It's time for banks to reach the un-banked areas

Mohammed Tajul Islam Amid global gloom and caution over the domestic macroeconomic environment, the Bangladesh Bank (BB) released the third issue of its annual Financial Stability Report (FSR)-2012 on September 15 last. The FSR highlighted the BB's views on prudential surveillance of the market in Bangladesh and potential risks to financial stability. It has also suggested a few corrective actions. The FSR states that despite a few negative indicators, asset quality in particular, the financial sector in Bangladesh stands sound and resilient. Though the risk to financial stability has aggravated due to global risks and the domestic macroeconomic conditions, the financial system of the country remains healthy. It is led by the inherent strength of the domestic economy, comfortable capitalised banks and their ability to withstand the liquidity pressure. Also, the results of a series of stress tests to study the impact of adverse macro-financial shocks showed that the banking system remained resilient even under stress to some extent. The FSR points out the historical economic growth and risks but has not elaborated much how it could impact the growth and outlook in near future. This article is intended to highlight a few observations of the writer on the FSR. Over the past couple of years, the banking sector in Bangladesh displayed a moderate to high level of resilience. This is in the face of high domestic inflation (back to a tolerable level now), the capital market shock after which the market has not yet recovered fully and the biggest scam in the banking sector. These may lead to a real problem, if corrective actions are not taken in an effective way. Showing an overall economic stability in Bangladesh, the BB has highlighted stable GDP growth, tolerable inflation, a wide current account surplus, a healthy foreign exchange reserve and reduction in government borrowing from the banking system. However, both credit and deposit growth in the banking sector decelerated during the calendar year (CY) 2012. The growth in credit from the scheduled commercial banks at 16.3 per cent year-on-year (y-o-y) in the CY12 was lower than the credit growth of 18.6 per cent y-o-y in the CY 2011. Deposit growth stood at 21.0 per cent y-o-y in the CY12 compared to 20.2 per cent y-o-y in the CY 2011. Deterioration in overall asset quality and capital adequacy positions of banks would put pressure on banks remaining resilient to credit, market and liquidity risks and withstand macroeconomic shocks. However, the growth in deposit vis-a-vis credit does not reflect any disparate trend which led to less dependence on borrowed funds, especially short-term funds. However, the growing short-term maturity mismatches the balance sheets of banks which might lead to liquidity risks in future. ASSET QUALITY CHALLENGES: The pace of growth in the banking system has moderated. Gross non-performing loans (Gross NPLs) reached Tk 427.3 billion, 10 per cent of gross advances as of December 31, 2012, up from 6.2 per cent as of December 31, 2011. A further upward spike to 11.91 per cent was observed at the end of June 30, 2013. The deterioration may be the result of a lack of emphasis on credit evaluation standards, less stringent credit sanction norms and focus on recovery, weak governance and management oversight, new legislation on classification by the BB as well as the unpredictable political situation in the country. Overall, the credit profiles of borrowers weakened in 2012 because of the factors, among others--moderate/slowdown in demand, compression of operating profitability because of cost pressures and inability of companies to pass on the higher costs in the backdrop of increasing competitive intensity, higher interest rates, project implementation-related delays, reduced profitability of new projects (because of competitive pressures, higher feedstock prices and interest costs) funded with relatively higher leveraging; and increase in counterparty risks and increasing concerns over fuel linkages in the power sector. However, this scribe thinks that the cyclical pressure may not ease in the short to medium term. Therefore, banks will remain exposed to loan impairment risk. The volume of rescheduled loans may therefore rise. However, recovery initiatives as well as strengthening the risk management function may help maintain the asset quality in the long term. The deterioration in asset quality has impacted banks' profitability and solvency. Incremental credit provisions (in relation to average advances) have increased while unprovoked NPLs (net NPLs), despite the higher credit provisioning, have also increased leading to an increase in net NPLs in relation to the net worth. However, despite the decline, the profitability and solvency ratios have not yet reached an alarming level although the ability of the banking system to absorb incremental stress has declined. The incremental stress on banks' asset quality could be more pronounced than the weakness in the credit profiles of companies. The current asset quality numbers possibly do not reflect the actual stress in the system. For instance, the Gross NPL percentage was not considered on the basis of restructured advances and some of these restructured accounts could slip into the NPL category. Furthermore, the stress test insight of the FSR shows that the three largest borrower defaults will drive down the CAR (compound annual return) level to 6.96 per cent from the baseline CAR of 10.46 per cent. In the event of 10 largest borrower defaults, the CAR will come down to 3.50 per cent only, which is very alarming for the banking sector. It is not likely that all top borrowers will default at a time, but it increases the concentration risk in the banking system. Development of a bond market could defuse the risk. CYCLICALITY AND PRO-CYCLICALITY OF BANK ASSET QUALITY: Our banks have gradually emerged as stronger entities over the last 12 years and have managed to reduce their bad loans continuously from as high as 31.5 per cent in 2001 to 6.2 per cent in 2011 and are focusing on better lending practices. Despite the improving scenario, it is of great significance to know how the effects of the changing macroeconomic scenario and monetary policy stances work upon the financial health of banks as the economy of Bangladesh integrates with the global economy. We have to keep it in our mind that there are cyclicality and pro-cyclicality of the bank asset quality. Economic expansion which is associated with an increase in corporate profits and household incomes enables borrowers to be in a better position to service bank loans leading to reduction in bad loans. But when tensions heighten on the economic front, the result is usually reverse. This is known as cyclicality of bank lending. When the asset quality deteriorates due to economic slowdown, there is likely to be a second round of effect of the banking sector on the real economy. The pressure to maintain minimum capital adequacy due to enhanced credit risk reduces the credit supply and further amplifies the business cycles and bad loans in bank books. This is referred to as the pro-cyclicality of bank loans. Considering the need to understand the contributory factors of such hike and few major scams, the BB may explore the macroeconomic determinants of the asset quality of the banking sector in the country by conducting a comprehensive study. The study may use different quantitative analytical models for analysis of the impact of real, financial and monetary policy shocks on the banking system and the feedback effects. BETTER DEPOSIT GROWTH IN FUTURE: In the banking system, historically, there has been a positive correlation between growth in the deposit base and increase in interest rates. Periods with high interest rates have seen relatively a high growth in deposits, as in a high interest rate regime banks' fixed deposits become more attractive than many other instruments. At present, it appears that given the outlook on interest rates, banks may be able to mobilise retail deposits at a higher or same pace in 2013 and 2014 than in the previous year. In 2012, the overall deposits of private banks increased by around 20 per cent, and within deposits, low cost deposits (CASA, current and saving accounts) increased by only 1.84 per cent. The CASA deposits represented 35.68 per cent of the total deposits in 2012 vis-a-vis 42.11 per cent in 2011. On the other hand, CD (Certificate of Deposit-Term Deposit) and other deposits increased by around 34 per cent in 2012 from that of the previous year. The shift in deposit mix in the recent time is the outcome of relatively a higher deposit rate and slow recovery of the capital market. Having significantly high cost deposits as a proportion of total deposits would exert pressure on banks' cost of fund. PROFITABILITY COULD SLIP FURTHER: The BB Financial Stability Report states that the central bank's soundness and profitability indicators slightly deteriorated compared to that in 2011. The banking sector's net interest margins (NIMs) declined from 3.0 per cent in 2011 to 2.8 per cent in 2012. Additionally, credit provisioning is expected to increase, which could impact profitability by 15-25 bps in 2013. A decline in NIMs at a time when credit provisions are also expected to rise could dent profitability. Rationalisation of operating expenses and marginally higher treasury profits could cushion the impact to some extent. The profitability (ROA) of banks is expected to decline from 0.6 per cent in 2012 to 0.4-0.5 per cent in 2013 while the return on net worth is likely to drop from around 7.8 per cent to 5-6 per cent over the same period. This assumes the provisioning cover on NPLs would remain at the current levels. But in case it is lower, the impact on profitability would be less severe, although the net NPLs in relation to net worth could worsen from the projected levels. Capital requirement for Basel II and migration to Basel III is large but manageable over a long period of time. The CAR as of December 31, 2012 was reported at 10.46 per cent, just marginally above the required level of 10.0 per cent, but challenges lie ahead. Slow growth in credit in 2012 resulted in a marginally comfortable capital adequacy level. Most banks may require significant capital in the mid-term to fund their growth plans. The banking sector as a whole managed to increase its pre-provision profit by 5.6 per cent, but due to high provision required on the back of deterioration of asset quality, the profit before tax showed a negative growth of 22 per cent in 2012. There is no sign of rebound of the profitability level in the banking sector. Therefore, additional capital may also be required to support a growth rate that exceeds the internal capital generation rate, which is likely. In case banks are unable to mobilise the required additional Tier I capital and the gap is bridged by raising the common equity, the incremental equity requirement may go up. Although the contribution required from the government appears substantial for state-owned banks, the same can be met through consistent equity infusions. In Bangladesh, commercial banks have witnessed an increase in their risk weighted asset (RWA) density (proportion of RWAs to total assets) with significant variations across banks. It indicates the increasing risk being taken by the banks and raises concerns over the quality of their capital ratios. Furthermore, the limited progress made by banks in implementing the advanced approaches to Basel II also gives rise to concerns over the risk management of banks. The FSR by the BB also mentions that banks in Bangladesh are currently maintaining the regulatory minimum capital requirement of Basel II (10 per cent of RWA) or a minimum absolute amount of Tk 4.0 billion, whichever is higher, and are not required to maintain additional capital under the ICAAP. As per the BB FSR, the position is not alarming yet and the capital adequacy position of banks provides some comfort ensuring that the banking system remains resilient even during any contingency period. But the increasing divergence of credit and NPL growth rates widened in the recent past and could put further pressure on asset quality in the near term. The slippage ratio increased to 11.91 per cent as of end-June, 2013 that emphasised the asset quality concerns and the need for proactive management of NPLs by banks. During 2013, the quantum of restructured accounts also increased, surpassing both credit growth and growth rate of gross NPLs. The FSR by the BB has made some interesting observations about the increasing systemic importance of some five worst banks. It argues that the maximum possible loss is caused to the banking system due to the failure of the 'worst 5' banks. The classified loan concentration ratios (based on NPL amounts) of the worst five banks and the worst 10 banks were 62.7 per cent and 73.2 per cent respectively at end-December, 2012. Almost two-thirds of the classified loans are concentrated in three state-owned commercial banks and two specialised development banks. The situation warrants more rigorous and prudential supervision of these 'most concerned' entities. Financial inclusion, technology and human capital could make the difference. Asset quality, capital adequacy, financial inclusion and talent management are some of the key issues facing the local banking sector, which despite serving the people of one of the largest populated countries in the world with a total of 55 banks, reaches out to only about a part of the country's households, scripting no global footprint. The rising consumerism among the emerging 'middle' class in Bangladesh and the higher purchasing power in rural areas on account of rising employment provide an opportunity for banks to look beyond the traditional customer segments. However, these segments would require flexible operating models which would ensure responsiveness at the last mile and at the same time be viable for the banks. On the other hand, global aspirations call for funding cross-country acquisitions, greater sophistication in services and scaling up resources from banks. The BB's recent move to issue licences for new private sector banks to spur competition in the sector and garner fresh capital for financial inclusion would entail a debate over the need for consolidation vis-a-vis numerical expansion of the sector. Capital adequacy will be a big issue for the commercial banks in Bangladesh, as they start gearing up for growth and becoming compliant with the Basel II guideline. Financial inclusion will require innovative operating models. The banking sector has woken up to its potential in the unbanked areas. To enter those uncharted territories and capture the unsaturated segments of market, the banking sector will have to come up with innovative operating models which will be different from the conventional ones. Technology will hold the key to accessing this market, as setting up extensive branch networks in remote regions or regions with poor physical infrastructure may not be economically viable. The break-even period for a rural branch could take three to four years. Technology-based models such as mobile banking will inevitably change banks' operating models and help banks lower their cost-income ratio. The trend clearly shows a significant year-on-year increase in the use of alternate channels for transactions like automated teller machines (ATMs), internet and mobile banking. The writer is Head of Ratings at the Credit Rating Agency of Bangladesh Limited (CRAB). The views expressed here are the writer's own. [email protected]