New banks: Challenges and way forward

When regulators gave licences to nine new banks, most analysts were justifiably sceptical regarding their prospects in an already saturated industry. Political motivations aside, not too many were convinced that these new players in the banking sector would serve the purpose of truly increasing competition, lowering interest rates or enhancing financial inclusion. Since beginning business more than two years ago, these initial doubts have emerged as full-fledged challenges. In this context, this article discusses major challenges new banks are facing and strategies they need to adopt going forward to overcome these issues.  
The first major challenge is that the new banks, as one would expect, are relatively liquidity-constrained. This is in contrast with the rest of the sector, where banks have been rushing towards treasury securities and the Bangladesh Bank's monetary instruments to invest their excess liquidity. New banks have had to offer deposit rates substantially higher than the industry average to attract savers, incurring higher cost of funding. The Bangladesh Bank (BB) data show that they are offering deposit rates of around 8-9 per cent compared to an industry (weighted) average of around 6.5 per cent. Lowering deposit rate remains a daunting challenge given that they are competing with more reputed banks as well as financial instruments outside the banking industry which offer high returns (for instance, term-deposits of non-banking financial institutions as well as national savings schemes).
Second, since the new banks are constrained by higher cost of funding, they have little choice but to charge high lending rates. The BB data show these banks are lending at 13-15 per cent compared to an industry average of around 11-11.5 per cent. Given that they are competing with established foreign and private commercial banks, such high lending rate will certainly constrain asset growth going forward. With big entrepreneurs now also able to borrow from foreign sources at around 5.0 per cent interest rate, new banks are essentially at a tremendous competitive disadvantage.
Third, these new entrants are facing serious challenges in conducting foreign exchange and trade-related transactions. More specifically, most of these new banks have not been able to open Nostro accounts. These are bank accounts held in foreign countries by domestic banks (denominated in the currency of the foreign country) and are used for treasury and foreign-exchange related business. Banks in the USA and Europe have refused to open these accounts with the new banks due to scepticism regarding the 'economic' motivation behind their inception and increasingly strict international banking regulations. Consequently, their ability to conduct financial services like opening letters of credit (and receiving the associated commission) is seriously constrained.
Fourth, there is a widespread belief that the sector as a whole is suffering from an acute shortage of skilled human capital. Most established local banks depend on professionals trained by only three well-known foreign commercial banks. New banks, by extension, lack skilled professionals especially in leadership roles to oversee financial, treasury and stock market operations.
Now, what strategies can the new banks adopt going forward to counter these challenges?
First, the top agenda going forward is the need for hiring highly skilled professionals who can provide the intellectual leadership necessary to compete in a highly saturated industry. In this aspect, new banks will have to attract the most experienced professionals with sound track-record in the banking industry who can guide them in different areas such as lending practices, risk management, treasury operations, stock market investment and governance issues. The incremental premium associated with hiring of such professionals is certainly acceptable given the potential gains they can bring over the medium term.
Second, new banks have to make tough choices regarding their interest rate spread and immediate profitability. Admittedly, they have little option in substantially cutting deposit rates given that they are still in the process of developing a stable deposit base. If they lower deposit rates, savers might shift to more established and reputed banks or national savings scheme. In the light of this risk and the need to maintain asset growth, they can consider lowering their interest rate spread by reducing lending rates. There is no way new banks can compete in the industry if they charge 14-plus lending rates when their established counterparts have brought down lending rates to around 11 per cent. Additionally, the BB is likely to continue easing access to foreign loans, further squeezing their scope of tapping into top private sector firms. It is important to realise that new banks have one significant advantage over the rest of the industry when it comes to lowering interest rate spread. Unlike many of their established counterparts, new banks are not constrained by high non-performing loans (and associated provisioning requirements) which compel banks to maintain high interest rate spread to protect profitability. Based on this reasoning, they have more room to reduce interest rate spread while searching for alternate avenues to protect operating revenue.
Third, what can new banks do to protect overall operating revenue if they lower lending rates and/or if they cannot attract sufficient corporate clients to lend to (given large number of banks they compete with)? Financial statements of several new banks show that their exposure in the stock market is relatively minimal and investment-related income is mostly dependent on low-yield treasury securities. Regulators have recently taken various steps to improve banks' exposure in stock market. These new players will have to seriously consider reallocating their capital from low-yield treasury bonds to financially robust publicly listed companies. Well-known concerns related to the stock market notwithstanding, as of November 15, fundamentally strong stocks from cement and pharmaceutical sectors generated annualised return in excess of 13 per cent. This is higher than 1-year risk-free rate plus 5 per cent risk premium. Given this underlying potential, a strategic balance between treasury securities and stocks can be considered. Recognising the risk element involved in stock market, a strong team experienced in equity market issues is of utmost importance.
Fourth, these new players could consider entering into agreements with the BB for long-term financing projects. While several established banks have recently entered into such agreements with the BB on long-term financing facilities (supported by the World Bank), new banks are yet to tap this opportunity. It is worth mentioning that cost of fund in such projects is only around 3-4.5 per cent with a cap on interest rate spread of 3 per cent. Two benefits can be obtained from this channel. One, on an average, cost of fund for new banks will fall. Two, new banks will get the all-important access to corporate entities from various manufacturing sectors which will come forward for loans under this scheme. This can help build a client relationship which can potentially bring future business.
Fifth, it is important to recognise that until these new banks create a strong reputation within the industry, they will always be at a disadvantage when it comes to attracting top corporate borrowers. Logically, diversifying loan portfolio to alternate avenues becomes necessary. One such viable alternative is greater exposure in SME (small and medium-sized enterprises) financing, which has strong regulatory support from the BB and the government. SMEs are generally considered riskier relative to top corporate borrowers. Banks' success in transforming these potential clients into a sustainable stream of revenue will depend on identifying pragmatic SME business models and demand-outlook of associated industries.
Sixth, the biggest opportunity for new banks lies in targeting the unbanked population in rural areas with appropriate products and services. Instead of investing excessively in urban office buildings, which unnecessarily drive up administrative expense, they need to consider opening cost-efficient branches and service centres in rural areas. Gaining a first-mover's advantage over more established banks can help expand asset size in a sustainable manner while reducing risk of losing urban clients due to differences in lending rate and/or reputation. It is worth mentioning this strategy is constrained by the central bank-imposed cap on urban-rural branch ratio. Strong and financially compelling proposals may need to be drafted to entice the BB to relax this cap.   
Finally, opening accounts overseas for trade-related transactions will ultimately depend on how healthy new banks can develop their balance sheets. Building a solid track-record of impressive deposit and asset growth while minimising politically-motivated decisions regarding banking practices, becomes a key priority going forward. Most importantly, new banks will have to maintain their one major advantage over the old ones - limited non-performing loans. While searching for new options of asset growth is certainly warranted, it should not come at the expense of compromising asset quality. Ensuring risk-management capacity of the highest standard will play a crucial role for their medium-term development in the country's banking sector.
The writer currently works as a macroeconomic analyst for an organisation in Washington D.C. He is a Fellow at the Asian Centre for Development in Dhaka.  
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