How to survive capital shortfall at banks

If media reports are followed closely, it can then be concluded that our banking industry is battling a persisting malady: capital shortfall.     

As reported, at the end of the December quarter of 2021, the capital shortfall in 10 banks was more than Tk 30,000 crore.

Most of the banks have been managing their capital adequacy little over the regulatory requirements. Due to the reduction of capital, the CAR (capital adequacy ratio) reduced to 11.08 per cent from 11.68 per cent last year against the minimum requirement of 12.5 per cent as prescribed by the Bangladesh Bank. 

The situation marginally improved at the end of March 2022 but the verdict is still out on how our banking industry will fare by the end of the year.

The collaboration between Bangladesh Bank and Bangladesh Securities and Exchange Commission is crucial for the development of a vibrant bond market, which can support banks in dealing with capital shortfall

It is important that banks are equipped with meeting their payment obligations and absorbing losses under any circumstances. A bank's capacity for absorbing losses is derived from its capital base.

In Bangladesh, the central bank has implemented a set of guidelines in line with Basel III, which prescribes that each bank maintains a minimum capital requirement.

The riskiness of loans impacts how much regulatory capital it must maintain: If a bank has less risky loans, its minimum capital requirement will then be less than a bank that has more risky loans and advances.

ASSET QUALITY OF BANKS

The asset quality of our banks has been historically unsatisfactory and managing non-performing loans (NPLs) has been an uphill battle. The addition of the Covid-19 pandemic and the measures taken to help consumers and businesses survive have just exacerbated the situation.

The central bank relaxed loan classification policies to counteract the financial devastation brought about by the pandemic. The ideology behind the decision was that as the borrowers' financial health improves, they will start meeting their debt obligations. However, the borrowers have a long history of defaulting on loans and advances.

As reported in the March-end, the NPL ratio has increased by more than 16 per cent and default loans are about 7.9 per cent of the total outstanding loans. This figure is supposed to go up as the moratorium period for many restructured loans ended as the June quarter came to a close.

The central bank recently relaxed the loan repayment facility for the large industries, SMEs and flood-hit agro businesses for up to December 2022 considering the negative impact of the pandemic, rising virus infections, the recent floods in the northeastern part of the country and the Ukraine war. This action would temporarily inhibit the NPL but it will intensify stress on banks' profitability since banks can't recognise the income on uncollected revenue.

Media reports indicate that a portion of the NPL arises from willful defaults. However, there are other factors in play as well.

Our banking industry is heavily exposed to the readymade garment (RMG) sector and the SME industry. Both sectors were hit the hardest during the pandemic.

A slew of cancelled or postponed orders and a dearth of new orders shook the financial makeup of the organisations operating in these sectors.

While new orders have started coming in, the pressure of continuing to do business for almost two years with minimal turnover has exhausted many organisations and their recovery period has been lengthy. The recent hike in the prices of commodities and raw materials and other inputs as well as the transport cost has also impacted heavily on the cash flow of the borrowers to repay bank debts.

OTHER FACTORS CAUSING CAPITAL SHORTFALL

Banks are growing concerns. They are undergoing a process of continuous growth, which requires them to keep procuring assets. The continuous inclusion of new loans and advances in a balance sheet creates upward pressure on the minimum capital requirement as both total asset value and the risk profile of the asset portfolio remain ever-changing.

This model of continuous growth also encourages less introspection. A failure to analyse the credit quality of existing loans and advances periodically may result in a deterioration in the asset quality.

As per current classification practices, 1 per cent provision is held against a regular loan. Due to the pandemic-induced moratorium periods, most of the loans were considered regular for more than a year and now it has been extended to December.

As the final stages of the moratorium deplete, the true status of the assets held by banks will be revealed and the sudden necessity to keep higher provisions against classified accounts will create issues of its own. With the increase in provisioning, less of the company's retained earnings will make it to the capital base, further weakening the capital base of banks.

Another reason for the persisting problem of the capital shortfall may be the pricing method used in the banking industry to determine interest rates.

Traditionally, institutions would determine interest rates for loans by adding a spread to the average cost of funds or the deposit rate. In the past couple of years, even this archaic practice has taken several steps back.

As per guidelines issued by the central bank, banks are required to maintain an interest rate ceiling of 9 per cent and a deposit rate floor equal to the rate of inflation. This policy has not left banks with many choices but to lend to all types of customers at similar interest rates. In an industry where innovative ideals such as the Basel III guidelines are to be implemented, the existence of a virtually static interest rate is daunting.

It should be kept in mind that the virtually static interest rate and the implementation of Basel III guidelines are contradictory concepts and should not be forced together. Therefore, some regulatory intervention is necessary to ensure that the capital shortfall in banks decreases.

GLOBAL PRACTICES

During the pandemic, European banks retained their earnings instead of paying out dividends. This strengthened their capital bases and increased their resilience.

Even before the pandemic, in strained situations, banks preferred paying out stock dividends as opposed to cash dividends. Thus, retaining adequate profit as reserves.

Some banks maintain a buffer while calculating their minimum capital requirement. They ensure that their capital to risk-weighted asset ratio is well above the required parameter. This ensures that in an event of unforeseen default, the bank can maintain the regulatory capital.

Furthermore, most banks practice risk-based pricing for their loans and maintain extra provisioning against risky assets to safeguard the bank's capital base.

WAY FORWARD

It is prudent that we undertake regulatory and management reforms regarding the management of capital shortfall because the continued issue sends a signal of a weakening financial system.

It needs some short-term and long-term planning to reduce the capital shortfall. Besides establishing strong corporate governance and a prudent credit approving system to improve asset quality, the industry also needs clear guidance from regulators to stabilise the capital shortfall.

The collaboration between the Bangladesh Bank and the Bangladesh Securities and Exchange Commission is now crucial for the development of a vibrant bond market (including perpetual and subordinated bonds), which can support banks in dealing with capital shortfall.

Moreover, investment in such bonds needs to be channelled from the life insurance funds, pension funds, mutual funds, corporate houses and individuals rather than taking investments from banks and financial institutions, which is currently being practised.

Along with the influx of various funds and individuals' small investments in the market, the regulators may also bring an amenable policy for the listing of such bonds with easier terms and a convenient approval system to make the secondary market vibrant.

The author is an analyst.