What to do with excess liquidity in banks?

A recent FE report, quoting the Bangladesh Bank officials, says that the excess liquidity with the commercial banks in the country stood at Tk 1,022.23 billion on May 01 this year.
Banks as financial intermediary accept various short-term deposits and grant medium and long-term loans. They also need to meet the withdrawal of deposits at any time by customers. In doing so, banks need to maintain two types of reserves: mandatory reserves imposed by the central bank and excess reserves as tools for managing liquidity risks. However,  a situation may arise sometimes in an economy where maintaining excess reserves goes beyond the limit of precautionary threshold and banks accumulate the excess liquidity involuntarily due to many external factors such as contraction in investment activities, decline in credit growth, economic stagnation and many more. Consequently, banks face an excess liquidity situation which the banking sector in the country is facing at this moment. The reasons for this accumulated liquidity have mostly been attributed to contraction in investment activities and subsequent decline in credit due to political unrest, gas and electricity shortage in industrial units and high interest rates.
Such a situation has raised concerns among policymakers for its long-term impact on the economy and initiatives are being taken by them to curb its impact. In an attempt to reduce inflationary pressure, the central bank has raised the cash reserve requirement (CRR) by 50 basis points to 6.50 per cent for the commercial banks for withdrawing excess liquidity from the market.
THE ROLE OF COMMERCIAL BANKS: While the regulatory authority tries to control this situation, what can commercial banks, overburdened with excess liquidity, do to deal with the problem?
If banks start making use of excess liquidity to expand credit, it may give rise to inflationary pressure as money supply will increase over and above the growth rate. But obviously, sensible banks are not going to throw the money out of the window to the borrowers in the country. After all, because of unfavourable conditions, persistent low growth in investment and decline in credit growth, banks are stuck with excess liquidity because excess cash and other liquid assets held by them cannot be beneficially and usefully deployed.
But for how long will banks flourish on fees and charges when they are flooded with billions of taka in excess liquidity unmatched by investment loans? Obviously, such a situation will lower banks' profitability. Lower profit in the banks means lower tax revenue for the government.  
Normally, when a situation prevails where the economy experiences decline in credit growth and banks hold excess liquidity, banks try to reduce the costs of funds. The first step banks normally can take is to invest the excess liquidity in various government T-bills and Bonds. According to the Bangladesh Bank, the commercial banks' investment in the treasury bonds and treasury bills increased to Tk 929.09 billion, which was 94.34 per cent of the total excess liquidity, as of February 20, 2014 from Tk 790.09 billion on January 9, 2014.  
Secondly, banks can reduce their deposit interest rates and try to attract low-cost deposits. Low cost deposits are those that either do not bear interest or very low interest or do not fluctuate with the market rates. Normally, savings account and current accounts are the main low-cost products for banks. Some banks also offer STD account which also can be regarded as low-cost deposit products. Low-cost deposits have the capacity to affect bank interest rate risk profile positively and profitability by enhancing margins, non-interest income and thereby increase bank's ability to compete for and retain loan customers. Low-cost deposits will bring down the costs of deposits which will help banks to keep intact net interest margin (NIM).  With cheaper funds, banks will be able to lend at a profit without raising their lending interest rates in the era of intense competition. Even, holding large volume of low-cost deposits also reduces dependence on alternative funding sources, and thereby reduces the risk of liquidity constraint, increased interest rate and increased credit risk to preserve interest margins.
However, attracting low-cost deposits will not be easier in today's competitive environment.  In a liberalised interest rate policy, it is really difficult for banks to design and attract low-cost deposits. But washed with excess liquidity and low demand for credit, this might be one of the viable alternatives at this moment.
 All commercial banks offer savings and current accounts. These two accounts are one of the major sources for banks' income from fees and provides opportunities to cross-sell other products. While providing these products, banks can develop strategic pricing to attract low-cost deposits. For example, instead of charging flat fees for all savings or current accounts, banks can give up a portion of fees for customers who maintain minimum balance requirements. Banks also can offer some value added services for customers who maintain certain range of balance for a certain period of time. This may encourage customers to maintain a healthy balance in the accounts all the time.  Based on demographics, banks can design different categories of savings and current accounts and sell them on basis of the customers. Banks also can offer their customers a greater variety of other value added products and services for remaining competitive. The Bangladesh Bank should formulate a policy which will facilitate banks to diversify their products.
Along with low-cost deposits, banks will also have to attract loan customers. Attracting customers on demographics may increase the banks' capability to compete favourably and retain customers which may ultimately increase retail loan customers. Besides, low- cost deposits as source of funds will increase banks' ability to offer competitive lending rate and hence, more loan customers.
It is to be mentioned here that banks also need stable deposits. Since all deposits are not of the same duration and all customers do not behave in the same way, banks will have to adopt a very careful deposit pricing strategy by tailoring deposit products and sales strategies according to the customers' rate sensitivity, deposit and withdrawal behaviour.
LASTING SOLUTION: The above attempts can be taken for the time-being by the banks to reduce the impact of excess liquidity, but cannot be taken as lasting solution of the problem. The causes of accumulation of excess liquidity in an economy are manifold and these vary from economy to economy.  While the causes of excess liquidity in our country are subject to more research, some of the apparent reasons are as follows:  
* The investment activities have declined in the country. This has resulted in decline of demand for credit. The reason for contraction in investment activities can be attributed to political instability, lack of infrastructure and corruption.
* Due to the Hall-Mark loan scandal and other scams, banks in the country, especially private commercial banks, became more cautious in approving loans. This also contributed to accumulation in excess liquidity.
* Due to the fall of share market, people lost their confidence in the capital market and there is a lack of other scopes to go to the capital market in the country.  Therefore, people go to the banks for FDR (fixed deposit receipt) and savings certificate for securing safest investment. This has obviously helped banks to increase their deposits whereas the disproportionate credit demand has contributed to the accumulation of excess liquidity.
The government has taken some initiatives to revive credit growth in the country. Foreign investors are now allowed to take term loans from local banks.  The central bank has taken initiatives to extend more credit facility to SME (small and medium enterprises) and agriculture sector.  
However, the solution to this excess liquidity problem is dependent on many other factors.  For example, rising CRR is undeniably a good effort for withdrawing excess liquidity from market and raising CRR can go on until the excess is mathematically eliminated.  But no attempts will be fruitful until the overall business situation of the country improves, people start investing in real economic activities and demand for credit increases.  One of the factors among others that can ensure such a congenial atmosphere is political stability which is much needed at this moment.
The author works in a private bank in Bangladesh and has a post-graduate degree in Islamic Banking,
Finance and Management
from the United Kingdom.
akbar.chowdhury@yahoo.com