How have the banks really fared?

The operating profits of banks have reportedly declined 9% but net profits increased 73% in 2020 (TBS, 2 February 2020) despite decline in reported "growth" in bank credit to the private sector and a 9% cap on the lending rate from 1 April. Does this mean the banking sector is all hale and hearty and concerns about financial stability risks were akin to crying wolf?

What is beneath the surface?

Stability risks in the banking sector pre-date the pandemic. Weak asset quality and capital buffers were key concerns. The overall capital to risk-weighted assets ratio (CRAR) was marginally above internationally accepted minimum requirements before the pandemic came to Bangladesh. Stress tests by the Bangladesh Bank at the end of 2019 flagged credit concentration risk as the biggest threat to capital adequacy. Default of the top three large borrowers could result in 20 out of 48 complying banks falling below the minimum regulatory CRAR.

Reduced operating profits, lower credit growth, and weaker asset quality is likely to have worsened asset quality and capital buffers in 2020. The NPL ratio declined to 8.9% in September 2020 as would be expected when loan classification is suspended across all loans for the whole year. About 23% of loans availed the deferral facility.

The fate of these deferred loan repayments is not certain yet. Given that a large fraction of the deferrals was availed by borrowers from banks that had high NPLs, it will not be surprising if a significant portion of the deferred loans become classified eventually. NPLs are therefore significantly underreported in addition to the underreporting resulting from the downgraded definition (at 180 days relative to the previous 90 days internationally accepted definition of default).

With the economic downturn induced by the pandemic, the vulnerabilities of the financial sector are likely to have increased. The share of state-owned banks (SOBs) in NPLs is likely to have risen from the 50% pre-pandemic level. The gross NPL ratio for SOBs was 22.7% as of June 2020. As is well known, this is a result of directed lending, poor risk management, weak corporate governance, and lax prudential oversight. Generous write-off and rescheduling policies have not resolved the underlying credit weaknesses. Recoveries are constrained by lengthy legal processes.

While the economy has recovered from the bottom reached in March-May 2020, the private demand for credit has remained below normal by any criteria. The stock of credit to the private sector at end-December 2020 was 8.4% higher relative to end-June. However, if you deduct the amount availed for deferral from the end-December stock of private credit in 2020, private credit declines by 15.9%, compared with 8.7% growth the same period the previous year when there was no suspension. The decline in private credit (net of deferral) is understandable given the decline in import of capital machinery and intermediate inputs as well as exports. Production, trade, and investment are all struggling to get back to the pre-pandemic normal.

Reduced provisioning has camouflaged the impact of decline in credit volume on bank profitability. Banks are required to provision only 1% of the loan deferrals. There could not have been any additional classification in 2020. Consequently, regular provisioning could be held in abeyance by imprudent bankers. This has painted the reported net profits rosier than it was. The real picture will unravel as the mandatory provisioning requirements kick in now that the freeze on the classification status of credit exposures has been discontinued.

Incomes from government securities have come under pressure because of decline in interest rates. High interest rates and a large volume of government borrowing provided lifelines to the banks when the rest of the economy was struggling to survive the impact of the pandemic. The government borrowed Tk675.5 billion from the deposit money banks in 2020.

There has however been a drastic downward shift in the administered yield curve of the government securities with interest rates declining much faster for the shortest tenor securities. The rate on 90-day treasury bills has declined from 7% in December 2019 to 0.52% in December 2020 and that on the 5-year Bangladesh Government Treasury Bond has declined from 8% to 4.5%. Bankers no longer have the luxury to bathe in the safety of high yielding government securities and relatively low opportunity cost of liquidity.

From whom has government borrowing declined?

The government had set a large Tk849.8 billion bank borrowing target in its FY21 budget. Its net borrowing in the first half of FY21 amounted to only Tk101.3 billion, according to Bangladesh Bank's Monetary Survey data. What accounts for such a slow rise in government borrowing from the banking system so much so that the Bangladesh Bank lowered the public sector credit growth ceiling from 44.4% in its original Monetary Policy Statement for FY21 to 31.7% in the revisions to the policy announced on 2 February?

Fiscal deficit appears to be running below the projected level. Fiscal rescue programs and the need for providing necessary stimulus to an ailing economy during the pandemic so far have not led to fiscal stress despite weak nominal growth (4.1%) in tax revenues in the first half of the current fiscal year. Preliminary expenditure data indicates that spending on social protection programs and interest rate subsidies increased, but expenditure on the ADP declined. Some expenditure austerity measures have been implemented to restrain the budget deficit at less than 6% of GDP. Overall domestic financing needs have been contained additionally due to over 10% increase in net foreign financing (credit plus capital grants) in the first half of FY21 relative to the same period the previous year.

This does not mean the deposit money banks (DMBs) faced volume contraction in their business with the Treasury. Government borrowing from the deposit money banks amounted to Tk509.3 billion in the first half of FY21, higher than Tk403.8 billion borrowed from DMBs during the same period in FY20. The decline in total government borrowing from the banking system occurred entirely in the form of retiring debt to the Bangladesh Bank. By end December 2021, the central bank's net claim on government declined by Tk408 billion relative to its level at end-June 2020, compared with a 32.5 billion increase during the same period the previous year.

Excess liquidity and lower funding costs

When the government retires debt to the Bangladesh Bank, it depletes the stock of high-powered money. However, this was more than replenished by the Tk551.4 billion increase in the central bank's holding of net foreign assets leading to an increase in the stock of reserve money by 6.9% at end December relative to its level at end June 2020. Reversal of deficit monetisation did not lead to contraction of high-powered money.

Excess liquidity and reduced cost of funds have provided some respite to the ailing banking system. Thanks to a surge in the overall balance of payment surplus, Bangladesh Bank's foreign exchange purchase injected Tk465.6 billion liquidity into the banking system in the last half of 2020. Total deposits in the banking system increased by Tk1096 billion in the first half of FY21, compared with 725.3 billion mobilised during the same period the previous year.

Combined with depressed demand for credit in the private sector, the banking system is currently flushed with excess liquidity looking for good yields. It is therefore not too keen to mobilise deposits by offering attractive rates. At 4.7% on average in November 2020, deposit rate was in fact 1.1 percentage point lower than in November 2019 and at its lowest level in the last seven years.

Can't breathe easy yet

The business model of banking in Bangladesh has been challenged by two developments. The first is the cap on lending rates and decline in rates on government securities. These are affecting the profitability of financial institutions, particularly those more reliant on maturity transformation and net interest income. They have also lessened their competitiveness relative to shadow banks. The second is increased prudential laxity in the wake of the pandemic. These have weakened the stability of several financial institutions and enhanced contagion risks.

Although banks benefit in the short run from being the channel of liquidity support in the crisis and having access to refinancing from the Bangladesh Bank, the deep crisis in the real economy is likely to bring a new surge in non-performing loans and eventually threaten banks' solvency. This raises questions over the ability of weak banks to survive the crisis without persistent life support at public expense, generate and attract capital, and over the future structure of the banking sector. Consolidation will be an escape route, but the regulatory and political obstacles to mergers continue to block in the way.

The Bangladesh Bank had expanded regulatory forbearance prior to and made greater accommodation in response to the pandemic. Additional measures have recently been announced to support liquidity, term financing and risk-sharing targeted for the most affected sectors and firms. Despite allowing the extension of term loan repayment for two years maximum based on bank-customer relationships, the Bangladesh Bank is under pressure from the business community to revisit the decision to not extend the loan classification suspension period. Whether the decision to end the generalized suspension can stick is an open question.

Banking may never be the same

Several economic scenarios indicate global recovery of varying magnitudes and timing in 2021. Recent vaccine rollouts have raised hopes of a turnaround in the pandemic later this year, but renewed waves and new variants of the virus pose concerns for the outlook. The current economic and market environment warrants additional stress testing that will have direct implications for decisions that the financial institutions make in real time.

The pandemic has led to massive leapfrogging of digital technologies and the emergence of new competitors. While these have allowed for many new products and services and helped improve the efficiency of incumbent banks, they have also favored FinTech plays and players in banking-related activities, in competition with traditional bank business models.

While the long-term implications of the pandemic are still unknown, when the virus is finally tamed, banks and NBFIs will hopefully have learned a few lessons, including how to retain operational resilience when confronted with future pandemics, and redesign new operating models in a remote set-up. Further acceleration in migration to digital channels and connectivity is now only a matter of time. Institutions sensitive to the changing ecosystem will be able to truly differentiate and eventually sustain themselves with steady growth.