Banks under pressure: NPL is the spoiler

Eight banks in the country have reported capital shortage as of quarter that ended in March of this year, according to media reports. Besides, surplus capital of 48 other banks has sharply declined as total surplus capital accumulated by all banks have come down from Tk 23.96 billion to Tk 10.83 billion. Erosion of surplus capital of majority banks is more alarming than capital shortage of eight banks. Capital inadequacy and erosion of accumulated capital are not a good sign for banks and financial institutions because capital is their most important pillar. Banks deal with other people's money. More precisely, banks or financial institutions play intermediary role in channelling fund from surplus units to deficit ones. Further funds, mobilised from surplus units, are refundable on demand whereas money lent out to borrowers may not be called back immediately. Even a bank is obliged to repay the term deposit on demand if withdrawal request is placed. So the banks' resilience as well as ability to repay depositors' money is the most important parameter of banks' solvency as well as soundness which is reflected in strong capital base.
Whenever any financial crisis arises, strong capital base helps the banks survive. During financial meltdown in 2008, many large banks' existence in developed countries was at stake and those banks were saved by strengthening their capital structure through injecting additional capital by major shareholders. So in any circumstance, banks' capital base is taken into consideration to assess their performance. Before introduction of BASEL and other modern approaches, CAMEL theory was applied to evaluate banks' soundness and capital was the first and foremost component of that theory. Now the importance of banks' capital base has assumed significance manifold after the implementation of BASEL III because one of its most important recommendations is capital adequacy requirement by banks and financial institution.
Bangladesh is in the process of implementing BASEL III setting 2019 as the deadline of its full implementation and we believe that our country has made a good headway towards this implementation. So capital inadequacy during full implementation of BASEL III is not desired at all and may severely hinder the entire implementation process.  
BASEL III AND OUR REALITY:   It is said that BASEL III recommendation was adopted with more focus on banking structure as well as product and services of banks and financial institutions of developed countries. Counterparty risk and its rating have been given importance in calculating risk weighted asset (RWA) but this counterparty risk has very insignificant role in the banking business of our country. Similarly market-to-market is another important factor in determining RWA but this factor is mostly applicable for market trading investment, viz. Commodity Trade Finance, Interest Rate Swap, Fx. Rate Swap, Exchange Traded Derivatives and many others. These types of sophisticated financial products are very common in the financial industry of developed countries whereas these are totally absent in our country. Besides, long-term lending is linked with the issuance of bond in developed countries. In order to finance mortgage and commercial projects, banks and financial institutions in the developed world issue long-term bond matching with the tenor of mortgage and project. Issuance of bond by banks and financial institutions is far away in our country.
Loan trading is another established procedure by which banks and financial institutions may manoeuvre its asset volume and can thereby adjust its RAW so as to maintain capital adequacy requirement all the time. In the developed financial industry, Loan Trading has a structured market where both accrual and non-accrual secondary loans are traded among banks and financial institutions. Because of the existence of loan trading facility, banks facing difficulty with maintaining capital adequacy requirement may sell out the part of its assets (loans) which other banks with enough capital surpluses may purchase. The concept of this modern but simple banking practice is totally absent in our financial industry. Moreover, banking in our country is still confined to traditional services comprising mobilisation of deposits and disbursement of loans. Although zero or near zero interest rate is applied on bank deposits in the developed world, excessively high interest rate is charged in retail lending as 19 per cent to 29 per cent interest rate is applied on credit card borrowing and consumer financing while 9 per cent to 15 per cent interest rate is charged on personal loans. Because retail lending is always considered as highly risky loan and therefore substantial provision is retained against outstanding retail loans.
Even effective interest rate on corporate lending also varies from 6.0 per cent to 9.0 per cent although LIBOR rate is around 1.0 per cent and as a result, banks can conveniently maintain enough provision all the time whereas in our country, both deposit rate and lending rate are very high and these rates move parallel keeping a constant spread between these two rates which does not allow the banks to retain adequate provision against outstanding loans. In consequence of these structural changes and adjustments, banks in the developed world are in an advantageous position while our country's banks remain in disadvantageous position in maintaining capital adequacy requirement as per BASEL III recommendation. This is obvious because the theory designed for the developed world's banking creates an adverse situation when applied to an emerging market and therefore, banks in our country will always remain under extra pressure in maintaining capital adequacy requirement.
Further, there are similarity and consistency among banks in the developed world. The structure and market of the developed financial industry is well consistent. Whenever any change is brought about in any part of the developed world, all other participants make well adjustment in their policies and services so as to remain at par with all peer groups. When the Dodd Frank Act was passed in the USA, banks of all other developed countries immediately do their necessary adjustment so that they can align with the US banking system. Therefore, there are always homogeneous products and services among the banks of developed financial industry. The opposite scenario is found in the banking system of emerging market where there are heterogeneous products and services. Risk participation is a very popular product in one part of emerging market viz. China, Vietnam, Hong Kong and Singapore while the same is completely unfamiliar in other parts, viz. Bangladesh, India and Pakistan. It may be mentioned here that Risk Participation is a very latest and popular trade finance product through which counterparty risk is well managed and mitigated.
This is, however, not a problem of our country alone; rather all countries of emerging market are facing this common problem. As a result, the rating of banks in emerging countries is now being downgraded and resultantly many banks in the developed world are gradually terminating or limiting their correspondent relationship with the banks of emerging market. However, nobody has anything to do with BASEL III recommendation but to implement it by deadline 2019 as this is an agreed-upon decision. All central banks from developed and developing worlds have unanimously adopted BASEL III recommendation and agreed to fully implement by the set deadline 2019. So they have now no choice but to implement it.  
REASONS FOR CAPITAL SHORTAGE:  There are various reasons behind capital shortage of banks. These are mainly high cash dividend payout ratio, lack of injecting additional capital, inappropriate lending and deposit ratio, especially excess lending over deposit, solely depended on deposit for loanable fund, substandard lending, deterioration of asset (loans) quality and inadequate provisioning. Among these, high cash dividend payout ratio, deterioration of asset quality which is commonly termed as non-performing loans (NPL) and inadequate provisioning are very common reasons held responsible for banks' capital shortage in our country. Historically, cash dividend payout ratio is relatively high in our country because this is a kind of good incentive for common shareholders. In our country, the number of high-grade investment companies is very limited.
So shares of banks and financial institutions are always considered high-grade investible securities and therefore, investors always expect high rate of cash dividend. Without considering future growth, strength of capital and adequate provisioning, the banks pay out good amount of cash dividend in order to make common shareholders apparently happy. Even a kind of subtle competition prevails among the banks' managements in paying cash dividend. This is of course a very good sign for the investors but long- term goal of the institutions is compromised. In general, there is inverse relationship between capital accumulation and cash dividend payout as the former is reduced when the latter increases or vice versa.  Similarly standard ratio between deposit and lending is not maintained properly by many banks in our country. There is a common tendency that many banks lend more than deposit allowed for lending after deducting statutory reserve requirement (SRR).
Besides, in many cases, there is a mismatch between the tenor of deposit and lending as long-term lending is commonly funded with short-term deposit. Deviation from standard ratio between deposit and lending, coupled with mismatching of loans and deposits, causes adverse impact on the risk factor of banks' assets which eventually affect capital adequacy requirement. More importantly the quality of assets plays a very significant role in banks' capital calculation. The amount of NPL is historically very high and has become an ever- increasing phenomenon in the banking industry of our country. Total NPL, as of last June quarter-end, stood at Tk 633.65 billion which increased from Tk 517.71 billion as of December 31, 2016 i.e. 23 per cent rise during six-month period which is really very alarming. This trend is not expected to improve soon; rather it may continue to deteriorate further because no extensive measures have so far been taken either at individual banking level or at national level to address this massive NPL problem in our country's banking sector.
We have experienced that bank management and the CEOs mostly prefer sanctioning of new loans to recovering NPL. So there is no sign of improvement in the country's NPL. Needless to say, high rate of NPL has the most negative impact on capital shortage or erosion of surplus capital in banks. Increase of NPL has caused simultaneous impact on rising risky assets and dropping quality assets which eventually result in the increase of RWA and increase of RWA calls for higher capital requirement. So among others, high rate of NPL is considered as the most contributory factor in causing capital shortage and wiping out of surplus capital. (The next part of the article will be published on Saturday.)
The writer is a banker based in Toronto, Canada.
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