The Spanish Flu epidemic, the Great Depression of the 1930s, and World War II -- all had one thing in common -- besides casualties, they all saw "bank runs." A bank run occurs when a depositor rushes to withdraw his savings from the account, fearing that banks will run short on the money supply.
The current Covid-19 pandemic has reported more than 5.3 million infections worldwide, causing businesses to shut operations and people to return to the solace of their homes, which have now started to resemble a prison cell. But as people need to purchase their essential commodities, access to money has, therefore, become an important factor.
Bangladesh currently has 60 scheduled banks, and another three are in the pipeline waiting to open their "newly decorated branches". Although the banking sector has experienced a fair share of criticism in the recent past, the new measures implemented worldwide have forced most central banks to "print more money".
While a rise in inflation and aggregate price levels are inevitable, one aspect that is keeping most commercial and retail banks on high alert is maintaining enough reserve deposits to avoid a bank run.
The process of money creation is simple. If any individual goes to a bank to deposit a particular amount, the bank accepts the deposit and "credits" the bank's own statement of accounts. This money can then be given out as a loan to businesses for an additional spread on top of the principal amount which will act as an asset for the bank.
These deposits are further mobilized through issuing new loans and advances, investing in government and/or other approved securities for fulfilling liquidity stipulations and investments in short term money market instruments like commercial papers, debentures, etc. up to a specified level.
Most central banks will have a set "reserve requirement" (RR) for commercial banks, which they must always have available to cater to their depositors. If the RR is 20%, it can loan out 80 BDT in exchange for 100 BDT of deposits.
The loopholes with this system of fractional reserve banking should now be prominent. The Advance-to-Deposit Ratio (ADR), as it is commonly known, is a ratio of the overall advances to total deposits. The advances i.e loans, consist of all banking loans, except for foreign currencies (FC) which are held against both the refinance and offshore banking unit (OBU) exposure and export development fund (EDF). Deposits typically consist of all demand and time deposits excluding bank deposits and additional net borrowing. Thus, the ratio is a reflection of a bank's ability to make optimal use of its available fund.
2019, both private commercial banks (PCBs) and state-owned commercial banks (SCBs) adopted to strict measures to ensure that the ADR was at 83.50%. The ratio was brought down from 85% with a view to curb excessive lending. Similarly, the Investment deposit ratio (IDR) for shariah-compliant Islamic banks had been brought down to 89% from the previous limit of 90%.
Although the move was aimed to improve the capital adequacy of the country's banking sector, we have seen little progress in terms of the recovery of non-performing loans. The liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) required to implement the Basel III framework has taken precedence over the need to distribute these loans to needy businesses in a timely manner.
Banks are similar to black boxes: observers have very little insights about the value of their assets. Even most industry personnel lack the capability to assess whether any particular bank has presented their book of accounts in a more favourable light through the application of "window-dressing". The aftermath of a shock creates a broad-based plunge in asset prices. Consequently, bad news leads depositors to question the solvency of those banks.
A natural progression to these doubts would be a person redeeming deposits at face value through the first-mover advantage: those who get to the bank first get paid in full, while those who are slow to react may receive nothing. This eventually leads to an avalanche effect causing a bank run.
Similar to the virus, bank runs are contagious. The news about a run regarding any specific bank would cause people to directto belief that there may be "other insolvent banks" the universe of banks, turning the run into a panic. In other words, when people have insufficient information, shocks can pave the way to amplify the disturbance. Even if everyone believes that most banks are solvent, uncertainty about one particular bank can be sufficient to motivate a run.
So, will altering the ADR be enough to generate the various stimulus and welfare packages? Definitely not. This is where Quantitative Easing (QE) entered the monetary policy scene. Besides manipulating the ADR, central banks can increase the money by printing more money and distributing it to commercial banks in exchange for other assets like government bonds. This will enable banks to lend more money and stimulate investment activity.
While the supply of money used to be linked to gold back in the day, modern monetary theorists have defied the odds in terms of implementing QE. Ever since the US Dollar was removed from the pegged currency system, central banks around the world have continued the use of QE whenever an increase in the supply of money was required. Although this has enabled central banks to provide sufficient liquidity to the global economy in the last two decades, aggregate price levels have also increased sufficiently leading to a loss in purchasing power.
Since bank runs have been a common phenomenon in past pandemics, it is very natural for some to wonder if these runs can repeat themselves? However, with the potential of modern technology the problem of not having enough "physical cash in hand" has been dealt with. Most of the advances created through fractional reserve banking are simply "numbers on a screen". If a temporary run on the banks were to occur, a central bank can easily manage the situation, by lending to solvent banks against good collateral to prevent a liquidity-driven run. But if a banks' solvency is in question, then the problem shifts to one where authorities need to credibly demonstrate the health of the bank.
Keeping hyperinflation aside, most banks in Bangladesh have been suffering from Non-performing loans (NPL), liquidity crisis, declining loan growth rate, zombie lending, and capital flights to countries abroad. However, banks with strong capital base (higher capital adequacy ratio), good asset quality (lower NPL ratio), higher free-flowing liquidity (lower Advance-to-Deposit Ratio), greater ability to utilize owners' equity (higher ROE), and lower cost (higher CASA, lower cost to income ratio) are relatively better equipped to face the economic disruptions.
Based on previous analysis, the most effective mechanism to arrest financial contagion driven by solvency concerns is an extraordinary disclosure mechanism. Stress tests of 2008-2009 in the US were the first to reveal banks' true conditions via implementing this tool. When doubts about the capital adequacy of the largest US intermediaries made potential investors, creditors, and customers wary of doing business with them, it led to the virtual collapse of unsecured finance. The stress test results of May 2009 for the 19 largest US banks constituted a key part of the remedy.
But why did the US stress tests restore people's faith in the banking system? People believed that a bank that had passed the test could still lend to healthy borrowers despite a deep recession.
Similarly, if the disclosed data about the listed banks are to be believed, banks with higher capital adequacy and lower NPL's will most likely survive a run. Excluding banks with poor credit due diligence,inadequate audit standards and zero interest in the KYC process, most banks need to ensure adequate liquidity in term of having enough central banks reserves to ensure cheque, debit card or online payments can be made to other banks within Bangladesh Bank's closed-loop clearing system and having enough of their demand deposit in the form of "cash" so that solvent customers can get access to their money whenever they want. With tools such as QE, ADR and REPO rate manipulation to facilitate inter-bank lending, a bank run will most likely not take place for banks with strong disclosure mechanisms which people have faith in, unlike the virus which most certainly is proving to be unfaithful!
An experienced investment analyst, the author is currently a Senior Lecturer in Finance at American International University Bangladesh (AIUB) pursuing research along the lines of capital markets and economic policy.