Problem of plenty: Banks face tough choices

Sharjil Haque
Published : 11 Jan 2016, 02:58 PM
Updated : 11 Jan 2016, 02:58 PM

The banking sector in Bangladesh is currently experiencing a classic 'problem of plenty' with rising volume of excess liquidity. Press reports state excess liquidity has surpassed BDT 1 trillion. This is certainly a matter of concern, as it reflects inability of the economy to productively utilize available capital. What created this rapid escalation of excess liquidity?

Increasing availability of foreign currency loans, depressed commodity prices in international markets and infrastructural constraints have subdued credit demand from the private sector. Advance-deposit ratio has fallen to around 70 percent from 80 percent (and higher) in previous years. Banks usually invest excess liquidity in treasury securities. But rise in sale of National savings schemes (NSS) prompted government to reduce sale of treasury bills and bonds, squeezing investment options for banks. As an alternative, banks have been rushing towards Bangladesh Bank's (BB) monetary instrument, known as reverse repo. There again, BB switched from using reverse repo to lower-yield 30-day BB bills as its primary instrument to manage surplus liquidity. BB's view is that this shift will incentivize banks to find investment opportunities in productive sectors by lowering their lending rates. Against this background, banks face tough choices in key areas if they want to better utilize surplus liquidity.

First, if banks take BB's advice and significantly slash lending rates to attract fresh credit, they will have to decide whether or not to pass on lower interest income to their clients through lower deposit rates. Interest-rate spread (difference between lending and deposit rate) remains virtually constant at around 5.0 percent, give or take 10 basis points. This relatively large spread is attributable to high non-performing loans (NPL). At present, there is little evidence of an expected reduction in NPL. Indeed NPL actually went up in the first quarter of the current fiscal year, suggesting that a reduction in interest rate spread will substantially shrink profit margins. This line of reasoning implies that banks will be tempted to lower deposit rates in line with lower lending rates.

However, reducing deposit rate is likely to divert savings away from banks to alternate financial instruments offering significantly higher returns like NSS or Term Deposits of non-banking financial institutions. Banks have already felt the brunt of such misaligned interest rates. As the chart below shows, recent reduction in bank deposit rates has sharply reduced deposit growth to around 12-13 percent in 2015 from 15-percent (and higher) seen in previous years. A prolonged reduction in deposit growth (due to growing interest-rate spread with alternate financial products) will certainly hamper the sector's ability to extend credit in the medium term. Limited capacity to extend credit not only hurts banks, but could impede the government's growth and development targets in the new five-year plan. Should banks reduce interest-rate spread, sacrificing immediate profitability, or maintain interest-rate spread and risk lower growth in deposit base?

Second, regulators appear interested in seeing banks increase their stock market exposure. Recently government stated that it would extend deadline for banks to reduce their stock market exposure by another two years. Earlier in January, BB relaxed frequency of banks' stock market exposure reports from daily to weekly. The central bank is currently considering further relaxing this reporting requirement to a bi-weekly basis. Given these encouraging initiatives, banks need to decide whether to invest excess liquidity in listed stocks or continue with low-yield BB bills.

Exposure in stocks entails higher risk, warranting higher return. It is worth mentioning that the DSEX index fell by 4.8 percent last year. Profits announced by listed companies in the third quarter of 2015 were generally sluggish. Presence of institutional investors, and the stability they generally bring to a stock market, is still below-par. From such broad perspectives, there is little evidence of a bullish outlook. Yet during the same period, selected stocks with robust fundamentals from sectors such as cement, pharmaceutical and food etc. generated returns in excess of 10 percent, which is higher than 1-year risk-free rate plus 5 percent risk premium. So the choice of investing excess liquidity in stock market instead of risk-free securities (like BB-bills), essentially comes down to a bank's risk tolerance level. Should banks adopt greater risk and invest prudently in stocks, or resort to 30-day BB bills, earning less but avoiding uncertainty?

Third, banks need to accept the ground reality that foreign lenders are here to stay. Regulators have rightfully eased access to foreign loans since borrowing rate is much lower and international lenders can facilitate much larger loans than domestic banks. Given an outlook of higher presence of international lenders in Bangladesh, banks will have to decide whether or not to reduce dependence on "traditional" corporate clients who will have increasing access to foreign loans. Greater SME (small and medium enterprises) financing, which has strong regulatory support, could be considered as an alternative.

It is important to note that SMEs are considered relatively high-risk borrowers and often do not have the necessary collateral required by banks. Their financial profiles have potential implications for NPL, asset quality and loan-loss provisioning. They would require greater monitoring, entailing higher cost. On the other hand, this option would reduce risk of losing clients to foreign lenders and potentially be a source of sustainable income, provided clients are chosen carefully based on feasibility of business model and industry outlook. Giving SMEs greater access to capital would certainly promote inclusive growth, which will have positive effects on banks in the medium-term. Should banks remain concentrated in urban or reputed corporates and risk losing clients to foreign lenders, or diversify to SMEs despite relatively lower credit-worthiness?

Finally, banks face the tough choice of allocating additional financial and human resources necessary to bring down their interest rate structures in a sustainable manner. It is encouraging to note that banks have started bringing down lending rates in recent times to attract entrepreneurs. But a sustained pickup in private sector credit demand – necessary to break the 6 percent GDP growth trap – requires single-digit lending rate of around 8-9 percent. Achieving this feat requires two major steps: (i) reduction in deposit rate (ii) reduction in interest rate spread.

In this context, a top priority should be to attract low-cost deposits. While that is certainly not easy, banks need to invest more financial and human resources to comprehensively understand the demographic profile of their target market and devise differentiated current and savings-account related products accordingly. Lower cost of fund will allow greater space to reduce lending rates, but banks will also have to work towards reducing their interest rate spreads. Significant strides are required in loan monitoring, recovery and overall risk management in order to bring down excessively high volume of non-performing loans. Only then can banks bring down spread to around 4 percent or even lower in the medium term. Are banks willing to invest the necessary resources to push down the interest rate structure in a sustainable manner?

There is little doubt that the banking sector will continue to drive Bangladesh's financial system in the absence of a liquid bond market. The sector's contribution to fiscal revenue and private sector development will also continue to play key roles in Bangladesh's medium-term growth trajectory.  As such, the banking sector needs to take prompt action in these key areas and return to a more promising growth trajectory.