness of the banking system and its ability to cope with a significant pick up in the pace of credit growth. In assessing performance, we look beyond published indicators of banking soundness by making adjustments to the ratios where needed, as well as analyzing variations between firms. The paper also examines the impact of greater market concentration on interest spreads and explores other determinants of bank profitability and interest spreads in a panel regression framework.

B. Size, Structure, and Recent Development

3. Bangladesh’s financial system is relatively shallow. Total financial sector assets amount to about 69 percent of GDP, with banking sector assets accounting for the bulk of assets or 58 percent of GDP. Capitalization of the securities market amounts to another 6 percent of GDP, and the remainder represents estimated assets of insurance companies, nonbank financial institutions, and microfinance.

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Financial Sector Assets, 2001-06

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 230; 10.5089/9781451804232.002.A003

4. Private commercial banks and the stock exchange have seen the most rapid growth in the last five years. There are currently four nationalized commercial banks, five special development banks, 30 private commercial banks and 9 foreign commercial banks. Assets of domestic private commercial banks increased from 19 percent of GDP to 29 percent of GDP between 2001 and 2006. The stock exchange more than doubled in size relative to GDP. Although the number of microfinance institutions has nearly doubled, their assets have increased only slightly relative to GDP and remain under 2 percent, but their reach has increased to about 60 percent of households.

5. The sector remains small in a regional and global perspective. Broad money and credit to the private sector amount to 38 and 29 percent of GDP, respectively. Nonbank financial institutions are relatively small and short-term treasury bills are the dominant financial asset. Insurance activity is limited and life insurance policies total to less than half the average for low income countries.

6. Stock market growth has been much slower than in other countries, and average market capitalization at 6 percent is very low compared to the average of low income countries, which is 55 percent of GDP. Banks, which are required to list on the stock exchange, constitute the bulk of stock market shares.

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Broad Money (M2)

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 230; 10.5089/9781451804232.002.A003

7. The sector’s development benefited from financial liberalization measures in the 1990s. Key among these were liberalization of interest rates and opening the sector to entry of additional foreign banks and new private banks. A total of 8 foreign banks and 10 new private banks opened in the 1990s, while some banks exited. Macroeconomic stability, aided by fiscal discipline, has had a positive impact in improving confidence in the taka and supporting financial deepening. Alongside market deregulation measures, BB has moved gradually to tighten prudential regulations with a view to bringing them closer to international standards and to strengthen its supervisory procedures and capacities.

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Domestic Credit to Private Sector

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 230; 10.5089/9781451804232.002.A003

C. Overview of Bank Performance

8. The pace of financial sector growth has recently picked up. Since 2000, banks’ deposits have grown at a more rapid pace than lending. During the same period, banks’ cash on hand and holding of government securities have been increasing at a somewhat faster rate. This may be due to banks’ inability to find enough viable projects for their increased liquidity.

9. Relatively high lending rates are a sign of weak financial intermediation. Bangladesh’s bank lending rates are on average around 15 percent with some rates much higher, while rates on lending to agriculture and state-owned enterprises (SOEs) by the state-owned banks are much lower. These rates are relatively high compared to other Asian countries where they are between 8 and 12 percent on average although inflation rates are at similar levels. The higher lending rates could reflect perception of higher risk in Bangladesh.

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Deposit Growth, Lending and Investment in Securities, 1992-2006

Citation: IMF Staff Country Reports 2007, 230; 10.5089/9781451804232.002.A003

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Lending Rate

(In Percent)

Citation: IMF Staff Country Reports 2007, 230; 10.5089/9781451804232.002.A003

10. Persistently high interest rate spreads are another sign of inefficiencies in the banking sector. Interest rate spreads have remained high at between 6 and 8 percent since 1993. Improved economic conditions, the more rapid increase in deposits, greater competition, and measures to strengthen bank performance have not been translated into lower interest rates. Spreads have remained around 6 percent on average as both lending and deposit rates have remained high over the last six years. Consistent with inflation developments, average lending and deposit rates for the sector as a whole declined in 2003, but have been rising over the last two years. Rate trends have, however, varied between groups of banks.

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Interest Rate Spreads

(Lending rate minus deposit rate)

Citation: IMF Staff Country Reports 2007, 230; 10.5089/9781451804232.002.A003

11. Private banks’ deposit rates have risen most sharply, while both deposit and lending rates for NCBs have dropped significantly. Deposit rates of private banks average 9 percent compared to 5–6 percent for foreign banks. In contrast to the situation three years earlier, deposit rates of private banks now significantly exceed rates offered by state banks. This may reflect banks’ efforts to increase their market share in the context of rising competition and deserves further investigation. As part of their restructuring plans, the nationalized commercial banks (NCBs) have been subject to limits on their lending to non-public sector entities. This has driven some of their business away to private banks and may explain the decline in their lending and deposit rates since the NCBs lend at below market rates to the public sector.

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Deposit Rates, Weighted Average, By Bank Type, 1992-2006

Citation: IMF Staff Country Reports 2007, 230; 10.5089/9781451804232.002.A003

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Lending Rates, Weighted Average, By Bank Type, 1992-2006

Citation: IMF Staff Country Reports 2007, 230; 10.5089/9781451804232.002.A003

12. The benefits of sector reform can be seen in relative improvements in asset quality and banks’ capital positions. The ratio of nonperforming loans (NPLs) declined from around 35 percent in 2000 to around 14 percent in 2006, but with variations by type of bank. As the capital adequacy requirements were raised, banks’ average capital position also strengthened.

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Bank Nonperfoming Loans to Total

(In percent)

Citation: IMF Staff Country Reports 2007, 230; 10.5089/9781451804232.002.A003

uA03fig10

Bank capital to assets

(In percent)

Citation: IMF Staff Country Reports 2007, 230; 10.5089/9781451804232.002.A003

13. Even with these improvements, asset quality and capitalization remains relatively weak. The NPL ratio is high by international standards (although country comparisons are complicated by varying local definitions of nonperforming loans). Similarly, the ratio of bank capital to total assets is much lower than in neighboring countries, and as noted below, reported ratios overstate banks’ capital adequacy. Some of the reasons for these persistent weaknesses are explored in the following section.

D. Weak Financial Intermediation and Implications for Rapid Credit Growth

14. This section investigates the nature of bank inefficiencies and the potential risks in the context of robust credit growth. First, it reviews the extent to which competition has increased following deregulation by examining various measures of market concentration. Second, it explores the variations between banks’ performance (including intermediation spreads) and the characteristics associated with banks that have higher operating costs and more rapid lending growth. Third, it presents results of some stress testing on the ability of banks to withstand an increase in non-performing loans stemming from an economic shock.

Indicators of Market Concentration

Market concentration has declined significantly since 1992. In terms of loans and deposits, the Herfindahl Index (defined as the sum of squares of the shares of the banks) has declined from around 0.14 to 0.06, which is relatively low by international comparison.

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Market Concentration: Herfindahl Index

Citation: IMF Staff Country Reports 2007, 230; 10.5089/9781451804232.002.A003

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Market Concentration: Percent Share of the Largest Bank

Citation: IMF Staff Country Reports 2007, 230; 10.5089/9781451804232.002.A003

The relative decline in deposit concentration is somewhat greater that that of loan concentration. The largest three banks (all NCBs) now hold 32 percent of total deposits compared to 60 percent of total deposits in 1992. The share of the largest bank, Sonali Bank, declined from 27 percent to about 18 percent of deposits, with a more modest decline in its share of loans, assets, or branch network.

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Market Concentration: Percent Share of the Largest Three Banks

Citation: IMF Staff Country Reports 2007, 230; 10.5089/9781451804232.002.A003

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Market Concentration: Percent Share of the Largest 10 Banks

Citation: IMF Staff Country Reports 2007, 230; 10.5089/9781451804232.002.A003

Market Concentration

15. A variety of indicators show that market concentration has declined following liberalization (Box 1). However, it is worth noting that among bank types, the largest NCBs and foreign commercial banks (FCBs) enjoy considerable market power. Although there are 9 FCBs, the three largest account for 85 percent of the FCB market share.

Performance indicators and large intermediation spreads

16. High intermediation costs are a sign of either operating weaknesses and/or rigidities giving rise to rents that reduce the efficient utilization of savings. As noted above, interest rate spreads have remained stubbornly high in the face of reforms. Based on analysis of pooled bank data for 50 banks from 2000 to 2006, there is considerable variation in net interest margins (the ratio of net interest income to assets), profitability, and cost efficiency of banks. This variation suggests that some banks are unprofitable or inefficient while others are benefiting through high rents.

17. Low interest margins of problem banks result from the large size of their nonperforming loan portfolio. By dividing all banks into quintile groups based on NPL ratios, we can see that the banks with the highest NPL ratios (averaging 41 percent of their loan portfolio) have the lowest interest margins, and consequently low profitability and low return on assets.

Average Interest Spreads and Profitability by NPL Quintile

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18. Interest margins vary widely between banks and operating inefficiencies are not evenly distributed. In the highest quintile, interest margins have averaged 8 percent of assets. This group has the lowest NPL ratio, at under 3 percent. It also has the best operational efficiency indicators as measured by the operating expense ratio to assets and the number of employees per total value of loans, and consequently, the highest profitability. In contrast, the interest margins are less than 1 percent in the least profitable banks.

Bank Performance by Interest Margin Quintile

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19. While the interest margins vary widely, there is little variation in the interest rate spreads between banks. The difference between the weighted average lending rate and weighted average deposit rate appears to be uniform across banks with varying degrees of efficiency, all ranging between 5 and 6 percent. The interest margin of the least efficient banks, as proxied by the highest number of employees per loan, does not substantially differ from other banks. The difference in the interest margin appears to reflect the lower share of nonperforming loans and higher share of other interest earning assets in the more profitable banks.

Characteristics of Banks with High Personnel Cost by Personnel Cost Quintile

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Determinants of high intermediation spreads and profitability

20. Bank ownership has a significant impact on banks’ profitability as does the degree of nonperforming loans. This can be seen from an exploration of characteristics that are associated with banks’ high intermediation costs and profitability provided in the Annex using regression analysis for a longer time period from 1992 to 2006. The analysis also finds no significant decline in intermediation spreads over time and little impact from reduced market concentration, which suggests that the large banks still hold considerable market power that diminish potential efficiency gains.

Characteristics of banks with high credit growth

21. Rapid credit growth poses particular risks when banking intermediation is inefficient. Credit to the private sector has increased at an average annual rate of 18 percent over the past three years, even while lending to the private sector by the largest three state banks has been restricted to no more than 5 percent annually. Some private banks saw strong growth in their loan portfolios, averaging over 40 percent annually.

22. At this time, the risks posed by recent credit growth appear to be limited, but they need to be closely monitored. Newer small banks are experiencing the most rapid growth in their loan portfolio, but they are the smallest banks and together this group accounts for 5 percent of banking system deposits. The second quintile of banks in terms of credit growth is also relatively small with a total share of 10 percent of system assets but whose performance ratios appear sound. However, much stricter monitoring is needed of the middle quintile, representing ten banks whose average loan growth is 25 percent annually and who already have nonperforming loans slightly over 10 percent of their loan portfolio. This group of banks represents about 17 percent of total system deposits.

Characteristics of Faster Growing Banks

Asset Quality and Efficiency by Credit Growth Quintile

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Banks’ capital strength and stress testing

23. According to published indicators, most banks meet the 9 percent statutory capital-to-risk weighted assets ratio (CAR). Each group of banks meets the required ratio, with the exception of NCBs that had a reported CAR of -0.5 percent in June 2006 and around 1 percent for December 2006. Foreign banks maintained capital close to 25 percent of their risk weighted assets. Three smaller private banks were under the close supervision of BB’s Problem Bank Unit, but, in aggregate, private commercial banks had a CAR of close to 10 percent.

24. However, published indicators overstate the capital strength of the banking system. There are several ways in which the capital adequacy ratio is overstated. First, the published figures do not net out the provisioning shortfall and accumulated losses of the banks. Doing so results in a CAR ratio of -10 percent for NCBs and -11 percent for SDBs and 8 percent for the group of private domestic banks. Second, classification rules are fairly lax for agricultural loans and micro/medium sized loans. Instead of being classified as bad/loss when overdue by more than 12 months, they are classified as such only after 60 months. Similarly, substandard and doubtful classifications are based on 12 and 36 months of default compared to 6 and 9 months for other banks. In addition, these classified loans require provisioning of only 5 percent instead of 20 and 50 percent when classified as substandard and doubtful. Making adjustments for these loans, which are concentrated in the NCBs and SDBs, reduces the CAR further to -11 percent for NCBs and -47 percent for SDBs. With these adjustments, the capital shortfall of the NCBs and SDBs is about 4½ percent of GDP. The capital requirement could be greater to the extent that loans are misclassified and losses are underreported.

Capital Adequacy, 2006

(Capital to risk weighted assets)

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Capital Shortfall, 2006

(In percent of GDP)

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25. Stress testing sheds some light on the resilience of the banking system to adverse economic conditions. If due to an adverse external shock, the NPL ratio of each bank increased by 20 percent, the number of banks that would not meet the required CAR would increase from 10 to 13 and the capital shortfall would increase from 4½ percent to 5 percent of GDP. If the NPL ratio increased by 50 percent for each bank, 21 banks would fall below the CAR and the capital shortfall would increase to 6 percent of GDP. These scenarios point to the need for close monitoring of recent credit growth, particularly in the relatively weaker banks.

Impact of an Increase in NPL Ratio on Capital Adequacy

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E. Policy Considerations

26. Bank soundness has improved with the strengthening of regulation and supervision, but much more needs to be done. BB has moved steadily toward adopting international best practice in its prudential regulations. BB circulars have facilitated banks’ compliance with reporting, prudential regulations, and risk management. However, the upward trend in published bank soundness indicators must not detract from the need to carefully watch bank weaknesses and vulnerabilities. In particular, the medium-sized banks whose credit is growing by 20 to 30 percent and whose NPL ratios are about 10 percent should be more closely watched. BB needs to move more closely in line with best practice standards for banks’ accounting, loan classification, and provisioning requirements. The recently mandated increase in the capital adequacy ratio to 10 percent by end-2007 is a welcome step, as is the proposal to amend the Banking Act so that BB can more flexibly adjust classification and other prudential guidelines.

27. Bangladesh needs a sound financial sector and efficient financial intermediation to support sustained growth. The financial sector has seen considerable growth, benefiting from the improved macroeconomic environment. Beyond maintenance of macroeconomic stability and stricter prudential regulations, further steps are needed to reduce state control in the banking system in order to improve efficiency, enhance intermediation, and reduce vulnerabilities. The recent liberalization of the banking system and entry of new banks has not yet translated into efficiency gains due to the continued predominance of large weak state banks that are not operating on commercial basis. Corporatization of the remaining three nationalized commercial banks should allow for more stricter enforcement of banking regulations on these banks. The government should also review the role of the SDBs in achieving its policy objectives with a view to separating out their commercial activities and taking measures to improve their performance.

Annex. Determinants of Bank Profitability and Intermediation Spreads

1. Several studies have found that bank performance improves with financial liberalization, leading to lower profits and intermediation spreads. Claessens et al. found a positive effect on lower intermediation spreads using cross-country bank-level data. Koeva (2002) and Sanyal and Shankar (2005) have reported positive results for India, but to our knowledge, this relationship has not been tested with Bangladesh data. It is explored here using bank data from 1992 to 2006, with the number of banks varying in different years.

2. We first look for trends in performance over time, then attempt to attribute variations in bank spreads and profitability to bank specific, industry specific, and economy wide variables. The industry specific variables include two measures of market concentration, the Herfindahl index and the share of the largest ten banks. Economy wide variables are GDP growth and inflation. Regressions used OLS as well as fixed effects which has the advantage of controlling for bank-specific factors that are not explicitly included in the regressions. Three measures of intermediation costs and three measures of profitability were used in the analysis.2

3. The main findings expand and lend further support to the analysis in the main text:

  • Reduced market concentration has not led to lower spreads. The Herfindahl index has a significant negative effect in only one equation. There is no clear evidence of a decline in interest margins over time (Table 1). Using time dummies only gave similar results.
  • Ownership matters. Intermediation spreads and profits are higher in foreign banks and lower in NCBs and SDBs as seen in a significant effect in almost all specifications.
  • In terms of bank-specific variables, higher market share of total loans, and lower cash and investment ratio have a significant effect on interest margins.
  • Lower inflation also has a significant effect on higher interest margins, suggesting market rigidities that do not allow interest rates to decline as much as inflation. (Table 2)
  • Branch network has a significant positive impact on profitability. The coefficient has a significant effect and negative sign in the OLS regression but positive and significant in the fixed effects model, which controls for other unexplained bank specific factors.
  • Market share, lower reserve ratio, lower share in cash and securities, lower operating expenses, and low NPL ratios, all have a significant effect on profitability. (Table 3)
  • Higher GDP growth has a significant positive effect on profitability of banks, while there is no discernible effect for higher inflation, which as suggested above is likely due to interest rate rigidities.
Annex Table 1.

Panel Regressions for Variations in Interest Margins and Profitability Over Time and Bank Type 1

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The reference year in the regressions is 1996 and the reference category is banks established pre-1996. The significance levels are denoted by * for 1 percent, ** for 5 percent, *** for 10 percent. Interest margin definitions: 1. Net interest margin over assets, 2. Interest income normalized by assets less interest expense normalized by deposits. 3. Similar to 2 but includes other liabilities with deposits. Profitability definitions: 1. Profits before tax over assets, 2. Return on equity, 3. Return on assets.

Annex Table 2.

Panel Regressions for Determinants of Intermediation Spreads

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The significance levels are denoted * for 1 percent, ** for 5 percent, *** for 10 percent. Interest margin definitions: 1. Net interest margin over assets, 2. Interest income normalized by assets less interest expense normalized by deposits. 3. Similar to 2 but includes other liabilities with deposits. Profitability definitions: 1. Profits before tax over assets, 2. Return on equity, 3. Return on assets.

Annex Table 3.

Panel Regressions for Determinants of Profitability

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The significance levels are denoted by * for 1 percent, ** for 5 percent, *** for 10 percent. Interest margin definitions: 1. Net interest margin over assets, 2. Interest income normalized by assets less interest expense normalized by deposits. 3. Similar to 2 but includes other liabilities with deposits. Profitability definitions: 1. Profits before tax over assets, 2. Return on equity, 3. Return on assets.

References

  • Bangladesh Bank, 2006, Annual Report 2005–06 (Dhaka).

  • Brock, P., and Suarez, 2002, “Understanding the Behavior of Bank Spreads in Latin America,” Journal of Development Economics, Vol. 63, pp. 113– 134.

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  • Claessens, S., Demirguic-Kunt, A., and H. Hiuginga, 2001, “How does Foreign Entry Affect the Domestic Banking Sector” Journal of Banking and Finance, Col. 25, pp. 891– 991.

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  • International Monetary Fund, Bangladesh: Financial System Stability Assessment, 2003, SM/03/205.

  • Koeva, P., 2002, “The Performance of Indian Banks During Financial Liberalization, IMF Working Paper No. WP/03/150 (Washington: International Monetary Fund).

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1

Prepared by Wafa Abdelati (APD).

2

Several measures of profit and interest margin are used consistent with Brock and Suarez (2002) who argue that the study of determinants of interest rate spreads makes sense in a fully liberalized economy.

Bangladesh: Selected Issues
Author: International Monetary Fund