Nofel Wahid

The banking sector needs to diversify its business model

September 16, 2012

220px-BBK-LOGONews of alleged corruption in nationalised commercial banks (NCBs) is of course all the rage now. And so it should be, a Tk 4000 crore swindle deserves every bit of column space it gets, despite the protestations of our finance minister.

That said, all these allegations of dodgy deals by politically-appointed directors at NCBs are nothing new. We have heard these stories before, and I am afraid we will continue to hear them as long as the Government continues to own banks, and the Bangladesh Bank fails to diligently regulate NCBs because it is too beholden to the Government.

So instead of talking about old wine in an old bottle, I figured it would be worth our while to use this opportunity – given how everybody’s attention is fixated on the banking sector right now – to discuss a potentially more important issue affecting our banking industry, and in turn, the economy.

Banks are meant to perform a very simple function. Their job is to act as a conduit that channels people’s savings to investors who need capital to invest. Taking deposits and lending out that money, and recording those transactions as assets and liabilities on a balance sheet are one of many ways banks can perform that role of a conduit. A key strategy used by banks to manage the risks associated with taking deposits and lending it out is known as ‘duration matching.’

sonali-bank-300Duration matching basically involves banks making sure that their assets and liabilities mature at the same time. For example, if a depositor puts money in a 6-month fixed deposit (FD) account, the bank will try to make sure that its corresponding loan to an investor is also for 6 months.

This ensures that the bank will be repaid by its client in time to meet any cash withdrawals by the depositor when the FD term expires. When the maturity of a bank’s asset and liabilities don’t match, banks run the danger of becoming illiquid – i.e. they don’t have enough cash in hand to meet depositor withdrawals.

So how good are our banks at duration matching? Turns out they do a pretty decent job on that front, and there are no major problems to speak of. However, the way the banks match their asset liability durations speaks volumes about how our economy works, and what it means for future economic growth.

Let me illustrate that point with two sets of charts. Chart 1 below shows the share of deposits under different types of accounts as a percentage of the total deposits. For example, it shows that normal savings accounts that pay low interest rates (averaging 5.25%) and allow you to withdraw money whenever you please make up nearly 20% of all deposits in the banking system.

Chart 1: Share of deposits by account type

Nofel 1Source: Bangladesh Bank, Scheduled Bank Statistics January-March 2012. Data is for March quarter 2012.

More importantly, the chart shows that FD accounts with a duration of 3-6 months make up about 18% of all deposits, while the 1-2 years duration class constitutes another 15%. In other words, close to 60% of all deposits in our banking system have a duration ranging from money on demand to 2 years.

That begs the questions – why do the banks seem to care so much about short-term deposits? Surely banks would need to attract lots of long-term deposits (say for 5 years or longer) in order to match the duration of long-term loans needed to build factories and for other investment projects?

The chart below provides the answer to those questions. It turns out that banks lend most of their money to finance international trade – i.e. opening LCs (letters of credit) for importers/exporters. And – surprise, surprise! – most LCs are usually drawn for short time periods of between 3 to 6 months.

Chart 2: Percentage share of banks loans by economic activity

Nofel 2Source: Bangladesh Bank, Scheduled Bank Statistics January-March 2012. Data is for March quarter 2012.

To put it simply, our banks make most of their money from servicing RMG exporters and importers of goods and services ranging from Indian onions to Chinese fridges. I am of course trivialising the issue here to make a broader point!

The point being – our banks are in danger of becoming excessively focused on trade financing, and it may end up hurting other sectors of our economy. There is a strong case to be made for the fact that banks are starving credit from investors such as a rickshaw-puller who wants a loan to start a ‘dokan’ or a BUET graduate who wants a loan to manufacture solar panels that use his more efficient design.

Evidence to that effect can also be drawn from the fact that total investment in our economy has stagnated at 24% of GDP over the last few years. This has happened despite the increase in national savings from about 24% of GDP to nearly 30% of GDP over that same period.

The relationship between savings and investment is important because investment is basically funded from two sources: domestic savings or foreign funding (whether it be in the form of development aid or FDI). The foreign funding we receive is negligible relative to the size of our GDP, and it pales in comparison to the importance of domestic savings as a source of funding for investment.

The fact of the matter is – there is now a gap between what we save and what we invest, when there once used to be none. We are saving more and that is good news, but we are not putting those savings to productive use.

And the banks must take their fair share of blame for this. As I mentioned earlier, they are the primary conduit through which savings are channelled to investors. Their neglect of industrial credit in favour of making easy money through trade financing is causing imbalances in the economy.

But it doesn’t have to be this way!

The surprising bit in all of this is that trade financing is actually a low-profit margin business. The general consensus in the financial industry is that profit margins are higher in fee-based wealth management and investment banking services.

So what are wealth management and investment banking services? Those are alternative services banks can offer to facilitate investment by providing expert investment advise to clients in return for fees and commissions.

That means providing a whole gambit of services ranging from advising young professionals or retirees on whether to invest in shares or bonds, and if so, which shares and bonds to invest in and which ones to avoid. On the corporate side, banks can advise their clients on business finance issues ranging from how to manage cash flows to whether a business should issue shares or bonds when looking to raise capital from the market.

Put simply, our banks need to change the way they do business. Instead of constantly trying to channel savings into fixed deposit accounts, the banks would be better-off trying to establish fee based financial advisory businesses with higher profit margins.

The benefits are not just limited to helping banks make more money. There are wider benefits to the economy as a whole. It will enable the channelling of savings to a wider variety of domestic investors who need funding for varying time lengths, as opposed to just simply facilitating short-term trade financing that structurally forces the economy to be heavily reliant on external trade as a source of growth.

This is important because despite the strong growth in exports and imports over the last few years, our overall economic performance hasn’t improved. Our GDP growth today, at 6-6.5%, is the same as it was 5 years ago, even though international trade has increased by many folds. Why?

The answer is pretty simple – the economy has hit its natural growth rate given our current level of land, labour and capital resources. We need more investment to grow faster!

We certainly have the savings to invest more and grow faster. It’s a question of using those savings as productively as possible. The banks need to lead the charge in that respect. And that process starts with diversifying their business model and moving into the business of providing expert advise that guides savings to investors who need it the most.

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Nofel Wahid is an applied economist.

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10 Responses to “ The banking sector needs to diversify its business model ”

  1. PR on September 17, 2012 at 9:31 pm

    That there is a gap between our savings and investment, is understood by all except for our illustrious finance minister. To him Tk 4000 crore scam is nothing. And probably he thinks that our investment is increasing leaps and bounds.

  2. Rabbi Alam on September 17, 2012 at 9:26 pm

    I would like to request the writer to write a piece on the Hallmark scam and Sonali Bank/Bangladesh Bank role.

  3. Mo on September 17, 2012 at 9:22 pm

    The share debacle, the Hallmark scam and many more have created a dent that is unlikely to attract potential investors.

  4. Mo on September 17, 2012 at 9:03 pm

    Will the people in power pay heed to what the writer has raised in this piece? Will the authorities concerned take steps to create better environment for more and more investment? Will scams like Hallmark and others be contained and the responsible brought to justice?

  5. Lamiya Alam on September 17, 2012 at 8:40 pm

    This is an excellent write-up. A must read for all.

  6. Nasir Amin on September 17, 2012 at 8:37 pm

    I still cannot believe our finance minister termed the Tk4000 scam as insignificant!

  7. Kamruzzaman on September 17, 2012 at 8:35 pm

    Yes we do need more and more investment to grow economically. Incidents like Hallmark scam and the government’s handling of it will only discourage more and more genuine potential investors.

  8. bashirul haq on September 17, 2012 at 8:33 pm

    The government will never take initiatives to use our savings productively. What can you expect from a lethargic government like the incumbent one.

  9. bashirul haq on September 17, 2012 at 8:32 pm

    An excellent write-up. This must be read by the people in power.

  10. Mr.Curious on September 17, 2012 at 6:20 pm

    Could bdnews24.com translate it for its Bangla version? Undoubtedly the piece is thoughtful. Thanks to the writer.

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