The bad practice of bank recapitalisation

A central issue of the management of the financial sector is maintenance of capital adequacy of banks. The inability of many banks, particularly the state commercial banks and the state specialized banks, to maintain adequate capital makes the regulatory response one of the key issues facing the authorities. The repeated recapitalization of government-owned banks and the forbearance of the central bank on capital adequacy of the private banks have failed to achieve acceptable outcomes. A significant component of the banking sector is unable to achieve or to maintain the capital required by the central bank.

The single most important parameter describing the banking system is the volume of non-performing laws (NPL). The share of NPL in total loans is rising. It is common knowledge within the banking community that amount of NPLs is significantly higher than the official records. The rising level of NPLs undermines the capital of the banks. Continuation of present weak enforcement of rules and governance oversight will simply delay facing the corrections and actions that are needed. Waiting makes the problems more difficult to solve.

We begin by discussing what these terms mean. [Many readers understand these next paragraphs very well; please be patient] A commercial bank has assets — loans, holdings of government securities, holdings of shares in the stock market, deposits at Bangladesh Bank, deposits at or loans to other banks, and a small amount of real property. The bank has liabilities, largely deposits placed with the bank by the public but also borrowing from other banks and from Bangladesh Bank. The value of the bank's capital is assets minus liabilities. Any other definition of capital is not relevant to the issues discussed here. This is a common sense idea value equals things you own (assets) less what you owe (liabilities).

Central banks require that the bank's capital be maintained at a level determined by its assets and liabilities. The quest for an appropriate way to determine required minimum capital has been going on for years. Some believe the required minimum bank capital should be linked to assets, some that it should be linked to liabilities. There is much fuss over an appropriate measure of minimum capital; but this fuss is really guess work. The increasing complexity of calculation of minimum capital obscures the need for simplicity, public understanding and empirical relevance. It does not matter. The central bank sets a rule and the commercial banks are supposed to conform and maintain at least the capital required.

Why does a central bank establish a rule for the minimum required capital of a bank? In the course of its business a bank may run into difficulties in its functions of taking deposits and making loans. For example if its loans are not repaid the depositors funds are at risk. If loans are not repaid then losses are borne by the owners [Assets fall, capital falls] as the capital declines. But if there is only a little capital then after all the capital is lost, the depositors begin to lose their funds. The more capital the less likely the bank's depositors will face losses.

When loans are not repaid the assets of the bank are reduced. The way this actually happens rests on the idea that once a loan falls behind in its payment then it becomes more and more likely that it will not be repaid. Even if there is collateral in the form of property pledged to the loan the reality in Bangladesh is that getting hold of the collateral and then selling it is a very long uncertain process; collateral while demanded by the banks turns out to be surprisingly useless in actually recovering the value of a defaulted loan. The central bank requires that when loans fall behind schedule in repayment the bank must set aside a provision for the possibility that the loan will not be repaid. The amount of provision depends on how late the borrower is. These provisions must be deducted from the loan assets. As bad loans emerge provisions increase, the loan assets decrease and the capital of the bank declines. [Remember Capital = Assets — Liabilities]. If the value of the assets falls too far and capital becomes negative then the bank is insolvent. Normally an insolvent bank is closed down or taken over by the central bank. When the bank is insolvent its owners no longer have any stake in the bank, their investment in the bank is lost.

When a bank makes a profit from its operations what can it do with the money? It can distribute dividends to the owners. It can retain the earnings and thereby increase its capital. Normally any bank that does not meet capital requirements would not be allowed to distribute dividends but required to use the earnings to replenish the capital. If the bank makes a loss then capital declines.

What happens if there is not enough capital? The bank can increase its capital by earning and using the earnings to increase capital; the bank can ask existing owners to contribute more capital to the bank; the bank can search for new investors who will purchase newly issued shares in the bank. Existing owners resist all of these actions! They do not want to forego the cash dividends; they do not want to provide more money and they do not want their share in the bank diluted by bringing in new investors.

Another solution for the bank short of capital is to merge with another bank such that the merged bank has sufficient capital. Bank owners in Bangladesh resist this as it usually means some directors lose their positions and there may be a dilution of the value of their shares in the merger. Nevertheless when the central bank insists capital requirements be met this may be the only solution.

With all this background we look first at the SCBs. The SCBs are characterized by a large volume of non performing loans. The SCBs are so bad at lending money and collecting the loans that one cannot really call them banks. The reason for the large volume of non performing loans is three-fold: Poor management resting on a long history of corruption, slough, and low levels of skills. Second, is the constant intervention of political persons in the choice of who should receive loans. Third, the government insists on keeping functioning state-owned enterprises (SOEs) that cannot earn enough to cover their costs; instead of subsidizing the SOE directly the government forces the SCBs to make loans to these SOEs that likely will never be repaid. The government deficit is then made to appear smaller.

Despite years of effort to improve the SCBs no real progress has been made. These reform efforts were never supported by the political leadership of either party and much money has been spent on futile efforts to improve performance. The government will not reduce the fake lending to the SOEs nor will it act to stop making loans that are not going to be repaid. The SCBs will always have difficulty maintaining capital requirements as there is continuous reduction in the value of their assets through making these bad loans.

Correct public policy for SOEs is to subsidize them through the budget not through the SCBs. The SOE may lose money due to some rule the government wants to achieve. For example, the selling price of petroleum products was kept below cost resulting in the BPC running large losses that were reflected in a large amount of borrowing that was classified for failure of the SOE to repay. BPDB buys electricity at a price higher than the selling price. Hence it runs large deficits covered by borrowing that often leads to classified loans.

It is also poor public policy to make loans that will not be repaid as a matter of political reward or as a consequence of corruption. Hopefully, the government will stop such activity. Recapitalization of the state banks essentially rewards the banks for making these bad loans. Over the past 25 years the government has regularly recapitalized the state banks enabling the corruption and political lending to continue. This may be good politics but it is very bad economics. The saving of the people is not invested in good projects and so the same does not generate more income and wealth.

If one stops the recapitalization of the state banks then there is direct pressure on these banks to improve the loans that they make. For the past 25 years there has been no real pressure on the SCBs and it was business as usual. If these banks cannot maintain their capital requirements then the central bank must stop them from making loans and instead invest their deposits in government securities or loans to other banks. Furthermore the banks would not be able to deal with foreign banks shifting all such transactions to banks that are able to achieve their capital requirements. At present the poor performance of the SCBs makes the cost of foreign transactions more expensive for everybody. Pretending to fix the SCBs is not fooling anybody. As these are state banks the Government will ultimately cover the depositors, so if you are a depositor you need not worry about the bank capital.

As for the private banks, the central bank has two kinds of actions it can take to deal with those private banks with inadequate capital: First the bank can be permitted temporarily allowed to not cover the required provisions, thus maintaining a higher value of assets and capital. In effect the value of capital is over stated due to inadequate provisions. Second the bank can be allowed to continue to operate with in adequate capital, what is called forbearance. The central bank may permit this so long as prompt corrective actions are implemented. There is no real excuse for allowing a private bank to continue to function for very long with insufficient capital. A reasonable time such as six months may be given to allow the bank to raise the capital or to find a way to merge with another bank. Only strict discipline will enable the central bank to improve the performance of the private banks.

The central bank should never allow the bank not to make full provisions for NPLs. Once full provisions are made the true capital position of the bank is known. The conclusion is that it is very bad public policy to recapitalize the state banks. It promotes the waste of the public saving. Bangladesh is too poor to continue to waste resources in making politically driven loans or in making loans due to corrupt payments to bank director or officials or their friends.

As for the private banks, the central bank should be very strict in requiring full recognition of non-performing loans and full provisions to be made. There are concerns that these governance requirements are not always maintained. If this strictness leads to inadequate capital in some banks, so be it. The private bank must either correct the situation or stop making loans until the required capital can be raised. The banking system requires a firm hand that forces the commercial banks, private or state owned, to meet capital requirements at all times. The people who operate the commercial banks know exactly what they are doing and unless the central bank makes the right kind of intervention, the bankers will keep on indulging in bad practices.

The losses to the economy and the risks of the bank insolvency grow with the growing NPL. Business as usual is a dangerous path. The central bank taking the steps given above will set the banking system back on a more stable path and result in more rapid economic growth.

In summary

1. Stop recapitalization of the SCBs.

2. SCBs that fail to meet capital adequacy will not be permitted to make new loans or reschedule existing loans until their capital is rebuilt.

3. Every bank must cover its required provisions for NPLs.

4. Private banks with inadequate capital will have six months to reach capital adequacy. After that the bank can make no loans.

5. Clear warning of intent to be strict is needed but the path forward must be clearly marked for the bankers to follow.

The writer is an economist. [email protected]