Chapter 6

The Financial Sector Policy Stance

At the present stage of development of the Bangladesh economy, the financial sector has a key role to play in facilitating smooth exchange of goods and services through monetization of the economy and improvements in payments and settlements, and acting as a well performing bridge between the savers and the investors and between the present and the future. The country's financial sector policy stance is geared to serve as a tool for poverty reduction in two major ways: first, through creating direct impact on productive activities and hence on employment and income generation; and second, through indirectly influencing the fiscal and monetary policy stances that are important determinants of employment and output growth and hence of poverty reduction. The direct effects of financial sector policies on poverty are mediated through different channels, such as cost and other conditions for accessing credit, level and pattern of private investment, and means of financing fiscal deficits. In this context, the financial sector policy stance emphasizes on bringing more efficiency in the financial sector especially the banking system and NBFIs so that the interest rate spread is reduced, new and more productive financial derivatives are introduced, growth of financial assets is enhanced, risks are minimized, non-performing loans are reduced, and new and more effective modalities are discovered for delivering agricultural (typically short-term), industrial (typically long-term), and infrastructure finance. In addition, the development of a strong and diversified secondary bond market is critical to increasing the depth and breadth of Bangladeshs financial sector that matches the fast growing emerging economy standards. The prime goal of bringing better financial intermediation is to ensure the availability of required pool of financial resources necessary to sustain smooth and adequate flow of credit to the economy, especially to the productive sectors, to realize high economic growth along with economic stability. In the backdrop of the above issues which are relatively long term in nature, no major changes are stipulated in the financial policy stance that was articulated in the previous issue of the Financial Sector Review (FSR, 3(2), June 2008). The concerns would be to maintain both quantity and quality of financial intermediation through ensuring efficiency, credibility, transparency, and accountability along with creating necessary financial safety-nets through implementing anti-money laundering safeguards. The Bangladesh Bank, in its bi-annual monetary policy statement (MPS) for the period JanuaryJune 2009, has stated its intention of pursuing monetary and financial policies that accord priority to ensuring adequate credit accommodation for productive supply side economic activities, and providing refinance support where necessary for income and employment generating priority sectors underserved by the market.28 As such, the monetary policy stance does not bring any major change in policies pursued by the Bangladesh Bank since FY08 which
28

See, Monetary Policy Statement, 14 January 2009, Bangladesh Bank Quarterly, 6(2), October-December 2008.

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succeeded remarkably in ensuring stability of the economy amidst the global financial crisis raging the world. The global financial crisis has created renewed pressures on the global credit market and the global economic outlook is undergoing fast changes in the backdrop of growing liquidity crunch in the global market. The financial strains remain acute, pulling down the real economy with world growth projected to fall to 0.5 percent in 2009, its lowest rate since World War II. The slump in global demand has also led to a collapse in commodity prices creating dampening impact on inflation pressures. Faced with deteriorating situations, central banks in most countries, especially in the advanced economies, have taken actions to cut policy rates, improve credit provision, and ease policy stance to improve market liquidity. Moreover, many governments have announced fiscal packages to boost their economies. Bangladesh has successfully cushioned itself from the headwinds of ongoing global financial crisis and remained largely unaffected by the global slowdown mainly due to its limited openness to short term capital flows and innate wariness about excessive debt exposure to the global financial system. Like other small economies, Bangladesh however is by no means invulnerable to fallouts from prolonged global downturns or to negative spill over of policies of large economies, and thus has a strong stake in global stability. The emerging challenges in an increasingly uncertain global economic environment require that the country's financial sector policy stance plays a key role in striking a balance between the healthy growth of the financial sector and economic growth with stability. Although till now relatively protected from the direct effects of the global financial crisis, Bangladesh's banking sector would probably face more pressure over time. The loan quality may deteriorate and liquidity may reduce if economic growth slows. Obviously, in view of the current experience, the longer term concern for Bangladesh would be to move toward a macro-prudential and regulatory architecture that is effectively integrated along with needed coordination among all financial sector institutions including commercial banks and the Bangladesh Bank. Macroeconomic Stability Bangladesh has performed well in terms of most macroeconomic indicators during the first two quarters of fiscal year FY09. The Policy Analysis Unit (PAU) projections show that the economy is now well poised to achieve a GDP growth rate of around 6 percent in FY09. Moreover, with an elected government in power and adoption of new economic measures, it is likely that business confidence and investment climate would further improve in the coming months and if no drastic shock to the present buoyant export growth takes place, the economy could grow even faster in FY09. Similarly, with easing of inflationary pressures and resulting decline in inflation expectations, it is likely that average inflation could fall to around 7.8 percent in FY09. The money and credit market developments have been satisfactory although both broad money (M2) and domestic credit growth during the first half of FY09 exceeded their programmed levels. However, BB's adjustment of repo and reverse repo rates in September and November 2008 would contribute toward fine tuning the short term liquidity mismatch in the money market and anchoring inflation expectations by mopping up excess liquidity from the banking system. In the fiscal sector, although revenue collection fell short of its target during the first half of FY09, overall fiscal stability depends much on effectively managing public expenditures to avoid creating any undue pressure on monetary targets along with ensuring proper implementation of the annual development program (ADP) with priority to productive public investments.
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Banking Sector Competition: Privatization and Restructuring Several qualitative improvements in the performance of the banking sector have been noted in the present Review. There have been improvements in sectoral lending activities of the SCBs which would contribute toward raising the overall banking sector performance and competitiveness. The corporatization of three nationalized commercial banks (Sonali Bank, Janata Bank, and Agrani Bank) has enabled them to operate as public limited companies (known as state owned commercial banks, SCBs) and created a larger space for improvement in their operation. It is expected that the SCBs will play a more market friendly role and thereby contribute to bringing more competitive environment in the banking sector, removing inefficiencies and market segmentation. The SCBs have initiated various actions to reduce their high share of non-performing loans (NPLs) in the banking industry. While their efforts are yet to produce visible results, it may be noted that the classified loan to total loan ratio of all banks has declined markedly from 41.0 percent in 1999 to 10.8 percent in December 2008. Similarly, total classified loan outstanding for the banking sector as a whole has shown declining trend till September 2008. The flow of newly classified loans also declined because of adoption of measures both by the banks and the Bangladesh Bank that include appointment of private recovery agents; paying commissions to lawyers and incentives to bank staff and real estate brokers; establishment of Money Loan Court in 2003; and strengthening of Bangladesh Banks supervisory role to improve the NPL situation. In Bangladesh, a major concern for the monetary authority is the adverse effect on bank balance sheets arising out of high NPLs of the banks. Along with other measures, Bangladesh needs to strengthen asset management companies to quicken recovery and improve efficiency in the banking sector. The BBs recent directives to the banks are: to take precaution while extending loans to high risk sectors and prioritize loans to productive sectors which would help to further improve the NPL situation in the country. The small and medium enterprises (SMEs) are considered both the driving force and the pillars of pro-poor economic growth in Bangladesh. In the FY09 budget, the sector has been treated as a thrust sector with focus on deepening the SME sector activities along with ensuring their sustainability. A well developed SME sector is a pre-requisite to attaining higher productivity through building local capacity in Bangladesh. The Bangladesh Bank (BB) has arranged refinancing facilities for banks and NBFIs to accelerate credit flows to the SME sector. The refinancing scheme is conducted from the proceeds of BBs own fund and funds from IDA (under the Enterprise Growth and Bank Modernization Program), and ADB (under the Small and Medium Enterprise Sector Development Program). Both banks and NBFIs are increasingly coming forward to provide finance to the SME sector in order to uphold financial strength and increase technical capacity, productivity, and contribution to industrial performance. In order to ensure cost effectiveness, BB has given permission to the scheduled banks to open SME service centers to receive application and disburse, monitor, and recover loans to the SME sector. For further boosting the development of the SME sector, new generation of financial institutions are needed along with financing mechanisms to provide access to appropriate finance and meet up the diversified needs of financial services of this potential sector.

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Capital Market Development An efficient bond market is important for managing public debt and bank liquidity and for facilitating the efficient conduct of the monetary policy. So far, the bond market (as well as the stock and share markets) has played a limited role in the economy. The stock prices showed significant upturn during the first half of 2008 while the second half witnessed downward movement. The country's capital market showed declining trend during the first half of FY09. A major weakness of the market is its failure to adequately reflect the company fundamentals and there exists the possibility that insider trading is manipulating prices in the market. A substantial increase in prices of the shares of a few companies does not reflect sustainable market development. Moreover, volatility in the market remains high, which needs careful investigation and monitoring by the stock market regulators. The dominance of banks, with high bad loan portfolios and non-transferability of most of their debt/savings instruments, acts as a hindrance to the development of a well-performing bond market in the country. The absence of a vibrant capital market makes the financial sector less competitive as it fails to generate market interest rates that reflect the opportunity cost of funds at different maturities and results in excessive reliance on the banking system. In recent years, around 70 percent of the domestic savings are held in the form of bank deposits, while only 30 percent are investments in the debt market which is entirely dominated by government instruments. There hardly exists a corporate bond market in the country; it has a debenture market with only a small number of well-known issuers, relatively small size of tradable government bonds, almost non-existent secondary trading of government bonds, and absence of public issue of corporate bonds since 1996. It may be noted that till FY08, only one corporate bond has been floated. In view of the above, the bond market has played a very limited role in the Bangladesh economy. The size, access, efficiency, and stability of the bond market across countries may be used to gauge the state of the bond market development in Bangladesh. While the ratio of public sector bonds to GDP is small relative to other countries in the region, the ratios of private sector corporate bonds and international bonds to GDP are nearly zero as these bonds are virtually nonexistent in Bangladesh. For developing an efficient and broad based bond market, a robust secondary market of fixed income securities is essential. The development of the bond market also requires steps to enhance disclosure requirement to improve investors' confidence and steps to improve market infrastructure and reduce transaction costs of new issues. Above all, establishment of internationally competent credit rating agencies and regular reporting of credit rating by the participating companies would be an essential part of overall development of capital market. Regulatory Framework In order to fulfill the requirements for building up a sound financial system, modernizing the banking sector, and strengthening their balance sheets by ensuring the capital base after adequate provision for risky assets, Bangladesh Bank issued several prudential guidelines during the period under review relating to banks capital base, reserve ratios, SME financing, corporate governance, legal issues, and charges and fees for bank deposits.

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The present global financial crisis has put forward the agenda on rethinking of regulation and supervision of banks and large cross boarder financial institutions. The weaknesses in banks' risk management of securitisation and off-balance sheet exposures resulted in large unexpected losses during the crisis for the banks in most countries. It is now recommended that all risks arising from securitization, particularly those that are not fully captured under Pillar I should be addressed in a bank's internal capital adequacy assessment process (ICAAP). These risks include: credit, market, liquidity, and reputation risks of each exposure; potential delinquencies and losses on the underlying securitized exposures; exposures from credit lines or liquidity facilities to special purpose entities; and exposures from guarantees provided by monopolies and other third parties. To mitigate these risks, a bank's on and off-balance sheet securitization activities should be included in its risk management disciplines, such as product approval, risk concentration limits, estimates of market, credit and operational risks. Since the financial crisis began in mid 2007, the majority of losses and most of the build up of leverage occurred in the trading book. The current capital framework for market risk (based on 1996 amendments to Basel I) does not capture some key risks, particularly for un-securitized products, and hence the Basel Committee has proposed to supplement the current value-at-riskbased trading book framework with an incremental risk capital charge (IRC), which includes default risk as well as migration risk, for un-securitized credit products. For securitized products, the capital charges of the banking book would apply. In March 2008, the Basel Committee on Banking Supervision decided to expand the scope of the capital charge to capture not only defaults but a wider range of incremental risks, to improve the internal value-at-risk models for market risk and to update the prudent valuation guidance for positions subject to market risk of the Basel II framework. Overall, Basel II provides comprehensive tools for banks and bank supervisors to better capture and assess an increasing set of complex risks and helps reduce a number of perverse incentives that might contribute to crisis. It provides incentives for concerned institutions to improve governance, risk management, and the measurement and aggregation of firm wide risks. The three pillars of Basel II would help ensure that capital regulators are better positioned to handle periods of rapid innovation and resulting new products. The implementation of Basel II brings out several challenges for Bangladesh especially relating to measurement of credit, market, and operational risks. In December 2007, an action plan was released by Bangladesh Bank which envisaged the implementation of Basel II starting from January 2009. The action plan aimed to assist the scheduled banks in formulating internal plans and gearing up efforts for implementing Basel II. The Bangladesh Bank issued a revised regulatory framework in line with risk based capital adequacy framework (Basel II) along with guidelines for the banks to implement 'Risk Based Capital Adequacy for Banks' from January 2009. Under the framework, credit rating is to be determined on the basis of risk profile assessed by external credit assessment institutions. The Bangladesh Bank has also advised the banks to start quarterly reporting of status using existing reporting norms. Previously, a self-audit on compliance with Basel Core Principles (BCP) took place in order to establish effective banking supervision in Bangladesh. The initial implementation of Basel II will follow standardized, standardized (rule based), and basic indicator approaches to calculate risk weighted assets (RWA) against credit risk, market risk, and operational risk respectively.
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Bangladeshs Financial Sector Risks and Stability The global financial crisis, unprecedented in recent times, shows that there is no substitute of prudent government intervention and careful regulation even when market determined incentive structures operate. A liberalized, market based, and effectively supervised and regulated financial sector is necessary in order to promote and sustain rapid growth in Bangladesh. Clearly, Bangladesh needs to plug the gaps in regulatory and supervisory infrastructures and strengthen its regulatory regime in a comprehensive manner covering all institutions dealing with both household savers and institutional investors in order to avoid the creation of any systemic distress. The Bangladesh Bank, as the supervisor of the country's financial sector, carefully monitors the liquidity conditions and other financial developments and takes appropriate actions when needed. Supported by relatively strong macroeconomic fundamentals, the financial sector in Bangladesh has so far remained resilient. Although quick recovery of economic activities after the natural disasters of the last fiscal year created some liquidity stress in the interbank money market, activities quickly returned to business-as-usual situation with supportive measures from the Bangladesh Bank and prudent policies of the financial institutions. The recent stress condition of the interbank market, however, suggests that banks need to monitor their asset-liability mismatch closely while making financing decisions. Drawing on the lessons from the global crisis, sound principles for the governance, design, and implementation of stress testing programs at banks are needed. A sound stress testing program should (i) provide forward-looking assessments of risk; (ii) complement information from models and historical data; (iii) be an integral part of capital and liquidity planning; (iv) support internal and external communication; (v) guide the setting of a bank's risk tolerance; and (vi) facilitate the development of risk mitigation plans across a range of stressed conditions. In this context, the need for bank supervisors to be confident of audit quality has been reinforced by a variety of factors and events. These include: concerns about the risk of audit failures, global expansion of major audit firms, and increased complexity of both accounting standards and financial instruments. In addition, the challenges associated with fair value estimation processes, which have been amplified by the current market crisis, underscore the importance of high quality audits. As such, the Basel Committee's focus is on the following areas: bankers and supervisors reliance on external auditors expertise and judgments; high-quality audits which enhance market confidence particularly in times of severe market stress; and increasing reliance on high-quality bank audits to complement supervisory processes. For Bangladesh, policies are needed to maintain international auditing standard to avoid exposure to financial risks of different types. Overall Policy Stance After the floods and the cyclone, Sidr, of the last fiscal year, domestic demand and supply conditions have recovered significantly and the overall economy has regained its normal growth performance by early 2008. Under the situation, although booming credit and economic conditions have created flourishing businesses for the banks, it is important to remain cautious about potential interest rate and liquidity risks if prudent policies are not pursued. The financial sector, on its part, needs to remain vigilant and prepared to face any unforeseen developments
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including inflation risks radiating to interest rate risks although micro level indicators have improved in recent times along with declining rates of inflation. In the context of the present global financial crisis, a close watch on the unfolding situation and impact on the Bangladesh economy is the major issue in determining both short term and long term measures. At the forefront is the compulsion to promote faster economic growth for which the financial sector policies need to ensure adequate quantity and quality of financial services and their flow to productive and priority sectors. This requires policies for creating a more competitive and globally standard financial sector capable of reaching out to all sections of the community, both rural and urban, and to all sectors to provide different types of financial services including credit. For the purpose, financial deepening is necessary including a well functioning primary and secondary bond market where government and corporate bonds are traded freely along with more active equity and insurance markets for efficient allocation of risks in the economy. For minimizing credit and liquidity risks in the financial market, the priority is to create a competitive banking system (covering non-bank financial institutions as well) that has the capacity to overcome maturity-mismatch and classified loan problems. It is important for the banks to effectively identify, measure, monitor, and control credit risk, as well as to understand how credit risk interacts with other types of risk (including market, liquidity, and reputation risks). The global financial turmoil highlights the importance of addressing unexpected aspects of credit, concentration, market, liquidity, legal, reputation, and all other types of risks by the local banks. The important agenda for Bangladesh would be to convert the learning from the global crisis into an opportunity for developing risk mitigating strategies. It would be important for financial sector policies to encourage the banks to use any excess liquidity in the banking system for providing credit to productive activities. The Bangladesh Bank, on its part, should strengthen its prudential oversight and closely monitor the liquidity situation in the banking system. Prudent actions are also required to implement the Basel II framework of supervision and disclosure principles toward risk management and capital planning. In this context, further strengthening of the diagnostic review of the financial health of the banks, currently undertaken by the Bangladesh Bank, would contribute toward improving their operational efficiency and financial viability. In addition, it would be important for the Bangladesh Bank to continue its efforts in urging the banks to reduce their lending rates, increase competition among the financial intermediaries, and pursue strong monitoring and supervision measures so that the financial institutions reduce administrative cost by improving efficiency and reducing the burden of non performing loans. Obviously, a major concern of the financial sector policy stance is to bring into existence an appropriate institutional framework and regulatory structure for the financial sector in order to reinforce adopted policies and ensure that the quality and coverage of financial intermediation, especially in the priority sectors, are satisfactory. In this context, it is important to recognize that under the market based financial system if no regulations exist, the market is likely to direct less credit to sectors having activities where externalities are present and/or there exists divergence between private and social returns. Under such circumstances, in addition to playing the role of investment coordinator, market-consistent interventions by the Bangladesh Bank might be necessary to ensure adequate credit flows to the priority sectors from the point of view of poverty reduction and social development.
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