Prudential regulations provide the framework for ensuring stability and soundness of the banking system. "Asymmetry of information" and "Moral hazard" are inescapable features of the banking system. These features find expression in multiple ways.
There is asymmetry of information between depositors and bank management. As a result, depositors may perk their deposits in any bank that they come across without scrutinising the solvency status of the concerned bank. This tendency may be reinforced by "moral hazard" based on the perception that if the bank runs into difficulty, the government will bail it out and therefore depositors need not be concerned about the security of their deposits.
There is also an asymmetry of information between the banks and the borrowers. The latter are much better informed of the potential risks and returns of their loan proposals. It is not easy to bridge this asymmetry even though banks may diligently screen the loan proposals. Hence banks may end up financing high risk proposals some of which may fail. The tendency in this direction also may be reinforced by "moral hazard" on the part of the banks based on the perception that, in the event of any trouble, the government will bail them out. Such a perception may undermine due diligence by banks and exert strongly negative impact on the soundness of the financial system and real sectors of the economy. The Asian economic crisis of 1997-1998, the financial sector problems that occurred in the United States in 2008 and 2009 and the on-going debacle in several countries of Europe can be traced to asymmetry of information and moral hazard characterising the banking operations.
The above considerations provide strong justification for prudential regulation of banks. The need for such regulation is almost universally accepted though the details may differ from country to country. Besides, the emergence of unanticipated problems may give rise to new regulations.
Considerations of bank solvency become highly relevant in managing central bank's lender of last resort (LOLR) facilities and related payment system policies. Most central banks provide some form of credit facility, which can be used to provide liquidity and facilitate payments settlement for banks in distress. Central bank's last resort lending will generally take the form of liquidity injections directed to a particular bank or set of banks and may need to be sterilized by reducing liquidity elsewhere, for example, through open market operations or other instruments.
The intent of central bank LOLR facilities is not to provide resources to insolvent institutions, but to provide temporary liquidity to sound institutions, typically at a penalty rate. To manage its LOLR facility, the central bank must know (on the basis of information from supervisors) which banks are approaching insolvency or are insolvent. In practice, however, both central banks and supervisors often have difficulty distinguishing illiquid but solvent banks from insolvent ones. This is even more difficult when most banks or the entire system is in distress. Experience shows that banks that have major or protracted liquidity problems are invariably insolvent. In exceptional cases, the central bank may be called upon to lend to insolvent banks, for example, to buy time for the design of restructuring strategies when banks are viewed as "too big to fail" or when the lending is part of a systemic restructuring strategy. LOLR facilities must be managed with utmost caution, relying on careful monitoring of banking soundness.
DIRECTED CREDIT: Many developing countries have followed a policy of directed credit to selected sectors, often at subsidised rates, with a view to accomplishing certain development objectives which included industrialisation, employment creation, increase of food production, export promotion etc. Directed credit can, therefore, be viewed as an instrument of non-price rationing or non-market allocation. The justification is that private sector may be unwilling to undertake investment in some desirable activities because of market failures. For example, private sector may not be interested to develop new export products or explore new markets because of uncertainties of returns.
Governments may prefer directed credit at subsidised rates as an alternative to providing direct subsidies out of the budget for political reasons. Politically, it may be difficult to make direct subsidy proposals acceptable to Parliament. The leaders in the governments may also feel that tax-paying citizens would consider such subsidies as unjustified use of tax revenues for the benefit of some vested interests.
Another justification for preferring directed credit over budgetary subsidies is the presumption that banks which provide such loans are likely to exercise effective control over the utilization of funds as they have a direct stake in the success of the recipient enterprises. The failure of the concerned projects would jeopardise the recovery of loans. It would be unrealistic to expect government officials administering subsidies to exercise effective control since they do not directly stand to gain (lose) from the success (failure) of the projects.
It appears that very few countries could successfully use directed credit as a tool for accomplishing their development objectives. There are also some inherent limitations of this approach. The choice of firms and sectors may be arbitrary in the absence of well-articulated criteria. The entities receiving such benefits may choose a path of excessive leverage leading to fragility of their financial health. Banks may incur losses and, in some instances, may be forced to throw good money after bad money.
Many analysts are of the view that Japan and republic of Korea are among the few countries which successfully used directed credit as a tool of industrial development and export promotion.
BANGLADESH SCENARIO: Bangladesh has introduced over the years a host of measures which fall directly or indirectly in the category of prudential regulations. The important ones are listed below.
* Ceilings on disbursement of loans to a single party.
* 'Fit and proper' test for Chief Executives and Advisors of private banks.
* Requirement of Audit Committees in banks.
* Imposition of capital Adequacy requirement as per Basel II and announcement of intention to adopt Basel III.
* Promulgation of stress testing guidelines.
* Instruction to establish separate risk management unit in banks.
* Cash reserve and statutory liquidity requirement.
* Limits on banks' investment in stock markets and the requirement to operate merchant banks by constituting separate legal entity.
* Introduction of CAMELS (Capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risks ratings).
* Requirement of provision against bad loans.
However, the ever increasing volume of non-performing loans despite generous rescheduling and restructuring casts a gloomy shadow on the effectiveness of prudential regulations.
In Bangladesh it has been a common practice to influence allocation of credit. In most cases, efforts have been made to enhance the flow of credit to certain activities; sometimes credit to certain others has been discouraged. In the former cases, administrative pronouncements have been backed up by refinance facilities for banks at concessional interest rates. Some of the pronouncements of the central bank which are in the nature of directed credit are noted below.
* Fixation of the target for agricultural/rural credit
* A scheme titled "Solar Energy, Bio-gas and Effluent Treatment Refinance Scheme" was set up by Bangladesh Bank
* A "Refinancing Scheme for Small Entrepreneur" was instituted
* A refinancing scheme was introduced to provide credit at the existing bank rate for adoption of Hybrid/Hoffman Kiln equivalent technology by brick field owners.
* Group loans were introduced for women entrepreneurs and interest rate for such loans would be maximum 10 percent.
Bangladesh Bank should continuously monitor compliance with directed credit requirements and evaluate impact on cherished objectives.
EXCHANGE RATE MANAGEMENT: In most countries with floating exchange rate regimes, central banks do intervene in foreign exchange market from time to time in order to achieve broader macro-economic goals. Bangladesh has been no exception to this wide-spread practice. In reality the issue relates to the need for depreciation often demanded by exporters.
The case for depreciation rests on the ground that if exporters are facing hardship due to developments in the global economy, they need to be compensated and depreciation would be an effective tool to provide such compensation. In this context it should be noted that depreciation does not change the price of export in terms of foreign currency. What it does is to raise the price in terms of domestic currency. In consequence, domestic consumption of the export commodity is reduced, also the producers are enabled to move up along the supply curve. The combined result is to increase the volume of exports. The exporters earn greater revenue, proportionate to the increase in the volume of exports and the magnitude of depreciation.
The above result can be realized only if certain conditions are met. First, the depreciation - induced domestic price increase causes a fall in the domestic consumption of the export commodity. In the case of garments exports, this is likely to be the case in a country like Bangladesh. With low per capita income, the demand for garments may be fairly price elastic. The second condition is that for the full realisation of the beneficial impact of devaluation, the supply curve has to remain unchanged. This is the most unlikely scenario in Bangladesh. The garments industry is substantially dependent on imported inputs, including chemicals and fabrics. Depreciation would cause an increase in the domestic price of these inputs. As a result, the supply curve would shift to the left undermining the increase in export volume relative to what would be the case if the supply curve remained unchanged. Furthermore, labour engaged in the garment industry may press demand for higher wages more forcefully, leading to a further shift of supply curve to the left. The third condition is that the prices of garments remain unchanged in terms of foreign currency and that Bangladesh satisfies small country assumption meaning that the country can sell any volume at the existing international price. This condition is also most unlikely to be met in the present circumstances. Garments exporters frequently complain that they were facing pressure from foreign buyers to reduce prices in terms. Depreciation might well add fuel to such pressures and if our exporters have to yield, a significant portion of the potential benefit of depreciation would be appropriated by foreigners.
The above analysis suggests that the beneficial impact of depreciation on garments exporters is at best uncertain. Those who clamour for depreciation pitch their argument primarily on depreciation of the currencies of competitor countries. In order to come to grip with the question of whether greater depreciation of the currencies of some competitor countries has cut into exports of Bangladesh, it would be worthwhile to examine whether export volumes of those countries have increased by a greater extent than those of Bangladesh. The experience in recent times has been that most of the increase in export earning has been generated by increase in volume.
At this stage, let me recall a couple of the well-known undesirable consequences of depreciation. It should be reiterated that depreciation increases the domestic price of most goods - imported machinery, raw materials, intermediate goods and final consumption goods (including those which are exported and domestically produced import - competing products). As a result, depreciation may stoke inflation.
Depreciation would also cause an adverse impact on government finances. The subsidy requirements for food, fuel and fertiliser imported mostly by the government would go up if the present price level is to be maintained. Furthermore, taka cost of external debt service will also increase.
Depreciation is a macro-economic policy tool which a country may need to deploy when it suffers from persistent imbalance in external accounts and the deficit cannot be financed within the limits of sustainable external debt service. In considering depreciation, the government and the central bank should carefully weigh (i) the likelihood of increasing exports and remittances in the present global climate through depreciation, (ii) the impact on inflation and (iii) consequences for the government budget.
CONCLUDING OBSERVATIONS: I would like to conclude by posing a few questions which Bangladesh Bank may wish to ponder over:
* Should Bangladesh Bank have the authority to refuse credit to the government and state-owned enterprises? This is connected with the issue of the independence/autonomy of Bangladesh Bank which I have not dealt with.
* Should Bangladesh Bank take the initiative for mandatory mergers to reduce the number of banks?
* Should there be an Anti-trust/Anti-monopoly law applicable to banks to prevent collusive interest rate fixation?
* Why have prudential regulations failed to keep non-performing loans within a reasonable level?
* What sorts of reforms are needed in the Loan Courts Act and Bankruptcy Act to recover non-performing loans and penalize defaulters?
* Shouldn't there be an objective review of the compliance record of directed credit and how can non-compliance be punished? Also what has been the impact of such credit on desired objectives?
Mirza Azizul Islam is a former Adviser to the Caretaker Government, Ministries of Finance and Planning and presently a visiting Professor in BRAC University.
[This write-up is based on the Second AKN Ahmed Memorial Lecture sponsored by Bangladesh Institute of Bank Management.]
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