Banks

Bangladesh CountryReport

The Bangladeshi Banking System

SummaryOpinion
The Bangladeshi banking system is one of the weakest in emerging Asia, with a weak operating environment contributing to persistently poor performance and solvency issues, especially among the systemically important stateowned commercial banks (SOCBs). The system is undermined by very weak asset quality, inadequate provisioning for loan losses, poor capitalisation and constrained profitability. The operating environment in Bangladesh is characterised by a weak macro economy and political instabilities, both of which pose significant risks. The weakness in the operating environment is further exacerbated by frequent natural disasters. Bangladeshs banking system is made up of 48 banks, which include four SOCBs, 30 private commercial banks, nine foreign commercial banks and five development banks. The four SOCBs accounted for 33% of the banking system assets at end2007 (1997: 68%). Although the SOCBs are still the most dominant, they are fast losing market share to private banks (52%) and to a lesser extent foreign banks (8%). Despite the various steps taken to turn around the ailing SOCBs such as privatisation attempts, conversion into limited liability companies (LLCs) and the appointment of new management progress has been slow. In addition to the challenging operating environment, Fitch Ratings notes that the very weak asset quality in Bangladesh (reported gross NPL ratio of 13% in June 2008) is also influenced by weak standards of corporate governance, underdeveloped risk management systems and directed lending. Asset quality in the SOCB sector is of greater concern given their very high reported gross NPL ratio of 29.3% at end September 2008 (1999: 41%). Fitch also notes that 80% of system NPLs are in the loss category with low probability of recovery, while provision coverage of NPLs was well below the regulatory minimum, as a result of which the systems net NPL/equity ratio was extremely weak at 105% at end2007. The agency also views the valuation adjustment created during the conversion of three SOCBs Sonali Bank, Janata Bank and Agrani Bank into LLCs in 2007 as a book adjustment as it merely restated the equity position without any actual capital infusion to correct the underlying capital deficiency. In fact even after this valuation adjustment, the loss category NPLs still exceeded the restated equity position, underlying their technical insolvency. These risks are in fact reflected in the low Individual Ratings of E assigned to the four SOCBs rated by the agency. An Individual Rating of E indicates a bank with very serious problems, which either requires or is likely to require external support. Although Bangladeshs banking system is lessdeveloped it does have a credit information bureau and a deposit insurance scheme which protects deposits up to BDT100,000 (USD1,450); however, the efficacy of both remains to be seen. Whereas prudential regulations governing banks have generally improved over the last few years, Fitch notes that there is further scope for alignment of these regulations with regional norms, especially with regard to asset classification standards which appear lax. While parallel computation of Basel II commenced in January 2009, its implementation is scheduled for January 2010, with the standardised approach for credit and market risks and the basic indicator approach for operational risk, which may put more stress on an already undercapitalised banking system.

Analysts
J Anandakumar +65 6796 7234 j.anandakumar@fitchratings.com Arshad Khan +91 22 4000 1733 arshad.khan@fitchratings.com Ambreesh Srivastava +65 6796 7218 ambreesh.srivastava@fitchratings.com

www.fitchratings.com

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SovereignOverview
Bangladesh is a lowincome country with an annual per capita income of less than USD500. It is characterised by widespread poverty (more than 40% of the population), susceptibility to severe natural disasters such as floods, cyclones and tidal waves and persistent political instability. These factors have resulted in Bangladesh struggling to develop into a middleincome country. GDP growth was healthy at 6.4% during the fiscal year 2006/2007 (the fiscal year is July to June), although it moderated somewhat to 6.2% in 2007/2008. The slowdown was due to high inflation, weaker global demand for exports and the effects of the natural disasters of 2007/2008 on agricultural production. Among the larger contributors towards national GDP were manufacturing, agriculture and forestry and the wholesale and retail trade, which respectively accounted for 17.8%, 16.2% and 14.4% of GDP. Although the financial intermediation sector grew faster than the overall GDP average at 9.0%, its relative importance to GDP was low, at less than 2% of the latter. This illustrates the limited nature of financial activity in the economy compared with other regional countries such as Pakistan and Sri Lanka, where the financial intermediation sector accounted for around 5.2% and 8.7% of GDP, respectively.
Chart 1: Key Economic Indicators
CPI (avg.) (%) 10 8 6 4 2 0 2 4 6 8 2001 2002 2003 2004 2005 2006 2007 2008 Real GDP growth Current account balance (% GDP) Fiscal deficit (% of GDP)

Source: Bangladesh Bank

Worker remittances from migrant Bangladeshis remain a key contributor in driving not only private consumption but also providing a steady flow of muchneeded foreign exchange reserves. Worker remittances reached a record USD7.9bn for the 2008 financial year and accounted for 10% of GDP. This enabled Bangladeshs current account to post a surplus during the fiscal year 2007/2008, despite the deficit in the trade account. The garments sector continued to dominate exports and accounted for nearly 75% of all merchandise exports. Foreign direct investments into Bangladesh have been relatively limited compared with the rest of South Asia, at less than 1% of GDP. This could be attributed to the countrys rather high risk profile as well as bureaucratic limitations that discourage potential investors. Although inflation was on an increasing trend during mid2008 (peaking at 10.8% in July 2008) due to rising food prices, energy costs and stronger demand stemming from monetary and credit expansion, it has since declined to 6.0% at December 2008 on a pointtopoint basis. Bangladeshs fiscal position is also weak, with the government constrained by its heavy subsidies on fuel and fertiliser as well as the need to incur rehabilitation expenses due to the frequent natural calamities. The tax collection system is characterised by complex tax laws and a high level of tax exemptions. As a result, the budget deficit has persisted at around 5%6% of GDP. On the political front, after two years under a caretaker government, parliamentary elections were held in December 2008. These elections were won by the Awami League with a clear majority. However, it remains to be seen whether the new government will be able to bring in muchneeded political stability to the country.
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Overview and StructureoftheFinancialSystem
The Bangladeshi financial system is composed of scheduled banks (which include commercial banks and specialised development banks), nonbank financial institutions, microfinance institutions, cooperative banks and other institutions such as merchant banks, mutual fund operators and insurance companies.

Table 1: Share of Banking System Assets (%)

Type of bank Stateowned commercial banks Specialised development banks Private commercial banks Foreign commercial banks Total
Source: Bangladesh Bank

2002 47 9 35 9 100

2003 44 8 39 10 100

2004 42 8 42 8 100

2005 39 7 44 10 100

2006 33 7 48 12 100

2007 33 7 52 8 100

Commercial Banks
The commercial banks are at the core of the financial system and account for more than 80% of all financial system assets. They could be subdivided based on ownership as SOCBs, private commercial banks (PCBs) and foreign commercial banks (FCBs). At present there are 43 commercial banks in Bangladesh, comprising four SOCBs, 30 PCBs and nine FCBs. Although the influence of the SOCBs has gradually been waning, they nevertheless still exert significant influence over the broader banking system, accounting for 33% of banking system assets in 2007 compared with nearly 68% in 1997. Following financial liberalisation in the 1990s, eight FCBs and 10 PCBs were opened, resulting in increased competition. This, coupled with the inherent weaknesses in SOCBs, resulted in market share shifting away from the SOCBs to PCBs and FCBs.

Specialised Banks
The specialised banks are development financial institutions formed to meet specific credit needs in sectors such as agriculture and industry. There are currently five of them in Bangladesh. Like the SOCBs, they have very weak financial profiles characterised by weak asset quality, low capitalisation and poor profitability, which require significant restructuring to ensure viability.

NonBank Financial Institutions

Compared with the commercial banks, the nonbank financial institutions (NBFIs) have a rather limited role in the financial system, accounting for less than 5% of financial system assets. The NBFIs are mainly engaged in the provision of financial and operational leases (about 40% of assets), term lending (about 21% of assets), working capital financing (16% of assets), housing finance (about 14% of assets), merchant banking and venture capital financing. NBFIs also face competition from commercial banks that have started to offer the same products as them, especially leasing. NBFIs, however, appear to have managed to handle asset quality better than the commercial banks, as reflected by an NPL ratio of 8.2% at endJune 2008. That said, it should be noted that this ratio could be understated due to the relatively lax asset quality regulations for NBFIs compared with banks. Currently, there are 29 NBFIs, of which 13 are joint ventures with foreign participation. The NBFIs are licensed and regulated under the Financial Institution Act, 1993, by Bangladesh Bank.

Microfinance Institutions
Microfinance institutions (MFIs) in Bangladesh play an important role in providing access to finance for segments of Bangladeshi society that would otherwise not have access to any form of financing. It is estimated that nearly 17% of the Bangladeshi population have borrowed from the micro finance system. (See Fitch Special Report: The Microfinance Sector: Its Success Could be its Biggest Risk, 16
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June 2008.) While there are more than 1,000 MFIs in Bangladesh, the four largest (including the Grameen Bank) account for 70% of outstanding MFI loans. In addition to specialised government organisations and nongovernmental organisations, microcredit programmes are also implemented by various formal financial institutions such as SOCBs and specialised banks.

Table 2: Selected Indicators for Microfinance Institutions

Indicators Loans outstanding (BDTbn) NPL ratio (%)
Source: Bangladesh Bank

2004 49.9 4.8

2005 60.8 5.1

2006 80.6 4.1

2007 98.8 3.7

H108 121.5 4.6

The Micro Credit Regulatory Authority (MCRA), which was incorporated by an act of parliament in 2006, is responsible for the supervision of MFIs. A certificate of registration from the MCRA is required to set up an MFI.

Physical Infrastructure
Bangladesh lags its regional peers in terms of physical reach and technological advancements. As Table 3 shows, it has very low branch and ATM penetration. The low penetration could be viewed as a result of the low demand for banking services due to the widespread poverty and the inability on the part of the banks to spread out due to their limited financial strength (especially for SOCBs).

Table 3: Access to Banking A Regional Comparison

(As of 2006) Per 100,000 people Branch penetration ATM penetration Bangladesh 4.73 0.29 India 6.37 1.93 Nepal 1.73 0.28 Pakistan 4.96 1.25 Sri Lanka 7.69 5.67

Source: Getting Finance in South Asia, The World Bank, 2009

Banking System Reforms

Banking system reforms in Bangladesh were required due to the serious weaknesses that threatened to destabilise the system, including weak asset quality and capitalisation. The more severe weaknesses were at the stateowned commercial banks that were affected by poor credit underwriting standards, politically linked lending, weak management and, to some extent, regulatory inaction. The four large state banks recorded substantial losses, compelling the government to initiate reforms with the assistance of multilateral agencies. As a first step, the stateowned Sonali Bank, Agrani Bank, Janata Bank and Rupali Bank; all carrying an Individual Rating of E and a Support Rating of 5 from Fitch were required to enter into a Memorandum of Understanding (MOU) with Bangladesh Bank. Rupali Bank is a public company, which is majority owned by the government, while the other three banks are fully owned by the government. This MOU included several provisions such as limiting new lending to 5% of their net loan portfolios at FYE03. This was followed by various specific steps that included enhanced recovery of NPLs, the appointment of a firm of accountants as advisors to Agrani Bank and the appointment of management consultants at other banks, the gradual conversion of the state banks to corporate entities and plans for their eventual privatisation. Given the governments fiscal constraints, which limit its ability to recapitalise the SOCBs, the government announced its intention to divest three of the four state banks by 2007, the exception being Sonali Bank, which the government wanted to hold on to in the medium term, considering the banks strong rural presence and the need for a stateowned bank. However, success with reforms has been somewhat limited, given the political volatilities and other sensitivities such as

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resistance from trade unions. For instance, in the case of Rupali Bank, the privatisation decision was made with the government agreeing to sell a majority stake to a strategic overseas investor. However, the deal fell apart in 2008 after the potential buyer reduced his original offer to USD185m from USD458m. Nevertheless, what was achieved was the conversion of Sonali Bank, Janata Bank and Agrani Bank into public LLCs by mid 2007 in order to make them more autonomous, so that an eventual privatisation may be pursued. In addition, new CEOs were also appointed. In order to expedite the recovery of the three unlisted SOCBs the Ministry of Finance (MOF) has set quarterly performance targets for the CEOs. Fitch notes that during the conversion of the three banks the assets and liabilities were revalued and a valuation adjustment created. This valuation adjustment effectively resulted in the accumulated losses being converted into an intangible asset, thereby restating the equity position without any capital infusion. Fitch views this exercise as an accounting adjustment which does not remedy the underlying capital deficiency in these banks. Given the short time since the conversion of these banks into LLCs, notable improvements are yet to be seen. For instance, the reported gross NPL ratio for the four SOCBs was still high at 29.3% at endSeptember 2008, indicating that significant progress still needs to be made.

Performance
Historically, the performance of the Bangladeshi banking sector has been weak, characterised by high NPL ratios (at times as high as 40%), inadequate provisioning, negative capitalisation in systemically important state banks and constrained profitability. State banks were at times used to lend to politically important economic sectors and institutions as well as politically linked persons. Similarly, the private banks lacked sufficient checks and balances in the form of effective standards of corporate governance, resulting in high levels of relatedparty lending. However, these trends have started to reverse in more recent times, with some efforts made to restructure ailing state banks and improve standards of risk management, corporate governance and bank supervision.

Table 4: Selected Key Performance Indicators

SOCB Indicators (%) ROA ROE Interest spread Gross NPL Net NPL Provision shortfallb Total CAR
a b

SB 2007 0.27 3.40 2.88a 28.58 18.96 50.2 10.36 H108 0.61 14.59 3.20 26.21 17.20 n.a. 5.56

PCB 2007 1.28 16.65 5.36a 5.01 1.37 19.5 10.63 H108 1.61 22.01 5.10 4.94 1.17 n.a. 10.88

FCB 2007 3.10 20.44 9.02a 1.43 1.93 9.4 22.73 H108 3.11 19.85 8.54 1.51 2.17 n.a. 22.88

All Banks 2007 0.89 13.78 5.75a 13.23 5.13 23.7 7.37 H108 1.24 21.26 5.34 13.02 3.99 n.a. 9.49

2007 n.m. n.m. 5.85a 29.87 12.92 20.9 7.12

H108 0.59 22.19 4.48 33.13 10.89 n.a. 6.28c

As at March 2008 Provision shortfall = (Required loan loss provisions as per regulations actual provisions)/required provisions C The CAR is affected by a valuation adjustment conducted during the conversion of SOCBs into limited liability companies. Without this adjustment, the CAR would be negative. Please see Banking System Reforms Source: Bangladesh Bank, Fitch

Profitability
Despite benefiting from high interest spreads, profitability has been modest for Bangladeshi banks. This is attributed to high operating costs which are a result of a lower level of automation as well as overstaffing (especially in state banks), a lack of a broad base to generate feebased income and in more recent years due to increased provisioning. While the ROA and ROE for the banking system improved, to 1.24% and 21.26%, respectively, in H108, from 0.89% and 13.78% in 2007, the agency does not expect the system to sustain H108 profitability ratios in the medium term given the declining interest spreads and the increase in credit costs to offset deficient provisions as well as meet expected new delinquencies.

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While profitability was weakest for the SOCBs, the PCBs and FCBs have performed better, although in line with the weak operating environment. For instance, the ROA for PCBs was 1.3% in 2007 and 1.6% in H108 well above the system Chart 2: Profitability average. The profitability ratios of the ROA (LHS) ROE (RHS) FCBs the best among the banks in (%) (%) Bangladesh (ROA of 8.5% in H108) 1.5 25 benefited from the selective market 1.2 20 segments they catered to as well as 0.9 15 funding (in terms of intrafirm borrowings) and risk management 0.6 10 advantages derived from their head 0.3 5 office. Despite Bangladesh Bank advocating 2001 2002 2003 2004 2005 2006 2007 H108 that banks lower interest spreads on Source: Bangladesh Bank concerns over hampered credit allocation to priority sectors of the economy, the inherent inefficiencies resulting from weak asset quality, a Chart 3: Interest Rate Spread high cost base and to a lesser extent the Deposit rate Lending rate high level of taxation have been used as Interest spread justification by the banks for the higher (%) interest spreads. As a result, interest 14 12 spreads were generally high in 10 Bangladesh with FCBs benefiting from a 8 high of 8.54% in June 2008, while the 6 state and private banks recorded 4 2 spreads of 4.48% and 5.10%, 0 respectively. At present, Bangladesh Bank imposes interest controls on export credit facilities (7%) and lending Source: Bangladesh Bank for import financing (12%) of identified essential commodities, although there were tighter interest controls prior to the introduction of the Financial Sector Reforms Programme in the 1990s.
Jan 01 Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 Jan 07

0.0

The high cost/income ratio (inclusive of credit costs) continues to be a drag on profitability, at 90.4% in 2007. In fact, given their weak revenue generation ability the cost/income ratios of SOCBs and specialised banks were in excess of 100%. The ratio was lowest for FCBs, at 72.9%, followed by PCBs at 88.8%, which was nevertheless still high by regional standards. It is notable that the advantage Bangladesh banks derive from high interest spreads is negated by the high cost base. Profitability at least in the medium term is not expected to improve significantly, due to deficiencies in provisioning requirements that need to be offset, renewed pressure on asset quality that would require further provisioning and inflationdriven increases in operational costs.

LoanBookComposition
The loan book of banks has concentration to the trade and industry segments, which collectively account for more than 50% of total outstanding loans. However, given that the trading segment would have greater granularity in the portfolio, the concentration risk is somewhat mitigated. The transport and communication sector has shown fast growth due to greater activity in this market, while demand for bank financing to set up power plants has also driven growth in the industrial segment.

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Table 5: Banking System Advances by Economic Purpose
(At endJune) 2006 Economic sector Agriculture, forestry and fishing Industry Working capital financing Construction Transport and communication Trade Others Total
Source: Bangladesh Bank

2007 (%) 8.8 19.0 20.0 6.7 1.5 33.9 10.2 100.0 (BDTbn) (%) 109.0 7.4 301.1 20.5 285.1 19.5 105.1 7.2 28.7 2.0 486.2 33.2 150.5 10.3 1,465.7 100.0

2008 (BDTbn) (%) 122.3 6.7 368.6 20.3 328.3 18.1 116.7 6.4 39.5 2.2 640.5 35.3 199.5 11.0 1,815.5 100.0

(BDTbn) 113.5 244.8 258.0 86.7 19.6 437.6 131.5 1,291.7

Financing of household durables, educational expenses and credit cards were the more common forms of consumer lending, which mostly tends to be on a secured basis. Although consumer loan growth has started to pick up in Bangladesh, especially among some private and foreign banks, it is somewhat constrained by low disposable income among households.

AssetQuality
Asset quality has been persistently weak in Bangladeshi banks with nearly onethird of the loan portfolio being classified as NPLs for the systemically important state banks and the smaller specialised banks. At endH108, the reported gross NPL ratios for the SOCBs and specialised banks were 33.1% and 26.2%, respectively, whereas they were more acceptable at 4.9% and 1.5% for PCBs and FCBs. Meanwhile the reported systemwide gross NPL ratio of 13.0%, although still very weak, is nevertheless much improved on the high of 41% posted in 1999. The high level of NPLs at SOCBs and specialised banks is largely attributed to politically directed lending extended on Chart 4: Asset Quality Indicators nonmarket terms as well as lending Gross NPL ratio Net NPL ratio (net of LLR) under governmentdirected schemes. (%) Deficit provisions/NPLs This position is also worsened by the 35 limited credit appraisal, post 30 disbursement credit monitoring and risk 25 20 management skills in these institutions. 15 Furthermore, Fitch notes that some 10 banks are reluctant to write off 5 historically bad loans because of the 0 poor quality of underlying collateral 2001 2002 2003 2004 2005 2006 2007 H108 (and therefore to avoid the recognition Source: Bangladesh Bank, Fitch estimates of hefty losses on their income statement) as well as the legal impediments in recovering loans that are written off. Provisioning for loan losses has also been very poor. In fact, Bangladesh Bank has reported that the banks could only maintain 77.1% of the required provision in 2007 (60.5% in 2001). The central bank attributes the continuous shortfall in provision adequacy to the inability of the state banks and some of the private banks to make sufficient provisions due to weak profits or in some cases even operating losses. Fitch observes that this low level of provisioning is prevalent despite the rather lax loan classification standards for NPLs compared with regional countries and relatively low provisioning requirements (see Regulatory Environment). The decline in the NPL ratio from 20012005 was aided by a reduction in absolute NPLs, while in more recent years it was influenced by higher loan growth (2007: 11.9%). Some reduction from the absolute NPL base was also made possible due to
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recoveries during the initial restructuring of the state banks and the writeoff of longoverdue NPLs, in keeping with guidelines issued by Bangladesh Bank in 2003. With nearly 80% of all classified loans in the loss category, the reduction of NPLs through recoveries seems remote and writeoffs appear to be the likely outcome. Asset quality is likely to come under pressure with recoveries becoming tougher on the back of a weaker economy.

Funding
Deposits constitute the core of the funding mix at around 75% of assets. Deposit growth has generally been steady at 13%18% over the last seven years. Among the major types of banks, private banks accounted for 56% of all deposits at endMarch 2008, while the SOCBs saw their share decline steadily to 31%. Foreign banks Chart 5: Deposit Mix and specialised banks accounted for the (As of March 08) remainder at 8% and 5%, respectively. Others The deposit mobilisation efforts of 14% Bangladesh banks are constrained by the Pension Fixed lower disposable income among 9% 41% households and the national savings scheme a captive source of financing for the government, which offers higher Short interest rates than bank deposits. term &
savings

Deposits of commercial banks are 36% subject to a statutory liquidity Source: Bangladesh Bank requirement (SLR) of 18% inclusive of an average 5% (at least 4% in any day) cash reserve requirement (CRR) on a biweekly basis. The CRR is to be kept with Bangladesh Bank and the remainder as qualifying secure assets under the SLR, in cash or government securities. Furthermore, SLR for the banks operating under the Islamic Shariah principles is 10% and the specialised banks are exempt from maintaining the SLR.

Capitalisation
Capitalisation levels of Bangladeshi banks are poor and are affected by weak capitalisation in state banks as well as marginal capitalisation in some private banks. The weak capitalisation levels and inadequate provisioning on a high NPL base resulted in an extremely weak net NPL/equity ratio of 105% at end2007. The reported riskweighted capital adequacy ratio (CAR) for the system improved to 9.5% at endH108 from 7.4% at end2007, although it was still well below the 10% statutory minimum, which the individual banks are required to maintain. Even this improvement was largely enabled by a valuation adjustment made during the conversion of three SOCBs (Agrani, Janata and Sonali) into limited liability companies. (See Banking Sector Reforms) Consequent to this exercise, the reported CAR for SOCBs was 6.3% at endH108 compared with negative 7.1% Chart 6: RiskWeighted Capital at end2007. The decline in CAR of Ratio specialised banks is attributed to a SOCB SB PCB change in reporting policies for (%) FCB System specialised banks whereby cumulative 28 24 losses are now shown as negative 20 16 retained earnings, thereby affecting the 12 ratio. 8 Bangladesh Bank increased the minimum capital requirements (MCRs) of banks to BDT4bn in 2008 from BDT2.0bn. Accordingly, the banks have been given
4 0 4 8 12 2001 2002 2003 2004 2005 2006 2007 H108 Source: Bangladesh Bank

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till August 2011 to raise their MCR or merge with other banks to fulfil the requirements. Any bank with a shortfall of required capital and reserve is prohibited from paying or declaring cash dividends. Fitch notes that this increase in MCR is a positive development that could help to strengthen the banking system, if implemented without any regulatory compromise. Furthermore, the total and Tier 1 CARs have been increased to 10% and 5%, respectively, since 2007, from 9% and 4.5%. Nevertheless, the banking system as a whole and the SOCBs currently do not meet the regulatory capital ratios. While capitalisation could improve in future, due to the enhanced minimum capital requirements, sustaining such improvements would depend on the ability of the banks to ensure their equity base is not affected by operational losses, especially in a challenging environment with renewed pressure on asset quality.

RiskManagement
In an attempt to improve the risk management practices in banks, Bangladesh Bank issued guidelines on Managing Core Risks in Banking in 2003. Under these guidelines, the banks were advised to put in place an effective risk management system, with Bangladesh Bank monitoring the implementation of these guidelines through its onsite inspection teams. Bangladesh Bank also prescribes a preferred organisational structure for the credit department, where the business development and credit risk management functions are structured under different reporting authorities. It has also stipulated lending limits for industry segments, type of loan facilities, singleexposure limits and an eighttier risk grading system to classify loans. The application of advanced techniques or recruitment of specialist personnel is often hampered due to management attention being diverted towards seemingly greater problems of weak asset quality and capitalisation. As a result, despite the steps taken by the central bank and initiatives by some individual banks, overall risk management capabilities remain weak.

BaselIIImplementation
Bangladesh plans to implement the standardised approach for credit and market risks and the basic indicator approach for operational risk from January 2010. While a quantitative impact study to assess the readiness for implementing Basel II was conducted in 2007, the actual parallel run of Basel I and Basel II only commenced in January 2009 and is expected to continue till December 2009. However, Fitch believes that the planned implementation of the IRB version of Basel II on a system wide basis by 2012 is unlikely to take place as scheduled, as most banks lack the required risk infrastructure.

CreditInformation
A Credit Information Bureau (CIB) was set up in 1992 within Bangladesh Bank. The CIB database contains information in respect of individual borrowers, owners and guarantors. The CIB collects data from banks on a monthly basis (outstanding loans of BDT10m and above) and a quarterly basis (outstanding loans of BDT50,000 BDT10m). Nonbank financial institutions are required to report outstanding loans above BDT50,000 on a halfyearly basis. A donorfunded project to automate the bureau is under way. It appears that CIB, in addition to being an integral part of the financial information infrastructure, is also a politically sensitive body, as not only are banks not permitted to extend new credit facilities or renew existing credit facilities to defaulting borrowers, but the listed defaulters themselves are not allowed to participate in parliamentary elections, promote shares for flotation in the capital market, qualify for directorship of banks/financial institutions, or insurance companies or achieve the status of a commercially important person. Furthermore,

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the efficacy of the bureau is undermined by the actions of some defaulting borrowers who manage to obtain court stay orders to prevent the release of negative credit information and therefore continue to secure banking facilities despite their delinquent position.

DepositInsuranceandPositionofDepositors
Bangladesh introduced a deposit insurance scheme (DIS) in 1984 under the Bank Deposit Insurance Ordinance. However, this ordinance was repealed in 2000 and replaced with the Bank Deposit Insurance Act of 2000. According to the new act, all commercial banks operating in Bangladesh are required to participate in the DIS. Noncommercial banks such as specialised banks or nonbanking financial institutions are not covered by this scheme. The scheme covers deposits up to BDT100,000 (USD1,450) per depositor per bank. Insurance premium rates for the scheme are fixed at 0.07%, while banks that are identified as problem banks by Bangladesh Bank are levied 0.09%, with the central bank vested with the authority to change premiums with the prior approval of the government. The DIS also empowers Bangladesh Bank to debit the accounts maintained by a bank with it to recover any overdue premium payments. Fitch notes that the pricing of premiums based on risk (although it is very basic in structure) and the ability to recover overdue premiums help to strengthen the efficacy of the DIS. At endJune 2008, the Deposit Insurance Trust Fund (DITF) had an asset base of BDT7.3bn, which is less than 5% of total deposits in the Bangladesh banking system. However, if the DITF incurs a shortfall of funds during the course of settling the deposit dues during a bank default, the government, through the central bank, may lend the shortfall to the DITF at the bank rate. As the administrator of the DITF, Bangladesh Bank is also a member of the International Association of Deposit Insurers. Claims of depositors up to the insured amount of BDT100,000 rank higher than those of unsecured creditors during the liquidation of a bank. Amounts in excess of BDT100,000 rank on a par with unsecured creditors.

Support
Given the perceived importance of banks to the economy, it is likely that there would be some government support. However, the timeliness of such support is not certain, given the weak fiscal position of the state. As a result, the four state owned commercial banks in Bangladesh rated by Fitch (ie Sonali Bank, Agrani Bank, Janata Bank and Rupali Bank) are assigned a Support Rating of 5. The Support Rating of 5, the lowest on Fitchs scale is based on the agencys assessment that although the propensity for state support would be high due to the systemic importance of these banks, there are significant uncertainties regarding the governments ability to provide timely support, due to its own fiscal weaknesses. Fitch notes that no local bank has been allowed to fail and thereby default on its deposits. Where possible, Bangladesh Bank has simply exercised regulatory forbearance, engaged itself in closer scrutiny of the bank including appointing observers to the bank and in more serious cases overseen the takeover of a weak bank by a stronger bank. A recent example of this was Oriental Bank Limited, a private commercial bank which had serious asset quality concerns primarily due to weak corporate governance. In this case, the regulator dismissed the CEO in 2006 and appointed an observer in place, while imposing restrictions on the banks business activities. After a competitive bidding process, it sold the bank to an overseas party and business activities recommenced in 2008. Fitch does not expect any major shift in this approach at least in the medium term.

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Accounting and Disclosure
General accounting and disclosure standards have been rather weak in Bangladesh, although they are on an improving trajectory. While emerging international standards and best practices are often adapted with delays, local accounting standards are still broadly drawn in line with international standards. Unlike other banks in the region, Bangladeshi banks publish some additional information such as deficits in provisioning or capital position according to different bank classes. While this is indeed welcome, such disclosures are necessitydriven, more as a compromise, given the rather poor record of compliance with the underlying prudential regulations. Bangladesh Bank for its part has attempted to improve standards of disclosure. Some such steps have required banks to publish annual financial statements in newspapers and display these for public viewing in their places of business and obtain a credit rating from a rating agency. Such credit ratings when obtained are required to be published in the banks annual and halfyearly financial statements. Previously a credit rating was only required for banks that were raising capital through IPOs. In addition, Bangladesh Bank requires banks to list on the stock exchange, with a target of listing at least 50% of their shares. Auditing requirements for banks are more stringent than for nonfinancial corporations, with the audit conducted by the member of a panel of auditors approved by Bangladesh Bank.

CapitalMarkets
Bangladesh has two stock exchanges (the Dhaka Stock Exchange (DSE) and the Chittagong Stock Exchange (CSE)). The DSE (established in 1954) and the CSE (established in 1995) list equities of companies as well as mutual funds and debentures. The DSE is the larger of the two and has 378 listed issues (including debentures and mutual funds). While capital markets have generally elicited investor interest, overall market capitalisation remains low at around 16% of GDP. The banking sector accounted for 53% of the market capitalisation on the DSE, while the manufacturing sector accounted for a further 24% of market capitalisation.

Table 6: Selected Data From the Dhaka Stock Exchange (DSE)a

(For fiscal year ending in June) Year 2003 2004 2005 2006 2007 2008
a

General price index (at endJune) 830 1,319 1,713 1,339 2,149 3,001

Market capitalisation (BDTbn) 69.2 142.4 213.0 205.3 412.2 789.4

Turnover (BDTbn) 30.6 24.8 74.1 46.0 164.7 209.2

Excludes data listed on government bonds Source: Bangladesh Bank

Bank financing seems to be the preferred source of raising capital. For instance, in FY08, the capital raised through the stock exchange was BDT7.4bn, as opposed to BDT201.5bn disbursed by banks and financial institutions as industrial term loans. This reflects the rather undeveloped nature of Bangladeshs capital markets and other constraints in accessing capital from the market. The Securities and Exchange Commission of Bangladesh regulates capital markets activities in Bangladesh under the Securities and Exchange Commission Act.

RegulatoryEnvironment
Banks and nonbank financial institutions are regulated by Bangladesh Bank the countrys central bank. The Bank Company Act of 1991 empowers the central bank to issue licences to carry out banking business in Bangladesh. Bangladesh Bank monitors the performance of the banking sector using the CAMELS framework
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(CAMELS; capital adequacy, asset quality, management soundness, earnings, liquidity and sensitivity to market risk). Banks are subject to periodic comprehensive inspections and adhoc special inspections. During comprehensive inspections, the overall performance of the banks is evaluated and assigned a numerical rating of 15; a lower numerical rating indicates a stronger bank. Special inspections are conducted when specific issues arise or to investigate any complaints received. Commercial banks with a CAMELS rating of 35 are inspected every year; while banks rated 1 or 2 are inspected once every two years. At end 2007, 74% of the banks were rated 2 or above, indicating satisfactory performance according to the regulator. However, given the underlying risk profile of the banks and their relative performance, Fitch believes that some of them may have been rated higher on the CAMELS rating scale than was possibly merited. Bangladesh Bank also employs a supervisory Early Warning System (EWS). Banks with persistently poor performance are brought under the EWS and monitored closely to help improve their performance. At end2007, there were eight banks in the EWS. The central bank also has a problem bank unit to closely monitor weak banks. At end2007, there were two banks under the purview of the problem bank unit. An important challenge for Bangladesh Bank is to bring its prudential regulations in line with international norms, especially in areas such as asset quality, as they are rather lax in Bangladesh, as illustrated in Table 7. For instance, term advances of more than five years are classified as loss only after 24 months, while agricultural and microcredit facilities are classified as loss after 60 months.

Table 7: Classification and Provisioning Regulations for NPLs

Type of advance Continuous and demand Term < 5 years Term > 5 years Agricultural and micro credit
Source: Bangladesh Bank

Substandard Months Specific overdue provision (%) 6 20 6 12 12 20 20 5

Doubtful Months Specific overdue provision (%) 9 50 12 18 36 50 50 5

Loss Months overdue 12 18 24 60 Specific provision (%) 100 100 100 100

The relative weaknesses in NPL recognition and therefore specific provisioning are somewhat mitigated by stronger general provision regulations, as shown in Table 8.

Table 8: General Provision Requirements

General provision (%) Type of advance All unclassified loans except for loans for SMEs, consumers and specialmention 1 accounts. Offbalancesheet exposures. (Implemented in two phases with 0.5% provision by endDecember 2007 and the remaining up to 1.0% by endDecember 2008) 2 Unclassified amount for SME financing. Unclassified amount for (i) housing finance and (ii) loans for professionals to set up business under consumer financing scheme. 5 Unclassified amount for consumer financing except for loans granted to finance housing and to professionals to set up businesses. Outstanding amount of loans kept in the 'specialmention account' after netting off the amount of interest in suspense.
Source: Bangladesh Bank

Bangladeshi banks are among the highest taxed business enterprises in the country (along with insurance companies, NBFIs and mobile phone operators). Banks are levied a corporate tax rate of 45%, while listed companies are levied 30% and unlisted companies 40%.

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Although Bangladesh has introduced various prudential regulatory measures over the last four to five years, Fitch notes that their effective execution remains an important challenge. For instance, the banking systems deficient provision ratio (deficient provisions/required provisions) of 23% in 2007 highlights the inability of the system to maintain adequate provisions against impaired loans.

CorporateGovernance
Corporate governance standards in Bangladesh have historically been weak. The boards of state banks often had political appointees who were less familiar with banking and finance, while in some private banks, which were often promoted by consortiums of local businessmen, family members and loyal proxies were preferred. As a result, there was a high level of relatedparty transactions as well as weak lending without any underwriting standards one of the key reasons for the deterioration of the financial profile of the banking system in Bangladesh. However, in more recent times, Bangladesh Bank has taken some steps to improve corporate governance standards such as: Demarcation of the responsibilities and authority among the board of directors, its chairman, CEO and adviser (if any). Introduction of a fit and proper test for bank directors. Fitch notes that this is mostly in line with what is used by other regulators in the region and requires a minimum 15 years of relevant professional experience as well as a clean track record as a debtor. While there is no maximum age limit for a board director, the maximum age for a CEO is fixed at 65 years. Restricting the board of directors to 13 members. This is a notable reduction for some banks, which have had as many as 20 directors. The tenure of a director has also been restricted to six years. Furthermore, independent directors are required to represent minority shareholder and depositors interests. No board is allowed to have more than two members from each family. Restricting the maximum shareholding by any single shareholder to 10% of capital to prevent shareholder concentration in locally incorporated banks. Restrictions on lending to directors of private banks. Accordingly, loan facilities extendable to a director or to his relatives should not exceed 50% of the paidup value of the shares of that bank held in the director's own name. Furthermore, clearance in the form of no objection has to be obtained from the regulator for loans above certain thresholds (BDT5m and BDT1m based on facility types).

IslamicBanking inBangladesh
Islamic banking in Bangladesh was introduced in 1983 and is conducted through six fully fledged Islamic banks and Islamic banking counters/branches operated by 10 conventional banks. At endJune 2008, Islamic banking deposits (in fully fledged Islamic banks and Islamic banking outlets of conventional banks) collectively accounted for 16.1% of banking sector deposits, while Islamic banking investments (akin to advances in conventional banks) accounted for 19.3% of banking sector advances. The Islamic banking sector also appears to have a broader presence in terms of its branch network, accounting for 5.6% of all banking sector branches. Bangladesh Bank regulates and supervises conventional and Islamic banks broadly under the same framework. The regulator has extended certain preferential treatment for Islamic banks to promote their development, such as a lower statutory liquidity requirement. A notable development was the issue of a Mudaraba Bond, the "Bangladesh Government Islamic Investment Bond" in 2004 to enable Islamic financial institutions to invest their funds. This bond is also considered a liquid asset in the calculation of the statutory liquid assets ratio.

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Copyright 2009 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries. One State Street Plaza, NY, NY 10004.Telephone: 18007534824, (212) 9080500. Fax: (212) 4804435. Reproduction or retransmission in whole or in part is prohibited except by permission. All rights reserved. All of the information contained herein is based on information obtained from issuers, other obligors, underwriters, and other sources which Fitch believes to be reliable. Fitch does not audit or verify the truth or accuracy of any such information. As a result, the information in this report is provided "as is" without any representation or warranty of any kind. A Fitch rating is an opinion as to the creditworthiness of a security. The rating does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. Fitch is not engaged in the offer or sale of any security. A report providing a Fitch rating is neither a prospectus nor a substitute for the information assembled, verified and presented to investors by the issuer and its agents in connection with the sale of the securities. Ratings may be changed, suspended, or withdrawn at anytime for any reason in the sole discretion of Fitch. Fitch does not provide investment advice of any sort. Ratings are not a recommendation to buy, sell, or hold any security. Ratings do not comment on the adequacy of market price, the suitability of any security for a particular investor, or the taxexempt nature or taxability of payments made in respect to any security. Fitch receives fees from issuers, insurers, guarantors, other obligors, and underwriters for rating securities. Such fees generally vary from US$1,000 to US$750,000 (or the applicable currency equivalent) per issue. In certain cases, Fitch will rate all or a number of issues issued by a particular issuer, or insured or guaranteed by a particular insurer or guarantor, for a single annual fee. Such fees are expected to vary from US$10,000 to US$1,500,000 (or the applicable currency equivalent). The assignment, publication, or dissemination of a rating by Fitch shall not constitute a consent by Fitch to use its name as an expert in connection with any registration statement filed under the United States securities laws, the Financial Services and Markets Act of 2000 of Great Britain, or the securities laws of any particular jurisdiction. Due to the relative efficiency of electronic publishing and distribution, Fitch research may be available to electronic subscribers up to three days earlier than to print subscribers.

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