The impact of capital shortage in banks

Banks' capital shortage has far-reaching impact on our growing financial industry and the country's economy as a whole. Even this will cause severe negative effects in our domestic market and international arena as well. Capital shortage will weaken banks' resilience and ability to refund depositors' money. Banks with weak capital base cannot withstand even a minor crisis in the economy. Depositors' confidence may be shaken with weak capital base, which is likely to lead widespread withdrawal from banks resulting in contagious impact on the whole industry. Because of capital shortage, banks' investment will be affected and as a result, earnings will significantly decline. Because of revenue drop, banks will not be able to declare dividend which will frustrate the common shareholders and thus the country's capital market will be adversely impacted.
In addition, banks' ability to lend will be limited and this will result in credit crunch in the economy. The business community will have serious problems in borrowing money from banks for which the country's economic growth will be affected. Finally, regulatory compliance failure will become a big challenge for our commercial banks, the central bank and above all, the country. Deadline for complete implementation of BASEL III is set for 2019 when 12.50 per cent capital adequacy requirement, as determined by the Bangladesh Bank, will have to be achieved. This implementation deadline is the commitment of our central bank. So failure to meet the deadline will be viewed negatively by international regulators including the Bank for International Settlement and the BASEL committee. This compliance failure may even adversely affect sovereign risk rating of our country.  
IMPACT IN INTERNATIONAL MARKET:  Banks in our country may face a very tough situation in the international market due to capital shortage. It may be mentioned here that all banks in the developed world periodically evaluate and internally rate all their counterparty banks and while evaluating, capital base of each bank is given utmost importance. This is important for those banks because their capital adequacy requirement is also affected if their counterparty risk rating deteriorates. Banks in the developed world usually reject banks with poor capital base at first hand although some other parameters may be favourable. So capital strength is very important in maintaining correspondent relationship with foreign banks.
Weak capital base is one of main reasons for which many banks in the developed world are terminating or limiting correspondent relationship with those of the  developing world. If correspondent banking facility is restricted, international trade will be badly affected. Confirmation, negotiation and discounting of letters of credit (LCs) issued by our banks and even remitting funds will become very challenging due to lack of correspondent relationship and counterparty bank limit. If such an adverse situation arises, our import-export business and foreign remittance will face the most difficult situation. Even it is not unlikely that import cost will rise and export price will decline to a great extent as supplementary arrangement viz. EDC (Export Development Corporation) Insurance, IFC (International Finance Corporation) Guarantee etc. may have to be made in the absence of proper correspondent relationship with our banks. In short, international banking cannot be carried out without maintaining correspondent relationship and counterparty limit with maximum number of banks in the world including the developed ones and strong capital base is the prime requirement of each bank to avail this opportunity.       
COMPREHENSIVE STRATEGY: Addressing capital shortage problem of banks is not an easy task as it requires both short and long-term comprehensive strategy and action programme. More importantly, without bringing about structural changes in line with the developed world's banking practice, it would be very difficult to maintain capital adequacy requirement all the time as recommended in BASEL III. Needless to say, fundamentals of our economy and long tradition as well as practice may not allow complete structural change in our country's banking system. However, some common concepts, which are not difficult at all, may easily be adopted. Even this partial adjustment will undoubtedly leave our banks in an advantageous situation, which may immensely help the banks overcome the problem related to capital shortage.
The trend of capital shortage and erosion of surplus capital must have to be stopped immediately because, if such situation continues, the remaining surplus capital will be wiped out very soon when all other banks will face the same fate of capital shortage for which a chaotic situation is likely to be created in the financial industry of our country. So it is now right time to undertake very comprehensive strategy comprising both short and long-term measures.
SHORT-TERM MEASURES: Under short-term measures, restricting cash dividend payout ratios, injecting additional capital, tax incentive for retaining excess reserves, maneuvering approaches of recovering outstanding loans and disbursement of new loans are very important. Dividend payout can be well-balanced between cash dividend payout ratio and stock dividend ratio so that capital adequacy requirement improves. Although this decision may make the common shareholder unhappy, yet they will have to be ready to bear such momentary sacrifice for achieving long-term goal. They will have to understand that although small investors receive very nominal amount of cash through cash dividend, its lion's share is taken out by the majority shareholder, preferably the members of the Board of Directors. Common shareholders' small sacrifice of cash dividend can substantially increase banks' capital base which will ultimately strengthen banks' position in the market.  
Manoeuvring  the approaches of recovering outstanding loans and disbursing new loans are another difficult task. Recovery of non-performing loans is one of the most difficult and challenging jobs for banks and past experience reveals that fruitful results from banks' recovery drive are very insignificant. At the same time, one-way traffic i.e. without recovering outstanding loans, persistent disbursement of new loans is not an acceptable proposition because this will eventually accumulate inferior assets for which banks' capital requirement will go up. Again relating new disbursement with recovery may create credit crisis in the economy and therefore, new investment and business impetus may be adversely affected. Therefore, a good balance between these core functionalities of banks will have to be maintained through establishing some predetermined parameters.  
Capital base, particularly minimum requirement of capital, buffer capital and the amount of surplus capital can be linked with recovery amount of NPL and disbursement limit for new loans so that all objectives, viz. capital adequacy requirement, reducing NPL and increasing quality loan portfolio are well maintained. This is not an easy job but attainable through some extensive measures, commitment and direct monitoring. In our country, hardly there is a practice of injecting additional capital by sponsors or majority shareholder. Initial paid-up capital is full and final capital payment by sponsors and majority shareholders. There must be provision and legal binding for sponsors, majority shareholder and the members of Board of Directors in particular for injecting additionally required amount of capital as soon as capital base goes below the statutory rate. Tax rate on profit earned by banks is very high; so after tax, profit is not good enough for making additional reserve or provision. In this context, the government may actively consider allowing tax waiver on the amount of pre-tax profit if directly taken into reserve as a part of capital.
LONG-TERM MEASURES: Long-term measures may include expeditious recovery of NPL, allowing banks to issue subordinate debt, introduction of risk-based loan pricing and considering loan trading facilities among banks and financial institutions. The major impediment to maintaining capital adequacy requirement for banks is its enormous amount of NPL. Even ever-increasing trend of NPL will place banks and financial institutions under tremendous pressure to maintain its capital requirement. Further, the state of NPL has reached beyond individual bank's capability of recovery and therefore, very extensive measures with support from the government are inevitably required to get rid of this acute problem of our financial industry. Qualitative change is necessary for loan pricing and traditional approach of applying flat interest rate on all type of loans must be transformed to risk-based loan pricing. Highly risky loan must be charged with higher interest rate which must include risk premium and the amount of risk premium must be maintained as provision against potential loan loss.
The concept of loan trading may be very new in our financial industry, but this is a very good mechanism by which assets (loans) balance cab be manoeuvred to ensure appropriate amount of RWA in banks' books and thus additional pressure on capital adequacy requirement is reduced. Since establishing structured loan trading market is a difficult and time-consuming measure, limited trading of both accrual and non-accrual secondary loans may be allowed among banks under direct supervision of the Bangladesh Bank. Under loan trading arrangement, banks facing capital shortage will be able to sell out necessary amount of loans to banks which have surplus capital. Loans can be traded at discount and premium, as the case may be, depending on nature and quality of loans. The authority, particularly of the Bangladesh Bank, should actively consider introducing secondary loan trading in a limited and selective way to create an environment for the banks to have easy option opened to manoeuvre loan portfolio for the sake of maintaining capital adequacy requirement all the time. In addition, banks will be encouraged to issue both corporate bond and subordinate bond for mobilising funds for their long-term finance. This will bring about a positive change to quality and quantity of RWA and capital adequacy requirement can be adjusted accordingly.  
Capital requirement, as per BASEL III recommendation, is inevitably required to maintain a minimum standard of our banking system. When only two years are left to meet deadline for complete implementation of BASEL III, the report of capital shortage and erosion of surplus capital by half is not desired at all and as such, must not be allowed to go further. As per BASEL III recommendation, the Bangladesh Bank has set minimum capital requirement of 10.625 per cent and 12.50 per cent for the years 2016 and 2019 respectively. But target for 2016 has received a setback with reported capital shortage of eight banks which has created skepticism about achieving 12.50 per cent target capital requirement by 2019. Maintaining the threshold of capital is definitely a very challenging job. At the same time, this is such a crucial issue that cannot be ignored at all. Now is the high time for all stakeholders, particularly the central bank, banks' owners association and MDs / CEOs  Association to take this issue seriously and develop a very comprehensive strategy comprising both short and long-term measures so that this problem can be addressed for respective banks, financial industry and the country as a whole.  
The writer is a banker based in Toronto, Canada.
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