What should Bangladesh Bank do about Islami Bank?

Shahbagh protestors' demand for a boycott of the Islami Bank (IB) appears to be having some impact (Islami Bank seeks help from central bank) indicating that IB has asked the Bangladesh Bank (BB) for assistance. It is not entirely clear what kind of assistance has been requested, but the report's references to depositor withdrawals suggest that IB may be experiencing a liquidity crunch.

How serious is this development?  What will happen next? Will BB provide assistance?
The following facts may help answer some of those questions. Islami Bank is the third largest bank in the country by total asset value and deposits, with Tk 46,000 crores in assets and Tk 40,000 crores in deposits.

The table shows the 5 largest banks in the country.
Source: Bangladesh Bank, Islami Bank and Prime Bank.

Common sense would dictate that you cannot just let the third largest bank in the country fail. To put things into perspective, Lehman Brothers, the large US investment bank whose collapse caused a global financial crisis, was the fourth largest bank in the US.

Allowing the third largest bank in a country, in any country, to suddenly fail can have some very serious ramifications. That is not hyperbole.

There is a reason why the phrase – too big to fail – entered the lexicon of financial regulators after the global financial crisis. Because banks can play such a vital role in connecting savers and borrowers, in effectively, greasing the cogs that turn an economy, big banks can become too big to fail. IB could very well be one such bank.

But there is more to it.

There is a greater principle at play here. When customers decide that they are going to boycott a business, that business will eventually fail. That's business101.

Big banks might be special types of businesses that are systemically important; but they don't defy the laws of economic gravity.

Bangladesh Bank faces a very peculiar dilemma here. On the one hand, it cannot let IB fail chaotically over a short period of time – let's say, the next two months. That would lead to pandemonium. But on the other hand, it would simply be bad economic policy to not let IB fail if it was experiencing a slow, year-long proverbial death by a thousand withdrawals due to a sustained public boycott.

One way to tackle such a problem is to have a bank resolution regime in place. Their purpose is to essentially buy time for regulators to ensure an orderly and least-costly unwinding of bank operations.

Lots of countries have these bank resolution regimes in place, and we do too. In our case, it came into effect in its current form after the Bank Deposit Insurance Act 2000 was passed in Parliament.

So, briefly, what is bank deposit insurance?

A bank deposit insurance scheme ensures that depositors are protected against bank failures. One way a bank can fail is when all depositors try to withdraw their money from the bank at the same time. No bank obviously has enough cash in its vault to meet withdrawals by all of its depositors, in which case, it naturally becomes illiquid. In finance, that is known as a bank run. It can happen due to a lack of confidence in the bank, or in the case, a boycott.

Our deposit insurance scheme guarantees that retail or small depositors will be able to recover savings up to a maximum of Tk 1 lakh in the event of a bank run. To put it more crudely, if IB suddenly fails overnight, you will be able to go to BB tomorrow morning and demand to have at least Tk 1 lakh of your savings returned to you. And BB is required, under law, to give you that money. But if your savings in IB is more than Tk 1 lakh, you might unfortunately end up losing the rest of your cash.

The reason behind highlighting this law is to note that there are provisions for a baseline level of protection for depositors during a bank run. In reality, we are some distance away from reaching that point as far as IB is concerned. No one is suggesting that IB will fail tomorrow!

But going by bdnews24.com's report, it does sound as though that IB is experiencing a mini-bank run. And it is a serious issue. If for no other reason than the fact that a bank has other customers too, who are not protected from bank failure.

IB has borrowers ranging from other banks borrowing in the overnight call money market (essentially 1-day loans between banks) to businesses that depend on them for their working capital. None of those borrowers are covered by our bank resolution regime.

There is a good reason for that. Conventional thinking on this issue dictates that corporations are expected to be in a better position to judge the health of a bank compared to small depositors, and so it is argued that small depositors need protection, not big corporate clients.

However, the reality during a bank failure is quite different. The global financial crisis has taught us that even big corporate clients can misjudge the health of its banker and get into trouble. Case in point – GM, the largest car company in the US, was bailed out by the US Government during the global financial crisis.

No bank wanted to lend to GM because of uncertainty about the impact of Lehman Brothers' collapse on the economy in general meant that no bank was sure if GM would be able to sell enough cars to repay its loans. That is how a big bank failure can spread from being an isolated banking industry problem to something that affects the whole economy.

Remember – the US has had a deposit insurance scheme since the Great Depression in the 1930s. The global financial crisis happened regardless, not because of bank runs, but because banks stopped lending to businesses.

That is a key risk facing us too. If IB suddenly gets into trouble, we might be looking at a serious credit crunch too. In fact, it has already happened to a certain extent after the Hallmark-Sonali Bank fraud case came to light. Business lending – especially against inland bill purchases, a trade financing tool – has taken a hit, and confidence in our banking system is at an all-time low. It is not difficult to see how a Tk 4,000-crore fraud in the largest bank in the country might affect confidence in the whole banking industry.

Combine that with trouble in IB – the third largest bank – and you are looking at a recipe for disaster. If you think they are two separate issues that cannot morph into a bigger problem, you clearly don't understand what the global financial crisis was all about and how it happened.
The simple reality is – if I am the CEO of a business that borrows from Sonali or Islami Bank or the CEO of another bank with exposures to both, I would be very nervous about the latest developments.

In fact, I would call the head of my credit division and ask – 'What is our exposure to IB and Sonali? Cut them loose, they're too risky.' I would do so because it is in our human nature to fear what we don't know, what we are uncertain about.

In a scenario like that, BB has a very important role to play to prevent a sudden bank collapse from a credit or liquidity crunch. The key tonic to prevent those kinds of situations from emerging is information. Reliable information helps to cut down the perception of uncertainty and fear.

BB needs to proactively contact all bank CEOs and key business clients of IB, and say – 'You know IB has X amount of liquid assets and capital, it's able to manage its overnight exposures in the call money market, so don't worry about them collapsing tomorrow. Whatever you decide with respect to this boycott, take your time, don't rush things.'

That might sound like a weird thing for a central bank to be doing, but that kind of informal, back-channel communication that conveys sensitive market information to key players is absolutely vital in boosting confidence and preventing financial panics.

It helps to address what economists call – informational asymmetries. Informational asymmetries arise when different market players have access to different levels of information. Problems occur when key market players make the wrong decisions due to not having the right kind or amount of information.

In this case, only IB knows how critical its situation is and by sharing that information with BB, the BB will know too. The rest of the market is probably looking at this sharing of information and speculating – what did the IB tell BB? How bad is it?

When the flow of information, per se, becomes the key issue or cause of a problem, regulators have a special role to play. Joseph Stiglitz won a Nobel prize in economics for his research on this issue of informational asymmetries. His basic conclusion was – government regulators have a role to play in facilitating the flow of information between market players.
But government institutions, generally speaking, are hopelessly bad at understanding this key point.  I don't know why. It may be because government policymakers don't read the economic literature. Or, maybe because regulators think their job is to regulate and prevent things rather than to allow things to happen, such as allowing freer flow of information.

Either way, Bangladesh Bank has a tough job ahead. If they do their job well, you won't hear about their facilitating role. They will be like unsung heroes. But if there is a sudden collapse of Islami Bank – I can't stress enough on the word 'sudden', a slow bankruptcy is part and parcel of business life – followed by a financial crisis, you will know that Bangladesh Bank will have partly failed at its job. It wouldn't so much be a sin of commission, as it would be a sin of omission. The least Bangladesh Bank could do is not be afraid to think outside the box!

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Nofel Wahid is an applied economist.