Transition from command to market economy

Under the financial sector reform programme, the government allowed licences to commercial banks, leasing companies and insurance companies since 1982. As part of the series of banking reforms, the Banking Companies Act was passed by parliament. Insurance Regulatory Authority was also established. Regulation was made mandatory so that within three years of incorporation, banks and financial institutions move towards an IPO, and list in the stock market.
The Bank Companies Act 1991 allowed a banking company to hold less or equal to 30 per cent shares of any borrower company as mortgage or in the form of pledge and absolute owner of shares maximum 30 per cent of paid up capital including reserves. The BCA also allows a bank company to invest in the shares of various companies in an aggregate of 10 per cent on the bank company liabilities of its own. However, the exposure of bank companies as well as FIs investment in the stock market during the 1996 crash made an insignificant impact on the banking sector. In late 2007, their investment exposure in the stock market increased significantly.
This is evident from the annual financial statements of these banks and FIs (financial institutions). Shares of profits from merchant banking division demonstrated 15 to 35 per cent of total profit of banks and FIs in financial year 2009 and 2010. This indicated that banks and FIs took the opportunity, earning speculative profit exploiting public deposit money. During this time, the private sector banks were involved aggressively in the process, while exposure of the public sector banks was small compared to their size and volume. Eventually, the stock market crash took place by the end of 2010. As a result, policy makers woke up and started rethinking the separation of conventional as well as merchant banking to resolve the issue. In October 2009, the central bank came up with a regulation that banks and FIs must create a separate legal subsidiary company to carry out merchant banking operations to protect the interests of the deposit holders.
Consequently, the legal shape of separating conventional banking officially took place. The regulation further detailed the rules and procedures for the formation of a subsidiary company under the parent bank. The regulation prescribes to hold more than 15 per cent shares of any company. Meanwhile, the subsidiary merchant bank has to take prior permission from the central bank. In the case that the subsidiary company borrows a loan from the parent bank, prior permission from the central bank must be obtained. In order to avoid the conflict of interest dilemma, restrictions have been imposed.
Under the amended central bank ordinance and banking company in share and security business 5.0 per cent of its paid up capital plus share premium, statutory reserve and retained earning but not exceeding 10 per cent of paid up capital of investing Company.  Moreover, in extending lending or contribution to any fund to the subsidiary formed for such purposes shall be restricted to 25 per cent of the paid up capital plus share premium, statutory reserve and retained earnings. Later on, the Bangladesh Bank (BB) allowed some space through issuing a circular (Dos Circular Letter No.-7, dated 25/02/14) regarding maximum amount of investment in capital market on consolidated basis. Now the maximum limit is 50 per cent of the sum of its consolidated paid up capital, balance in share premium account, statutory reserve and retained earnings (on consolidated basis). Critics observe that this needs to be reviewed on two issues. The first one is on the basis of limit, which stated, market price of investment in place of cost price but in reality investors had no control over market price exposure at all which needs to be at cost price. The second one is that the consolidated paid up capital is a misleading term for this purpose. The central bank should come forward to address this criticism if this argument has any sort of valid justification.
CONCLUDING REMARKS:  This is the overall picture of the positive and negative sides that a separation between commercial and investment banking induces. The evidence suggests that a universal banking system does not necessarily lead to more profitable banks but there is no evidence showing that a separation of commercial and investment banking would be more beneficial for the society as a whole.
There is, however, compelling evidence showing that the increased degree of diversification within banks has increased the similarity between institutions and their systematic risk exposure. It is, therefore, argued that regulators should focus on limiting the interconnectedness and similarity between financial institutions to prevent banks from failing simultaneously, thereby minimising the risk of systemic crises and market contagion. It is up to the financial market regulators to set up the playing field for banks, and a separation of commercial and investment banking is one of the tools in the regulators' toolbox.
Capital market in Bangladesh is in transition. Obviously, the regulatory institutions are shouldering great responsibility to smoothen the tricky way. Every situation faced by Bangladesh's capital market is new. We must remember we are in transition from command to market economy. We are developing our institutions for capital market.
Our financial system was dominated by the state until the mid-eighties. Slowly we moved to bank financing, and now we are moving to equity and bond financing. This is a long way. USA, which is considered as the engine of capitalist development since the World War II, made the separation of Conventional and Merchant Banking after the recession of 1933 by enacting GSA (General Services Administration) in 1949. Other developed countries of Europe took the initiative much later. Bangladesh also responded to the call since 2009 accommodating the latest developments nationally and internationally.       
RECOMMENDATIONS:
I. Carrying out further research on economic rationale of separating conventional and merchant banking at this stage of economic development of Bangladesh.
II. Coordination among financial and capital market regulators and all other should be made functional from the current level.  
III. Engaging high level coordination committee comprising of financial, capital, fiscal regulators to review the current situations with follow up action points; there is also the need for further extension of listed, non-listed financial sector, manufacturing sector, public and private limited companies including public interest entities.   
IV. There should be an official fact-finding study on the impact of conventional banks' participation in merchant banking operation during stock market crash of 2010 and its impact on the economy and GDP (gross dopmestic product) growth.
V. Strict monitoring and implementation of operational guidelines issued by central bank with regard to merchant bank subsidiary unit of commercial banks.
VI. Ensuring reliable gate-keeping functions of the multiple corporate gate keepers like, company directors, audit firms, legal counsel, financial analysts, IPO managers, and valuation firm's failure of who would entail huge loss to the investors and the country.
VII.    Like other market-led countries, creating an Institute of Directors to promote and disseminate roles and responsibilities to company directors to institutionalise corporate governance practice towards the growth of public and private sectors of Bangladesh.
The writer, an FCA and a Ph.D, is Chairman, Emerging Credit Rating Ltd. The article is adapted from a paper he presented at a seminar jointly organised by the Bangladesh Young Economists' Association
and Emerging Credit Rating Limited on  October 17, 2014.  [email protected]