Regulatory Measures for Banking System: Way Forward

 

Very recently, the board of directors of a private bank belonging to first generation has been dissolved by the central bank. The dissolution has been executed by an order issued in terms of the Bank Company Act. Subsequently, relevant directors have been appointed to form the board. It is reported that the central bank has taken the decision in accordance with the recommendations of the capital market regulator of the country.

This is a milestone decision by the central bank to bring discipline in banking industry. Regarding financial health of the relevant bank, it is reported that the amount of defaulted loans, due to irregularities, stood at more than 13.5 thousand crore at the end of September of 2023, of which 92.14 per cent are bad or loss loans. As per business insiders, it is not so easy to recover bad loans. As a result, the bank fell into a capital shortfall amounting to more than 2 thousand crore Taka.

Due to the existing floor price in the capital market, the bank’s share price cannot fall below 8 Taka since January of 2023. However, in May of 2023 it went down to 7.2 Taka as per media reports. Poor financial health would not permit the bank to pay cash dividends after 2019. In 2020, it distributed a 5 per cent stock dividend for its shareholders. In the January-September period of 2023, earnings per share of this bank stood at negative 3.49 Taka, the report quotes. The bank is reported to have earned profits of 480 crore Taka in 2017. The profit came to 38 crore Taka in 2021 and it went to a negative territory last year.

Banks scheduled with central banks are regulated institutions in the sense that they do businesses depending on customers’ deposits. In operational point of view, banks are to measure maturity mismatches so that they can be able to extend term loans by short term deposits. How it is possible to manage maturity mismatches is a question. Banks working in money market should confine their operations in short term lending. This is basically working capital finance with a tenure of maximum one year.

Working capital finance is as good as supplier’s credit. It is extended by suppliers in the form of inputs. But supplier’s credit in all cases cannot work well. There are other expenses in addition to inputs - such as wages, salaries and different utilities. Working capital from banks supports a lot to facilitate payments needs before conversion of sales into cash. Working capital finance is linked directly to sales proceeds. This can easily be realizable.

 
Term finance is a capital market product. Banks provide term finance in absence of deep capital market. There are many types of capital market products - equity and different debts such as debentures, subordinate bonds, perpetual bonds, convertible bonds, etc. These are instruments with longer tenure. On the other hand as per business insider, it is not easy to provide loans by money market operators for longer periods beyond seven years. The loan is basically repaid at equal installments consisting of principal repayments and interest payments.

Working capital is washed out through profit and loss account as it is used on account of product-costs. In case of term loans, interest payments are charged in profit and loss account. But repayment of principal is not chargeable in this account. If the repayment size is equal to non-cash payment item: depreciation, the borrower does not face problems. In other cases, profit needs to be used for repayment if it is excessive in size. Problems may come across due to inadequate profit for reasons beyond control.

Recently a think-tank assessed the siphoning of money from banking system. This could be an arranged game for which loan was extended for nothing, there might be a tie-up arrangement between parties. There are some cases of willful defaults. Whatever the situation is, the genuine cases may face defaults due to short tenure for term finance.

According to Hyman Minsky, an economy may experience three credit lending stages with risk levels increasing in each subsequent stage, which ultimately leads to crash. These are hedge phase, speculative phase, and ponzi phase.

The hedge phase is the most stable phase, where borrowers have enough cash flow from businesses to cover both principal and interest payments. In the speculative borrowing phase, cash flows from business transactions cover only interest payments, not principal repayment. The ponzi phase is the riskiest in the cycle. Cash flows from the business transactions are not enough to cover the interest and principal payments. Term finance is characterized by risk factors. To minimize risk factors, banks are on vigilance. There are different tools prescribed by regulators. Fundamentals of them are provisions against leading, and capital charges for non-loan assets. Basel framework is in operations. In the current decade, other tools are in operation such as bank recovery plans, prompt corrective action frameworks, etc.

Very recently, Bangladesh adopted prompt corrective action framework. Under the framework, the relevant bank needs to carry out a schedule of corrective actions based on selected parameters presented in banking terminologies such as capital to risk weighted assets ratio, tier 1 capital ratio, common equity tier 1 ratio, net non-performing loan and corporate governance. Banks are identified in four categories 1, 2, 3 and 4. Banks will come under prompt corrective action framework in case of failure to meet the threshold of the prescribed parameters.

As said earlier, banks may be in problems in case cash flows from lending face challenges. The situation can be the result of loopholes in determining the installment sizes. In another situation, assets of banks may be distressed due to illegitimate tie-up arrangements between parties. This is due to lack of good governance in banks. No medicine used as tools such as Basel framework, bank recovery plan, prompt corrective action, loan provisioning, capital charges, etc. can work in such situations.

The recent action by the central bank indicates that it has been vested with adequate powers under regulatory framework to take actions against wrong doing banks. Accordingly, a bank’s board was dissolved with appointment of new directors so that a new board can be formed. The regulations also empower the central bank to appoint administrators to banks by dissolving their boards. The recent actions by the central bank can bring back the lost image of the respective bank. In addition, it has a long term impact on the banking system to the effect that watch dog is alert for actions in case of wrong doings.

Industry insiders indicate that banks need to do different types of works relating to compliances. But there is a question if the compliances such as Basel framework, weak bank resolutions, etc. can bring fruitful results in the same way as found from the reformation of a board done recently. Different frameworks can bring some post facto indicators but these cannot solve fundamental problems in risk factors. What is to be done to find a solution is a question. Simple answer is that banks should operate money market instruments, keeping capital market products aside. But it is merely possible for countries like ours. In this case, safeguard audit and inspection can be solutions for which risk based audit needs to be introduced by central bank phasing out compliance audits. The risk based auditing system can dig out what is happening in the banking system and what needs to be done. As a forward looking approach, it can treat problems of banks at early stages. In case of necessity, regulatory actions should also be applied to bring back the image of banks in the edge of problems.


Mehdi Rahman works in the
development sector.