Financial Sector Reform in Bangladesh: Developments and Achievements

1. Financial Sector Reform in Bangladesh: Developments and Achievements March 2005

2. Structure of the Banking Industry: 2004

3. Market Share of Fund Under Management (FUM)

4. Structure of the Banking Industry • NCBs’ role has declined. • NCBs’ share in total assets: down from 54% in 1998 to 37% in 2004. • Private banks’ share: up from 33% in 1998 to 54% in 2004. The remarkable development was due to • increased competition, • policy decision to restrict and strengthen NCBs, • Strengthening regulation of PCBs by BB.

5. Performance • Capital requirement of banks raised, • Asset quality of the banking system improved, • Healthy Return on assets/equity.

6. Capital Adequacy of the Banks Measures Taken (2002-2003) • Minimum capital requirement on risk-weighted basis was raised from 8% to 9%; • Minimum capital requirement raised from Tk. 40 crores to Tk. 100 crores ($17 million). Outcome • Increased floating of banks’ share in capital market to source capital; • Healthy increase in share prices of banks; • Banks’ share in total market capitalization rose from 10% in June 1998 (PCBs capital adequacy ratio was 9.2%) to 47% in December 2004; • Private banks’ capital adequacy ratio has increased from 11 % in 1998 to 12.2% in 2004.

7. Non Performing Loans Reduced – All Banks Measures Taken during 2002-04 • Stringent loan rescheduling conditions introduced, • Limitation on dividend payout introduced, • Strict measures enforced on loan loss provisioning, • Loan write-off guidelines issued • Effective use of Credit Information Bureau, • Large loan limitation (single party exposure) introduced, • Total of large loans by banks linked to bank’s NPL ratio, • Money Loan Courts Act revamped in 2003, • Corporate Governance measures substantially enhanced,, • Early Warning System introduced. • Outcome (2001-04) • Gross NPL ratio of banks down from 31.5% • to 17.6% • Net NPL ratio of banks down from 16.8% to 9.8%.

8. Gross and Net NPLs – 1998-2004 • Gross and net NPL ratios of all banks improved during 1998-2004; • Gross NPL: for private banks declined from 28% to 8% during 1998-2004. Net NPL ratio: declined from 16% to less than 3%. • Gross NPL ratio of NCBs: declined from 40% to 25% and net NPL ratio from 27% to 18% during 1998-2004.

9. Corporate Governance: Measures taken during 2002-2004 • Fit and Proper test for CEOs of banks tightened, • Fit and Proper test for bank directors introduced, • Provision of independent directors representing depositors’ interests, • Maximum number of directors for bank reduced to 13, • Limiting directorship of banks to six years or two terms, • Only one director allowed from each shareholding family, • Instructions issued to constitute Audit Committee of each bank’s Board to assist in financial reporting, audit, and internal control, • Much enhanced annual financial disclosures required including publication in newspapers and ensuring availability for public view in bank branches, • Risk Management Guidelines introduced.

10. Risk Management Guidelines • Risk management guidelines on major risk areas covering Credit, Market and Operational risks issued, [Credit, asset-liabilities, foreign exchange, internal control/systems, anti-money laundering]; • Prudential Guidelines for Consumers Credit issued, • Prudential Guidelines for Small Business lending issued.

11. Supervision and Enforcement Measures • Four Managing Directors (CEOs) of banks removed; • A number of banks fined for violation of regulations, • 65 Bank directors and Chairmen lost their directorships for loan default, insider lending practices and other violations. • Guidelines on Early Warning System and Problem Bank introduced, • Systems Audit with a risk rating [calculation of standard of a system (viz., core risk areas) of a bank after completion of an inspection] introduced, 50 audits in different risk areas completed so far, • Audit and IT security for banks initiated. 25 banks audited so far.

12. NCB Resolution Strategy Goal: Improve Performance and Divest NCBs • MOUs between BB and the four NCBs signed, setting a ceiling of 5% on annual growth in lending and a single party exposure to only 5% of paid up capital of each bank. • Rupali. Financial Advisor appointed; began work in June, 2004. Information Memorandum being finalized. Goal: Divest majority ownership to a private sector strategic partner. • Agrani. A firm (PWC) has taken over management in October, 2004. Goal: Restructure, corporatize and bring to a point of divestment. • Janata. A team of external experts being contracted to help manage the bank better. Goal: Restructure, corporatize and bring to a point of divestment. • Sonali. External management advisory team began work in August 2004. Goal: Restructure, corporatize and bring it to point where a minority shareholding can be divested over the medium term.

13. Fiscal Policy Provided Cornerstone of Macroeconomic Stability • Financial sector reforms & achievements during the last 3 years occurred in a stable macroeconomic environment; • Macroeconomic stability and improvement in monetary policy framework made possible by prudent fiscal policy; • During the 3-year period, FY02-FY04, government brought down fiscal deficit from over 5 percent of GDP in the previous years to below 4 percent of GDP by raising revenue and streamlining expenditure; • More importantly, increasingly higher share of deficit has been financed from concessional aid leading to a marked decline in domestic financing, allowing private sector credit growth at a healthy rate and reduction in interest rate.

14. Monetary Policy Operation – Made More Effective • Daily and weekly Liquidity Forecasting Framework Developed [since 2002]; • BB introduced repo [2002] and reverse repo [2003] facility for more effective monetary policy operation – i.e., managing liquidity on a daily basis; • Long-term Treasury Bonds for 5 year and 10 year introduced in 2003 for effective benchmarking of long-term loans; • Electronic registry of bonds (scrip less) introduced in 2003.

15. Foreign Exchange Rate Policy and Operation • Taka was floated against all major currencies in June 2003; • BB managed the transition successfully. Move to floating exchange rate regime done without volatility in exchange rate; • To mitigate short-term fluctuations in exchange rate, mechanism for BB intervention in forex and money markets developed; • Banks are allowed to make currency swaps subject to counterparty limits.

16. Interest Rate Development • FACTS • Interest rate was deregulated in early 1990s • Nominal lending rates remained at high levels until recently. • In 2001 inflation rate was 1.9% and average lending rate 14.4%. • Recent Measures • Macro stability achieved; strict limit on govt. borrowing from bank; • BB introduced repo and reverse repo for more effective monetary operation; • SLR reduced from 20% to 16%;      • BB publishing rates to promote transparency and competition. • OUTCOME • Yield on T-bills reduced • In Dec. 04 weighted average lending rate of commercial banks declined by about 2 percentage points from the level of FY 03; • Credit to private sector grew at a healthy double digit rate; • M2/GDP ratio increased indicating financial deepening.

17. Financial Market Development Lending to Specialized Sectors • Small Enterprise Fund, a refinance window for SME (at 5% interest rate) created in May, 2004: BB resources (about $17 million); World Bank ($10 million); and ADB ($30 million). $20 million disbursed May 04 – Feb 05. • Refinance window on micro-finance operated by PKSF financed by govt. and donors. Growth over 20% in FY04. • Equity Entrepreneurship Fund, venture capital fund, funded by Govt. & operated by BB created. Disbursement growing fast. About $7 million in FY03 and about $9 million in FY04 and $30 million in FY 05 up to March 2005.

18. Financial Market Development Development of Bond Market: • Govt. Bond Market: Bonds of different tenors (5 and 10 years) issued (2003) to develop yield curve & encourage term lending by setting benchmarks for long-term interest rates. • Securitization: BB, SEC and NBR developed an enabling legal, regulatory framework for bonds/securitization of receivables. Securitization of receivables of private financial institutions started. First ever securitization was completed. Work ongoing on securitization of Jamuna Bridge revenue. Housing Finance: • Initiatives underway to develop long-term housing finance. Key issues being addressed: transaction costs (property transfer tax, registration, title transfer etc.) tax incentives, availability of long-term funds. • Private commercial banks have begun to move to housing market with longer tenures and lower interest rate. Development of Inter-bank Market: • Inter-bank market for foreign exchange developing fast – following floating of Taka • Initiatives underway to further develop inter-bank money market- for effective intermediation of surplus liquidity in banks.

19. BB accounts now fully compliant to International Financial Reporting Standards (IFRS) • International audit firm KPMG and its local affiliate certified that BB financial statement & disclosures for FY2004 have been fully complied with IFRS without any qualifications; • In accordance with the IFRS guidelines, provisions were made against non-performing assets (some bad loans were written off); • A set of reconciliation of inter-branch accounts, and central & subsidiary ledger has been made; • Revaluation of forex account and fixed assets done to comply with the IFRS; • Employee provident fund separated from the Bank’s account; • BB is currently implementing a program to strengthen the Accounting and Budgeting Department by recruiting a Chartered Accountant and training of the staff.

20. Strengthening of the BB Measures Already Taken • Departments restructured; • Services standards established for different department to speed up decision making; • Work flow analysis completed for some departments to reduce unnecessary steps in decision making; • Same day clearing service introduced for high value checks; • Clean note campaign initiated – number of soiled/torn notes in circulation reduced significantly; • Direct recruitment through competitive examination being done on an annual basis; • Recruitment for some specialized positions being made through open competition.

21. Strengthening of the BB Components of Bangladesh Bank Strengthening Program: • computerization of operations of BB, • human resource development through reforms of recruitment, promotion and compensation policies, • Direct recruitment taking place every year for the past three years, • Promotion policy being radically changed to emphasize merit, • restructuring the different departments, • reengineering the business processes, • capacity building in the core activities • With enhanced capacity has come better enforcement of laws and regulations, • Within Research Department, Policy and Analysis Group being set up through open advertisement. Agreement with WBI signed. The goal is to transform the decades-old traditional and manual system to a modern, automated system.

22. Challenges Ahead • Broadening access to Middle and Lower Income Groups: By broadening their client base to cover the “missing middle” with new products, banks can diversify their risks and earn higher profits, • Implementation of NCB Resolution Strategy, • Introduction of information technology in banking system in an aggressive manner, • Corporate Governance has to improve further. It should be a continuous process, • Financial soundness indicators show an upward trend, but there are weaknesses and vulnerabilities that will need continued watching, • Infrastructure Financing: The investment requirement for infrastructure development is large. While these investment needs continue to be financed through public investment, there is a need to develop ways to bring in larger private sector financing through the banking system and capital markets.

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