fitch ratings - ban glades hi banking system

8/6/2019 Fitch Ratings - Ban Glades Hi Banking System

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Bangladesh

Country Report

The Bangladeshi Banking System

Summary OpinionThe Bangladeshi banking system is one of the weakest in emerging Asia, with aweak operating environment contributing to persistently poor performance andsolvency issues, especially among the systemically important stateownedcommercial banks (SOCBs). The system is undermined by very weak asset quality,inadequate provisioning for loan losses, poor capitalisation and constrainedprofitability. The operating environment in Bangladesh is characterised by a weakmacro economy and political instabilities, both of which pose significant risks. The

weakness in the operating environment is further exacerbated by frequent naturaldisasters.

Bangladeshs banking system is made up of 48 banks, which include four SOCBs, 30private commercial banks, nine foreign commercial banks and five developmentbanks. 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 losingmarket 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 asprivatisation attempts, conversion into limited liability companies (LLCs) and theappointment of new management progress has been slow.

In addition to the challenging operating environment, Fitch Ratings notes that thevery weak asset quality in Bangladesh (reported gross NPL ratio of 13% in June 2008)

is also influenced by weak standards of corporate governance, underdeveloped riskmanagement systems and directed lending. Asset quality in the SOCB sector is ofgreater concern given their very high reported gross NPL ratio of 29.3% at endSeptember 2008 (1999: 41%). Fitch also notes that 80% of system NPLs are in theloss category with low probability of recovery, while provision coverage of NPLs waswell below the regulatory minimum, as a result of which the systems netNPL/equity ratio was extremely weak at 105% at end2007.

The agency also views the valuation adjustment created during the conversion ofthree SOCBs Sonali Bank, Janata Bank and Agrani Bank into LLCs in 2007 as abook adjustment as it merely restated the equity position without any actualcapital infusion to correct the underlying capital deficiency. In fact even after thisvaluation adjustment, the loss category NPLs still exceeded the restated equity

position, underlying their technical insolvency. These risks are in fact reflected inthe low Individual Ratings of E assigned to the four SOCBs rated by the agency. AnIndividual Rating of E indicates a bank with very serious problems, which eitherrequires or is likely to require external support.

Although Bangladeshs banking system is lessdeveloped it does have a creditinformation bureau and a deposit insurance scheme which protects deposits up toBDT100,000 (USD1,450); however, the efficacy of both remains to be seen. Whereasprudential regulations governing banks have generally improved over the last fewyears, Fitch notes that there is further scope for alignment of these regulationswith regional norms, especially with regard to asset classification standards whichappear lax. While parallel computation of Basel II commenced in January 2009, itsimplementation is scheduled for January 2010, with the standardised approach for

credit and market risks and the basic indicator approach for operational risk, whichmay put more stress on an already undercapitalised banking system.

Analysts

J Anandakumar+65 6796 [email protected]

Arshad Khan+91 22 4000 [email protected]

Ambreesh Srivastava+65 6796 7218

[email protected]


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The Bangladeshi Banking SystemMarch 2009 2

Sovereign OverviewBangladesh is a lowincome country with an annual per capita income of less thanUSD500. It is characterised by widespread poverty (more than 40% of the

population), susceptibility to severe natural disasters such as floods, cyclones andtidal waves and persistent political instability. These factors have resulted inBangladesh struggling to develop into a middleincome country.

GDP growth was healthy at 6.4% during the fiscal year 2006/2007 (the fiscal year isJuly to June), although it moderated somewhat to 6.2% in 2007/2008. Theslowdown was due to high inflation, weaker global demand for exports and theeffects of the natural disasters of 2007/2008 on agricultural production. Among thelarger contributors towards national GDP were manufacturing, agriculture andforestry 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 fasterthan the overall GDP average at 9.0%, its relative importance to GDP was low, atless 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% ofGDP, respectively.

Worker remittances from migrant Bangladeshis remain a key contributor in drivingnot only private consumption but also providing a steady flow of muchneededforeign exchange reserves. Worker remittances reached a record USD7.9bn for the2008 financial year and accounted for 10% of GDP. This enabled Bangladeshscurrent account to post a surplus during the fiscal year 2007/2008, despite thedeficit in the trade account. The garments sector continued to dominate exportsand accounted for nearly 75% of all merchandise exports. Foreign direct

investments into Bangladesh have been relatively limited compared with the rest ofSouth Asia, at less than 1% of GDP. This could be attributed to the countrys ratherhigh risk profile as well as bureaucratic limitations that discourage potentialinvestors.

Although inflation was on an increasing trend during mid2008 (peaking at 10.8% inJuly 2008) due to rising food prices, energy costs and stronger demand stemmingfrom monetary and credit expansion, it has since declined to 6.0% at December2008 on a pointtopoint basis. Bangladeshs fiscal position is also weak, with thegovernment constrained by its heavy subsidies on fuel and fertiliser as well as theneed to incur rehabilitation expenses due to the frequent natural calamities. Thetax collection system is characterised by complex tax laws and a high level of taxexemptions. 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, parliamentaryelections were held in December 2008. These elections were won by the AwamiLeague with a clear majority. However, it remains to be seen whether the newgovernment will be able to bring in muchneeded political stability to the country.

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Real GDP growth Fiscal deficit (% of GDP)(%)

Chart 1: Key Economic Indicators

Source: Bangladesh Bank


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Overview and Structure of the Financial SystemThe Bangladeshi financial system is composed of scheduled banks (which includecommercial banks and specialised development banks), nonbank financial

institutions, microfinance institutions, cooperative banks and other institutionssuch as merchant banks, mutual fund operators and insurance companies.

Table 1: Share of Banking System Assets (%)Type of bank 2002 2003 2004 2005 2006 2007

Stateowned commercial banks 47 44 42 39 33 33Specialised development banks 9 8 8 7 7 7Private commercial banks 35 39 42 44 48 52Foreign commercial banks 9 10 8 10 12 8Total 100 100 100 100 100 100


Commercial BanksThe commercial banks are at the core of the financial system and account for morethan 80% of all financial system assets. They could be subdivided based onownership as SOCBs, private commercial banks (PCBs) and foreign commercial banks(FCBs). At present there are 43 commercial banks in Bangladesh, comprising fourSOCBs, 30 PCBs and nine FCBs. Although the influence of the SOCBs has graduallybeen waning, they nevertheless still exert significant influence over the broaderbanking system, accounting for 33% of banking system assets in 2007 compared withnearly 68% in 1997. Following financial liberalisation in the 1990s, eight FCBs and 10PCBs were opened, resulting in increased competition. This, coupled with theinherent weaknesses in SOCBs, resulted in market share shifting away from theSOCBs to PCBs and FCBs.

Specialised BanksThe specialised banks are development financial institutions formed to meetspecific credit needs in sectors such as agriculture and industry. There are currentlyfive of them in Bangladesh. Like the SOCBs, they have very weak financial profilescharacterised by weak asset quality, low capitalisation and poor profitability, whichrequire significant restructuring to ensure viability.

NonBank Financial InstitutionsCompared with the commercial banks, the nonbank financial institutions (NBFIs)have a rather limited role in the financial system, accounting for less than 5% offinancial system assets. The NBFIs are mainly engaged in the provision of financialand 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 fromcommercial banks that have started to offer the same products as them, especiallyleasing. NBFIs, however, appear to have managed to handle asset quality betterthan 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 therelatively lax asset quality regulations for NBFIs compared with banks. Currently,there are 29 NBFIs, of which 13 are joint ventures with foreign participation. TheNBFIs are licensed and regulated under the Financial Institution Act, 1993, byBangladesh Bank.

Microfinance InstitutionsMicrofinance institutions (MFIs) in Bangladesh play an important role in providingaccess to finance for segments of Bangladeshi society that would otherwise nothave access to any form of financing. It is estimated that nearly 17% of theBangladeshi population have borrowed from the micro finance system. (See FitchSpecial 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 additionto specialised government organisations and nongovernmental organisations,

microcredit programmes are also implemented by various formal financialinstitutions such as SOCBs and specialised banks.

Table 2: Selected Indicators for Microfinance InstitutionsIndicators 2004 2005 2006 2007 H108

Loans outstanding (BDTbn) 49.9 60.8 80.6 98.8 121.5NPL ratio (%) 4.8 5.1 4.1 3.7 4.6


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

Physical InfrastructureBangladesh lags its regional peers in terms of physical reach and technologicaladvancements. As Table 3 shows, it has very low branch and ATM penetration. Thelow penetration could be viewed as a result of the low demand for banking servicesdue to the widespread poverty and the inability on the part of the banks to spreadout due to their limited financial strength (especially for SOCBs).

Table 3: Access to Banking A Regional Comparison(As of 2006)

Per 100,000 people Bangladesh India Nepal Pakistan Sri Lanka

Branch penetration 4.73 6.37 1.73 4.96 7.69ATM penetration 0.29 1.93 0.28 1.25 5.67

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

Banking System ReformsBanking system reforms in Bangladesh were required due to the serious weaknessesthat threatened to destabilise the system, including weak asset quality andcapitalisation. The more severe weaknesses were at the stateowned commercialbanks that were affected by poor credit underwriting standards, politically linkedlending, weak management and, to some extent, regulatory inaction. The four largestate banks recorded substantial losses, compelling the government to initiatereforms with the assistance of multilateral agencies.

As a first step, the stateowned Sonali Bank, Agrani Bank, Janata Bank and RupaliBank; all carrying an Individual Rating of E and a Support Rating of 5 from Fitchwere required to enter into a Memorandum of Understanding (MOU) withBangladesh Bank. Rupali Bank is a public company, which is majority owned by thegovernment, while the other three banks are fully owned by the government. ThisMOU included several provisions such as limiting new lending to 5% of their net loanportfolios at FYE03. This was followed by various specific steps that includedenhanced recovery of NPLs, the appointment of a firm of accountants as advisors toAgrani Bank and the appointment of management consultants at other banks, thegradual conversion of the state banks to corporate entities and plans for theireventual privatisation.

Given the governments fiscal constraints, which limit its ability to recapitalise theSOCBs, the government announced its intention to divest three of the four statebanks 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 andthe need for a stateowned bank. However, success with reforms has beensomewhat limited, given the political volatilities and other sensitivities such as


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While profitability was weakest for the SOCBs, the PCBs and FCBs have performedbetter, although in line with the weak operating environment. For instance, theROA for PCBs was 1.3% in 2007 and 1.6%

in H108 well above the systemaverage. The profitability ratios of theFCBs the best among the banks inBangladesh (ROA of 8.5% in H108)benefited from the selective marketsegments they catered to as well asfunding (in terms of intrafirmborrowings) and risk managementadvantages derived from their headoffice.

Despite Bangladesh Bank advocatingthat banks lower interest spreads on

concerns over hampered creditallocation to priority sectors of theeconomy, the inherent inefficienciesresulting from weak asset quality, ahigh cost base and to a lesser extent thehigh level of taxation have been used asjustification by the banks for the higherinterest spreads. As a result, interestspreads were generally high inBangladesh with FCBs benefiting from ahigh of 8.54% in June 2008, while thestate and private banks recordedspreads of 4.48% and 5.10%,

respectively. At present, BangladeshBank imposes interest controls onexport credit facilities (7%) and lendingfor import financing (12%) of identifiedessential commodities, although there were tighter interest controls prior to theintroduction of the Financial Sector Reforms Programme in the 1990s.

The high cost/income ratio (inclusive of credit costs) continues to be a drag onprofitability, at 90.4% in 2007. In fact, given their weak revenue generation abilitythe cost/income ratios of SOCBs and specialised banks were in excess of 100%. Theratio was lowest for FCBs, at 72.9%, followed by PCBs at 88.8%, which wasnevertheless still high by regional standards. It is notable that the advantageBangladesh banks derive from high interest spreads is negated by the high cost base.

Profitability at least in the medium term is not expected to improvesignificantly, due to deficiencies in provisioning requirements that need to be offset,renewed pressure on asset quality that would require further provisioning andinflationdriven increases in operational costs.

Loan Book CompositionThe 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, theconcentration risk is somewhat mitigated. The transport and communication sectorhas shown fast growth due to greater activity in this market, while demand for bankfinancing to set up power plants has also driven growth in the industrial segment.

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Chart 2: Profitability


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Chart 3: Interest Rate Spread



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Table 5: Banking System Advances by Economic Purpose(At endJune)

2006 2007 2008

Economic sector (BDTbn) (%) (BDTbn) (%) (BDTbn) (%)Agriculture, forestry and fishing 113.5 8.8 109.0 7.4 122.3 6.7Industry 244.8 19.0 301.1 20.5 368.6 20.3Working capital financing 258.0 20.0 285.1 19.5 328.3 18.1Construction 86.7 6.7 105.1 7.2 116.7 6.4Transport and communication 19.6 1.5 28.7 2.0 39.5 2.2Trade 437.6 33.9 486.2 33.2 640.5 35.3Others 131.5 10.2 150.5 10.3 199.5 11.0Total 1,291.7 100.0 1,465.7 100.0 1,815.5 100.0


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

Asset QualityAsset quality has been persistently weak in Bangladeshi banks with nearly onethirdof the loan portfolio being classified as NPLs for the systemically important statebanks and the smaller specialised banks. At endH108, the reported gross NPL ratiosfor the SOCBs and specialised banks were 33.1% and 26.2%, respectively, whereasthey were more acceptable at 4.9% and 1.5% for PCBs and FCBs. Meanwhile thereported systemwide gross NPL ratio of 13.0%, although still very weak, isnevertheless much improved on the high of 41% posted in 1999.

The high level of NPLs at SOCBs andspecialised banks is largely attributed topolitically directed lending extended onnonmarket terms as well as lendingunder governmentdirected schemes.This position is also worsened by thelimited credit appraisal, postdisbursement credit monitoring and riskmanagement skills in these institutions.Furthermore, Fitch notes that somebanks are reluctant to write offhistorically bad loans because of thepoor quality of underlying collateral

(and therefore to avoid the recognitionof hefty losses on their incomestatement) as well as the legalimpediments in recovering loans that are written off.

Provisioning for loan losses has also been very poor. In fact, Bangladesh Bank hasreported 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 provisionadequacy to the inability of the state banks and some of the private banks to makesufficient 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 laxloan classification standards for NPLs compared with regional countries andrelatively low provisioning requirements (see Regulatory Environment).

The decline in the NPL ratio from 20012005 was aided by a reduction in absoluteNPLs, 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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Gross NPL ratioNet NPL ratio (net of LLR)Deficit provisions/NPLs(%)

Chart 4: Asset Quality Indicators

Source: Bangladesh Bank, Fitch estimates


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recoveries during the initial restructuring of the state banks and the writeoff oflongoverdue 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 onthe back of a weaker economy.

FundingDeposits constitute the core of the funding mix at around 75% of assets. Depositgrowth has generally been steady at 13%18% over the last seven years. Among themajor types of banks, private banks accounted for 56% of all deposits at endMarch2008, while the SOCBs saw their sharedecline steadily to 31%. Foreign banksand specialised banks accounted for theremainder at 8% and 5%, respectively.The deposit mobilisation efforts of

Bangladesh banks are constrained by thelower disposable income amonghouseholds and the national savingsscheme a captive source of financingfor the government, which offers higherinterest rates than bank deposits.

Deposits of commercial banks aresubject to a statutory liquidityrequirement (SLR) of 18% inclusive of anaverage 5% (at least 4% in any day) cashreserve requirement (CRR) on a biweekly basis. The CRR is to be kept withBangladesh Bank and the remainder as qualifying secure assets under the SLR, in

cash or government securities. Furthermore, SLR for the banks operating under theIslamic Shariah principles is 10% and the specialised banks are exempt frommaintaining the SLR.

CapitalisationCapitalisation levels of Bangladeshi banks are poor and are affected by weakcapitalisation in state banks as well as marginal capitalisation in some private banks.The weak capitalisation levels and inadequate provisioning on a high NPL baseresulted in an extremely weak net NPL/equity ratio of 105% at end2007. Thereported riskweighted capital adequacy ratio (CAR) for the system improved to9.5% 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 thisimprovement was largely enabled by a valuation adjustment made during theconversion of three SOCBs (Agrani, Janata and Sonali) into limited liabilitycompanies. (See Banking Sector Reforms) Consequent to this exercise, thereported CAR for SOCBs was 6.3% atendH108 compared with negative 7.1%at end2007. The decline in CAR ofspecialised banks is attributed to achange in reporting policies forspecialised banks whereby cumulativelosses are now shown as negativeretained earnings, thereby affecting theratio.

Bangladesh Bank increased the minimum

capital requirements (MCRs) of banks toBDT4bn in 2008 from BDT2.0bn.Accordingly, the banks have been given

Short

term &

savings

36%

Pension

9%Fixed

41%

Others

14%

Chart 5: Deposit Mix

(As of March 08)


1284048

1216202428

2001 2002 2003 2004 2005 2006 2007 H108

SOCB SB PCBFCB System(%)

Chart 6: RiskWeighted Capital

Ratio



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till August 2011 to raise their MCR or merge with other banks to fulfil therequirements. Any bank with a shortfall of required capital and reserve isprohibited 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, ifimplemented without any regulatory compromise. Furthermore, the total and Tier 1CARs have been increased to 10% and 5%, respectively, since 2007, from 9% and4.5%. Nevertheless, the banking system as a whole and the SOCBs currently do notmeet the regulatory capital ratios.

While capitalisation could improve in future, due to the enhanced minimum capitalrequirements, sustaining such improvements would depend on the ability of thebanks to ensure their equity base is not affected by operational losses, especially ina challenging environment with renewed pressure on asset quality.

Risk ManagementIn an attempt to improve the risk management practices in banks, Bangladesh Bank

issued guidelines on Managing Core Risks in Banking in 2003. Under theseguidelines, the banks were advised to put in place an effective risk managementsystem, with Bangladesh Bank monitoring the implementation of these guidelinesthrough its onsite inspection teams. Bangladesh Bank also prescribes a preferredorganisational structure for the credit department, where the businessdevelopment and credit risk management functions are structured under differentreporting authorities. It has also stipulated lending limits for industry segments,type of loan facilities, singleexposure limits and an eighttier risk grading system toclassify loans.

The application of advanced techniques or recruitment of specialist personnel isoften hampered due to management attention being diverted towards seeminglygreater 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 riskmanagement capabilities remain weak.

Basel II ImplementationBangladesh plans to implement the standardised approach for credit and marketrisks and the basic indicator approach for operational risk from January 2010. Whilea quantitative impact study to assess the readiness for implementing Basel II wasconducted in 2007, the actual parallel run of Basel I and Basel II only commenced inJanuary 2009 and is expected to continue till December 2009. However, Fitchbelieves that the planned implementation of the IRB version of Basel II on a systemwide basis by 2012 is unlikely to take place as scheduled, as most banks lack therequired risk infrastructure.

Credit InformationA Credit Information Bureau (CIB) was set up in 1992 within Bangladesh Bank. TheCIB database contains information in respect of individual borrowers, owners andguarantors. The CIB collects data from banks on a monthly basis (outstanding loansof BDT10m and above) and a quarterly basis (outstanding loans of BDT50,000BDT10m). Nonbank financial institutions are required to report outstanding loansabove BDT50,000 on a halfyearly basis. A donorfunded project to automate thebureau is under way.

It appears that CIB, in addition to being an integral part of the financial informationinfrastructure, is also a politically sensitive body, as not only are banks notpermitted to extend new credit facilities or renew existing credit facilities todefaulting borrowers, but the listed defaulters themselves are not allowed to

participate in parliamentary elections, promote shares for flotation in the capitalmarket, qualify for directorship of banks/financial institutions, or insurancecompanies 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 defaultingborrowers who manage to obtain court stay orders to prevent the release ofnegative credit information and therefore continue to secure banking facilities

despite their delinquent position.

Deposit Insurance and Position of DepositorsBangladesh introduced a deposit insurance scheme (DIS) in 1984 under the BankDeposit Insurance Ordinance. However, this ordinance was repealed in 2000 andreplaced with the Bank Deposit Insurance Act of 2000. According to the new act, allcommercial banks operating in Bangladesh are required to participate in the DIS.Noncommercial banks such as specialised banks or nonbanking financialinstitutions 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 areidentified 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 thegovernment. The DIS also empowers Bangladesh Bank to debit the accountsmaintained by a bank with it to recover any overdue premium payments. Fitchnotes that the pricing of premiums based on risk (although it is very basic instructure) and the ability to recover overdue premiums help to strengthen theefficacy of the DIS. At endJune 2008, the Deposit Insurance Trust Fund (DITF) hadan asset base of BDT7.3bn, which is less than 5% of total deposits in the Bangladeshbanking system. However, if the DITF incurs a shortfall of funds during the course ofsettling the deposit dues during a bank default, the government, through thecentral bank, may lend the shortfall to the DITF at the bank rate. As theadministrator of the DITF, Bangladesh Bank is also a member of the InternationalAssociation of Deposit Insurers.

Claims of depositors up to the insured amount of BDT100,000 rank higher than thoseof unsecured creditors during the liquidation of a bank. Amounts in excess ofBDT100,000 rank on a par with unsecured creditors.

SupportGiven the perceived importance of banks to the economy, it is likely that therewould be some government support. However, the timeliness of such support is notcertain, given the weak fiscal position of the state. As a result, the four stateowned 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 SupportRating of 5, the lowest on Fitchs scale is based on the agencys assessment thatalthough the propensity for state support would be high due to the systemicimportance 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 itsdeposits. Where possible, Bangladesh Bank has simply exercised regulatoryforbearance, engaged itself in closer scrutiny of the bank including appointingobservers to the bank and in more serious cases overseen the takeover of a weakbank by a stronger bank. A recent example of this was Oriental Bank Limited, aprivate commercial bank which had serious asset quality concerns primarily due toweak corporate governance. In this case, the regulator dismissed the CEO in 2006and appointed an observer in place, while imposing restrictions on the banksbusiness activities. After a competitive bidding process, it sold the bank to anoverseas party and business activities recommenced in 2008. Fitch does not expectany major shift in this approach at least in the medium term.


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Accounting and DisclosureGeneral 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 accountingstandards are still broadly drawn in line with international standards. Unlike otherbanks in the region, Bangladeshi banks publish some additional information such asdeficits in provisioning or capital position according to different bank classes. Whilethis is indeed welcome, such disclosures are necessitydriven, more as acompromise, given the rather poor record of compliance with the underlyingprudential regulations.

Bangladesh Bank for its part has attempted to improve standards of disclosure.Some such steps have required banks to publish annual financial statements innewspapers and display these for public viewing in their places of business andobtain a credit rating from a rating agency. Such credit ratings when obtained arerequired to be published in the banks annual and halfyearly financial statements.

Previously a credit rating was only required for banks that were raising capitalthrough IPOs. In addition, Bangladesh Bank requires banks to list on the stockexchange, with a target of listing at least 50% of their shares. Auditingrequirements for banks are more stringent than for nonfinancial corporations, withthe audit conducted by the member of a panel of auditors approved by BangladeshBank.

Capital MarketsBangladesh has two stock exchanges (the Dhaka Stock Exchange (DSE) and theChittagong Stock Exchange (CSE)). The DSE (established in 1954) and the CSE(established in 1995) list equities of companies as well as mutual funds anddebentures. The DSE is the larger of the two and has 378 listed issues (includingdebentures and mutual funds). While capital markets have generally elicitedinvestor 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 General price index (at endJune) Market capitalisation (BDTbn) Turnover (BDTbn)

2003 830 69.2 30.62004 1,319 142.4 24.82005 1,713 213.0 74.12006 1,339 205.3 46.02007 2,149 412.2 164.72008 3,001 789.4 209.2a

Excludes data listed on government bondsSource: Bangladesh Bank

Bank financing seems to be the preferred source of raising capital. For instance, inFY08, the capital raised through the stock exchange was BDT7.4bn, as opposed toBDT201.5bn disbursed by banks and financial institutions as industrial term loans.This reflects the rather undeveloped nature of Bangladeshs capital markets andother constraints in accessing capital from the market. The Securities and ExchangeCommission of Bangladesh regulates capital markets activities in Bangladesh underthe Securities and Exchange Commission Act.

Regulatory EnvironmentBanks and nonbank financial institutions are regulated by Bangladesh Bank thecountrys central bank. The Bank Company Act of 1991 empowers the central bankto issue licences to carry out banking business in Bangladesh. Bangladesh Bankmonitors 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 periodiccomprehensive inspections and adhoc special inspections. During comprehensive

inspections, the overall performance of the banks is evaluated and assigned anumerical rating of 15; a lower numerical rating indicates a stronger bank. Specialinspections are conducted when specific issues arise or to investigate anycomplaints received. Commercial banks with a CAMELS rating of 35 are inspectedevery year; while banks rated 1 or 2 are inspected once every two years. At end2007, 74% of the banks were rated 2 or above, indicating satisfactory performanceaccording to the regulator. However, given the underlying risk profile of the banksand their relative performance, Fitch believes that some of them may have beenrated higher on the CAMELS rating scale than was possibly merited.

Bangladesh Bank also employs a supervisory Early Warning System (EWS). Banks withpersistently poor performance are brought under the EWS and monitored closely tohelp 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. Atend2007, there were two banks under the purview of the problem bank unit.

An important challenge for Bangladesh Bank is to bring its prudential regulations inline with international norms, especially in areas such as asset quality, as they arerather lax in Bangladesh, as illustrated in Table 7. For instance, term advances ofmore than five years are classified as loss only after 24 months, while agriculturaland microcredit facilities are classified as loss after 60 months.

Table 7: Classification and Provisioning Regulations for NPLsSubstandard Doubtful Loss

Type of advanceMonths

overdueSpecific

provision (%)Months

overdueSpecific

provision (%)Months

overdueSpecific

provision (%)

Continuous and

demand

6 20 9 50 12 100

Term < 5 years 6 20 12 50 18 100Term > 5 years 12 20 18 50 24 100Agricultural andmicro credit

12 5 36 5 60 100


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

Table 8: General Provision RequirementsGeneralprovision (%) Type of advance

1

All unclassified loans except for loans for SMEs, consumers and specialmentionaccounts.

Offbalancesheet exposures. (Implemented in two phases with 0.5% provision byendDecember 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 upbusiness under consumer financing scheme.

5 Unclassified amount for consumer financing except for loans granted to financehousing and to professionals to set up businesses.

Outstanding amount of loans kept in the 'specialmention account' after netting offthe amount of interest in suspense.


Bangladeshi banks are among the highest taxed business enterprises in the country

(along with insurance companies, NBFIs and mobile phone operators). Banks arelevied a corporate tax rate of 45%, while listed companies are levied 30% andunlisted companies 40%.


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Although Bangladesh has introduced various prudential regulatory measures overthe last four to five years, Fitch notes that their effective execution remains animportant challenge. For instance, the banking systems deficient provision ratio

(deficient provisions/required provisions) of 23% in 2007 highlights the inability ofthe system to maintain adequate provisions against impaired loans.

Corporate GovernanceCorporate governance standards in Bangladesh have historically been weak. Theboards of state banks often had political appointees who were less familiar withbanking and finance, while in some private banks, which were often promoted byconsortiums of local businessmen, family members and loyal proxies were preferred.As a result, there was a high level of relatedparty transactions as well as weaklending without any underwriting standards one of the key reasons for thedeterioration of the financial profile of the banking system in Bangladesh. However,in more recent times, Bangladesh Bank has taken some steps to improve corporategovernance 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 ismostly in line with what is used by other regulators in the region and requires aminimum 15 years of relevant professional experience as well as a clean trackrecord 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 forsome banks, which have had as many as 20 directors. The tenure of a directorhas also been restricted to six years. Furthermore, independent directors arerequired 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% ofcapital to prevent shareholder concentration in locally incorporated banks.

Restrictions on lending to directors of private banks. Accordingly, loan facilitiesextendable to a director or to his relatives should not exceed 50% of the paidupvalue 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 regulatorfor loans above certain thresholds (BDT5m and BDT1m based on facility types).

Islamic Banking in BangladeshIslamic banking in Bangladesh was introduced in 1983 and is conducted through sixfully fledged Islamic banks and Islamic banking counters/branches operated by 10

conventional banks. At endJune 2008, Islamic banking deposits (in fully fledgedIslamic banks and Islamic banking outlets of conventional banks) collectivelyaccounted for 16.1% of banking sector deposits, while Islamic banking investments(akin to advances in conventional banks) accounted for 19.3% of banking sectoradvances. The Islamic banking sector also appears to have a broader presence interms of its branch network, accounting for 5.6% of all banking sector branches.

Bangladesh Bank regulates and supervises conventional and Islamic banks broadlyunder the same framework. The regulator has extended certain preferentialtreatment for Islamic banks to promote their development, such as a lowerstatutory liquidity requirement. A notable development was the issue of a MudarabaBond, the "Bangladesh Government Islamic Investment Bond" in 2004 to enableIslamic 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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The Bangladeshi Banking System 14

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