Excess liquidity: Challenges facing BB

Persistent excess liquidity in the banking sector has become an urgent concern for Bangladesh as it represents lower lending for growth-enhancing investments. Despite an improved political environment, credit growth remains subdued at around 12-13 per cent compared to healthier growth rates in previous years of around 16-18 per cent (Chart 1).Slowdown in credit demand has also pulled down banking sector's Advance-Deposit ratio (ADR) to below 70 per cent (July 2015).
Bankers state that excess liquidity in the sector has crossed BDT 1000 billion because of non-utilisation of funds. This massive buildup of excess liquidity is attributable to a "go-slow" policy by entrepreneurs since election turmoil, greater caution by banks in sanctioning new loans, lower price of commodity imports and increased access to foreign currency loan at lower rates relative to domestic lending rates. The resultant fall in credit growth meant banks turned to government-approved securities with returns between 8-11 per cent depending on maturity. Around 90 per cent of excess funds are now invested in treasury bills and bonds which earn less relative to commercial bank loans, eroding profitability of the sector.
However, it is not just the sector itself which is under pressure. Bangladesh Bank (BB) faces formidable challenges amid persistent excess liquidity in banks. The remainder of this note discusses these issues with particular emphasis on challenges of utilising available policy instruments.
Removing excess liquidity comes at substantial cost: Massive amounts of excess liquidity has flooded the overnight call money market (a platform for banks to borrow from and lend to each other) complicating BB's regulatory objectives. BB has been ceaselessly mopping up excess liquidity from the market using its reverse repo at a cost of 5.25 per cent (this is the policy rate at which BB borrows from commercial banks). Senior banking sector officials are of the opinion that call money market rate would have fallen well below 5 per cent from its current range of around 5.3-5.7 per cent (October, 2015) if BB had not pursued this continuous mopping up policy.
This challenge was amplified recently as the government suspended treasury-bill auctions, having received more than adequate funds through sale of national savings schemes (NSS). This meant banks could not invest excess liquidity in treasury securities. Consequently, demand for BB's reverse repo facility escalated. This policy of removing surplus liquidity through reverse repo creates huge interest costs for BB as it has recently been mopping up around BDT 100 billion per day from the market.  
Given that rate of return on NSS is still 4-5 per cent higher than bank deposit rates, demand for the former is expected to remain high. This suggests government will continue receiving adequate funds through sale of NSS and may not require significant sale of treasury securities. In such a situation, banks will continue rushing towards BB's reverse repo (unless credit demand picks up). Inevitably, BB will continue incurring tremendous interest costs if it wants to mop up excess liquidity to keep the call money market stable. If BB stops accepting 100 per cent of reverse repos, interest costs could be slightly mitigated, but will lead to further excess liquidity pressure. Is there a balance to such a dilemma?
Threat to monetary policy transmission and inflation: In addition to financial loss through massive interest costs, excess liquidity threatens monetary policy transmission. Economists as well as institutions like the World Bank and Reserve Bank of India (RBI) argue that excess liquidity weakens the ability of central banks to influence aggregate demand. They warn that if banks are already highly liquid, further attempts to stimulate demand could prove ineffective since the interest rate channel -- a crucial medium of monetary policy transmission -- becomes weaker. Many central banks design monetary policy taking this view into consideration.
For instance, RBI's monetary policy framework tries to ensure that the banking sector runs on a balanced to moderately-deficit liquidity position. This framework is consistent with RBI's belief that if banks pile up large amounts of excess liquidity for long periods, reducing policy rate will not result in proportionate lowering of banks' retail rates (weakening the interest rate channel). This would prevent policy rate changes from reaching the real economy. The Indian experience suggests that monetary policy transmission in Bangladesh may also be reduced due to excess liquidity. If authorities accept this line of argument, they would have to work closely with banks to ensure that if they were to lower policy rates (as many stakeholders often demand), retail lending rates reflect this accordingly. Only then can lowering of policy rates trigger a rebound in aggregate demand.
The issue of a rebound in demand needs to be evaluated in the context of excess liquidity, given underlying risks. Due to massive amounts of pent-up excess liquidity, a marked increase in demand for domestic loans could give rise to rapid lending -- with an increased risk of money wandering off to unproductive sectors. We all know how that works. Inflationary pressures, induced by such demand shocks, may quickly become difficult to control.
Can past strategy be utilised? To mitigate similar issues of inflationary pressure and cost of mopping up excess liquidity, BB had hiked its Cash Reserve Ratio (CRR) in June 2014. CRR is the percentage of total deposits a bank is required to hold as reserves with BB. In theory, raising CRR should help mitigate the excess liquidity problem. However in Bangladesh, changing CRR is most effective if excess liquidity is prevalent in a largely uniform manner across the banking sector. Does that assumption hold?
The well-known variations in lending practices across the industry as well as differences in general reputation dictate that banks' ability to lend, and avoid buildup of excess liquidity, differ markedly. This can be confirmed by recent reports in the media which state that 15 banks are heavily burdened with excess liquidity. Going beyond this evidence, we can look at wide differences in Advance-Deposit ratio of publicly listed commercial banks. Their financial statements from June 2015 show that some banks have ADR over 90 percent while there are several whose ADR is less than 80 percent. Such wide differences confirm that excess liquidity is unevenly distributed within the sector.
This creates a tricky situation for BB if it wants to use CRR as a tool to control money supply and contain inflation. Utilising CRR could create a strong differential impact across the sector. For instance, if BB decides to raise CRR to mop up excess liquidity, it will have two distinct effects. It will reduce excess liquidity from banks which do have massive excess funds. But for banks which do not have excess funds, it may create a liquidity shortage, undermining their capacity to lend in an environment where loan growth is already subdued. This scenario implies that utilizing CRR becomes extremely risky and consequently reduces BB's available policy toolkit which regulate banking sector liquidity and inflation.  
Differences in interest rates reflect distribution of excess liquidity: Uneven distribution of excess liquidity further complicates matters for BB if it wants to uniformly bring down the interest rate structure (as popularly demanded). Imbalanced distribution of excess liquidity has already manifested in growing difference in interest rates across the sector. A better understanding of this issue requires carefully looking at the distribution of interest rates over the last 2-3 years, given that the problem of unevenly distributed excess liquidity has exacerbated in this period.
Chart 2 shows the distribution of deposit rates across all private commercial and foreign commercial banks for the last three years. We observe that, on average, deposit rates have come down in response to low demand for loans (as well as pressures from BB). But this has not happened uniformly and consequently distribution of deposit rates have become more uneven in the sector. Whereas in 2013, deposit rates for 80 percent of banks (private and foreign commercial) were between 8-10 percent, in 2015 there are greater number of banks in different intervals. Chart 3 shows a similar story for lending rates across the same sample. Greater number of banks across different interest rate intervals confirm that uneven distribution of excess liquidity has contributed to uneven reduction in interest rates. Not surprisingly, some banks which have reduced relatively more, now have lending rates close to deposit rates of other banks.
Bankers suggest such variation in lending and deposit rates has created a dangerous platform where large corporates can borrow at low rates from one bank and deposit the money in another bank which offer relatively high rates. This leads to a re-shuffling of assets across different banks without any overall growth, undermining development of the sector. Notwithstanding a reduction in overall interest rates, competitiveness and efficiency within the industry is seriously reduced due to these issues. It also complicates regulatory objectives for BB, as policy initiatives to uniformly bring down the interest rate structure may yield limited success as banks will be constrained by different excess liquidity positions.
In conclusion, vulnerabilities created by excess liquidity needs heightened attention from authorities. Certainly, it is not BB's responsibility only to tackle this issue given that reviving credit growth needs supply-side incentives like adequate energy and infrastructure. But BB definitely has a key role given its influence on borrowing rates and money supply. A strategic plan, in collaboration with the government and banking sector, needs to be formulated immediately. Allowing excess liquidity to escalate will only amplify challenges for BB in terms of regulating the banking sector, stabilizing the interbank call market and ensuring monetary policy effectiveness.  
Sharjil Haque completed graduation studies in International Economics from Johns Hopkins University, and currently works as a Macroeconomic Analyst for an organisation in Washington D.C. He is also a Fellow at the Asian Center for Development in Dhaka.  Email: [email protected]