SAJID ZAMAN

DU EMBA ( Banking & Insurance)

Change in Financial Sector of Bangladesh: An Analysis

Abstract

The financial sector of Bangladesh is generally small and underdeveloped. This sector consists of a banking segment and an emerging but still nascent capital market segment. The banking segment in the country is relatively more developed than the equity market segment, even though both are quite underdeveloped in international comparison. The root causes of the Bangladeshi financial sector problem are the lack of market discipline due to lack of competition in the banking industry. Excessive government intervention and political connections, economic and political corruptions, operational and managerial inefficiency and ineffectiveness result in vicious circle that inhibits economic development, industrialization, and social progresses in poor and developing countries in general and in Bangladesh in particular. Better financial services and diversified financial products would be the natural consequence of competitive financial industry. The authors argue that a strengthened regulatory environment and additional much needed financial sector reforms, a better and more efficient financial sector may evolve over time and serve better the development needs of the country.

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

1.0

Introduction

Since the independence of the country on December 16th, 1971 until December 1989, the Bangladeshi financial sector has been controlled under the strict directives of government and Bangladesh Bank-the Central Bank of Bangladesh. From 1974, the discount rate policy was often used to support Bangladesh Banks administered interest rate policy. In the early years of Bangladesh, discount rate, reserve ratios and moral suasion (known as open mouth operation) were important instruments to control money supply. With the introduction of Financial Sector Reform Program in 1990, the Bangladesh Bank almost closed both the refinance and rediscount windows with a view to developing an inter-bank market. Nevertheless the central bank kept the discount rate between 5-8 percent. Any bank that needed finance started approaching the inter-bank market instead of Bangladesh Banks windows; thereby, discount rate policy, though intentionally, lost its credibility.

The banking system at independence consisted of two branch offices of the former State Bank of Pakistan and seventeen large commercial banks, two of which were controlled by Bangladeshi interests and three by foreigners other than West Pakistanis. There were fourteen smaller commercial banks. Virtually all banking services were concentrated in urban areas. The newly independent government immediately designated the Dhaka branch of the State Bank of Pakistan as the central bank and renamed it the Bangladesh Bank. The bank was responsible for regulating currency, controlling credit and monetary policy, and administering exchange control and the official foreign exchange reserves. The Bangladesh government initially nationalized the entire domestic banking system and proceeded to reorganize and rename the various banks. Foreignowned banks were permitted to continue doing business in Bangladesh. The insurance business was also nationalized and became a source of potential investment funds. Cooperative credit systems and postal savings offices handled service to small individual and rural accounts. The new banking system succeeded in establishing reasonably efficient procedures for managing credit and foreign exchange. The primary function of the credit system throughout the 1970s was to finance trade and the public sector, which together absorbed 75 percent of total advances.

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

The government's encouragement during the late 1970s and early 1980s of agricultural development and private industry brought changes in lending strategies. Managed by the Bangladesh Krishi Bank, a specialized agricultural banking institution, lending to farmers and fishermen dramatically expanded. The number of rural bank branches doubled between 1977 and 1985, to more than 3,330. Denationalization and private industrial growth led the Bangladesh Bank and the World Bank to focus their lending on the emerging private manufacturing sector. Scheduled bank advances to private agriculture, as a percentage of sectoral GDP, rose from 2 percent in FY 1979 to 11 percent in FY 1987, while advances to private manufacturing rose from 13 percent to 53 percent. The transformation of finance priorities has brought with it problems in administration. No sound project-appraisal system was in place to identify viable borrowers and projects. Lending institutions did not have adequate autonomy to choose borrowers and projects and were often instructed by the political authorities. In addition, the incentive system for the banks stressed disbursements rather than recoveries, and the accounting and debt collection systems were inadequate to deal with the problems of loan recovery. It became more common for borrowers to default on loans than to repay them; the lending system was simply disbursing grant assistance to private individuals who qualified for loans more for political than for economic reasons. The rate of recovery on agricultural loans was only 27 percent in FY 1986, and the rate on industrial loans was even worse. As a result of this poor showing, major donors applied pressure to induce the government and banks to take firmer action to strengthen internal bank management and credit discipline. As a consequence, recovery rates began to improve in 1987. The National Commission on Money, Credit, and Banking recommended broad structural changes in Bangladesh's system of financial intermediation early in 1987, many of which were built into a three-year compensatory financing facility signed by Bangladesh with the IMF in February 1987.

One major exception to the management problems of Bangladeshi banks was the Grameen Bank, begun as a government project in 1976 and established in 1983 as an independent bank. In the late 1980s, the bank continued to provide financial resources to the poor on reasonable terms and to generate productive self-employment without external assistance. Its customers were landless persons who took small loans for all types of economic activities, including housing. About 70 percent of the borrowers were women, who were otherwise not much represented in institutional finance. Collective rural enterprises also could borrow from the Grameen Bank for investments in tube wells, rice and oil mills, and power looms and for leasing land for joint cultivation. The

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

average loan by the Grameen Bank in the mid-1980s was around Tk2,000 (US$65), and the maximum was just Tk18,000 (for construction of a tin-roof house). Repayment terms were 4 percent for rural housing and 8.5 percent for normal lending operations.

The Grameen Bank extended collateral-free loans to 200,000 landless people in its first 10 years. Most of its customers had never dealt with formal lending institutions before. The most remarkable accomplishment was the phenomenal recovery rate; amid the prevailing pattern of bad debts throughout the Bangladeshi banking system, only 4 percent of Grameen Bank loans were overdue. The bank had from the outset applied a specialized system of intensive credit supervision that set it apart from others. Its success, though still on a rather small scale, provided hope that it could continue to grow and that it could be replicated or adapted to other development-related priorities. The Grameen Bank was expanding rapidly, planning to have 500 branches throughout the country by the late 1980s.

Beginning in late 1985, the government pursued a tight monetary policy aimed at limiting the growth of domestic private credit and government borrowing from the banking system. The policy was largely successful in reducing the growth of the money supply and total domestic credit. Net credit to the government actually declined in FY 1986. The problem of credit recovery remained a threat to monetary stability, responsible for serious resource misallocation and harsh inequities. Although the government had begun effective measures to improve financial discipline, the draconian contraction of credit availability contained the risk of inadvertently discouraging new economic activity.

Foreign exchange reserves at the end of FY 1986 were US$476 million, equivalent to slightly more than 2 months worth of imports. This represented a 20-percent increase of reserves over the previous year, largely the result of higher remittances by Bangladeshi workers abroad. The country also reduced imports by about 10 percent to US$2.4 billion. Because of Bangladesh's status as a least developed country receiving concessional loans, private creditors accounted for only about 6 percent of outstanding public debt. The external public debt was US$6.4 billion, and annual debt service payments were US$467 million at the end of FY 1986.

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

The financial sector of Bangladesh is generally small and underdeveloped. This sector consists of a banking segment and an emerging but still nascent capital/equity market segment. The banking segment in the country is relatively more developed than the equity market segment, even though both are quite underdeveloped in international comparison. The primary research question of the study is to examine the current state of the financial sector and whether it can play an important and necessary role in resource mobilization and economic development of the country. A brief analysis of the two major segments of the countrys financial system is given in the following two sections, with the banking segment discussion first followed by a discussion of the equity market segment. The next section discusses challenges; the final section providing some concluding remarks.

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

2.0

Banking Industry

In the banking segment, immediately after the independence of the country in 1971, the then government nationalized the commercial banks (except a few foreign banks) and organized them into six distinct banks by the Bangladesh Bank (the central Bank of the country) nationalization order 1972. As saving and investment in the country is very low, in order to channel saving and investment through the formal sector and to expand banking services in the remote areas of the country, the nationalization of the banking sector was considered as one of the major objectives at that time. The central bank, known as the Bangladesh Bank (BB) is the central body to oversee the banking sector of the country and at that time, the BB directly controlled the interest rates (both lending and deposit rates) by fiat. During this time, bank branches have expanded rapidly, particularly in the rural areas. On the positive side, the expansion of bank branches reduces transaction costs associated with the mobilization and transfer of funds and to thereby to increase savings and investments, and deposit creation. But due to corruption, mismanagement, and government interference, many branches of the commercial banks cannot work properly and some branches incurred heavy losses, and some of these branches were subsequently closed down. To overcome these problems, financial sector reform program has started in earnest since 1990. These reforms include flexible interest rate, convertibility of taka, introduction of 91 days bill, recapitalization of banks, and new procedures for loan classification system, introduction of REPO in the money market, and strengthening of money and capital markets. Although before 1990, open market operations and bank rate policies were hardly used, currently they are getting emphasis due to change in the post-reform policy environment.

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

In the initial years after independence, six nationalized commercial banks (NCBs) dominated the banking segment. In the post reform period, the structure of the banking system has changed significantly. Total numbers of scheduled banks are forty seven. As part of the reform program, some NCBs were privatized, foreign ownership of banks has been opened up, and additional new commercial banks were allowed to start and operate. Consequently, the banking system in the country consists of several NCBs along with a number of home based privately owned commercial banks (PCBs), some foreign owned commercial banks (FCBs), some privately owned Sharia compliant Islamic banks (IBs) and some state owned specialized financial institutions (SFIs) such as the Bangladesh Krishi (agricultural) Bank and Bangladesh Development Bank ltd., all under the supervision of the central bank. Besides that, the Investment Corporation Bank (ICB) also plays vital role as an investment banking .Unfortunately for the last ten years, their services were not active like previous time periods, though it has been divided into three wings with the objective of improving its performance.

Table:-5.1:Total assets and deposits scenario by types of bank. 2010 (June) Bank types SCBs DFIs PCBs FCBs Total Number Number Total of Banks of Assets branches 4 3394 1272.64 4 30 9 47 1366 2427 59 7246 291.37 2539.27 308.70 4411.98 % of Deposits Industry Assets 28.85 952.72 6.60 57.55 7.00 100 177.90 1967.78 230.68 3329.08 ( billion Taka) % of Deposits

28.62 5.34 59.11 6.93 100

Source: Bangladesh Bank (2010).

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

In spite of many different kinds of banks operating side by side, and even though the central bank no longer directly control the lending or deposit rates in the post-1990s reform period; however, a strong competitive and efficient banking system has not yet developed. The banking system is mired in corruption, mismanagement, and direct interference from government in power. Further, the commercial banks still do not determine interest rate under competitive environment. Rather they are determining interest rates (both lending and deposit rates) within an oligopolistic framework, possibly following some collusive or cartel type arrangements. This is perhaps true for all types of banks, nationalized banks, domestic private banks and foreign owned banks. The last decade witnessed some major policy shift as the Bangladesh Bank introduced repurchase agreement in July 2002 and Reverse Repo in April 2003 and reintroduced Bangladesh Bank Bill in 2006. These were introduced as indirect monetary policy tools for day-to-day liquidity management in response to temporary and unexpected disturbances in the supply of and demand for money. The initiatives of the Central Bank to face the situation through reform measures since 1990 no doubt have improved the capital adequacy, governance, regulation and supervision, and the legal and payment systems in the economy. Nowadays, the traditional banking business system of the country through depositing and advancing of money has almost ended. Segmentation in the banking system is required so that banks can provide a broad range of financial services. Through fund management, banks can earn profit.

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

The banking sector has evolved to become the dominant financial intermediary in Bangladeshi financial system due to the underdeveloped money and capital markets, limited availability of financial instruments, and lack of confidence in the financial system as a whole. Bangladesh Bank still cannot determine monetary policy independently. Government is still playing important role in the financial sector as borrowers from the banking system. In Bangladesh, there is very limited scope for individuals to invest in the capital markets and lack of alternative opportunities for investment compelled them to invest mainly in bank deposits, post office saving certificates and government bonds. Banks operate with old and outdated banking procedures, lack of coordination between proper manpower planning and bank schemes, lack of market research for customer psychology analysis, scarcity of financial derivatives, inefficient banking services, and lack of long term planning, to name a few, are creating bottlenecks preventing local banks from attaining international standards. Though reform measures in the financial sector were initiated in the nineties, the overall stability and performance of the banking sector is still not satisfactory.

Financial institution managers in general, and bank managers in particular, in this country does not properly assess risks as well as the costs of various types of bank sources of funds. While managing their financial assets, the financial institutions were not cautious about handling funds with the utmost care. Lack of ethics in the banking sector is a part of a wider and long lasting socioeconomic and political problems in Bangladesh. Loopholes in the financial sector are a part of the overall corruption that plagued almost all segments in the country. Unhealthy competition among different banks display lack of ethics in doing banking business. Variation of higher interest rate and profit paid to the client sometimes involve bankers in immoral practices. In the name of trade unionism, especially nationalized commercial banks, trade union leaders create unethical work culture in Bangladesh. Pervasive corruption in Bangladesh is a form of agency problem in which bank management tries to maximize the amount of its personal gains (bribery) has been documented in the literature.

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

ADB (2011) argued that the half-yearly monetary policy statement (MPS, JulyDecember 2011) aims to continue the central banks tighter monetary policy stance to rein in credit expansion to control inflation and preserve external sector balance. Economic Trends (2011) indicated that the annual rate of inflation increased to 9.43 percent at the end of August 11 from 7.87 per cent at the end of august 10. Bangladesh Bank (2011) described that in bolstering stability of the financial sector include mandatory implementation of the BASEK II capital regime from 2010, with the attendant shoring up of risk management structures and practices that this will entail. Mandatory periodical stress testing routines in banking sector have also been introduced to bring out early warnings about their vulnerabilities. Bangladesh Bank cannot guide commercial banks as evidenced by the fact that commercial banks are charging higher interest rates, even cross the limit of margin requirements, taking high spread between buying and selling rate of foreign exchange and devaluation of Bangladesh Taka against US Dollar has been going on. As such inflation rate is rising and purchasing power of the people has been declining Moreover, commercial banks are investing in the share market to gain short term profit since 2005 making depositors deposit risky as in Bangladesh if any bank fails then there is no reinsurance system from which depositors get their amount. These problems cannot be corrected without the infrastructure of the more modernized banking sector and proper staffing in the top management level i.e. Deputy Governor posts where one should be macroeconomic specialist and another one should have depth knowledge in practical commercial banking and developing an effective and efficient market economy. Moreover, government should take appropriate steps to develop bond market so that it can contribute in the growth of Gross domestic Product.

From the countercyclical monetary policy time lag perspective, empirical research suggests that when formulating the current countercyclical monetary policy, Bangladesh Bank is influenced by its actions taken in the last three quarters and the change in the real GDP a year ago. The countercyclical monetary policy actions and the change in the real GDP a year ago affect the current change in the real GDP. Stated differently, it will take two quarters for the implemented countercyclical policy to achieve it effectiveness fully Customarily, the time period when the adverse economic condition occurs until the corrective policy action achieves its effectiveness fully is divided into the recognition lag, the formulating and implementing lag, and impact lag. Thus,

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

however long it take for the Bank of Bangladesh to recognize the macroeconomic problem and to formulate and implement the corrective policy actions, it will take two quarters for the implemented countercyclical monetary policy to achieve its full effectiveness.

Figure-5.1: Percentage (%) of Industry Assets by Types of Banks.

% of Industry Assets

7.00% 28.85%

6.60% 57.55%

SCBs

DFIs

PCBs

FCBs

Source: Bangladesh Bank (2010) Figure-5.2: Percentage (%) of Industry Deposits by Types of Banks.
% of Industry Deposits

6.93% 28.62%

5.34% 59.11%

SCBs

DFIs

PCBs

FCBs

Source: Bangladesh Bank (2010)

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

3.0

Equity Markets

As to the capital market segment, Bangladesh is still at a nascent stage of capital market development. It is well documented in the literature that a wellfunctioning capital market is of great significance for a developing country like Bangladesh which is expected to help the countrys development by channe ling domestic saving to productive investments, attracting foreign investors to the market, and allocating the national savings most efficiently, among others. However, as in many other developing country equity markets, the Bangladesh equity market is relatively underdeveloped, it is small, the market is thin and non-transparent, and it is quite inefficient. Bangladesh has two major exchanges, the Dhaka Stock Exchange (DSE) and the Chittagong Stock Exchange (CSE). The DSE is the larger of the two stock exchanges in the country. Formal trading on the DSE began in 1956 two years after the establishment of the East Pakistan Stock Exchange Ltd. on April 28, 1954. It was renamed as the East Pakistan Stock Exchange Limited on June 23, 1962, and finally came to be known by its present name of the Dhaka Stock Exchange (DSE) Limited on May 14, 1964.

Prior to the independence of Bangladesh in 1971, there were 196 securities listed on the DSE with a total paid-up capital of about Taka 4 billion and the daily average transaction of shares during that period was about 20,000 (Basher, Hassan and Islam 2007). Trading activity of the Exchange remained suspended since the start of the war of liberation in 1971 until it restarted in 1976. When the DSE restarted in 1976, the DSE had only 9 listed companies with a paid-up capital of approximately Taka 137.52 million and at the end of that year total market capitalization of listed securities was about Taka 146.73 million. By 2002-03, the number of listed companies has grown to 251 companies listed with the DSE having total issued capital of Taka 35,537 million (US$ 612 million) and total market capitalization of Taka 72,167 million (US$ 1,244 million). In 2008, the number of listed companies is about 295 with a market capitalization of about US$ 7,067 million. The second stock exchange, the Chittagong Stock Exchange (CSE) was established in 1995 and started its operation in that year with 30 listed securities. Like the DSE, the CSE has been registered as a public limited company and is a self-regulated non-profit organization. It has currently 129 members even though there is a provision for up to 500 memberships. The foreigners can also become member of the CSE. But unlike the DSE, every member of the CSE has to be a corporate body. On September 30, 2003 there

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

were 187 listed securities with the CSE. On the same day, the total issued capital and market capitalization of all listed securities with the CSE stood at Taka 33,085 million (US$ 570 million) and Taka 59,855 million (US$ 1,032 million), respectively.

In terms of regulatory structure, the capital markets of Bangladesh received its first legal backing with the passage of Securities and Exchange Ordinance in 1969. More than two decades later, in 1993, the Securities and Exchange Commission (SEC) was established under the Securities and Exchange Act, 1993. The functions of the SEC include regulation of equity trading, protection of investors, ensure legislative and regulatory compliances, and promote a fair, transparent and efficient security markets. To supervise and regulate the activities of the capital markets in Bangladesh, the SEC does it by performing constant real time monitoring and post-trading analysis of transactions in the DSE and the CSE. The underdeveloped and non-transparent nature of the capital market in Bangladesh provides ample opportunities for unethical and even illegal manipulations resulting in market crashes as happened in 1996 (as reflected by a steep decline of the market capitalization value in US$ shown in Figure 1 below). Such unwarranted crashes usually cause severe financial damages to investors, particularly many small investors and erode confidence in the markets. This painful episode occurred at both stock exchanges in summer and fall of 1996. During this episode, DSE index increased from 832 in January 1996 to its peak at 3,567 on November 14, 1996 and back down to 507.33 in November 1999. To control the damages caused by the 1996 crash and with the support from Asia Development Bank (ADB), Bangladesh government introduced the Capital Market Development Program in November 20, 1997 with several objectives such as to (i) strengthen market regulation and supervision, (ii) develop the stock market infrastructure, (iii) modernize stock market support facilities, (iv) increase the limited supply of securities in the market, (v) develop institutional sources of demand for securities in the market, and (vi) improve policy coordination. Ali and Wise (2007) argued that Bangladesh capital market is not yet welldeveloped. Figure 1 shows the time trend of the number of listed companies along with the market capitalization in US$ from 1988 to 2008. This graph suggests that the stock market has grown rapidly from 101 companies with a market capitalization of US$ 430 million in 1988 to 295 companies with market capitalization of US$ 7,067 million in 2009, an impressive growth rate of 1,543% in market capitalization value over about 20 year time period. But the even with this growth rate, the market capitalization as the percentage of

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

GDP is still quite low compared to international standard.

Figure 1: Listed companies and Market Capitalization in Bangladesh: 1988-2009
8.E+09 Left Scale: Market Cap Value US$ Right Scale: No. of Listed Companies 300

250 6.E+09 No. of Listed Companies 200 4.E+09

150 100 Market Cap Value (US$)

2.E+09

50 Year

0.E+00
88 90 92 94 96 98 00 02 04 06 08 10

Source: World Bank: World Development Indicators CD Rom database

The market capitalization as the percentage of GDP increased from 1.68% in 1988 to about 8.39% in 2008, also an impressive growth. But this rate for Bangladesh (BGD) compares quite poorly compared to India (IND), Pakistan (PAK), and South Asia (SAS) as shown in Figure 2, which shows BGD line is at the bottom of Figure 2 below the other reference countries. In fact, the ratio for India and South Asia reached around 150% and 125% of GDP respectively in 2007, just before the crash of the markets due to the 2007-09 global financial crisis. It is worth noting that the Bangladesh capital market showed resilience in the face of this massive crisis. However, given the relatively low market capitalization-GDP ratio of 8.39% in 2008, it appears that Bangladesh capital market needs much more development in order to catch up even with its comparable neighboring countries.

Figure 2: Market Capitalization as % of GDP: 1988-2009

160 % of GDP 120 Market Cap as % of GDP IND

80 SAS 40 PAK 0 88 90 92 94 96 98 00 02 04 06 BGD 08 10

Year

Source: World Bank: World Development Indicators CD Rom Database

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

As to the relationship between Bangladesh money supply and the share price index, Figure 3 shows the two monthly percentage changes in the stock price index narrow money supply from 1999.01 to 2010.01. This Figure shows that both series has displayed significant month to month fluctuations. Further, the apparent synchronized comovement of the two series gives preliminary indications that the two series would likely be co-integrated.

Figure 3: Relations between Changes in Money Supply and Share Price Index: 1999.01-2010.01
30 % SPt: % Change in Share Price Index (Right Scale) 20 10 0 12 8 4 0 -4 MSt: % Change in M1 (Left Scale) -8 99 00 01 02 03 04 05 06 07 08 09 Month / Year -10 -20 -30

Source: Data obtained from International Financial Statistics databas

As to the long-run relationship, empirical studies confirm the co-integration relationship between the stock price index and the narrowly defined money supply. In fact their cointegrating relationships are asymmetric. This asymmetric relationship indicates that the counter cyclical monetary policies affect the cost to raise new financial resources of corporations differently in different phases of business cycles in the long-run. More specifically, the results reveal that the stock price adjusts more slowly to the threshold value when the Bangladeshi monetary authority eases the money supply than when the Bangladeshi monetary authority tightens the monetary policy. These findings suggest that the stock price is more responsive to signals of possible contractionary monetary policy as reflected in the decline money supply M1. These in turn indicate that equity (debt)market-dependent firms are more vulnerable to business cycle fluctuations (at least in regard to their cost of capital) than firms with access to other sources of financing. Thus, policymakers should be aware that counter-cyclical monetary policy may have different effects due to the asymmetric behavior of stock prices in their formulation of monetary policy.

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

Further, in a recent article, I found that due to the common characteristics associated with poor developing countries, their equity markets are not even weakly efficient. This is not viewed positively given that most well developed countries have efficient equity markets. This observation coupled with the status of a poor developing country and their attendant problems suggest that to develop an efficient equity market, Bangladesh should first concentrate its efforts on developing better market infrastructures for a more effective market economy. In this environment, a strong political will to reform the system and a strong commitment to implement the reforms are needed to establish a more competitive and efficient overall market economy that would be conducive for building an efficient stock market.

With regard to the short-run relationship, empirical studies further reveal that the shortrun counter-cyclical monetary policy is ineffective in stimulating or cooling down the equity market i.e., the stock price responds to monetary policy action in the long-run but not in the short run. These empirical result suggest the lack of central bank creditability, i.e., investors do not believe that central bank can carry out its policy objectives; thus, they wait and see. The Bangladesh Bank (Central Bank of Bangladesh) may have personally persuaded the commercial bankers to change their rate setting behavior because there are few of them, and there may be some incentives for banks to listen. The Bangladesh Bank authority cannot utilize the same tactic to deal with investors because there are more of them and they may not have any incentive to listen.

Further, there are many allegations of insider trading, market manipulation, and corruption in the equity market, leading to demonstrations by investors in the country on a number of occasions, eroding confidence in the equity market. Unfortunately, neither the government including the Securities and Exchange Commission, nor any regulatory authorities including the Bangladesh Bank had taken serious steps to deal with these allegations in a serious and effective manner to restore investor confidence in an already small and unstable market environment.

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

4.0

Challenges

With regard to the Bangladeshi corrupted business environment and for whatever it is worth, the Transparency International (2009, 2008, and 2007) ranked Bangladesh as the 147th, 147th, and 162th, most corrupted country out of 180 nations that it studies, 1st being the least corrupted. Moreover it is reported that 75% of the unethical practices in the banking sector are attributable to the personal gain motivation, 20% due to the business interest of banks such as charging high interest rates in the call money market or discrimination of charging commission or service charges from one customer to another. Only 5% of unethical practices are attributable to social reasons such as waiver of interest up to Tk. 10,000 against agricultural loans. Though this waiver is done due to the Government decision, it creates inequality among those persons who have taken loans. When such waiver is made, those who are not benefited get jealous and their interest is not protected. Moreover, when big defaulters get a lump sum amount of waiver for rescheduling, those who are regularly paying interest think that they are being deprived!

One of the consequences of corruption is that the pervasive default culture in the Bangladeshi economy, as evidenced by huge amount of nonperforming loans, which prevented reductions in loan pricing. This is because cost of funds is high. Through moral suasion, Bangladesh Bank has been requesting reduction in lending-deposit rate spread in veil because with the exception of few public banks, other banks want to earn super normal profits resulting in high lending rates. Lack of ethics in the banking sector is a part of wider and long lasting socio-economic and political problems in the country. Loopholes in the banking sector are a part of the overall corruption that plagued almost all segments in the country. There is a dilemma between the making money and business ethics. Corruption is the buyer-seller collusion resulting higher business cost structures and raising simulated shortage of funds in general, and in the banking sector, in particular. As a direct the consequence of extensive government interventions in the form of licenses and permits as well as directives, the ownership of private institutions and management and control of public institutions are given to a few interests (individuals or businesses) who are well-connected politically, explicitly or implicitly resulting in monopoly and oligopoly type behavior in the banking and financial system. The monopolistic and oligopolistic market structures coupled with the political connections of a few powerful

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

individuals and corruptions would invariably lead to cartels and price fixings. These factors would hinder the effectiveness of national economic policy actions and result in asymmetric adjustment in product and service pricing, and an unfair distribution of national income in favor of the few. Naturally, these above-mentioned phenomena would likely result in higher lending rates, lower deposit rates and hence higher lending-deposit rate spread as well as predatory pricing behavior in the banking industry. Customarily, originating loans would provide some non-interest incomes besides the interest incomes to the originating institutions in any economic environment. However, in a fairly corrupted environment, there may be some other benefits for both the originating institutions and possibly their management as well. Naturally, it is easier to ask for and the borrowers are more likely to agree to providing other benefits in the declining lending rate environment than when the rate is rising. Certainly, a decline in deposit rate widens the spread, which allows lending institutions to originate loans at lower lending rate and still maintain the old spread. This coupled with the high elasticity of demand precipitate a significant increase in demand for loans, which in turn will create opportunities for lending institutions and their management to generate lucrative other benefits and hence the observed quicker responses. Asymmetrically, in the rising rate environment, the new loans must be generated at higher lending rate and the possibly negative attendant impacts on other benefits do not provide attractive opportunities for lending institutions and their management, and hence the observed slower responses. As aforementioned, Bangladeshi banking industry is operating in the high rate, corrupted environment, when deposit rate changes causing changes in the spread, lending institutions must weigh the marginal non- interest benefits to both the originating institutions and their management against marginal loss in interest income in originating new loans at the new lending rate to restore the spread to the threshold. This benefit maximizing process in the face of highly elasticity of demand for loans precipitated by high rate environment would be a very plausible explanation of the empirical findings of the above pattern of the asymmetric adjustment process in the Bangladeshi banking industry.

Another challenge for the banking industry in the country is with electronic banking such

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

as online banking. This system was introduced since 2009, although online banking has bright prospects, it involves some serious financial risks. The major risk of online banking includes operational risks (e.g. security risks, system design, implementation and maintenance risks); customer misuse of products and services risks; legal risks (e.g. without proper legal support, money laundering may be influenced); strategic risks; reputation risks (e.g. in case the bank fails to provide secure and trouble free e-banking services, this will cause reputation risk); credit risks; market risks; and liquidity risks. Therefore, identification of relevant risks, and formulation and implementation of proper risk management policies and strategy formulations and implementations are important for the scheduled banks while conducting online banking system. It is theoretically well articulated and supported by empirical studies that investment in physical capital or otherwise is inversely related to the level of market interest rates. Moreover, the positive relationships between investments and economic growth as well as social progress are well established. National economic policy consists of three components: Monetary policy, fiscal policy and exchange rate policy. These three policies must be coordinated to achieve overall economic goals because their adjustment processes operate in different time frames. To this end, whatever reasons causing high market rates would definitely hinder the economic growth, industrialization, as well as social progress of the country. Bangladesh is, no doubt, one of the vivid examples of these phenomena in the world! It is a very difficult to address these issues using only one component without free market disciplines! Bangladeshi banking sector has gone through several restructuring and reforms, but cannot overcome any of these problems. The main reason is the nexus between bureaucrats, politicians, civilians, bankers. They are playing prisoner's dilemma game whose winning strategy is not to disclose the corruption but to participate in the process. Moreover, exchange rate is being manipulated in favor of a group of business magnets and remittance senders to Bangladesh to give them special privilege. How else can the fact of slow economic development, industrialization, and social progress in the last 41 years, including perennial banking sector problems be explained?

Not only Pareto optimality theory but even the theory of second best cannot be applied in

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

the economy as alternative funding sources from the non-government organizations are also charging too high interest rates. The effective interest rate charged by the four largest micro-credit institutions are the Grameen Bank, which charges around 30.5%, the BRAC at 44.8%, ASA at 44.8%, and the PROSHIKA charging at around 42.3%. Through Micro credit regulatory agency, the current government did set the ceiling interest rate in case of NGOs at 27% which is still relatively high. Moreover, starting from the Grameen Bank (which is a statutory institution) and some big NGOs have a number of other types of business for stated social development purposes in the informal sector. However, these activities of these micro credit agencies are not currently regulated, but needs to be supervised and regulated as well. It is not understandable why the micro credit regulatory agency doesnt look after these businesses.

5.0

Discussions and Conclusions

Clearly, the root causes of the Bangladeshi financial sector problem are the lack of market discipline due to lack of competition in the banking industry. Excessive government intervention and political connections, economic and political corruptions, operational and managerial inefficiency and ineffectiveness result in vicious circle that inhibits economic development, industrialization, and social progresses in poor and developing countries in general and in Bangladesh in particular. The desired characteristics of the economy have been elusive for Bangladesh due to the political will, or lack thereof. The competitiveness and the transparency of the market economy will reduce the lending-deposit rate spread. These cannot be achieved in the absence of the infrastructure of a well-functioning market economy. Bangladesh bank recently decides to give permission to open more new banks. This may bring fruitful results if it can be properly handled to mobilize savings and channel those into productive sectors. Besides, loans obtained by the government from the banking sector seems to overburden the banking system and may be a cause of crowding out private investment. Bangladesh Bank seems to even fail in its primary function of price stabilization with current inflation creeping into a rate around 8.126% per year (source: International Monetary Fund - 2011 World Economic Outlook).As a resultant factor purchasing power of the people of the country has declined. Moreover, the capital market, especially share market should be more properly regulated and try deal with the perennial problem of corruption, insider

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

trading, and market manipulation by selected but powerful and politically well-connected few elites. With a market economy structure, the following changes will significantly improve the financial sector, economic growth, industrialization, and social progress in Bangladesh. But first and foremost is still the free market discipline, provided by the free market economy subject to prudent regulation and oversight, and not excessive government direct interventions. Micro credit regulatory agency may be redesigned and renamed and it should take steps for regulating both lending as well as social businesses of NGOs as well as the Grameen Bank. Otherwise it will be difficult for reducing poverty in the rural areas and improving women empowerment. In a well-functioning market economy, financial business and management of bank and non-bank intermediaries would likely be more efficient; otherwise, they would be eliminated from the market place. Undesirable phenomena such as unethical behavior, crimes and irregularities like money laundering, black-marketeering, undue profiteering and loan defaulting are fairly easy to detect (sooner or later) and rectify by effective rules, regulations and supervision in a market economy. Additionally, sound financial business can be established so that financial sector can be free from all sorts of political interference. Political pressure for disbursing loans and prohibiting against those who create scam in the capital markets in 2010-11 and several other times should be stopped and legal actions against perpetrators should be taken without any sort of prejudice. Defaulters as well as market manipulators would be disciplined. Investment Corporation of Bangladesh should be reactivated and the DSE and the CSE should be strengthening by improved corporate governance. Additionally as to the personnel, code of conduct, audit and monitoring systems, depoliticizing the process of appointment of the directors to curb their excessive power to sanction loans and advances can be established to assure efficiency and effectiveness. Manpower planning process can be established in the banking industry to improve productive human resources to prepare the sector for the global challenges. In the financial sector an ombudsman may be appointed. The ombudsman can act independently to investigate any complaints regarding financial services and must work freely and independently. Better financial services and diversified financial products would be the natural consequence of competitive financial industry. Operational and administrative expenditures may be reduced through implementing contemporary financial and competent management structure. Improved customer relationship

SAJID ZAMAN

DU EMBA ( Banking & Insurance)

management system to retain existing customers of the financial institutions can be established in a market economy. If the above measures are carried out and implemented along with strengthened regulatory environment and additional much needed financial sector reforms, a better and more efficient financial sector may evolve over time and serve better the development needs of the country.