[Cover page]

Financial Sector Review

Volume 2, Number 1 December 2006

Policy Analysis Unit (PAU) Research Department

Bangladesh Bank Head Office, Dhaka, Bangladesh (www.bangladeshbank.org.bd)

(www.bangladesh-bank.org)

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The Financial Sector Review The Bangladesh Bank (BB) and the World Bank Institute (WBI) have initiated a project, “Partnership for Excellence in Research and Policy Analysis at Bangladesh Bank” which aims to upgrade the capacity for research and policy analysis at the Central Bank of Bangladesh. Accordingly a Policy Analysis Unit (PAU) has been set up within the Bank’s Research Department to spearhead research on all aspects of macroeconomics including monetary policy and central banking. Among other, PAU has been entrusted with the task of preparing the bi-annual flagship publications such as the Monetary Policy Review and the Financial Sector Review, as well as Policy Notes and Working Papers on a regular basis. This principal goal of the PAU activities is to provide sound policy advice to BB senior management.

Financial Sector Review (FSR) is designed to present a brief but comprehensive assessment of the financial sector as a whole and develops the financial sector outlook consistent with monetary policy stance of the Bangladesh bank based on its assessment of the real sector and financial and monetary aggregates and the near term macroeconomic outlook.

It is in this context that Financial Sector Review aims to

• improves the understanding of current developments of maintaining price stability underpinned by the highest sustainable output growth, and is therefore formulated around inflation and output growth rates as the basic policy targets

• improves the understanding of current developments, the major divergence between domestic and global financial services trade, prudential regulation and linked with financial regulations norms like Basle Accord

• summarises recent development on financial sector services, financial derivatives, financial sector innovations and also its implications for on monetary policy including monetary policy stance on the aspects of the monetary policy transmission channels

• inform individuals on all aspects of the finacial sector together increased interaction on these issues between public and private sector

The FSR contributes to maintain and develop financial sector by highlighting relevant information that improves awareness and encourages discussion of issues concerning financial system. The PAU of BB welcomes comments and suggestions on the material contained in the FSR.

Policy Analysis Unit Research Department

Bangladesh Bank

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Financial Sector Review *

Volume 2, Number 1 October 2006

Copyright © 2006 by Bangladesh Bank

* In an attempt to upgrade the capacity for research and policy analysis at Bangladesh Bank (BB), PAU prepares and publishes, among other, the Financial Sector Review on a bi-annual basis. Neither the Board of Directors nor the management of, or any agency of the Government of Bangladesh, however, necessarily endorses any or all of the views expressed in the Review. The latter reflect views based on professional analysis carried out by the research staffs of Bangladesh Bank, and hence the usual caveat as to the veracity of research reports applies.

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LIST OF CONTRIBUTORS

Professor Syed M. Ahsan, Editor

Senior Research Economists

Dr. Md. Akhtaruzzaman, Dr. Md. Habibur Rahman,

Dr. Sayera Younus, Coordinator

Research Economists

Md. Kabir Ahmed Md. Shahiduzzaman

Mainul Islam Chowdhury Md. Ezazul Islam Shamim Ahmed

Shubhasish Barua Md. Alauddin Majumder Md. Habibour Rahman

Md. Nehal Ahmed Md. Sakhawat Hossain

Md. Golam Mortaza Lutfunnahar Begum

Assistant Directors

Mohammad Mizanur Rahman Naima Nazneen Rikta Iftekhar Ahmed Robin

Acknowledgement: The document has also benefited greatly form valuable comments and suggestions received from Governor Dr. Salehuddin Ahmed, Deputy Governors M.A.M. Kazemi and Ziaul Hasan Siddiqui, Economic Advisor Habib Ullah Bahar, Executive Directors Md. Nazmul Hoque, K.M. Jamsheduzzaman, Khurshid-ul-Alam, Muhammad Yasin Ali, and other senior officers of Bangladesh Bank.

Monetary Policy Review is published on a bi-annual basis. Soft copies are available at

http:// www.bangladesh-bank.org/research/pau/mpr_07_01 or, www.bangladeshbank.org.bd/research/pau/mpr_07_01

Bangladesh Bank welcomes suggestions and comments from readers, which may be forwarded to: sahsanbb@bangla.net

raisaakhtar@yahoo.com

Policy Analysis Unit Research Department

Bangladesh Bank December 2006

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Financial Sector Review Volume 2, Number 1

December, 2006

List of Contents 

• List of Contributors • List of Contents • Overview and Summary

Chapter 1: The Macro-Financial Environment

1.1 A Brief Sketch of the Financial System in Bangladesh 1.2 Current World Growth Outlook and the Global Environment

(a) World Growth Outlook for FY06 (b) Outlook for FY06 Global Financial and Equity Market Development (c) Global Trade Growth and BOP Outlook for FY06 (d) Global Budgetary Outlook for FY06 (e) Global Inflation and Commodity Price Outlook for FY06

1.3 Recent Bangladesh Macro-Financial Developments

(a) Background (b) Recent Developments (c) The Interest Rate Structure (d) Government Borrowing Needs and Outstanding Debt and its Effects on Private Sector Lending

(e) Balance of Payments & Foreign Exchange Market (f) Micro-Finance (g) The Insurance Industry

1.4 The Extent of Financial Development in Bangladesh (a) Background (b) Indicators of Financial Development (c) Financial Development in Bangladesh: A Cross-Country Comparison (d) Financial Development and Economic Activity Linkage in Bangladesh

Appendix 1.1: Financial Development vs. Economic Activity Linkage Chapter 2: Supply of and Demand for Financial Products

2.1 Payment and Transaction Products 2.2 Saving Products 2.3 Loan Products 2.4 Specialized Loan Products 2.5 Access to Finance by Small and Medium Enterprises (SMEs)

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Chapter 3: The Banking Sector

3.1 Background 3.2 Interest Rate Spread 3.3 Earnings and Profitability 3.4 An Analysis of Non-Performing Loans in Bangladesh 3.5 Divestiture of the Nationalized Commercial Banks 3.6 Default Risk: Write-Offs and Loss Provisions 3.7 Maturity Profile of Assets and Liabilities 3.8 Capital Base Adequacy 3.9 Banking Sector Outlook

Appendix 3.1: Performance of Individual Bank in terms of NPL

Chapter 4: The Capital Market and the Non-Bank Financial Sector

4.1 The Capital Market in Bangladesh (a) Securities and Exchange Commission, DSE and CSE (b) Mutual Fund and Asset Management (c) Merchant Banking and Asset Management (d) Bond: Why Secondary Trading is Absent? 4.2 Non-Bank Financial Institutions 4.3 Microfinance Institutions (MFIs) 4.4 Insurance

Appendix 4.1: The Listing of NBFIs (as of December 2005) Appendix 4.2: Insurance Penetration and Density

Chapter 5: Financial Market Governance Infrastructure

5.1 The Overall Regulatory Framework for the Financial Sector 5.2 The Contractual Framework 5.3 Remittances: Governance and Infrastructure Issues 5.4 Oversight of Payment and Securities Settlement Systems 5.5 Factors Affecting Financial Sector Risk and Stability 5.6 Financial Market Outlook

Chapter 6: The Financial Sector Policy Stance

• References • Technical Appendixes • Boxes

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Chapter 1

The Macro-Financial Environment

1.1 A Brief Sketch of the Financial Sector in Bangladesh1

(a) Background The financial system in Bangladesh includes Bangladesh Bank (Central Bank), scheduled banks, various co-operative banks, non-bank financial institutions, insurance companies, credit rating agencies and capital market. Among scheduled banks there are 4 nationalised commercial banks (NCBs), 5 state owned specialised banks (SBs), 30 domestic private commercial banks (PCBs), 9 foreign commercial banks (FCBs) and 28 non-bank financial institutions (NBFIs) as on 30th November 2006. Besides these, three development financial institutions namely House Building Finance Corporation, Ansar VDP Unnayan Bank and Karma Shangthan Bank are operating in Bangladesh.

(b) Central Bank and its Policies The objectives of the Bangladesh Bank (BB) as the country’s central bank are to manage the monetary and credit system of Bangladesh with a view to stabilizing domestic monetary value and maintaining competitive external par value of Bangladesh Taka towards fostering growth and development of country’s productive resources in the best national interest. Bangladesh Bank supervises and regulates all scheduled banks and non-bank financial institutions operating in Bangladesh. It maintains the traditional central banking roles of note issuance and the banker to the government and banks. Its prudential regulations include, among others: ensuring minimum capital requirements, applying limits on loan concentration and insider borrowing and providing guidelines for asset classification and income recognition. The Bangladesh Bank has the legal authority to impose penalties for non-compliance and also to intervene in the management of a bank if serious problems arise. It has the delegated authority of issuing policy directives regarding the foreign exchange regime.

(c) Scheduled Banks

The scheduled banks in Bangladesh consist of 4 NCBs (of which, agreement to sell out the Rupali Bank to the foreign buyer has already been signed), 5 SBs, 30 PCBs and 9 FCBs as of end October 2006. Out of 6458 bank branches operating in the country the NCBs have 3384 branches, of which 2146 are in rural areas and 1238 are in urban areas; SBs have 1350 branches of which 1198 are in rural areas and 152 are in urban areas; PCBs have 1678 branches of which 447 are in rural areas and 1231 are in urban areas; and FCBs have 46 branches only in urban areas. Out of 30 PCBs seven have been operating as Islamic banks. Besides these

1 Prepared by Md. Habibour Rahman, RE and Md. Sakhawat Hossain RE.

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full-fledged Islamic banks four2 conventional banks in the private sector have opened some selected branches and Islamic banking counters respectively to deal with the Islamic banking business parallel to their conventional operations. NCBs owned 65.3 percent while PCBs, SBs and FCBs own 24.5 percent, 6.6 percent and 3.6 percent respectively of total assets of the scheduled banks. Of the total deposits NCBs share 38.8 percent while SBs, PCBs and FCBs shared 5.8 percent, 48.7 percent and 6.8 percent respectively. Among of PCBs the Islamic Banks share of deposits is 12.5 percent. On the other hand NCBs disbursed 32.3 percent of total advances while SBs, PCBs and FCBs disbursed 9.3 percent, 51.5 percent (of which 14.8 percent o disbursed by the Islamic Banks) and 6.9 percent respectively.

(d) Non-Bank Financial Institutions (NBFIs) Non-Bank Financial Institutions are the most important part of financial system in Bangladesh. NBFIs operations are regulated under the Financial Institutions Act 1993. The NBFIs consists of investment, finance, leasing companies etc. There were 29 financial institutions operating in Bangladesh as of 30 November 2006. Of these one is government owned, 15 are local (private) and the other 13 are established under joint venture with foreign participation. Bangladesh Bank has introduced a policy for loan and lease classification and provisioning for NBFIs from December 2000 on a half-yearly basis. Among the 29 financial institutions, 12 have been listed in the capital market up to 30 November 2006 to strengthen financial capability and the rest are under process to be listed in the capital market.

Capital Market The capital market in Bangladesh is yet to play its potential role as vehicle for financing long term investment. It is regulated and supervised by the Securities and Exchange Commission under the Securities and Exchange Commission Act, 1993. In addition Bangladesh Bank exercises powers under the Financial Institutions Act 1993 and regulates institutions engaged in financing activities including leasing companies and venture capital companies. The SEC so far has issued licenses to 27 institutions to participate in the capital market of which 19 institutions are Merchant Banker and Portfolio Manager while 7 are Issue Managers and 1(one) acts as Issue Manager and Underwriter.

The Dhaka Stock Exchange (DSE) which was established as a Public Limited Company in April 1954 and the Chittagong Stock Exchange (CSE) established in April 1995 are dealing in the secondary capital market. As of end November 2006 the total number of enlisted securities with DSE stood at 304 of which 254 are listed companies, 13 mutual funds, 8 debentures and 34 treasury bonds.3 Recently, two power sector companies namely Dhaka Electric Supply Company (DESCO) and Power Grid Company of Bangladesh (PGCB) have been listed in the capital market under the newly introduced direct listing regulation.

2 Prime Bank Ltd., Dhaka Bank Ltd., Jamuna Bank Ltd. and Premier Bank Ltd. 3 Note that as of end November 2006 around 215 of the DSE listed companies are also listed in the CSE.

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The Investment Corporation of Bangladesh (ICB) was established in 1976 with the objective of encouraging and broadening the base of industrial investment. ICB underwrites issues of securities, provides substantial bridge financing programs, and maintains investment accounts, floats and manages closed-end and open-end mutual funds and closed-end unit funds to ensure supply of securities as well as generating demand for securities. ICB also operates in the DSE and CSE as dealers. Some SBs, such as Bangladesh Shilpa Bank (BSB), Bangladesh Shilpa Rin Sangstha (BSRS), Bangladesh Small Industries and Commerce (BASIC) Bank Ltd. as well as NCBs and some foreign banks are engaged in long-term industrial financing.

(e) Insurance The insurance sector is regulated by the Insurance Act, 1938 with regulatory oversight provided by the Controller of Insurance on authority under the Ministry of Commerce. A total of 62 insurance companies have been operating in Bangladesh, of which 18 companies are life insurance and 44 are general insurance. Among the life insurance companies, the state owned Jiban Bima Corporation comprises the largest share and foreign American Life Insurance Company (ALICO) and out of 44 general insurance companies; state owned Shadharan Bima Corporation (SBC) is the most active in the insurance sector. Total 31 insurance companies are listed in the capital market, of which 8 are life insurance.

(f) Microfinance Institutions (MFIs) In recognition of the robust microfinance activities in eradicating poverty, the Grameen Bank and its founder, Dr. Muhammad Yunus have been awarded Nobel Prize 2006 for peace. Now, it has been established worldwide that microfinance can be used as an effective anti-poverty tool.

The member-based Microfinance Institutions (MFIs) have an explicit social agenda to cater to the needs of the poorer sections of population, and have a focus towards women clients. Grameen Bank was established in 1983 under a special law with the initial support from the Bangladesh Bank. The typically landless borrowers of Grameen Bank who are mostly women are owners of the bank and it is the pioneer organization of this type. Besides Grameen Bank, there are more than 1000 semi-formal institutions operating mostly in the rural sector of the country; of these, BRAC, ASA, and PROSHIKA are considered three largest NGO-MFIs.

MFIs in Bangladesh were left unregulated for a long time since their inception. The government, with the close cooperation of Bangladesh Bank, undertook huge efforts, to establish a regulatory framework which culminated in the enactment of the Microcredit Regulatory Authority Act (MRAA) on 27 August 2006. The Act is containing 52 articles and 98 sub-articles. An Executive Board consisting of eight members will be responsible for executing the general and administrative tasks of the management. The Board will incorporate the Governor of Bangladesh Bank as ex-officio chairman, six government officials nominated by the government and one executive vice president who will be also the member

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secretary of the board. The main responsibilities of the authority include issuance and cancellation of the license for microcredit, overseeing, supervising and facilitating the whole activities of the MFIs.

BRAC, one of the largest MFIs in Bangladesh, has taken recourse to structured finance by securitizing its microcredit operation recently. This revolutionary innovation is for the first time in Bangladesh. It is anticipated that if the process of microcredit securitization can go well and unhindered it will open up the opportunity for MFIs to diversify source of fund, reduce on-balance assets and have abundant fund for disbursement.

(g) Cooperative Banks In Bangladesh 119 cooperative banks are operating, f which 64 are central cooperative banks, 48 are land mortgage and rest 7 are other cooperative banks. The maximum share of total assets (90 percent) occupied by central cooperatives. Similarly maximum share deposits (85 percent) and advances (90 percent) are handled by central cooperatives.

1.2 Current World Growth Outlook and the Global Environment (Write-up on this section is in progress pending data availability)

1.3 Recent Bangladesh Macro-Financial Developments 4

(a) Background A healthy financial sector can spur economic growth. There are some obstacle to get better financial services for poor people, rural entrepreneurs, and small and medium size enterprises of Bangladesh. Providing, sufficient credit and other financial products to the private sector output growth can be optimize. It can also play an important role in reducing risk and vulnerability, and increasing the ability of individuals and households to access basic services like health and education, thus having a more direct impact on poverty reduction. As the mission is to achieve the Millennium Development Goals (MDGs) and the elimination of poverty by 2015, an assessment of the overall financial sector in Bangladesh is, therefore, crucial. The historical aspects macrofinancial developments had already been described in the earlier issue of FSR. The current section of the FSR discusses the recent developments in the macro financial environments in Bangladesh.

(b) Recent Developments Developments in the macro financial environments in addition to the last issue of FSR are:

4 Prepared by Md. Habibour Rahman, RE and Md. Sakhawat Hossain RE.

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(i) Successful negotiation of denationalization of Rupali bank;

(ii) To strengthening the capital market and attract the foreign and other well known companies to be listed in the capital market direct listing regulation have been approved by the SEC;

(iii) The government, with the close cooperation of Bangladesh Bank, undertook huge efforts to establish a regulatory framework which culminated in the enactment of the Microcredit Regulatory Authority Act (MRAA) on 27 August 2006;

(iv) The issue of Credit Rating of the banks has been reviewed further and with a view to safeguard the interest of the prospective investors, depositors and creditors and also the bank It has been decided to make it mandatory from January 2007 for all banks to have themselves credit rated by a Credit Rating agency;

(v) In term of Finance Act 2006, regulations have been made for collection of 3% Income Tax at source on credit bills for Credit Card users through the addition of new article 53GGG to the Income-Tax Ordinance, 1984;

(vi) Constituents of Supplementary Capital (Tier-2) has been reviewed and it has been decided to replace "General provision (1% of unclassified loans)" by "General provision maintained against unclassified loans". As such the components of Supplementary Capital now stands as: (a) General provision maintained against unclassified loans, (b) Assets Revaluation Reserves, (c) All other Preference Shares, (d) Perpetual Subordinated debt and (e) Exchange Equalization Account.

(vii) To encourage export trade, export subsidy/cash incentive policy has been further reviewed;

(viii) To promote the infrastructure development through private sector entrepreneurs the Government of Bangladesh (GoB) has signed a Financing Agreement for SDR 34.9 million (equivalent US$ 50.00 million) on 01 June 2006 with the International Development Association (IDA) in connection with implementation of the Investment Promotion and Financing Facility (IPFF) Project. The GoB and Bangladesh Bank have signed an Administrative Agreement on 21 August 2006 empowering Bangladesh Bank to administer and implement the project on behalf of GoB.

The monetary authority of Bangladesh has been continuing a series of Legal, Policy and Institutional reforms to improve the process of financial intermediation and ensure efficient allocation of financial resources and in the ultimate analysis improve the competitiveness of the private sector and thereby promote investment and growth in the real sector. The reform program focuses on: (i) greater autonomy to the Bangladesh Bank (BB); (ii) strengthening of the BB's capabilities and technical skills to perform its enhanced responsibilities; (iii) strengthening prudential regulations and supervision; (iv) restructuring the management and internal processes of NCBs and ultimately privatization of selected NCBs and

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SBs, (v) strengthening the legal and judicial processes and (vi) improving the money and debt markets.

(c) The Interest Rate Structure 5

Under the FSRP of the 1990s, commercial banks have been allowed to set both lending and deposit rates in line with market conditions, which were previously determined by the BB. Over the past decade or so, it is seen that the bank rate (i.e., the rediscounting rate of BB) has had an effect on the money market rates. Following the reduction of the bank rate, lending rates as well as deposit rates have also been reduced more or less proportionately in nominal terms. Starting from May 2003, both commercial lending and deposit rates have declined in nominal as well as in real terms (i.e., inflation adjusted) and continued up to the end of January 2006 (Figure 1.3.1).6 In particular, commercial banks increased deposit as well as lending rates in response to the rate increase of NSD certificates (3 and 5-year terms) in December 2005 by a comparable magnitude. It is also observed that the commercial real deposit rate becomes negative starting from June 2004 due to inflationary pressure. Moreover, all the above observations remain valid when lending and deposit rates of all scheduled banks of the country are considered except real deposit rate turns to be marginally positive in the July-September quarter of 2006 (Figure 1.3.2). If this situation persists, private sector savings as well as investment in the economy are likely to be discouraged in the near future. Finally, it is also noticeable that the spread remains high over the years (Figure 1.3.1 and 1.3.2), a point that has been explored in more detail in chapter 3.7

Figure 1.3.1: Nominal and Real Interest Rates: Commercial Lending and Deposit; and Bank Rates (monthly weighted average in percent)

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Commercial Lending Rate Commercial Deposit Rate

Commercial Real Lending Rate Commercial Real Deposit Rate

Note: 1. Monthly real rates have been calculated by subtracting monthly inflation rate (measured by 12 months average CPI, base: 1995-96=100) from the respective monthly nominal rates.

Source: Constructed based on data from Monetary Policy Department and Economic Trends, BB.

5 This section has been prepared by Shamim Ahmed. 6 Commercial lending and deposit rates are the monthly weighted average rates of 7 major scheduled banks of the country. Conversely, the lending and deposit rates of all scheduled banks are calculated only on a quarterly basis. 7 Spread of banks, also known as the banking spread, is the difference between weighted average commercial lending and deposit rates. It is basically a crude measure of the cost of intermediation in the banking industry. Therefore, higher banking spreads are unfavorable for the economy since these indicate institutional inefficiencies.

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Figure 1.3.2: Nominal and Real Interest Rates (All Banks): Lending and Deposit; and Bank Rates (quarterly weighted average in percent)

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Note: 1. Quarterly real rates have been calculated by subtracting quarterly inflation rate (measured by 12 months average CPI, base: 1995-96=100) from the respective quarterly nominal rates.

Source: Constructed based on data from Monetary Policy Department and Economic Trends, BB.

In actual practice the overnight market appear not to directly influence the lending and deposit rates prevailing in Bangladesh.8 The bank rate, which has of late not been targeted to be a major instrument of monetary control, does appear to influence the pattern of the deposit rate, and thus the lending rate as well. However, from the savers’ perspective a significant substitute of private bank deposits appears to be NSD certificates of different maturities, and others of this genre, especially, the postal savings certificates. In December 2005, there has been an increase in nominal yield rates of all types of NSD certificates. As a result, sales of NSD certificates in December 2005 and January 2006 moved up to BDT 11562.50 million and BDT 16331.10 million respectively as compared to BDT 8281.50 million in November 2005. Sales and redemption of NSD certificates during the July-December period of 2005 stood higher at BDT 60040.40 million and BDT 52019.50 million respectively compared to BDT 47428.60 million and BDT 38575.80 million during the same period of the preceding year. Therefore, net borrowing (i.e., net sale) through NSD certificates during July-December, 2005 stood lower at BDT 8020.90 million compared to BDT 8852.80 million during the same period of the preceding year. However, net borrowing through this instrument during July 2005 to January 2006 stood higher at BDT 15271 million compared to BDT 12221.20 million during the same period of the preceding year. This indicates a significant shift of private bank deposits to NSD certificates.

An interesting picture is observable, if the pattern of lending and deposit rates of the country is compared with that of India, Pakistan, and Sri Lanka. In India, lending rates and deposit rates in nominal as well as real terms are more or less similar to those of Bangladesh with a few exceptions. In particular, nominal prime lending rates of public sector banks were within the range of 10.25 to 11.25 percent and deposit rates of various maturities were within the range of 2.75 to 7 percent during December 2006. Moreover, real lending and deposit rates in India have also continued to decline due to inflationary pressure although they were higher than those in Bangladesh, Pakistan and Sri Lanka. In contrast, Pakistan has

8 See Monetary Policy Review (October 2005), chapter 3 for an elaboration.

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the lowest lending and deposit rates (both in the low single digit) in nominal terms as well as real terms among these South Asian countries starting from June 2003. Moreover, the spread of the banking system remains moderate in the low single digit. On the contrary, the lending and deposit rates in Sri Lanka have been the highest among these countries in nominal terms. The bank rate in Sri Lanka remains high at 15 percent since 2003 and the commercial lending and deposit rates are above 11 percent and 5.70 percent respectively since August 2005. Therefore, the spread of the banking system remains at a high single digit, the highest in South Asia.

Figure 1.3.3 shows the recent monthly trends of repo and reverse repo rates. It can be observed that between October 2003 and November 2004, both repo and reverse repo rates remained moderately low compared to January 2005 and onwards. In May 2003, the BB had withdrawn a large quantity of excess liquidity through reverse repo operations. The high repo rates observed again in 2005, originated from the tight liquidity situation that prevailed from January to May and then eased a bit which again become tight in the last quarter of 2005. Simultaneously, as in the case of previous years, the BB had withdrawn excess liquidity through higher reverse repo rates starting from August 2005. Along with repo, reverse repo, it can be observed that from July 2003 to December 2004, the call money rate has remained more or less stable in the low single digit, although, in the first quarter of 2003 it was high in double digits. In 2005, the call money rate remained high in double digits between January and May and afterwards, particularly, from June it fell to a low single digit level up to December. The contributing reason behind this situation is the tight liquidity position in the first half of 2005 and subsequent injections of considerably large liquidity associated with seasonal increased levels of government expenditures. Again in January 2006, the call money rate has reached 14.87 percent although it declined a bit in February 2006 to 12.13 percent. However, the call money rate reached 21.54 percent in April 2006 (highest in 2006) and started declining afterwards. As cited above, these overnight rates have not had a direct influence on the deposit and lending rates.

Figure 1.3.3: Repo, Reverse Repo: 1-2 day and 3-9 day, and Call Money Rates

(monthly weighted average in percent)

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Call Money Rate 1-2 Day Repo Rate3-9 Day Repo Rate 1-2 Day Reverse Repo Rate 3-9 Day Reverse Repo Rate

Note: 1. In the above figure, the discontinuous lines originate from the non-availability of data since auctions were not held in those respective months.

Source: Constructed based on data from Monetary Policy Department and Economic Trends, BB.

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Since July 2006, to enhance the ability of monetary intervention, BB has introduced its 30-day and 91-day BB bills. Figure 1.3.4 shows the movement in the yield rates of government treasury bills and BB bills with different terms of maturity in recent years.9 Between October 2002 and July 2003, yield rates of all types of government treasury bills remained high in nominal terms. From October 2003 to January 2005, all yield rates remained moderate in low single digits. Starting from February 2005, there has been an increase in all nominal yield rates (less for the 28-day maturity) due to somewhat tight monetary policy pursued by the BB as well as a higher credit demand. In particular, the weighted average yields on 28-day and 364-day treasury bills have increased to 7.28 percent and 8.42 percent respectively as of November 2006 compared to 7.00 percent, 7.68 percent, and 8.42 percent respectively in January, 2006. It is worth mentioning that if all yield rates are considered in real terms, a declining trend in real rates is observable in the economy due to a pick up in the inflation rate since the start of FY06.

Figure 1.3.4: Nominal Yield Rates of Treasury Bills (monthly weighted

average in percent)

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Note: 1. In the above figure, the discontinuous lines originate from the non-availability of data since auctions

were not held in those respective months. Source: Constructed based on data from Monetary Policy Department and Economic Trends, BB.

Figure 1.3.5 shows the most recent trend of the nominal yield rates of 5 and 10-year BGTBs. It can be observed that both yield rates in nominal terms have declined a bit since September 2004 with a gradual rise starting from April 2005. In addition to BGTBs, in December 2005, the government as noted already increased the yield rates of term NSD certificates. Particularly, the nominal yield rate on the 5-year term NSD certificate has been increased to 12 percent from the previous rate of 10.5 percent and the 3-year term NSD certificate has been fixed at 11.5 percent from 10 percent. In December 2005, the nominal yield rate on the pensioner certificate has also been increased from 11 percent to 12.5 percent and that on the postal savings certificate from 11.5 percent to 12 percent. Nominal yield on 5-year and 10-year maturity BGTB have increased from 10.50 percent

9 The auction of 5-year treasury bill has been discontinued since March 2004.

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and 11.65 percent respectively in December, 2005 to 10.60 percent and 12.09 percent respectively in February, 2006.

Figure 1.3.5: Nominal Yield Rates of BGTBs and NSD Certificates (monthly weighted average in percent)

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5-Year BGTB Rate 10-Year BGTB Rate3-Year NSD Certificate Rate 5-Year NSD Certificate Rate

Note: 1. In the above figure, the discontinuous lines originate from the non-availability of data. Source: Constructed based on data from Monetary Policy Department and Economic Trends, BB.

Finally, it can be concluded that with a reversing of the declining trend of recent years, both the nominal lending and deposit rates in the economy have started to increase steadily since the beginning of 2006. Besides, real lending and deposit rates have also started increasing gradually since January 2006, particularly, real deposit rates turns to be marginally positive in the July-September quarter of 2006. The deepening spread between lending and deposit rates of scheduled banks remain a feature that is of concern. If this situation persists, an adverse effect on the economic stability is likely to arise. It is also evident from the above analysis that the various short-term rates (e.g., repo, reverse repo) have allowed BB to have greater control over the overnight money market of the country. Nevertheless, as the inflationary and exchange rate pressures are persisting, BB’s involvement in the overnight money market is likely to remain crucial.

(d) Government Borrowing: Effects on Private Sector Lending10

Introduction With a view to financing budget deficit and meeting sudden expenses, government resorts to borrowing from domestic (both bank and non-bank) and external sources. It has long been a policy issue how and to what extent government borrowing affects overall economic activity. Generally, it can be argued that government borrowing from commercial banks reduces economic activity through raising interest rates and crowding out available funds for private

10 This Section is Prepared by Lutfunnahar Begum, Research Economist, PAU.

10

sector credit. Government borrowing from non-bank domestic sources attract funds from savers into government treasury bills, bonds, NSD certificates, etc. that would otherwise have been invested into corporate stocks. Since in most cases government borrowing is used for wealth redistribution rather than income generating productive investments, continued government borrowing may affect economy’s long-term flow of productive investment and capital formation. However, to what extent government borrowing affects private saving and investment depends on how the borrowed money is utilized and also on the specific characteristics of the economy.

Recent Trend of Government Borrowing Government borrowing from domestic sources has been much higher than foreign borrowing in recent years except 2002-03, as shown in Table 1. Among the domestic sources, borrowing from banking system has exceeded non-bank borrowing and borrowing from banks has arisen from Bangladesh Bank rather than scheduled banks in last two years. In 2005-06, domestic borrowing has comprised more than 62 percent of total Government borrowing amounting Tk. 134.33 billion. While borrowing from Bangladesh Bank is Tk. 89.38 billion, net borrowing from scheduled banks amounts Tk. -33.11 billion in 2005-06. The negative net borrowing from scheduled banks implies that government has paid back to the scheduled banks by borrowing a large amount from Bangladesh Bank.

Table 1: Net Flow of Government Borrowing (in Billion Tk.)

Year Borrowing from Banking System Non-bank Domestic Foreign

Bangladesh Scheduled Sub-Total Borrowing Borrowing Borrowing

Bank Banks 2001-02 27.27 -1.59 25.68 47.11 72.79 58.58 2002-03 -25.9 16.07 -9.83 47.95 38.12 65.6 2003-04 16.53 10.16 26.69 45.99 72.68 32.8 2004-05 38.27 -1.43 36.84 29.08 65.92 49.7 2005-06 89.38 -33.11 56.27 27.59 83.86 50.47 Source: Economic Trends and Major Economic Indicators: Monthly Update, MPD; various issues, Bangladesh Bank During the first quarter of FY07, a total of Tk. 34.78 billion has been borrowed, out of which Tk. 32.35 billion has come from domestic sources. Total borrowing during the first quarter of FY06 was Tk. 22.99 billion, out of which Tk. 11.31 came from domestic sources. Domestic borrowing during this period has increased by more than 100 percent, while foreign borrowing has followed just opposite trend, as shown in Figure 1. In case of domestic borrowing, borrowings from the Scheduled banks and non-bank sources have increased by more than 100 percent, while borrowing from Bangladesh Bank shows just opposite picture, compared to the same period in previous year.

11

Figure 1: Recent Trend of Government Borrowing

-20

-10

0

10

20

30

40

July-September, FY07 July-September, FY06

Period

Borr

owin

g (in

Bill

ion

Taka

)

Borrowing from Bangladesh Bank Borrowing from Scheduled Banks Non-bank BorrowingNet Foreign Borrowing

Source: Economic Trends and Major Economic Indicators: Monthly Update, MPD; various issues, Bangladesh Bank

The dominance of domestic borrowing over foreign financing in recent years and in the first quarter of FY07 attributes mainly to the lower aid receipts. Total aid disbursements and net receipts of foreign aid during the first quarter of FY07 was US$ 129.26 million and US$35.19 million, respectively compared to US$273.84 million and US$ 179.64 million, respectively during the same period of the previous year (Major Economic Indicators: Monthly Update, MPD, November 2006).

Government Borrowing and Outstanding Debt vs. Private Sector Credit Claims on Govt. by DMBs stood at Tk. 101.39 billion during September 2006, which was Tk. 111.94 billion during September 2005, showing a decline of almost 9 percent. On the other hand, claims on private sector increased by almost 18 percent, amounting to Tk. 1347.25 billion in September 2006 from Tk. 1144.74 billion in September 2005.

Figure 2: Growth of Total Credit to the Government Sector (GGDMB) and Private Sector (GPDMB) from DMBs

-40

-30

-20

-10

0

10

20

30

2001-02 2002-03 2003-04 2004-05 2005-06

year

Gro

wth

rate

GGDMB GPDMB Source: Economic Trends, various issues, Bangladesh Bank

12

Figure 3: Growth of Total Credit to the Government Sector From Banking Sources (GGB) and Private Sector Credit (GPC)

-10

-5

0

5

10

15

20

25

2001-02 2002-03 2003-04 2004-05 2005-06

year

Gro

wth

rate

GGB GPC Source: Economic Trends, various issues, Bangladesh Bank

A portrayal of the growth in the credit by DMBs over the past five years indicates that the growth rate has increased slightly for private sector, while it has declined sharply for the public sector, reaching negative growth from 2004-2005,as shown in Figure 2. Again, as shown in Figure 3, the growth rate of government credit from banking sources shows a sudden fall reaching negative growth in 2002-03 and starts rising in the following years, while private sector credit shows a steady rise over the years. Growth of government credit from banking sources has exceeded private sector credit growth during 2005-06.

Figure 4: Growth of Total Internal Debt (GID) and Private Sector Credit (GPC)

0

5

10

15

20

25

2001-02 2002-03 2003-04 2004-05 2005-06Period

Gro

wth

rate

GPC GID Source: Economic Trends, various issues, Bangladesh Bank

Figure 4 depicts the growth of outstanding domestic debt and private sector credit in recent years. It shows more fluctuation in the growth of outstanding domestic debt than private sector credit growth. The graphical representation depicted above shows the trend of government borrowing and debt and private sector credit over the past few years. The question of whether government borrowing is crowding out private sector credit, however, cannot be answered from this. To have an idea about the effect of government borrowing on private sector credit, simple OLS regressions have been performed.11 The equation to estimate the effects of government borrowing has been considered as follows: PC= ß0 + ß1 GB + ß2 GNB + ß3 INT + ß4 @trend + U

11 The regression is based on quarterly data for the period September 2001-September 2006.

13

Where, PC = Private sector credit GB= government borrowing from banking system GNB= government borrowing from non-bank sources INT= scheduled banks’ lending rate (weighted average) U= random error term

The estimated results have been reported in Table 2. The results suggest that government borrowing from non-bank sources (GNB) exerts a significant negative effect on private sector credit (PC) in Bangladesh. According to the results obtained, on average, a 1 percent increase in government non-bank borrowing leads to a decline in private credit by 1.48 percent. However, as the OLS estimations suggest, government borrowing from banking sources (GB) seems not to exert any significant effect on private sector credit. Table 2: Estimation results of OLS Regression Dependent Variable: PC Method: Least Squares Sample: 2001:3 2006:3 White Heteroskedasticity-Consistent Standard Errors & Covariance

Variable Coefficient Std. Error t-Statistic Prob. C -0.699839 60.10218 -0.011644 0.9909

GB 0.107541 0.170664 0.630131 0.5375 GNB -1.481959 0.757532 -1.956297 0.0681 INT 3.062791 4.597121 0.666241 0.5147

@TREND 1.397264 0.764121 1.828591 0.0862 R-squared 0.355747 Mean dependent var 36.06667 Adjusted R-squared 0.194683 S.D. dependent var 18.62939 S.E. of regression 16.71791 Akaike info criterion 8.675095 Sum squared resid 4471.816 Schwarz criterion 8.923791 Log likelihood -86.08850 F-statistic 2.208737 Durbin-Watson stat 2.587384 Prob(F-statistic) 0.114146

Conclusion The trend analysis shows that government borrowing shows a reversal pattern in the last two years, with domestic borrowing dominating foreign financing and borrowing from banking system exceeding that from non-bank sources. The analysis suggests that the private sector credit growth follows a steadily increasing trend, while growth in government credit and debt follows a more fluctuating trend. While government borrowing from non-bank sources seems to have a negative influence on private sector credit, the analysis finds no significant effect of government borrowing from banking system on private sector credit in Bangladesh. However, there is scope for further extensive research in order to find out the effect of government borrowing on private sector lending through developing a well-articulated model.

14

(e) Balance of Payments and Foreign Exchange Market12

(i) Balance of Payment Situation

Significant growth in exports and worker’s remittances and decelerated growth in imports were some of the favourable factors in the balance of payments development of FY06, which helped attaining an overall balance surplus of USD 365 million, against USD 67 million in FY05. There was a reduction in trade deficits by around USD 418 million and increase in the flow of worker’s remittances by USD 954 million. During the same time, however, financial account turned into a deficit of USD (-) 24 million, where foreign direct investment declined by around USD 125 million.

Following the record export and remittance growth in FY06 by 21.63 percent and 24.8 percent respectively, both reflect the same trend in the first four months of FY07. During the period export earnings increased by 23.92 percent and remittance by 27.26 percent over the same quarter of FY06. On the other hand, import payments increased by 19.39 percent during the July- October’06. At the same time, services and income account deficit increased by USD (-) 168 million and USD (-) 70 million respectively. There was also a fall in capital transfer during the July-October FY07, reduced to 6 million USD in FY06 from USD 126 million in FY05. Still current account balance recorded significant surplus in the first four months, which is higher by 14.67 percent over the same period of previous year. Financial account deficit also reduced to USD (-) 67 million in July-October FY07 from USD (-) 289 million in the same period of FY06 despite the fall in foreign direct investment by 17.35 percent. Due to positive inflow of short term loans and coupled with reduction in the outflow of trade credit. These factors altogether resulted in overall balance surplus of USD 82 million at the end of first four months of present fiscal year. (ii) Export

Following the record export growth of 21.63 percent in FY06, export earnings maintained its increasing trend in the first four months of FY07, which increased by 30.14 percent (or 799.35 million USD) over the same period of FY06. Knitwear products that recorded an impressive growth of 35.38 percent in FY06 increased by 30.14 percent during July-October period of FY07 thereby added an extra 370.68 million USD. At the same time, woven garments that showed a sign of good prospect in the last fiscal year with a growth of 13.5 percent also showed impressive outlook for FY07 –increased by 24.4 percent in the first quarter of FY07. Increase in exports of frozen food, engineering products and home textiles by 18.61, 34.53 and USD 58.05 million respectively, also contributed to the total export growth.

12 Prepared by Shubhasish Barua, Research Economist.

15

Figure 1.3.1: Percent Change of Export in FY07 Over FY06 (Jul-Oct)

24.4

30.1

18.6

34.5

-13.9-8.5

-20.0 -10.0 0.0 10.0 20.0 30.0 40.0

Woven Garments

Knitwear

Frozen Food

Engg. Products

Chemical Products:

Jute Goods

In FY06, RMG exports to European countries declined by 4.63 percent (or 190.8 million USD) in comparison to FY05, at the same time it increased by 31.29 percent (or 633.9 million USD) in USA. One important development of the period is that there was significant diversification of the destination RMG export, reflected in the increased flow of export to other countries, which added 1040 million USD more over the previous fiscal year.

In the first quarter of FY07 export performance in the European countries improved significantly as both Knitwear products and Woven garments recorded an impressive growth of 34.1 and 48.7 percent respectively in the region. RMG exports to USA and other countries also maintained their increasing trend with 15.9 and 44.7 percent growth over the same quarter of last fiscal year.

(iii) Import In FY06 import payments increased by 12.17 percent in comparison to FY05, the lowered import growth is attributed to reduction in food grain and other food items imports. On the other hand, imports of consumer & intermediate goods and capital goods & others increased by 15.66 and 17.11 percent respectively.

Figure 1.3.2: Growth Import in FY07 over FY06 and FY06 over FY05 (July- October)

35.3

19.3

3.9

51.946.0

58.8

27.3

37.2

15.0

28.0

-8.0

20.6

-5.4

15.4

-20

-10

0

10

20

30

40

50

60

70

POL Chemicals Rawcotton

Yarn Textilesand

articles

Iron, steel& basemetals

CapitalMachinery

perc

ent

Growth FY06 over FY05Growth FY07 over FY06

As per the available figures, in the first quarter of FY07 capital goods imports shows mixed pictures; capital machinery import increased by 96 million USD (or 28 percent), however, that of iron, steel & other base metals declined by 11

16

million USD (or 5.4 percent). Prospective import growth of RMG related goods is also observed in the first quarter of FY07 over the same quarter of FY06, where imports of yarn increased by 37.2 percent, raw cotton by 27.3 percent and textiles and articles by 15 percent. On the other hand, import payments decreased for crude petroleum, 20 million USD (or 16.81 percent) and that of POL increased substantially, 151 million USD (or 58.75 percent).

(iv) Remittance

The flow of worker’s remittances that registered a record growth of 24.75 percent (or 953.59 million USD) in FY06 over FY05 continues its prospective trend in the first four months of FY06. In FY06 significant increase in the flow of worker’s remittances from UK, KSA, UAE and Kuwait contributed to the growth. During the period remittance increased by around 18.14 percent thereby adding an extra 262.19 million USD over the same period of previous fiscal year. During the first three months of the present fiscal year remittances from UK grew significantly, around 36.16 percent of the total remittance growth of 262.2 million USD came from UK (Figure 1.3.15).

Figure 1.3.15: Workers’ Remittances from Major Countries in (July-October) FY07 and FY06

36.2

15.915.9

6.1

4.70

100

200

300

400

500

600

KSA UAE USA UK Kuwait

Mill

ion US

700

D

0

5

10

15

20

25

30

35

Percen

tage

Sha

r

40

e Jul-Sep FY06 Jul-Sep FY07 Share in Growth

At the same time worker’s remittances from UAE and Kuwait also grew significantly by 15.87 and 15.93 respectively. On the other hand, remittance growth for Saudi Arabia and USA, two main sources of worker’s remittances, were not significant. (v) Foreign Exchange Market

The weighted average BDT/USD exchange rate stood at BDT 68.99 at the end of November’06 from BDT 65.87 in the same period of the previous year, however, widely fluctuated within a range of BDT 65.87 to 72.41 during the period under comparison. Gross foreign exchange Reserve (GIR) reached to USD 3533.73 million at the end of November 2006, which is significantly higher than USD 2416.80 million recorded in October 2005. As per the available figure, in first quarter, import LCs opening also increased by 19.39 percent, thereby showing an early indication that import payment may well surpass the FY06’s restrained growth of 12.17 percent in comparison to FY05. Significant increase in worker’s remittances in November, which added 598.289 million (provisional) during the month also contributed to the healthier situation in the foreign exchange reserve

17

situation. With the stable tight monetary policy stance and relatively comfortable reserve situation, the foreign exchange market is expected to remain stable in FY07.

Figure 1.3.15 BDT/USD Exchange Rate

62.064.0

66.068.070.0

72.074.0

01-0

1-06

29-0

1-06

22-0

2-06

19-0

3-06

13-0

4-06

09-0

5-06

01-0

6-06

26-0

6-06

18-0

7-06

10-0

8-06

05-0

9-06

28-0

9-06

29-1

0-06

22-1

1-06

17-1

2-06

BDT/USD Exchange Rate

(f) Micro-Finance Microfinance in Bangladesh has been so extraordinarily successful both in eradicating poverty at home and in paving the way for world-wide poverty reduction that it has been able to draw the attention of the prestigious Norwegian Nobel Prize Committee. The committee has awarded the Grameen Bank, the leading micro-financier in Bangladesh, and its founder eminent economist Professor Dr. Muhammad Yunus, Nobel Prize 2006 for peace as recognition of their extensive contribution towards anti-poverty movement through micro-financial activities. As was reviewed in the previous ‘Financial Sector Review’, the microfinance sector in Bangladesh has been moving up in terms of size and relative share of total private sector credit. Table-1, showing the relative share of microcredit in total private sector credit as well as the comparison of the same with the GDP, confirms that the trend was not different during the FY06. According to the table, the share of microcredit in total private sector credit rose by 51 basis points in FY06 from 6.5 percent in FY05. The magnitude of microcredit also increased as percentage of GDP from 2.14 percent in FY05 to 2.45 percent in FY06. It is also found from the table that the gross disbursement and the gross outstanding of microcredit in FY06 over the previous fiscal year was higher by 30.79 and 28.73 percent respectively whereas the comparable figures for FY05 were 23.93 and 23.38 percent respectively, indicating that the progress of microfinance activities in Bangladesh happened at an exponential pace. A clearer picture can be had by looking at the latest statistics of the four big NGOs, the key providers of the microfinance services. The statistics suggests that till the end of the first quarter of FY07 they, covered a respectable number of beneficiaries (****), and disbursed a cumulative amount of (****). Meanwhile their cumulative savings reached (****).

18

Table-1.3.3: Growing Importance of Microfinance in the Bangladesh Economy (in million BDT)

FY02 FY03 FY04 FY05 FY 0613

Four big NGOs* Disbursement 49200 62200 76000 95300 129600 Outstanding loan 34300 40700 49900 60800 80600 Nationalized commercial banks Disbursement 6332 6430 8230 8849 9756 Outstanding loan 6368 5682 5671 7171 8319 Ministries and other govt. organs Disbursement 5048 6125 7885 10013 9962 Outstanding loan 6036 6842 8612 11224 13032 Gross14 Disbursement 60580 74755 92115 114162 149318 Outstanding loan 46704 53224 64183 79195 101951 Total private sector credit (outstanding) 796500 903600 1039600 1218600 1454000 GDP at current market price 2732010 3005800 3329730 3707100 4161600 Microcredit as % of private sector credit15 5.86 5.89 6.17 6.50 7.01 Microcredit as % of GDP16 1.71 1.77 1.93 2.14 2.45

Sources: 1. Bangladesh Economic Review 2006, Ministry of Finance 2.Various issues of Bangladesh Bank Quarterly, Bangladesh Bank *Grameen, ASA, Brac and Proshika.

References

Ministry of Finance (2006), Bangladesh Economic Review 2006, Dhaka, Ministry of Finance. Bangladesh Bank Quarterly, Various issues, Bangladesh Bank, Head Office, Dhaka.

(g) The Insurance Industry

(Write-up on this section is in progress pending data availability)

13 Figures of the institutions other than four big NGOs have been estimated on the basis of half yearly actual data. 14 These gross figures are somewhat distorted as they consider only four big NGOs (Grameen, ASA, Brac and

Proshika) rather than all. The distortion is however ignorable because as compare to the four big NGOs the contribution of the remainder is very little.

15 Calculated on the basis of outstanding figures. 16 Calculated on the basis of outstanding figures for microcredit and flow figures for GDP.

19

1.4 The Extent of Financial Development in Bangladesh

(a) Background In the backdrop of gradual international integration, deregulation and improvements in technology, financial systems in world economies have undergone through remarkable changes in recent years, which may affect the response of households and firms in terms of savings and investment behavior respectively. The changes in financial systems have transformed the opportunities for borrowing and saving facing households and firms and thus influence the cyclical behavior of national economies. As a result of improved financial environment, households now have access to a broader range of borrowing options (e.g., through the widespread use of credit cards and home equity loans) and can easily invest in a wide range of financial instruments, such as stocks, bonds, mutual funds, and derivatives. Firms have been able to increasingly diversify their financing away from banks through the issuance of bonds in capital markets, while banks themselves have increasingly moved away from their traditional deposit-taking and lending role into fee-generating activities, such as the securitization of loans and the sale of risk management products. Besides, the cross-border component of financial intermediation has also grown rapidly, particularly at the wholesale level i.e., between financial institutions (WEO 2006).

(b) Trends in Some Indicators of Financial Development in Bangladesh A comprehensive analysis of the extent of financial development in Bangladesh was made in the first issue of the FSR (May 2006) where various indicators of the financial development as well as inter-actions between the indicators of financial developments and economic activities were discussed in details. As mentioned in the first issue, a well-developed financial system has been widely understood to be a stimulant in accelerating economic growth by mobilizing savings and facilitating investment in an efficient manner. Development in the financial sector raises the overall efficiency of the financial institutions by reducing transaction costs, information asymmetries, market frictions, and by pooling risk (Levine, 1997). As “financial development” lacks any precise definitions, following the practice of existing literature some indicators of financial development may be used for effective policy formulation, implementation and evaluation. Accordingly, four alternative indicators of financial development, such as domestic credit to the private sector by banks to GDP ratio, total deposits to GDP ratio, broad money (M2) to GDP ratio and total market capitalization as a ratio of GDP have been used.17

17 Definitions of various indicators of financial development are as follows:

• Domestic credit to the private sector as a percent of GDP (denoted by cr_y) is one of the popular indicators of financial development. It includes all credit issued to the private sector by all financial institutions which indicates the degree of financial intermediation. This ratio measures the financial resources provided to the private sector through loans and advances, purchase of non-equity securities, and trade credits.

• The second indicator of financial development is total deposits (demand plus time) as a percent of GDP (denoted by dep_y) which is a relatively broad measure of financial development as it includes all the liquid liabilities of the financial system excluding currency in circulation.

20

Table 1.4.1: Trends in Some Indicators of Financial Development in Bangladesh

Year cr_y dep_y m2_y mcap_y FY01 26.34 32.17 37.22 2.81 FY02 28.54 34.22 39.13 2.37 FY03 28.36 35.41 40.23 2.40 FY04 29.76 37.11 42.24 4.26 FY05 31.12 38.85 44.45 5.73 FY06 31.47 38.04 43.53 4.89

Source: Economic Trends (October 2006), Statistics Department, Bangladesh Bank and author’s estimates. Notes: 1. cr_y = Domestic credit to the private sector as a percent of GDP. 2. dep_y = Total deposits as a percent of GDP. 3. m2_y = Broad money as a percent of GDP. 4. mcap_y = Market capitalization as a percent of GDP.

The data as presented in Table 1.4.1 show that all four indicators of financial development display steady increasing trend (with significant variations among them) during FY01-06 thus indicating the widening and deepening of the financial system in Bangladesh overtime. While broad money (m2) as a ratio of GDP showing the highest degree of financial development, market capitalization as a ratio of GDP displaying the lowest indicating very poor improvement in the equity and capital markets in Bangladesh. Domestic credit, deposits, broad money and market capitalization shares to GDP increased respectively to 31.47 percent, 38.04 percent, 43.53 percent and 4.89 percent in 2006 from 26.34 percent, 32.17 percent, 37.22 percent and 2.81 percent in 2001 reflecting gradual development of the financial sector in Bangladesh during FY01-06.

(b) Financial Development in Bangladesh: A Cross-Country Comparison Given the close link between the financial sector and household and firm balance sheets, a key question is how these differences in financial systems affect macroeconomic behavior across countries. As noted in the WEO 2006 that although the amplitude of business cycle fluctuations has been on a declining trend across economies, differences remain in the resilience of individual countries to business cycle downturns, asset price fluctuations, and technological changes (Cotis and Coppel, 2005). Yet few empirical studies to date have analyzed the effect of different financial structures on business cycle behavior—

• A third indicator, broad money as a percent of GDP (denoted by m2_y) is basically the liquid liabilities of

the financial system in Bangladesh that includes currency plus demand and interest-bearing liabilities of financial intermediaries. This is the broadest measure of financial development and is considered to be a typical measure of financial “depth”. It also indicates the degree of monetization with respect to the real economy.

• The forth indicator is total market capitalization as a ratio of GDP (denoted by mcap_y) where market capitalization (also known as market value) is the share price times the number of shares outstanding. Listed domestic companies are the domestically incorporated companies listed on the country's stock exchanges at the end of the year.

21

attention has mostly focused on the role of overall financial development for growth performance (see Levine, 1997; and Wurgler, 2000 for more details).

An attempt has been taken to make international comparison in the context of financial development to provide some meaningful signals to the policy researchers. The extent of the development in the financial sector of Bangladesh has been analyzed with reference to some of the South Asian countries, such as India, Pakistan and Sri Lanka, in terms of the above mentioned indicators. It has been observed that the degree of financial development in Bangladesh at a comparable level with other South Asian countries.

Three aggregate indicators, such as domestic credit to the private sector as a ratio of GDP, total deposits to GDP ratio and broad money (m2) to GDP ratio have been used to make an international comparison in the development of financial intermediaries. Figure 1.4.1 shows that all of the three indicators of financial development in Bangladesh are fairly close to the South Asian average countries. However, Bangladesh is well behind India in each of these categories. It has also been observed that private credit to GDP in Bangladesh performed relatively better than that of broad money to GDP ratio in the context of neighboring countries.

Figure 1.4.1 Financial Development Indicators: Cross-Country Comparison (200618)

0.00 10.00 20.00 30.00 40.00 50.00 60.00 70.00

cr_y

dep_y

m2_y

Sri LankaPakistanIndiaBangladesh

Source: IFS, November 2006, IMF and author’s estimates.

(c) Financial Development and Economic Activity Linkage in Bangladesh With a view to investigating the apparent relationship between each of the above mentioned indicators of financial development and economic activities (measured by real GDP growth as well as investment as a percent of GDP) a series of scatter plots along-with their trend-lines have depicted in figure 1.4.2 using annual data

18 Estimated / Provisional.

22

during FY01-06. The scatter-plots of all of the four indicators of financial development vis-à-vis economic growth and investment-GDP ratio robustly support the existence of strong and positive correlation between financial development and economic activities. Besides, almost a linear relationship is observed in another scatter-plots diagram between investment-GDP ratio and economic growth (Figure 1.4.3).

Figure 1.4.2: Financial Development and Economic Activity Linkage

c. D epo sit -GD P rat io and eco no mic gro wth

y = 0.2402x - 2.9918

4.0

4.5

5.05.5

6.0

6.5

31.0 33.0 35.0 37.0 39.0

Deposit-GDP ratio

Econ

omic

Gro

wth

a. Credit-GDP ratio and economic growth

y = 0.3027x - 3.2104

4.04.55.05.56.06.5

26.0 27.0 28.0 29.0 30.0 31.0 32.0

Credit-GDP ratio

Econ

omic

Gro

wth

b. Credit-GDP and investment-GDP ratio

y = 0.3766x + 12.842

22.5

23.5

24.5

26.0 27.0 28.0 29.0 30.0 31.0 32.0

Credit-GDP ratio

Inve

stm

ent-

GD

P ra

tio

d. D epo sit -GD P rat io and eco no mic gro wth

y = 0.2789x + 13.832

22.5

23.5

24.5

31.0 33.0 35.0 37.0 39.0

Deposit-GDP ratio

Inve

stm

ent-

GD

P ra

tio

g. M arket capita lizat io n-GD P rat io and eco no mic gro wth

y = 0.4679x + 3.8966

4.04.55.05.56.06.57.0

2.0 3.0 4.0 5.0 6.0

Market capitalization-GDP ratio

Econ

omic

Gro

wth

e. M2-GDP ratio and economic growth

y = 0.2244x - 3.5836

4.04.55.05.56.06.5

36.0 38.0 40.0 42.0 44.0 46.0

M2-GDP ratio

Econ

omic

Gro

wth

f. M2-GDP and investment-GDP ratio

y = 0.2597x + 13.18

22.5

23.5

24.5

36.0 38.0 40.0 42.0 44.0 46.0

M2-GDP ratio

Inve

stm

ent-

GD

P ra

tio

h. M arket capitalizat io n-GD P rat io and eco no mic gro wth

y = 0.4939x + 22.013

22.5

23.5

24.5

2.0 3.0 4.0 5.0 6.0

Market capiatalization-GDP ratio

Inve

stm

ent-

GD

P ra

tio

Source: Economic Trends (October 2006), Statistics Department, Bangladesh Bank.

23

Figure 1.4.2: Relationship between Investment-GDP ratio and Economic Growth

y = 0.8276x + 19.187

22.5

23.5

24.5

25.5

4.0 4.5 5.0 5.5 6.0 6.5 7.0Economic Growth

Inve

stm

ent-G

DP

ratio

Source: Economic Trends (October 2006), Statistics Department, Bangladesh Bank.

(d) Conclusion The importance of the financial system in facilitating economic growth and development has long been accepted. We have always known that banks and other financial institutions have a key role to play in the efficient allocation of resources that make rapid growth possible. As economies grow more sophisticated, the financial sector must follow suit; it must become broader and deeper (Anne O. Krueger, December 2004). A broader and deeper financial system helps economic performance in many ways as development in the financial sector raises the overall efficiency of the financial institutions. The statistical evidence suggest that the financial sector of Bangladesh is getting broader and deeper and sharing a positive relationship with the economic activities overtime.

References Anne O. Krueger, December 2004, First Deputy Managing Director, International Monetary Fund. Cotis, Jean-Philippe, and Jonathan Coppel, 2005, “Business Cycle Dynamics in OECD Countries: Evidence, Causes and Policy Implications,” in The Changing Nature of the Business Cycle, Reserve Bank of Australia 2005 Conference Volume, ed. by Christopher Kent and David Norman (Sydney). Economic Trends (October 2006), Statistics Department, Bangladesh Bank. Financial Section Review, May 2006, Bangladesh Bank. International Financial Statistics, November 2006, International Monetary Fund. Levine, Ross, 1997, “Financial Development and Economic Growth: Views and Agenda,” Journal of Economic Literature, Vol. 35, No. 2 (June), pp. 688–726. World Economic Outlook (September 2006), International Monetary Fund Wurgler, Jeffrey, 2000, “Financial Markets and the Allocation of Capital,” Journal of Financial Economics, Vol. 58 (October–November), pp. 187–214.

24

Chapter 2

Supply of and Demand for Financial Products

2.1 Payments and Transactions Products19 The customers of scheduled banks in Bangladesh maintain 14 types of deposit accounts through which payments and transactions are made20. The names of the accounts may differ from bank to bank or category to category but the nature and objectives of the accounts are mostly same in all the cases. The customers involved in business, or those who want to withdraw their money from bank accounts frequently, maintain Current Accounts and/or Short Term Deposit Accounts (STD a/c), which are mostly non-interest or low interest bearing. Out of the total deposits (demand and time deposits), approximately 50 percent are fixed deposits in nature, in which payments and transactions are infrequent21.

The share of the three major categories of deposit accounts- Savings Deposit Accounts, Fixed Deposit Accounts and Current/ Chequing Deposit Accounts- do not show any significant change from quarter to quarter over the one year period (June 30, 2005 to June 30, 2006). During the period, i.e. June 30, 2005 to June 30, 2006, fixed deposits increased from 36.31 percent to 37.65 percent, savings deposits decreased from 27.0 percent to 25.53 percent and current deposits decreased from 10.18 percent to 9.87 percent (Table 2.1.1).

Table 2.1.1: Percentage Distribution of Total Deposits of Scheduled Banks in Bangladesh

Types of Accounts % of Total Deposits as of

30-6-2006 as of

31-3-2006 as of

31-12-2005 as of

30-9-2005 as of

30-6-2005 1. Current / Chequing Deposits 9.87 9.13 9.57 9.1 10.18 2. Deposits withdraw able on Sight 1.34 1.48 1.55 2.03 1.68 3. Savings Deposits 25.53 25.96 26.81 26.86 27 4. Convertible Taka Accounts of Foreigners 0.13 0.32 0.3 0.18 0.12 5. Foreign Currency Accounts 0.54 0.33 0.35 0.47 0.33 6. Wage Earners’ Deposits 0.62 0.58 0.6 0.44 0.54 7. Resident Foreign Currency Deposits 1.06 1.12 1.19 1.01 1 8. Short Term Deposits 8.59 7.97 8.07 8.1 8.56 9. Fixed Deposits 37.65 37.59 37.08 37.36 36.31 10. Deposit Pension Scheme 10.16 10.72 10.28 10.33 10.1 11. Margin Deposits (Foreign Currency/ (BDT) 1.1 1.06 0.95 1.12 1.05

12. Special Purpose Deposits 2.71 3.26 2.7 2.22 2.43 13. Negotiable Certificates of Deposits 0.66 0.46 0.52 0.76 0.68 14. Restricted (Blocked) Deposits 0.04 0.02 0.03 0.02 0.02 Total 100 100 100 100 100

Source: Scheduled Banks Statistics, Bangladesh Bank 19 Prepared by Mohammad Mizanur Rahman, Assistant Director (General side), PAU. The author would like to acknowledge Dr. Akhtaruzzaman, SRE, for his valuable suggestions. 20 Scheduled Banks Statistics, Bangladesh Bank. 21 Basically, payments and transactions occur in the fixed nature deposits after its maturity

25

Basically, the Negotiable Instruments i.e. Cheque, Promissory note, Bill of Exchange, Demand Draft and Pay Order (quasi negotiable instruments) are the traditional payments and transactions products in the banking system of Bangladesh of which Cheque alone is being used as the principal means of payments and transactions. (To support the argument a table will be provided which is under process now)

The banking system in Bangladesh is continuously adopting new financial products and services including e-products, in addition to the traditional products, to make smooth payments and transactions as a part of extending better customer services to ensure profitability in the existing competitive business environment (Chart 2.1.1). The Foreign Commercial Banks (FCBs) in Bangladesh are playing pioneer role in introducing modern financial products and services. Private Commercial Banks (PCBs) have started to follow the same. The Nationalized Commercial Banks (NCBs) and the Specialized Banks (SBs), on the other hand, could not yet show notable performance in offering e-products. But due to the demands of time, they are now taking initiatives to launch new products.

The survey shows that during the last couple of years, the use of debit card, credit card and ATM as smart payments and transaction products and services has been increasing rapidly. ATM facility was available only to 7 banks (5 PCBs and 2 FCBs) at the end of 2001, but by the end of 2005, the number of banks reached to 22 (2 NCBs, 1 DFI, 15 PCBs and 4 FCBs) (Table 2.1.2). The Credit Card, Debit Card, On-line Banking and SWIFT facilities also increased to 8, 15, 18, and 18 banks respectively. Efforts of PCBs in offering e-products and services increased substantially during the period 2001-2005 (Table 2.1.2). To facilitate electronic payment and transactions, the commercial banks are adopting new technology driven electronic services like ATM, POS, Internet, Tele banking, On-line banking, SWIFT and Reuter and they caused positive effects on the volume of transactions 22 (Table 2.1.3).

Table 2.1.2: Number of Banks Adopted e-products and Services in Bangladesh By End of 2001 (A) By End of 2005 (B) Products and

Services NCBs DFIs PCBs FCBs Total NCBs DFIs PCBs FCBs Total Difference

(B-A) No. of Banks 4 5 30 10 49 4 5 30 9 48 - Credit Card 0 0 3 1 4 0 0 11 1 12 8 Debit Card 1 0 3 0 4 3 1 13 2 19 15 ATM 0 0 5 2 7 2 1 15 4 22 15 POS 1 0 2 1 4 2 0 8 1 11 7 Internet 1 0 0 0 1 1 0 3 3 7 6 Tele Banking 0 0 1 1 2 0 0 2 2 4 2 On-line 0 0 3 3 6 1 0 19 4 24 18 SWIFT 2 1 15 4 22 4 2 28 6 40 18 Router 3 0 9 3 15 3 1 16 5 25 10

Source: Commercial Banks in Bangladesh

22 The existing modern technology based banking products in Bangladesh include e-products like Debit Card and Credit Card and e-services like Automated Teller Machine (ATM), Point of Sales (POS), Internet, on-line banking, Society for Worldwide Inter-bank Financial Telecommunication (SWIFT) and Reuter.

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Chart 2.1.1: Transactions and Payments Products and Services Offered by Category of Banks in Bangladesh

Category of Banks

Payment and Transaction Product (Domestic)

Payment and Transaction Products (E-banking)

Payment and Transaction Products (Foreign)

NCBs, SBs, PCBs, FCBs

• Savings Deposit A/c • Current Deposit A/c • Short Term Deposit A/c • Demand Draft • Pay Order

• Debit Card • ATM • SWIFT • Reuter

• NOSTRO Account

NCBs, PCBs

• Fixed Deposit A/c • Cash Credit Account • SOD Account • Telegraphic Transfer • Mail Transfer • Pay Slip

• POS • Internet • On-line banking

• Foreign Demand Draft • Foreign Documentary Bills Purchase • Foreign Bills Purchase • Foreign Bills for Collection • Payment against Documents • Inland Foreign Bills Purchase

PCBs, FCBs, Islamic Banks

• Demand Draft • Telegraphic Transfer • Pay Order

• Debit Card • ATM • On-line banking • SWIFT • Reuter

• FC Account • Resident F.C Deposit (RFCD) A/c • Non-Resident F.C Deposit (NFCD) A/c • Foreign Demand Draft

NCBs • Deposit Pension Scheme A/c

SBs • Fixed Deposit A/c • Mail Transfer

PCBs • Monthly Savings Scheme • Special Savings Scheme

• Credit Card

• Non-Resident Tk Ac • Travelers’ Cheque • International Credit Card • Money Gram • Xpress Money

FCBs • Access Account • Recurring Deposits • Cash Credit Account

• Credit Card • POS • Internet • Card Cheque • Prepaid Gift Cards

• Travelers’ Cheque • International Credit Card

Islamic Banks

• Mudaraba Savings Deposit A/c • Mudaraba Term Deposit A/c • Al-Wadia Current Deposit A/c • Mudaraba SND A/c • Hajj Deposit A/c • Pension Scheme • Cash WAQF • Term Deposit

• NOSTRO Account • Foreign Tele Transfer

Source: Commercial Banks in Bangladesh

The volume of transactions using e-products and services grew significantly during 2001-2005. Transaction through PCBs against Debit Card grew from nil to Tk. 242 crore and the same against ATM grew from Tk. 1 to Tk. 280 crore. Transaction through FCBs against ATM increased from Tk. 210 to Tk. 2278 crore which shows a significant growth over the period comparing to the other categories of banks. The average growth of total volume of transaction against Debit Card and POS were about 184 and 248 percent respectively which were also significantly higher than that against Credit Card, ATM, and SWIFT & Reuter (Table 2.1.3).

Share of Transactions against e-products and services are shown in Table 2.1.4 which provides a clear indication regarding shifting of market share in payments and transactions among the category of banks during 2001-2005.

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Table: 2.1.3: Trends in the Volume of Transactions and Payments through e-products and Services by Category of Banks

(Figure in Crore Taka) Credit Card Debit Card ATM POS SWIFT & Reuter Category

of banks 2001 2005 2001 2005 2001 2005 2001 2005 2001 2005

NCBs 0 0 4 18 0 10 1 4 0 10735

DFIs 0 0 0 0 0 0 0 0 1350 4019

PCBs 142 402 0 242 1 280 2 135 40036 189252

FCBs 120 435 0 3 210 2278 0 301 8269 26712

Total 262 837 4 263 211 2568 3 440 49655 230718Average

Growth (%) 33.69 184.76 86.78 248 46.82 Source: Commercial Banks in Bangladesh Note: Average growth is calculated by using Geometric Mean formula

Table: 2.1.4: % Share of Transaction against e-products and services during 2001-2005

% Share of Transaction in 2001 % Share of Transaction in 2005 Products &

Services NCBs SBs PCBs FCBs NCBs SBs PCBs FCBs ATM 0 0 0 100 0 0 11 89 Debit Card 90 0 10 0 7 0 92 1 Credit Card 0 0 54 46 0 0 48 52

Source: Commercial Banks in Bangladesh

The survey data shows that a significant change in the market share of transactions between NCBs and PCBs has occurred against Debit Card during 2001-2005 in which the share of PCBs grew from 10 to 92 percent and share of NCBs declined from 90 to 7 percent. The share of transactions against Credit Card, however, decreased from 54 to 48 percent whereas the FCBs’s share increased from 46 to 52 percent over the period. In providing ATM services, the FCBs were the lone players (cent percent share) in the market up to 2001 of which 11 percent share was occupied by PCBs by end of 2005 (Table: 2.1.4).

Conclusion

In Bangladesh, the bank’s clients traditionally rush in long queues to perform daily payments and transactions. Since the trend of payment and transactions is no doubt increasing since the last couple of years, it is an urgently require to minimize the hazards in conventional banking and which have so far influenced e- banking in Bangladesh to diversify transactions and payments products. The survey data shows that at the end of 2001, the total number of credit card and debit card holders were about 40 thousand and 12 thousand respectfully, which reached to about 139 and 143 thousand respectively at the end of 2005. It is also observed that the use of ATM flourished substantially during the last couple of years which is reflected in the increasing trend in the volume of transactions and the increasing number of banks adopting ATM facilities (Table 2.1.3 & 2.1.2).

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The increasing trend of the number of the users of e-banking products and services offered by different categories of banks in Bangladesh reveals that paper-based and time consuming banking is being replaced by paperless e-banking which utilizes technology to allow bank’s customers and other stakeholders to interact and transact with the bank seamlessly through a variety of channels such as the internet, wireless devices, ATMs and physical branches.

2.2 Savings Products23

Commercial banks in the Bangladesh financial system mobilize savings through a good number of savings products24. The growth of deposit mobilization by type of banks shows a mixed trend during 2006. Total deposits mobilized by the commercial banks increased by 17.85 percent to Tk 466.45 Billion at the end of December 2006 from 17.45 percent growth during 2005. Deposit mobilization by type of banks indicates that deposits growth of private commercial banks (PCBs) is much higher than that of NCBs. It is to be noted that the share of NCBs in deposits declined to 39 percent in June 2006 from 41 percent in September 2005, while the share of PCBs increased to 48 percent in June 2006 from 46 percent in September 2005. Although the shares of DFIs and FCBs in the deposits are small, growth of deposits has declined during 2006 (Table 2.3.1 and Chart 2.3.1). The declining share in deposits of NCBs can be attributed mainly to closure of 207 branches under the rationalization/ consolidation program of NCBs during the last five years. Out of this, 111 branches were closed in the rural area and 96 branches in the urban area. The savings products, namely savings deposits, short term deposits, fixed deposits, pension and other deposits showed a mixed trend during the last year. Fixed deposits, which generally enjoy the highest share in the deposits, grew by

Table 2.2.1: Nominal Deposits Growth Mobilization by Type of Banks.

Year NCBs DFIs FCBs PCBs Total Deposits

2001 13.32 20.91 17.15 28.58 18.47 2002 9.81 16.91 8.47 25.10 14.95 2003 8.87 9.82 6.75 22.37 13.40 2004 8.29 21.74 10.37 25.61 16.27 2005 9.81 20.30 25.19 23.40 17.45 2006

( estimated) 8.42 12.81 9.05 28.06 17.85

Source: Schedule Banks Statistics, Bangladesh Bank. Note: Deposits growth is obtained based on billion Taka.

23 This section has been prepared by Md. Ezazul Islam, Research Economist, Policy Analysis Unit (PAU). 24 The major saving products are savings deposits, short term deposits, fixed deposits of various duration, pension scheme deposits and others including certificates of deposit.

29

Chart: 2.2.1: Share of Different Type of Deposits as of June 2006

NCBs39%

DFIs6%

FCBs7%

PCBs48%

Savings26%Pension

Deposit

Others18%

Short Term9%

Fixed37%

10%

Source: Scheduled Bank Statistics, Bangladesh Bank, various issues. Chart: 2.2.2: Share of Nominal Deposits by Type of Banks as of June 2006

Source: Scheduled Banks Statistics, Various issues

21.24 percent during 2006 as compared to 19.0 percent growth during 2005. Pension deposits also increased by 19.8 percent during 2006 as compared to 16.2 percent growth during 2005. Short term deposits, on the other hand, declined by 14.9 percent during 2006 as against 23.0 percent increase in growth during 2005. Higher interest rate on fixed deposits offered by the banks over short term deposits since last year, may be one of the main reasons of declining short term deposits during the period under review. The growth rate and share of deposits are presented in Table 2.3.2 and Chart 2.3.2 respectively.

Commercial banks mobilize savings from urban and rural area through their 6,435 branches (as of June 2006). The share of urban deposits increased from 80.39 percent at end of December 2001 to 85.69 percent at the June 2006. While the share of rural deposits declined to 14.31 percent at the end June 2006 from 19.61 percent at the end of December 2001. The main reason is closure of 111 rural branches of NCBs during the last five years. Share of rural and urban deposits by types of banks is given in Table 2.3.3.

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Table 2.2.2: Growth of Different Categories of Savings Deposits

Year Savings Short Term Fixed Pension

Deposit Others Total Deposits

2001 14.4 7.8 16.9 18.0 15.5 14.9 2002 10.9 12.4 18.4 15.0 7.4 13.4 2003 8.0 17.9 18.5 11.9 6.5 12.8 2004 15.7 13.2 19.1 15.8 13.2 16.3 2005 12.2 23.0 19.0 16.2 20.3 17.4 2006 (estimated) 7.55 -40.33 21.24 15.16 78.78 17.85

Source: Schedule Banks Statistics, Bangladesh Bank, various issues. Note Deposits growth is worked based on billion taka.

Table 2.2.3: Share of Deposits Distributed by Regions and Types of Banks Year(end December NCBs Specialized Private Banks

Foreign Banks All banks

Urban Rural Urban Rural Urban Rural Urban Urban Rural 2001 72.09 27.91 57.83 42.17 93.22 6.78 100.00 80.39 19.61 2002 72.66 27.34 59.18 40.82 93.12 6.88 100.00 81.21 18.79 2003 76.44 23.56 58.36 41.64 93.04 6.96 100.00 83.87 16.13 2004 75.78 24.22 61.51 38.49 93.53 6.47 100.00 84.40 15.60 2005 77.14 22.86 64.05 35.95 93.85 6.15 100.00 85.73 14.27 2006 (end June) 76.84 23.16 62.62 37.38 93.51 6.49 100.00 85.69 14.31

Source: Schedule Banks Statistics (various issues).

Total deposit mobilization as percentage of GDP by the banking system has been growing over time. The ratio was 29.61 percent in 1990 which grew to 39.27 in 2005. The ratio of deposit to GDP is shown in Chart 2.3.3. Data for saving deposits-GDP ratio for some Asian countries are presented in Table 2.3.3 and Char 2.3.4. It clearly indicates that deposits GDP ratio of Bangladesh was higher than that of Pakistan during 2000-2003 and the ratio was almost same with that of Sri Lanka in last three years.

Table 2.2.4: Trend of Deposits GDP Ratio for some Asian Countries

Year Bangladesh India Pakistan Sri Lanka Malaysia Indonesia Thailand 1993 22.72 36.45 31.67 25.61 69.29 39.23 72.451994 24.83 36.98 32.94 26.36 67.28 40.40 71.071995 24.71 34.11 30.83 32.53 72.42 43.98 72.061996 25.29 35.76 33.87 32.02 72.94 48.42 73.931997 25.48 38.41 36.71 32.34 78.93 51.45 84.461998 25.82 40.22 35.60 32.02 81.20 55.51 95.231999 27.13 42.31 33.00 33.44 90.92 53.00 94.332000 29.78 46.10 27.90 33.45 88.62 48.21 93.852001 32.17 48.62 29.06 34.36 93.01 45.57 93.452002 34.22 52.66 32.67 34.57 90.44 43.03 89.472003 35.42 52.90 35.16 35.90 91.18 42.01 85.812004 37.11 55.10 37.93 37.40 97.59 40.11 80.89

Source: International Financial Statistics, Yearbook, 2005.

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Chart 2.2.3: Trend of Deposits-GDP Ratio in Bangladesh

0.005.00

10.0015.00

1990 1994 1995 1999 2000 2001 2002 2003 2004 2005

Perc

enta

20.0025.0030.0035.0040.0045.00

ge of G

DP

ratio

Chart 2.2.4: Trend of Deposits GDP Ratio for some Asian Countries

15202530354045505560

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Bangladesh India PakistanSri Lanka Indonesia

2.3 Loan Products (a) Sectoral Pattern of Lending in the Economy25

The banking sector have continued to demonstrate risk averse lending behavior in most cases as discussed in the first issue of this review. Therefore, it is a concern that all the credit need for different economic purposes may not being well met. Figure 2.4.1 and 2.4.2 show the quarterly trend of scheduled banks’ credit (i.e., sum of advances and bills) disbursement (outstanding amounts) for the period between January-March 1999 and July-September 2006. It can be observed that the credit disbursement of scheduled banks in aggregate level maintained an increasing trend over this time period. This observation is also consistent (except for SBs and FCBs which declined a bit in July-September 2006) when credit disbursement is considered in terms of individual bank groups (i.e., NCBs, SBs, FCBs, PCBs (including IBs), and IBs). The rise in the credit disbursement of scheduled banks is mainly driven by the growth in advances. In addition, if credit disbursement of individual bank groups as a share of total credit is considered, an indicative trend can be observed. In particular, the shares of NCBs, SBs, and FCBs follow a declining trend although the credit disbursement by NCBs in terms of volume (i.e., BDT in billion) follows an increasing trend. On the contrary,

25 This section has been prepared by Shamim Ahmed.

32

PCBs (including IBs) alone has the highest share of about 51 percent suggesting their increasing participation in the credit market. Besides, the share of IBs in total credit disbursed follows an increasing trend. Finally, the credit-deposit ratio of scheduled banks excluding the SBs has decreased to 0.85 in June 2006 from 0.88 as of end June 2005 which, in turn, indicates a bit slowdown in credit demand and economic activities in the country.

Figure 2.4.1: Scheduled Banks Credit Disbursement (BDT in billions)

0200400600800

1000120014001600

Jan-M

ar '99

Jul-S

ep '9

9

Jan-M

ar '00

Jul-S

ep '0

0

Jan-M

ar '01

Jul-S

ep '0

1

Jan-M

ar '02

Jul-S

ep '0

2

Jan-M

ar '03

Jul-S

ep '0

3

Jan-M

ar '04

Jul-S

ep '0

4

Jan-M

ar '05

Jul-S

ep '0

5

Jan-M

ar '06

Jul-S

ep '0

6

BDT

in b

illio

n

NCBs SBs FCBs PCBs (including IBs) IBs All Banks

Source: Banking Statistics Division, Statistics Department, Bangladesh Bank.

Figure 2.4.2: Scheduled Banks Credit Disbursement (as percent of total credit)

0

10

20

30

40

50

60

Jan-Mar '99

Jul-S

ep '99

Jan-Mar '00

Jul-S

ep '00

Jan-Mar '01

Jul-S

ep '01

Jan-Mar '02

Jul-S

ep '02

Jan-Mar '03

Jul-S

ep '03

Jan-Mar '04

Jul-S

ep '04

Jan-Mar '05

Jul-S

ep '05

Jan-Mar '06

Jul-S

ep '06

NCBs SBs FCBs PCBs (including IBs) IBs

Source: Banking Statistics Division, Statistics Department, Bangladesh Bank.

(b) Sectoral Pattern of Advances Figure 2.4.3 shows the quarterly growth trend of advances of scheduled banks by economic purposes in the private sector for the period between July-September 2004 and July-September 2006.26 In this criterion, a mixed picture is observable. Particularly, the quarterly growth rate of advances for agricultural purposes follows more or less a declining trend and it is clear that credit growth has slipped of late. It is also noticeable that the growth rate of advances in the private sector

26 Quarterly growth rate refers to growth over the same quarter of the previous year.

33

for construction purposes follows a declining trend since October-December 2005 while working capital financing follows a volatile trend. However, the growth rate of advances for industrial (excluding working capital financing) purposes demonstrates a marked increment since the beginning of 2006. Moreover, transport and communication had the highest growth in attracting advances from scheduled banks in the private sector as of the most recent date depicted in Figure 2.4.3. It is worth mentioning that transport and communication in private sector had no growth at all in July-September quarter of 2004 and a very low (about 4-percent) growth rate in the October-December period of 2005.

Figure 2.4.3: Scheduled Bank Advances (Private Sector) Growth Rate (in

percent) by Economic Purposes

05

1015202530354045

Jul-Sep'04

Oct-Dec'04

Jan-Mar'05

Apr-Jun'05

Jul-Sep'05

Oct-Dec'05

Jan-Mar'06

Apr-Jun'06

Jul-Sep'06

Agriculture Industry (excluding working capital)

Working Capital Financing Construction

Transport and Communication

Notes: 1. In the above figure, quarterly growth rate refers to growth over the same quarter of the previous year. Source: Banking Statistics Division, Statistics Department, Bangladesh Bank.

Figure 2.4.4: Classification of Advances (in real terms) by Economic Purposes (BDT in billion)

0

20

40

60

80

100

120

140

160

180

Oct-Dec'03

Jan-Mar'04

Apr-Jun'04

Jul-Sep'04

Oct-Dec'04

Jan-Mar'05

Apr-Jun'05

Jul-Sep'05

Oct-Dec'05

Jan-Mar'06

Apr-Jun'06

Jul-Sep'06

Agriculture Industry (excluding working capital) Working Capital Financing

Construction Transport and Communication

Note: 1. Quarterly advances in real terms by economic purposes have been calculated from advances in nominal terms by using GDP deflator (base: 1995-96=100) constructed by Shamim Ahmed and Md. Ezazul Islam.

Source: Banking Statistics Division, Statistics Department, Bangladesh Bank.

34

If total advances (i.e., both public and private) in real terms by economic purposes are considered, it can be observed that all the sectors follow a stable pattern, except that advances for working capital financing had the highest share in total advances starting July-September quarter of 2004 (Figure 2.4.4). Moreover, in recent years advances to households for flat purchase, consumer goods (motor car/motor cycle, television, refrigerator, computer, etc.) purchase, purchase through credit cards, and educational expenses in real terms follow an upward trend (Figure 2.4.5). In particular, purchase through credit cards have increased in recent years with a quarterly growth rate of 6.32 percent and 6.86 percent in July-September quarter of 2005 and 2006, respectively.27

Figure 2.4.5: Advances (in real terms) for Specific Purposes to Households

(BDT in million)

0

5000

10000

15000

20000

25000

30000

Oct-Dec'03

Jan-Mar'04

Apr-Jun'04

Jul-Sep'04

Oct-Dec'04

Jan-Mar'05

Apr-Jun'05

Jul-Sep'05

Oct-Dec'05

Jan-Mar'06

Apr-Jun'06

Jul-Sep'06

Consumer Goods, Purchase through Credit Cards, and Educational Expenses Flat Purchase

Note: 1. Quarterly figures in real terms have been calculated from respective nominal figures by using GDP deflator (base: 1995-96=100) constructed by Shamim Ahmed and Md. Ezazul Islam.

Source: Banking Statistics Division, Statistics Department, Bangladesh Bank.

(c) Conclusion In recent years, credit disbursement of scheduled banks in aggregate level as well as for most individual bank groups level maintained an increasing trend, which in turn demonstrates their increasing participation in the credit market of the economy. NCBs as a group has maintained a steady level of total credit disbursement though both in real terms or as a share of the industry, it has fallen off. The rise in the credit disbursement of scheduled banks is mainly accelerated by the growth in advances. Moreover, major bank groups especially PCBs have created a competitive environment in their segment of the banking system.28 Finally, advances (in real terms) disbursed for different economic purposes follow a stable pattern with growing importance of working capital for the industrial sector. The increasing participation of the household sector in assessing consumer credit (especially the use of credit card loans), while still modest, is indicative of greater financial intermediation in aggregate consumption.

27 Quarterly growth rate refers to growth over the previous quarter. 28 The interpretation of the banking system as a segmented market is pursued in the first issue (Chapter 3, section 3.2 and 3.3) of this review.

35

2.4 Specialized Loan Products

Term Lending Financial institutions in Bangladesh has a good number of term loan schemes like project loan, house building loan, rural housing loan, loan for house renovation, transport loan, special credit program (for small and cottage industries and others) etc. Disbursement of term lending to industrial sector in the first quarter of FY07 was 26.5 billion taka whereas the annual figures for total disbursed term loan in fiscal years 03, 04, 05 and 06 were 39.7, 66.8, 91.1 and 96.5 billion taka, respectively. The major portion of this lending goes to large and medium scale industries. An increasingly greater portion of this disbursement were made by Private Commercial Banks (PCBs) followed by Non Bank Financial Institutions (NBFIs) for the last couple of years. The share of Development Financial Institutions (DFIs) in long term financing remained around 3 percent in FY06. Though the share of Nationalized Commercial Banks (NCBs) has rebounded and increased a bit from 4.9 percent in FY05 to 6.1 percent in FY06 that of Foreign Commercial Banks (FCBs) continued the decreasing trend. Share of term lending by major bank groups and NBFIs are shown in Figure 2.4.1.

Figure 2.4.1: Share of Term Lending by Major Bank Groups and NBFIs

NCBs6%

PCBs63%

FCBs10%

DFIs3%

NBFIs18%

Source: Bangladesh Bank Quarterly, Vol IV, No. 1

The growth of term lending in FY03, 04, 05 and 06 were 10, 68, 36 and 6 percent respectively. Therefore the growth of term lending has decreased significantly during FY06. Term lending by NCBs, PCBs and NBFIs grew by 31.1, 10.2 and 1.7 percent respectively during FY06. Term lending by FCBs declined by 17.5 percent in FY06 while that by DFIs remained essentially the same as the previous year.

36

Figure 2.4.2: Growth of Term Lending by Major Bank Groups and NBFIs (Nominal BDT)

-100

-50

0

50

100

150

FY04

:Q2

Q3

Q4

FY05

:Q1

Q2

Q3

Q4

FY06

:Q1

Q2

Q3

Q4

FY07

:Q1

NCBs PCBs FCBs DFIs NBFIs Source: Bangladesh Bank Quarterly, Vol IV, No. 1

Project and Infrastructure Financing Infrastructure financing includes financing in transport and communication and power and energy sectors. Figure 2.4.3 shows the outstanding loans to transportation and communication and power and energy sectors from the banking system. The transport and communication network in Bangladesh comprises of road, rail and air transport system including post, telecommunication and information technology. The share of this sector in total GDP is increasing and became 10.10 percent in FY06 from 9.79 in FY04. Growth of this sector in FY04, 05 and 06 were 6.27, 7.92 and 8.25 percent, respectively. This increasing growth is expected to continue as the telecommunication industry is expanding rapidly. Outstanding bank credit to this sector stood at 17.69 billion taka up to the third quarter of FY06. Figure 2.6.3 shows that bank lending to this sector remained stable in nominal terms over recent years. In real terms outstanding credit to this sector actually decreased in FY03 and 04 but started to increase again in FY05 and growth in real terms stood at 13.14 and 21.45 in FY05 and FY06 (up to March) respectively. Power and energy sector comprising 1.56 percent of GDP grew at a rate of 7.86 percent in FY06. Credit to this sector up to the third quarter of FY06 stood at 2.4 billion taka. In real terms outstanding credit has actually decreased as compared to FY05. One reason may be that a major portion of financing to project and infrastructure is done through government’s development programs and not directly linked with bank credit.

37

Chart 2.4.3: Level of Project and Infrastructure Financing by Banks (Nominal BDT)

0

2

4

6

8

10

12

14

16

18

20

FY02:Q1 Q2 Q3 Q4

FY03:Q1 Q2 Q3 Q4

FY04:Q1 Q2 Q3 Q4

FY05:Q1 Q2 Q3 Q4

FY06:Q1 Q2 Q3

Billi

on T

aka

Transport & Communications Power and Fuel Industry Source: Scheduled Banks Statistics, Various issues.

Housing Outstanding lending to the housing sector by banks, NBFIs and the state owned Bangladesh House Building Finance Corporation (HBFC) stood at 93.16 billion taka in FY0629. Of the total over 60 percent were made by banks, 29 percent by HBFC and the rest 11 percent by NBFIs. Share of Banks and NBFIs in housing finance continues to increase while that of HBFC is decreasing from FY02 to FY06. Outstanding credit to housing finance by banks and NBFIs increased, respectively by 5.83 percent and 19.64 percent in real terms whereas that by HBFC decreased by 8.4 percent in FY06. Figure 2.4.4 shows real growth of housing credit by banks, NBFIs and HBFC. HBFC has different housing loan products like simple loan, group loan - for constructing flats on a plot having multiple owners, loan for flats/apartments, loan for small houses for middle class and lower middle class families, loan for semi-constructed buildings etc. Two NBFIs are also specialized in housing finance and are providing credit for house building, flat purchase, expansion and renovation of houses, housing plot purchase, chamber and office space purchase, mortgage loan against projects etc. The Grameen Bank also provides housing loans for basic shelter housing in rural areas and the outstanding credit up to June 2006 is provisionally expected to have been 952 million BDT.

29 Housing finance data for banks is up to March 2006.

38

Figure 2.4.4: Real Growth of Housing Finance by Banks, NBFIs and HBFC

-15

-10

-5

0

5

10

15

20

25

30

FY03 FY04 FY05 FY06

Bank NBFI HBFC

Source: Scheduled Banks Statistics, Activities of Banks and Financial Institutions and Financial Institutions Department, Bangladesh Bank References:

1. Activities of Banks and Financial Institutions, Finance Division, Ministry of Finance, GOB (Various Issues)

2. Annual Report, Bangladesh Bank (Various Issues) 3. Bangladesh Bank Bulletin, Bangladesh Bank (Various Issues) 4. Bangladesh Economic Review 2005, Economic Adviser’s Wing, Finance

Division, Ministry of Finance, GOB 5. Scheduled Banks Statistics, Bangladesh Bank (Various Issues)

2.5 Access to Finance by Small and Medium Enterprises (SMEs)

(Write-up on this section is in progress pending data availability)

39

Chapter 3

The Banking Sector

3.1 Background

(Write-up on this section is in progress pending data availability)

3.2 Interest Rate Spread 30

Although most of the formal restrictions on the interest rate have been removed by the late 1990’s, lending and deposit rates are still not fully responsive to the market conditions. One major shortcoming here is the continuation of directed lending to certain sectors (especially state owned enterprise (SOE) in energy and civil aviation) which are mediated by NCBs, as well as more generally at the government owned SBs. Of course, it is the mandate of BB to influence lending and deposit rates in the desired direction through the monetary policy instruments such as open market operations (including repo and reverse repo auctions), setting of the bank rate, SLR, CRR, and the like. But, these polices have had an uncertain impact on the structure of borrowing and lending rates prevailing in the financial system.

In the recent Bangladesh experience, public (non-bank) borrowing through the NSD certificates has served as a source of an occasional shock to the credit market equilibrium. Historically these instruments offer non-market rates of return to depositors, and thus whenever the NSD rates are re-evaluated by MOF, the market experiences a jolt. Subsequent adjustments in the structure of deposit rates (and thus lending rate as well) reverberate throughout the financial system until a new equilibrium is reached. In this regard, empirical results reveal that over the past several years, the NSD rate as well as monetary policy instruments of BB have more or less influenced lending and deposit rates in the banking system (Annex Table).

The NSD rates were increased most recently in December 2005 by 1.5 percentage points. While deposits of less than six months (particular at FCBs) have yet to experience much of a general adjustment, those of six months and longer have gone up by at least one full percentage point at most banks. PCBs appear to have raised deposit rates across the board.31 While this may have helped to move the real deposit rate in the positive arena, but this has not been the motivating factor. During the first 5-months of FY06, the net sale of NSD certificates had been at BDT 5.66 billion as against 7.95 billion in FY05, about 29 percent less. Clearly an

30 This section has been prepared by Shamim Ahmed and Md. Ezazul Islam, Research Economists, PAU. 31 These statements are based on the Economic Trends (February/March, 2006).

40

increase was necessary to induce sales. Question remains if the scale of the increase was necessary to induce the anticipated amount of additional borrowing. Ordinarily it would be expected that on account of the perceived low risk of investing in government issued instruments, the NSD certificates should attract sizeable investments if the offered rate were close to the rate prevailing in the banking system on deposits of comparable maturity. Presumably this practice will disappear once the borrowing requirements moderate.

a. Recent Persistence of High Spread

Weighted Average Spread Figure 3.2.1 illustrates the weighted average spread of all banks as well as sector wise behaviour of the spread pattern between June 2003 and September 2006. The spread for SBs has declined during FY04, but stabilising at about 4-percent over the past 12 months or so, the lowest spread among all the major bank groups in the country. Conversely, the spread for FCBs has gradually increased from the fourth quarter of FY04 for the next six quarters before easing a bit (but still in the 8-percnt range) in December 2005 and again increased above 8-percent in the third quarter of FY06. Moreover, it is the highest among all bank groups over the same period. Finally, while the spread had moderated for most of FY04, both PCBs and NCBs have followed a rather similar and stable path (i.e., about 6 percentage points) over the past seven quarters of so. While historically NCBs charged a slightly lower spread than PCBs, it is no longer so as of December 2005.

Figure 3.2.1: Interest Rate Spread (quarterly weighted average in percent)

0

2

4

6

8

10

Jun-0

3

Sep-

03

Dec-0

3

Mar-

04

Jun-0

4

Sep-

04

Dec-0

4

Mar-

05

Jun-0

5

Sep-

05

Dec-0

5

Mar-

06

Jun-0

6

Sep-

06

All Banks NCBs SBs PCBs FCBs

Note: In the above figure, Islamic banks (IBs) are also included in the PCBs group. Source: BB Quarterly (various issues) and authors’ calculation.

It is hard to compare the weighted average spread internationally as consistent data is not typically available for this indicator. In India, nominal prime lending rates of public sector banks and deposit rates of various maturities were within the range of 10.25 to 11.25 percent and 2.75 to 7-percent respectively during December 2006. India’s spread had been the second lowest in South Asia in 2006 (Figure 3.2.2). In contrast, although Pakistan has the lowest lending and deposit rates in nominal terms as well as real terms among the South Asian countries starting from June 2003, the spread of the banking system however remains the

41

highest in the region as the rate on deposit has been too low. Although, the nominal lending and deposit rates in Sri Lanka have been the highest in the region since August 2005, the spread of the banking system remains the lowest. Though based on incomplete data, on the basis of the evidence cited above, the Bangladesh spread behaviour does not appear to be much of an outlier, though it is a good deal higher than that in India, which boasts as the more competitive of the banking systems in the region.

Figure 3.2.2: Interest Rate Spread in South Asia

0

1

2

3

4

5

6

7

Pakistan India Sri Lanka Bangladesh

2003 2004 2005 2006

Notes: 1. All the figures have been taken for the month of December in each period except the figures in 2006 has

been taken for the month of June. 2. For India, deposit and prime lending rates are the mid-points of the range where the rates relates to

five major banks. Moreover, deposit rates are for more than one year maturity. Bangladesh, Pakistan, and Sri Lanka figures are weighted average.

Source: Reserve Bank of India Bulletin (various issues), State Bank of Pakistan Bulletin (various issues), International Financial Statistics (2006), and authors’ calculation.

Net Interest Margin (NIM)32

Table 3.2.1 indicates that while the overall pattern of the interest margin is comparable between Bangladesh and India, there are major differences along market segments. Given that reforms have been deep rooted in India, it would be particularly interesting to compare the PCB segment in the two countries, as they are generally free of pubic directives. While in Bangladesh the margin has declined in each year for both PCBs and FCBs, which is encouraging, by contrast there has been a shift up in the Indian figures across the board in 2004. Importantly the private banks (as well as FCBs) in India are seen to be more efficient than in Bangladesh. Though FCBs in both countries exhibit the highest spread, the figures in Bangladesh while having moderated dramatically in 2004, have been significantly higher than in India. It would be interest to see how the figure evolves in 2006. It would thus appear that there is room for efficiency gains via enhanced competition among PCBs and FCBs.

32 NIM is typically defined as the difference between ‘interest expenses’ and ‘interest income’ per unit of ‘total bank assets’. This is believed to be an important an indicator of intermediation efficiency. In the wider banking literature, the alternative concept of NIM is more prevalent.

42

The overall pattern of NIM is driven by the robust figure for the public sector banks which still account for nearly 75 percent of banking assets in India, and which are on the whole rather profitable. In contrast the NCBs in Bangladesh exhibit low spread on account of various restrictions that are imposed on their priority lending as well as to the relevant interest rates they can charge of these clients. NIM behavior lends easily to an international comparison. Mohan (2005, p18) cites a set of figures for a number of countries which indicate that the spreads for 2003 was below 2-percent for both Thailand and China, and higher for Korea (2.5 percent), Philippines (2.3 percent) and Indonesia (4.22 percent). Thai figure primarily reflecting private banks can only be compared with that relevant to the private sector banks only (PCBs and FCBs in the present acronyms) in Bangladesh and India. Seen in this light the Bangladesh figures appear to be on the high side.

Table 3.2.1: Net Interest Margin of Major Bank Groups: Comparison With India30

33

Note: Data for Bangladesh are at the end of December of respective years, while data for India are at the end of March of respective years.

Bangladesh India Year All

Banks NCBs SBs PCBs FCBs All

Commercial Banks

Public Sector Banks

Indian Private Banks

FCBs

2002 2.65 1.25 2.25 3.88 7.11 2.57 2.73 1.58 3.25 2003 2.70 1.47 1.48 3.71 6.76 2.48 2.52 1.96 3.36 2004 2.17 1.00 1.12 3.27 3.84 2.87 2.97 2.24 3.47 2005 2.19 1.56 0.86 2.58 4.74

Source: Statistics Department and Off-site Department, BB and Mohan (2005).

How high are these rates? This can only be known with precision if one knew the true costs of intermediation in the financial sector. Note that the figures in Table 3.2.2 are a mere fraction of the weighted average spread discussed above, and also below the NIM applicable for each bank group. Overall, however, these figures are lower than those in India (2.2 percent in 2004, and stable over the past decade).34 Internationally China (1.01 percent), Korea (1.38 percent), Malaysia (1.61 percent), and Thailand (1.71 percent) yield lower costs than other Asian countries (Mohan, 2005, p18). Interestingly here Bangladesh comes out among the leaders, although not having access to the data behind the foreign figures the exact comparability remains to be further explored.

33 The Bangladesh figures are similar to those reported by Mian (2004) though the latter uses a different methodology. 34 In the Indian case, all figures are close to each other across the bank groups, such that none of the figures fall below 2-percent (Mohan, 2005, p12).

43

Table 3.2.2: Costs of Intermediation (Operating Expenses as % of Total Assets) in Bangladesh’s banking sector

Year All Banks NCBs SBs PCBs FCBs 2001 1.83 1.53 1.94 1.93 3.21 2002 1.77 1.43 1.55 2.08 2.71 2003 1.92 1.58 1.88 2.14 2.72 2004 1.87 1.54 1.91 2.06 2.49 2005 1.76 1.61 1.08 1.96 2.21

Source: Bangladesh Bank Annual Report (various issues) and Off-site Supervision Department, BB.

b. Causes and Consequences of the High Spread Before analysing the reasons behind the high spread, it is worth mentioning that SBs featuring a variety of government interventions are not meant to form an efficient and competitive financial sector, therefore, the analysis into the causes of high spread may largely ignore this segment of the market. Besides, for the present discussion it is also kept in the background that the deposit rate in the banking industry is sort of exogenous to the market due to public sector borrowing requirements via the NSD certificates and similar instruments offering non-market yields. In particular, empirical results presented in the Annex Table suggest that 3-year NSD rate-increase in general triggers shift in deposit rate (i.e., weighted average rate on all types of deposits), savings deposit rate and rate on fixed deposit with 1-year to less than 2-year maturity in the positive direction. In turn, deposit rate and quarterly import growth also influence lending rates offered by the scheduled banks. Apart from 3-year NSD rate, bank rate set by the BB has been generally successful in influencing deposit and savings deposit rates.35

An interpretation of the persistence of high spread may therefore proceed as follows.

1. If the banking industry were believed competitive, the high spread would be indicative of high costs of intermediation. Here the high volume of NPL may figure as an explanation. Clearly high NPL faced by NCBs (and even higher by SBs) do not permit these institutions to make full use of their assets in earning the required return unless the lending rates are relatively high in relation to deposit rates. The question that arises is why competition among PCBs do not lead to a lowering of the spread in their segment of the market, and thus in the banking industry.

2. Another argument that may be put forward in explaining the high spread is that given the ‘high’ deposit rates in the banking industry, the addition of even a ‘normal’ intermediation costs would render the final break-even lending rate ‘high’, though this by itself does not explain high spread. However, potential investors would have to be imaginative in the use of money as they need to earn a high enough return to be able to pay the bank off. Thus if they undertake riskier than usual projects which on average yield higher returns, given the risks of

35 The other monetary policy instruments such as SLR, CRR, Treasury bill auctions have not been considered in the empirical estimation to keep the analysis simple.

44

default, the prudent lender has to take that into account as well in setting the ‘break-even’ lending rate. In this mechanism high deposit rate leads to a ratchet effect on the high lending rate, and hence the high spread. The above argument holds a fortiori in a non-competitive setting. Note that the high deposit rate which serves as a trigger in this construction may originate from the high rates available on public debt (Annex Table).

3. The remaining hypothesis is that the market is non-competitive, and the spread is mainly indicative of ‘monopoly’ profit. This view primarily rests on the market segmentation hypothesis, namely that each segment of the market (i.e., NCBs, PCBs, and FCBs) have distinct demand features which are catered only by the respective segment. The recent FCB behaviour is supportive of market segmentation; not only does this part of the market display a much higher spread than the rest, the differential seems robust, actually having risen substantially over the past two years (Figure 3.2.1). Competition would have brought about the opposite trend.

The convergence of the spread between NCBs and PCBs over time may give an appearance of competition between these two segments of the market. However, the knowledge that the NCBs will not be allowed to exit the market simply on grounds of their losses would permit one to interpret the observed spread in the NCB-PCB segment of the market as the minimum necessary to meet the cash flow requirements of NCBs just to keep the latter functioning.36 It is thus plausible that the more efficient firms among them (typically PCBs) enjoy some market power, and they exploit the advantage (i.e., earn excess profit) by adhering to the spread below which NCBs simply cannot operate. In other words, these better-run banks do not play the competitive game by paring the spread in order to win market share. The overall behaviour may then appear as one of tacit collusion within the PCB sector.

c. Conclusion To a degree the high spread reflects institutional inefficiencies. The inefficiency originated from the government’s ‘interventionist policies’ of the past and inadequate technical skills in the arena of risk and portfolio management. In this regard, Mahmud (2004) has argued that Bangladesh adopted financial liberalization without preparing for adequate regulation and supervision. It is important to mention that if this situation of high spread continues indefinitely, private sector investment may be jeopardized. Given the preponderance of debt financing in the country, increases in the borrowing rates raise the cost of investment nearly proportionately and thus eliminates many possible investment projects that were at the margin of acceptance. Here the absolute level of the (real) lending rate matters more than the spread. Further, the resulting high cost of borrowing also puts strains on the government by increasing the cost of servicing public borrowing from commercial banks as well as that from the non-bank public (Mahmud, 2004). Therefore, lowering of the high banking spreads would require

36 Note that the current income of NCBs, high spread notwithstanding, does not permit them to make adequate provisions for bad and doubtful debts as required under BB regulations. They do not maintain the capital adequacy ratios either.

45

substantial improvement in the current situation of limited competition, overstaffing, high administrative costs, the burden of NPLs, and above all, congruence between monetary and fiscal policy stances.

References Bangladesh Bank. Economic Trends (various issues), Statistics Department, BB: Dhaka.

__________________. Bangladesh Bank Quarterly (various issues), BB: Dhaka.

Dickey, D. A. and W. A. Fuller (1981). “Likelihood Ratio Statistics for Autoregressive Time Series with a Unit Root,” Econometrica, Vol. 49, pp. 1057-1072.

International Monetary Fund (2005). International Financial Statistics (IFS), Washington, D.C.

Kwiatkowski, D., P. Phillips, P. Schmidt and Y. Shin (1992). “Testing the Null Hypothesis of Stationarity against the Alternative of a Unit Root,” Journal of Econometrics, Vol. 54, pp. 159-178.

Mahmud, W. (2004). “Macroeconomic Management From Stabilization to Growth?,” Economic and Political Weekly, Vol. 35, No. 36, pp. 4023-32.

Mian, Md. A.M. (2004). “Interest Rate Spread of Commercial Banks Operating in Bangladesh,” mimeo, BB, Dhaka.

Mohan, R. (December 2005). “Reforms, Productivity and Efficiency in Banking: The Indian Experience,” Address delivered at the 21st Annual General Meeting and Conference of the Pakistan Society of Development Economists.

Phillips, P. C. B. and P. Perron (1988). “Testing for a Unit Root in Time Series Regression,” Biometrika, Vol. 32, pp. 301-318.

46

Annex Table: Determinants of Lending and Deposit Rates (1997-2006)37

Dependent Variable: Lending Rate of Independent Variables All Banks PCBs FCBs Bank Rate 0.114

(0.089) 0.051

(0.121) 0.020

(0.112) Deposit Rate (of) 1.127*

(0.176) 0.7223* (0.250)

0.507* (0.142)

Import Growth Rate 0.002*** (0.001)

0.002 (0.001)

0.000 (0.001)

Adjusted R2 0.981 0.955 0.885 Sample Size 37 37 37 Dependent Variable: Deposit Rate (all types) of Independent Variables All Banks PCBs FCBs Bank Rate 0.344***

(0.168) -0.073

(0.345) 0.227

(0.140) 3-Year NSD Certificate Rate

0.223* (0.065)

0.070 (0.086)

0.297* (0.055)

1-2 Day Repo Rate 0.019 (0.031)

0.012 (0.040)

-0.079** (0.026)

Adjusted R2 0.665 0.628 0.761 Sample Size 15 15 15 Dependent Variable: Savings Deposit Rate of Independent Variables All Banks PCBs FCBs Bank Rate 0.678**

(0.234) 0.352

(0.290) 0.306

(0.557) 3-Year NSD Certificate Rate

0.245** (0.092)

0.075 (0.079)

0.055 (0.138)

1-2 Day Repo Rate 0.002 (0.042)

-0.003 (0.035)

-0.034 (0.065)

Adjusted R2 0.749 0.845 0.835 Sample Size 15 15 15 Dependent Variable: Fixed Deposit Rate (1 year to less than 2 years) of Independent Variables All Banks PCBs FCBs Bank Rate -0.225

(0.374) -0.363

(0.440) -0.413

(0.250) 3-Year NSD Certificate Rate

0.370** (0.147)

0.205*** (0.109)

0.454* (0.098)

1-2 Day Repo Rate 0.091 (0.066)

0.053 (0.051)

0.063 (0.047)

Adjusted R2 0.422 0.742 0.487 Sample Size 15 15 15

Notes: 1. *,**, and **** means significant at 1-percent, 5-percent and 10 percent levels respectively. 2. Standard errors in the parentheses are corrected for serial correlation.

37 All estimations have been performed based on quarterly data set retrieved from various publications of BB for the period of January-March 1997 to January-March 2006. Besides, the variables are stationary in level based on Augmented Dickey-Fuller (ADF, 1981), Phillips-Perron (PP, 1988), and Kwiatkowski-Phillips-Schmidt-Shin (KPSS, 1992) tests. For ‘1-2 Day Repo Rate’, unit root tests have not been performed due to small number of observations.

47

3.3 Earnings and Profitability

(Write-up on this section is in progress pending data availability)

3.4 An Analysis of Non-Performing Loans in Bangladesh

(Write-up on this section is in progress pending data availability)

3.5 Divestiture of the Nationalized Commercial Banks 38

Better performance in the financial sector is one of the major determinants of achieving sustainable growth in the private sector in any economy. It has more crucial role in the developing economies, in particular, where activities in the financial sector are, mainly, dominated by the banking sector with negligible role of the non-bank financial enterprises. Since activities of the banking sector in these economies are significantly governed by the state, performances and financial transparency of state-controlled institutions are still concerned issues. In the earlier version of FSR, it was urged to go for Nationalized Commercial Banks (NCBs) restructuring and divestment by granting more autonomy to bank management and their support teams over day to day operations and strategic reforms, and by strengthening the role of the NCB Working Group.39

In view of the above recommendation, the government has already selected a successful bidder for the Rupali Bank as the process of its disinvestment. After the announcement for the bidding at the end-August 2006, comp3.5rehensive technical evaluations and proper test of potential bidders have been done by BB. Finally, by the early October, the government, which owns 94 percent of shares of Rupali Bank, took the decision to hand-over 67.3 percent of its shares to the private sector at a cost of USD 330 million. Obviously, this is the most welcome news during the last couple of months in the banking sector of Bangladesh, and is viewed as an important milestone for the bank restructuring program. The respective parties are now negotiating with each other and working to finalise the draft documents of sale and purchase in order to sign a formal contract as early as possible. As per the decision of the reviewing committee, the party has to pay USD 330 million in a single chunk before signing the sale and purchase agreement. In this regard, it may be mentioned that total assets of the Rupali Bank as showed in December 2005 stood at $1.07 billion and it has over 5,000 employees spread over 493 branches across the country.

As part of the divestment process of the Rupali Bank, the government has already prepared a set of commitments with respect to: (i) the assumption of pension liabilities up to the point of scale; (ii) introduction of a voluntary retirement

38 This section is prepared by M. Golam Mortaza, Research Economist, PAU and has been compiled from IMF (2006). 39 See, for instance, BB (2006).

48

scheme (VRS); (iii) the issuance of a government bond to bring its level of capital to zero and to account for the underprovisioning for the private loans in the statutory accounts as of end-2005; and (iv) conversion of SOE loans and other clearly defined government liabilities into a single loan on market terms from Rupali Bank to the government.

In regard to three other NCBs, i.e., Agrani Bank, Janata Bank, and Sonali Bank, the objective is to bring those banks to position of divestment preferably after the January elections. The model of the Rupali Bank divestment will be applied in case of divestment of these state-owned banks. The initial steps that will be followed as a part of the corporatization of those banks among others are to revise the contract and terms of reference of the managing directors of these banks so that they can enjoy full management authority to take decisions on all operational matters without prior approval from the Ministry of Finance. At the same time, qualified general managers/deputy general managers will be hired on a contractual basis in key departments who will be paid competitive salaries and will carry out necessary operational restructuring of the banks.

The performance of the NCBs still remains an area of concern, particularly their weak financial performance in respect of low recovery of Non-Performing Loans (NPLs) and capital shortfalls. The government, with the collaboration from Bangladesh Bank (BB) is strengthening efforts to restructure these NCBs in order to reduce the deficiency of their financial performance. BB, in particular, in consultation with the World Bank, will closely monitor the NCB’s compliance with memorandum of understandings (MOUs) with BB.

References BB (2006) “Financial Sector Review,” Volume 1, Number 1, Research Department, Bangladesh Bank: Policy Analysis Unit. IMF (2006) “Bangladesh: Fifth Review Under the Three-Year Arrangements Under the Poverty Reduction and Growth Facility and Request for Waiver of Performance Criterion, Extension of the Arrangement, and Rephasing – Staff Report; Staff Statement; press Release; and Statement by the Executive Director for Bangladesh on the Executive Board Discussion,” IMF Country Report No 06/406, November, Washington, D.C.: International Monetary Fund. 3.6 Default Risk: Write-Offs and Loss Provisions

(Write-up on this section is in progress pending data availability)

49

3.7 Maturity Profile of Assets and Liabilities

(Write-up on this section is in progress pending data availability)

3.8 Capital Base Adequacy40

Introduction

Capital position of a bank reflects its ability to absorb risk deriving from its internal and economic environment and provides confidence among the depositors by protecting their money from any losses. It is also considered as one of the major financial soundness indicators of a bank. The issue of capital adequacy is gradually getting importance for another reason. Due to globalization, international business is playing much active role in the domestic economy and banks are now more exposed to this process. Since capital represents risk status of a bank, international banks like to see capital adequacy of banks before engaging any business with the local banks. On the other hand, international agency such as Basel Committee also likes to see whether banks are compliant of Basel Capital Accord II. However, this section highlights on capital mix, recent changes in capital regulation and capital behaviour as well as capital position of banks and compares capital adequacy of banks in Bangladesh with other South and South-East Asian countries.

Capital Mix

There is no consensus about optimal capital mix. Regulators like to see that banks maintain stronger capital (Tier I) to minimize financial system risk. On the other hand, banks want to maintain capital mix that provides lower cost of capital. However, existing regulation allows banks to maintain capital in 8 constituents of Tier I and 5 constituents of Tier II Capital. The study shows that banks in Bangladesh maintain their capital primarily in four constituents: equity or paid up capital (53 percent), statutory reserve (19 percent) and general provision (13 percent). First three of them are considered as stronger capital. Except general reserve, maintenance of capital in other items is indeed regulatory obligation. The issue of equity capital and build up of statutory reserve (only for local banks) are mandatory for banks under BCA, 1991. Banks are also required to maintain a certain percentage (1-5 percent) of their unclassified loans and advances as general provision under BRPD circular no... However, banks’ little willingness to maintain capital in other constituents may be, among other, for two reasons: (i) they are only interested to maintain regulatory requirement (ii) lack of explicit guidelines to issue debt capital such as subordinate debt.

40 This section is prepared by Md. Kabir Ahmed, Research Economist, PAU.

50

Capital mix, (based on June, 2006 data), differs across different categories of banks. PCBs maintained capital mainly in five components: paid up capital, general reserve, statutory reserve, retained earnings and general provision. Foreign commercial banks maintain their capital in three capital items such as capital fund, retained earnings and general provision. It can be noted that though NCBs, SBs and PCBs are maintaining capital in statutory reserve, this item is absent for FCBs. Statutory reserve has been made obligatory, under section 24 of BCA 1991, for banks that are registered in Bangladesh. Since existing bank licensing policies do not require foreign banks to be registered locally, they are technically exempted to maintain regulatory capital in this item.

Chart : Capital Mix of Scheduled Bank 

Capital Mix of Scheduled Banks

53%

6%

19%

2%

3%

13%4%

Paid up capital/Fund

General ReserveStatutory Reserve

Retained Earnings

Other Core Capital

General ProvisionOther Supp. Capital

Source: Chart is based on data obtained from Department of Off-site Supervision, Bangladesh Bank

Chart: Capital Mix by types of banks

-30

-20

-10

0

10

20

30

In b

illion

BD

T NCBs

SBs

PCBs

FCBs

Chart is based on data obtained from Department of Off-site Supervision, Bangladesh Bank

Capital positions of the scheduled banks

Total capital position of scheduled banks improved persistently since 2001 except a small fall in 2004. Indeed, significant improvement of capital position occurred during June 2005 to June 2006 (see chart ..). Though total capital of banks increased about BDT 19.93 billion since 2001 to 2004, it rose about BDT 28.77 billion during June 2005 to June 2006. This increase was caused by several factors such as issuance of right share, bonus share, IPOs and increased in general provision and retained earnings. PCBs mainly contributed to this rise followed by

51

NCBs and FCBs. Among the PCBs, Islami Bank, Prime Bank, Jamuna Bank, Dhaka Bank, Pubali Bank, National Bank, NCCB, Southeast Bank and UCB notably raised their capital. Rising paid up capital of Sonali Bank and retained earnings of Agrani Bank were the major sources of increase in total capital for NCBs. Among the FCBs, Citi Bank, HSBC and Standard Chartered significantly increased their capital. Fund from parent office, retained remittable profits and general provision were the main sources of enhanced capital in FCBs.

One possible explanation for recent capital enhancement in FCBs , among others, is that foreign banks usually provide big loans to a small number of customers. As Central Bank tightens large loan policy in 2003 (effective from June 30, 2003) and 2005, where loan exposure to a single borrower is linked to a bank’s capital, these banks tried to retain their existing customers by raising capital. Chart: Total Capital position of the Scheduled Banks

-20

0

20

40

60

80

100

120

1999 2000 2001 2002 2003 2004 J un'05 De c '05 J un '06

FBsPCBsSBsNCBs

Source: Chart is based on data obtained from Department of Off-site Supervision, Bangladesh Bank

Status of Scheduled Banks in terms of Regulatory Capital Requirement

Considering the regulatory capital standards (BDT 1 billion or 9 percent of risk-weighted asset whichever is higher) set by the Bangladesh Bank through different circulars and also by the Bank Company Act (BCA) 1991, it has been found that the gap between regulatory capital and actual capital decreased substantially, about BDT 12.52 billion, during June 2005 to June 2006. Total capital shortage in the banking sector in June 2005 was BDT (-) 31.57 billion which decreased to BDT (-) 19.05 billion by June 2006. However, NCBs are still suffering from substantial deficit (about BDT 34.4 billion) to meet regulatory requirement. On the other hand, foreign banks maintained capital considerably above the regulatory standard (about BDT 11.75 billion) and positively contribute to the financial system stability. Until June 2006, 5 (five) of the third generation private banks did not go for IPOs to collect 50 percent of their capital from capital market through issuing IPOs. It is expected that as soon as these banks will raise capital from the stock market, it will further improve overall capital position of banking sector in Bangladesh.

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Chart : Capital Surplus/Shortfall in terms of Regulatory Requirement

-40

-30

-20

-10

0

10

20

01 02 03 04 Jun'05 Dec'05 Jun'06

Billio

n Ta

ka

NCBs

SBs

PCBs

FBs

Total

Source: Char is based on data from Department of Off-site Supervision, Bangladesh Bank

Risk-weighted Capital of the Banks

Since banks' risk derive from the riskiness of its assets and hence capital behaviour of the scheduled banks in terms of risk-weighted capital approach needs to be monitored. It is observed that risk-weighted capital ratio (RCAR) improved notably from 7.1 to 8.0 during June 2005 to June 2006 but the RCAR was still lower than the regulatory standard. Further analysis shows that except NCBs, other types of banks maintained higher RCAR than the regulatory requirement. In fact, negative RCAR of NCBs caused the aggregate risk-weighted capital ratio to be lower than the regulatory standard. Though RCARs for SBs and PCBs were marginally higher (0.1 to 1.0 percent) than the official requirement, foreign banks maintained significantly higher (above13 percent) risk-weighted capital ratios than the regulatory requirements during the said period. Excluding NCBs, it can be argued that RCAR for the banking sector as a whole remained stable and above the regulatory requirement.

Chart : Capital Adequacy Ratio (CAR) by types of Banks

-4048

1216202428

2001 2002 2003 2004 Jun'05 Dec'05 Jun'06

NCBs

SBs

PCBs

FCBs

Total

Source: Chart is based on data from Department of Off-site Supervision, Bangladesh Bank

Component-wise risk-weighted capital

Current regulation requires the scheduled banks to maintain at least 4.5 percent of RWA in Tier I Capital. The chart indicates that even though aggregate risk-

53

weighted capital ratios for banking sector were lower than the regulatory requirements, performance of banking sector in terms of Tier-I (Core) capital requirement was noteworthy. Banking sector as a whole consistently maintained higher ratio in Tier I capital than the regulatory standard. However, it may also be argued that due to lack of instrument, suitable for inclusion in Tier II Capital, banks kept most capital in Tier-I. Though perpetual subordinated debt has been included as Tier II Capital component, regulator as well as banks are yet move positively in this direction. In a study conducted by Ashcraft (2006), Federal Reserve Bank of New York, concluded that an increase in the amount of subordinated debt in regulatory capital has an important positive effect in helping a bank to recover from financial distress. As a regulator, central bank is more concerned to improve capital adequacy of weak banks. Since weak banks provide lower returns, the equity holders may not have much incentive to supply further capital. These banks may be allowed to issue subordinated debt to strengthen their capital base.

Chart : Components of Capital as a percentage of Risk-Weighted Asset

0123456789

10

2002 2003 2004 Jun'05 Dec'05 Jun'06

Actu

al c

apita

l as

a pe

rcen

tage

of

RW

A

Tier ITier II

Total Capital

Source: Chart is based on data from Department of Off-site Supervision, Bangladesh Bank

Unweighted Capital Ratio41

Since June 2005 unweighted capital ratio (UCR) for banking sector improved though progress is not remarkable. The ratio reached to 4.10 in June 2006 from 3.59 in June 2005 indicating financial system’s ability to absorb higher losses. Rising UCRs of NCBs and PCBs were the main source of this gradual improvement. Unweighted capital ratio for the NCBs in June 2005 was (-) 0.36 which rose to 0.22 in June 2006. UCR for SBs remained almost stable within the range of 7.17 to 7.41. Both risk-weighted and unweighted capital ratio for the SBs steadily improved since 2003, though declined a little in 2005. Though UCR of FCBs remained high since 2003, it declined to 9.61 in June 2006 from 9.67 in June 2005 indicating that they engaged less capital relative to their assets. Efforts are being taken by both government and the Bangladesh Bank to improve their financial status including capital position. Deregulation of ownership is a major

41 Bank’s capital as a percentage of its size i.e., total assets, is termed the unweighted capital ratio.

54

step initiated by the government. One of them namely Rupali Bank is already in a final stage to be privatized under foreign ownership. New strategies are being adopted to handle capital inadequacy, bad assets and overstaffing. To this end, new management support teams were recruited for Sonali, Agrani and Janata Banks. NCBs also required to sign MOUs (Memorandum of Understandings) with the Bangladesh Bank in 2003 so as to closely monitor their activities and improve their financial position. It is therefore expected that these efforts will positively contribute to overcome their capital adequacy problems in future.

Status of CAR compared to South and Southeast Asia and Basel Accord II It is argued that in order to establish a common free trade area within SAARC countries, harmonization of banking regulation needs to be emphasized. The study shows that CAR of banking sector in Bangladesh is much lower than other SAARC countries such as India, Pakistan and Sri Lanka. The issue of regional integration through trade and finance is also getting prominence in the recent times where financial integration is a part. But CARs in Southeast countries are much higher than that of Bangladesh. On the other hand, New Capital Accord requires the banks maintaining of minimum capital against three kinds of risks such as credit risk, market risk42 and operational risk43. As per existing regulation, scheduled banks in Bangladesh are required to maintain minimum capital against credit risk only. It can therefore be argued that implementation of the New Accord may require the banks to raise their capital significantly.

It is argued that new accord may free up capital requirement for credit risk. This additional capital may be used to fulfill new capital requirement for operational risk. Since new capital accord will affect different banks in varying degrees depending on its exposure to risk, the above argument may not be true for all cases. Therefore it is argued that it will benefit the goods and penalize the bad Chart : Unweighted Capital Ratios

-2

0

2

4

6

8

10

12

14

2002 2003 2004 Jun'05 Dec'05 Jun'06

NCBs

SBsPCBs

FCBsTotal

Source: Chart is based on data from Department of Off-site Supervision, Bangladesh Bank

42 It is defined as the risk of losses in on and off-balance-sheet positions arising from movements in market prices. 43 It is defined as the risk of losses resulting from inadequate or failed internal processes, people and systems or from external events. It includes legal risk but excludes strategic and reputational risk.

55

Chart :Capital Adequacy Ratio of banks in South and South-East Asia

8.0

12.8

10.9

12.4

21.5

12.6

17.7

14.3

-2.6

-5.0 0.0 5.0 10.0 15.0 20.0 25.0

BAN (Jun06)

IND(FY04)

NEP(FY05)

PAK(05)

SRI(05)

INO(Apl.06)

MAL(May06)

PHI (Sep.06)

THA(Apl.06)

Capital Adequacy Ratio

Source: Asia Economic Monitor (July 2006)

banks making their requirements tougher. As a regulator, though BB’s medium to long term goal is to develop market efficiency, its immediate objective is improve soundness of weaker banks and provide security of public deposits. One of the alternatives is to increase capital base of banks. In a study conducted by Ashcraft (2006), Federal Reserve Bank of New York concluded that an increase in the amount of subordinated debt in regulatory capital has an important positive effect in helping a bank recover from financial distress. This result suggests that allowing banks to issue subordinated debt may be one of the suitable alternatives to resolve capital adequacy problem of banks. A gradual and orderly adjustment of capital adequacy would appear desirable for the overall stability of the banking sector.

Recent Changes in Capital Regulation and expected effect of capital adequacy of banks

Bangladesh Bank vide BRPD Circular No. 07, dated August 28, 2006 brought a change in Capital Regulation of scheduled banks in Bangladesh. As per new regulation, banks are required to maintain General Provision in the following way:

Rate of provisionAll unclassified loans (other than loans under Small Enterprise and Consumer Financing and Special Mention account)

1 percent

Small Enterprise Financing 2 percent Consumer Financing 5 percent Outstanding amount of loans kept in the 'Special Mention Account' after netting off the amount of Interest Suspense

5 percent

The table shows that banks are required to maintain general provision more than 1 percent of unclassified loan as general provision. Note that earlier banks were required to maintain 1 percent of general provision. Since general provision is one

56

of the constituents of Supplementary Capital, it may positively contribute to improve the capital adequacy of banks though the effect may not be significant due to its application to limited categories of loans.

Conclusion Banks in Bangladesh maintain their capital primarily in three constituents such as paid up capital, statutory reserve and general provision. Banks’ little efforts to maintain capital in other constituents may be, among other, their willingness to fulfill regulatory obligation only. Capital position of banks improved substantially, about BDT 28.77 billion, during June 2005 to June 2006. This increase was caused by several factors such as issuance of right share, bonus share, IPOs and increased in general provision and retained earnings. PCBs mainly contributed to this rise followed by NCBs and FCBs. Risk-weighted capital ratio (RCAR) also improved notably from 7.1 to 8.0 during June 2005 to June 2006 but the RCAR was still lower than the regulatory standard. Banking sector as a whole consistently maintained higher ratio in Tier I capital than the regulatory standard. It may be due to lack of instrument, suitable for inclusion in Tier II Capital. Lack of explicit guidelines to issue debt capital such as subordinate debt may be another cause. Since June 2005 unweighted capital ratio (UCR) for banking sector improved though progress was not remarkable. The ratio reached to 4.10 in June 2006 from 3.59 in June 2005 indicating financial system’s ability to absorb higher losses. Rising UCRs of NCBs and PCBs were the main sources of this gradual improvement. The study shows that CAR of banking sector in Bangladesh is much lower than South Asia and Southeast Asian countries. Recent changes in capital regulation may positively contribute to improve the capital adequacy of banks though the effect may not be significant due to its application to limited categories of loans.

3.9 Banking Sector Outlook

(Write-up on this section is in progress pending data availability)

57

Chapter 4

The Capital Markets and the Non-Bank Financial Sector

4.1 The Capital Market in Bangladesh

4.1. A Securities and Exchange Commission, DSE and CSE44

Introduction

After the stock market debacle in 1996 and a slower than desired recovery in FY04, stock markets in Bangladesh behaved moderately in FY06 and the first few months of FY07 (Figure 4.1.1). While the monthly average price indexes at Dhaka Stock Exchange (DSE) have shown a mixed pattern in the first two quarters of FY06, a steady declining trend was evident in the last two quarters of FY06, followed by some improvements in the first quarter of FY07. The monthly average of "all share price index (DSI)", DSEG, and DSE20, on twelve months point-to-point basis, changed by 5.04 percent, -3.5 percent and -19.4 respectively in Sept'06. In view of quarterly changes, the monthly average of DSI, DSEG, and DSE20 increased by 28.5, 19.8 and 7.09 percent respectively in Sept'06 over June'06. The monthly average turnover, however, experienced a record gain (244.04 percent in Sept'06 over June '06) in the first quarter of FY07 from a general declining or stagnant trend prevailing at DSE during the whole fiscal year of FY06.

The monthly average turnover increased by 104.8 percent in Sept'06 over Sept'05. The turnover had increased by as high as 138.5 percent in Aug'06 from the preceding month, as compared to 48.9 percent in July '06 and -3.1 percent in Sept '06. The increased market turnover in the first quarter was largely contributed by the trading of the shares of some companies including Dhaka Electric Supply Company Ltd (DESCO); a state-owned power company offloaded 25 percent of its share to public in June 2006 under the newly adopted Direct Listing Regulation-2006.45 DESCO trading accounted for 18.18 percent, 12.66 percent and 9.82 percent of DSE turnover in July '06, Aug'06 and Sept'06 respectively. In the face of the downward trend of price indexes and a sluggish turnover situation in FY06, market capitalization of all listed companies also increased substantially in the first quarter of FY07.

44 This section is prepared by Md. Shahiduzzaman, Research Economist, PAU 45 DESCO is the first company to come to market under the Direct Listing Regulation-2006. Under the regulations, well-established and reputed companies go to the public without making initial public offering (IPO).

58

Figure 4.1.1: Monthly Average of All Share Price Index (DSI), DSE General Index (DSEG), DSE20 and Turnover (million BDT)

1000.01100.01200.01300.01400.01500.01600.01700.01800.01900.0

Jul-0

5

Aug-05

Sep-05

Oct-05

Nov-05

Dec-05

Jan-06

Feb-06

Mar-

06

Apr-06

May

-06Ju

n-06

Jul-0

6

Aug-06

Sep-06

DSI

, DSE

G a

nd D

SE20

0.0

100.0

200.0

300.0

400.0

500.0

600.0

Turn

over

DSI DSEG DSE20 Turnover (In mn BDT)

Source: Constructed by the author by taking data from Monthly Review, DSE, various issues

Market Capitalization and Listed Securities

Market capitalization increased by 24.7 percent at DSE in first quarter of FY07 as compared to only 0.31 percent during the whole of FY06. The improvement of market capitalization in the first quarter of FY07 was attributed to the market capitalization by the listed companies; total market capitalization for mutual funds, debenture and bonds showed very minimal change during the quarter. Total market capitalization of all securities listed at DSE stood BDT 281021.0 million as on September 2006 compared to BDT 225301 million as on June '06 and BDT 224611 million as on June 2005 (Table 4.1.1).

Table 4.1.1: Overview of Capital Markets DSE CSE As on

Jun'05As on Jun'06

As on Sept'06

As on Jun'05

As on Jun'06

As on Sept'06

Market Capitalization (Million BDT) All Listed securities 224,611 225,301 281,021 202231.4 199,274.3 Companies 211,200 203,500 259,247 201034.2 197946.6 Mutual funds 1,247 1,185 1,158 1104.9 1235.3 Debentures 576 576 576 92.3 92.3 Debt Securities 11,589 20,040 20,040 - -

Number of Listed Securities All listed securities 277 303 302 198 213 Companies 239 256 253 184 198 Mutual funds 12 13 13 12 13 Debentures 8 8 8 2 2 Treasury bonds 18 26 28 - - Source: Various Reports of Securities and Exchange Commission (SEC), Dhaka and Chittagong

Stock Exchanges.

59

In view of sectoral composition, the financial sector including banks and insurance holds the majority share to total market capital capitalization of companies at DSE: 58.3 percent as compared to 32.1 percent manufacturing and 9.6 percent by "service and miscellaneous". The share of financial sector to total market capitalization was 54.6 percent in '06 and 48.4 percent for June '06 and June '05, respectively. Of the total market capitalization by companies at DSE, share of banking sector increased to 53.9 percent in Sept'06 as compared to 49.6 percent in June '06 and 43.7 percent for June 2005. Figure 2.1 shows the sub-sector wise composition of total market capitalization at DSE for the month of Sept'06.

Banking companies, as a whole, continued to perform well in FY06. As many as 11 banking companies are listed in the top 15 performing companies in terms of market capitalization at DSE (FE: July 1, 2006).46 Islami Bank Bangladesh Ltd. with 6.04 percent of total market capitalization ranked 2nd in terms of market capitalization behind Lafarge Surma Cement which ranked first by holding 9.79 percent share of total market capitalization at DSE in FY06.

Figure 4.1.2: Sector wise (selected) Composition of Market Capitalization in Sept'06 at DSE (in Million BDT)

Banks (53.9%) Insurance (3.6%)Foods (2.3%) Pharmaceuticals (10.5%)Textile (3.4%) Engineering (2.8%)Cement (11.7%) Fuel and Power (5.5%)Miscelleneous (2.8%)

Figures in the parenthesis show the share of sub-sector wise capitalization to total market capitalization by listed companies.

Source: Monthly Review, Dhaka Stock Exchange, September 2006

Earnings and Profitability

(a) Price Indexes

The price indexes reflect the market behavior in the capital market. During FY06 and first quarter of FY07 all three share prices indexes got the highest loss in April '06 and highest gain in August '06. The turnover value, however, gained by

46 The banking industries are Islami Bank BD Ltd.(6.04%), Rupali Bank Ltd. (3.59%), Prime Bank Ltd. (3.49%), Pubali Bank Ltd. (3.46%), Eastern Bank Ltd. (3.28%), National Bank Ltd. (2.91%), Dhaka Bank Ltd. (2.47%), City Bank Ltd. (2.16%), Export Import Bank Ltd. (2.10%), Dutch Bangla Bank Ltd. (2.02%) and Southeast Bank Ltd. (1.95%).

60

27.7 points in April '06 despite decrease in the all three share price indexes in the month; the turnover value experienced a highest loss in December '05 and gain in Aug '06. While DSE general index excludes companies of Z category, DSI includes shares of all categories and DSE20 includes the blue chips companies.47 Table 4.1.2 reports the monthly changes of DSE, DSEG, DSE20 as well as turnover value. While shareholders of all categories got a record price gain in the first quarter, DSEG (which excludes the Z category shares) performed best and DSE 20 behaved worst in August '06 in terms of change from preceding month. Furthermore, DSE20 experienced a loss by 41.7 point but DSI and DSEG gained in the month of September '06. This figures show the relatively better performance of the shares of A, B and G categories other than the blue chips shares listed at DSE.

Table 4.1.4: Sector Wise P/E Ratio of DSE Shares P/E Ratio Sector Dec'03 June '04 Dec'04 June '05 Dec'05 June '06 Sept '06 Bank 8.72 9.69 21.74 17.94 17.9 11.26 14.7 Cement 31.54 24.21 25.23 16.99 16.13 13.37 19.96 Ceramic 17.37 19.67 25.74 21.46 17.06 14.67 15.78 Engineering 15.22 15.48 18.62 17.83 14.14 14.67 15.95 Food and Allied 10.22 10.54 10.11 11.46 9.13 15.79 15.32 Fuel and Power 15.48 14.4 14.79 17.92 22.32 26.54 14.77 Insurance 12.36 17.58 26.92 20.97 20.87 9.94 10.23 Investment 8.48 8.43 8.27 8.37 6.55 5.35 5.64 IT 10.71 12.51 25.11 15 10.46 9.48 11.37 Jute 12.81 15.59 19.56 13.04 12.55 11.93 9.91 Miscellaneous 10.05 10.55 13.21 7.62 7.83 8.75 11.4 Paper & Printing 9.28 6.29 1.82 8.65 4.69 6.21 8.48 Pharmaceuticals 10.76 16.34 18.19 16.65 10.84 10.24 11.82 Service & Real Estate 34.23 11.94 9.61 18.51 8.16 8.12 16.94 Tannery 9.47 8.92 10.51 14.87 8.16 8.17 7.91 Textile 13.65 10.76 15.3 11.15 10.08 7.92 13.11

Source: Monthly Review, DSE; Various Issues. 47 DSE categorizes all shares at DSE as A, B, G, Z & N based on their financial strength and performance. Category A includes the companies that hold the current annual general meeting (AGM) and declare dividend at the rate of ten percent or more in a calendar year. Category B includes the companies that hold the current annual general meeting (AGM) but failed to meet declare dividend at least at the rate of ten percent in a calendar year, category Z includes the companies which failed to hold the current annual general meeting (AGM) or failed to declare dividend or which are not in operation for more than six months or whose accumulated loss after adjustment of revenue reserve, if any, is negative and expected its paid up capital, category G includes Greenfield companies and category N includes all newly listed companies except Greenfield companies.

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Table 4.1.3: Monthly Changes of DSI, DSEG and DSE20

DSI DSEG DSE20 Turnover

(In mn BDT) Jul-05 -65.3 -73.3 -71.0 -26.6

Aug-05 -39.4 -54.4 -91.9 -33.3 Sep-05 61.0 82.3 31.8 91.6 Oct-05 12.3 23.5 -14.1 -61.7 Nov-05 21.7 29.8 -46.8 72.8 Dec-05 -36.7 -50.3 -68.9 -86.4 Jan-06 28.2 33.6 7.2 -39.8 Feb-06 -60.7 -82.4 -62.8 -2.0 Mar-06 -37.8 -54.8 -48.6 11.2 Apr-06 -114.1 -155.6 -107.5 27.7 May-06 -4.3 -11.3 -17.0 10.2 Jun-06 -38.4 -53.0 -64.0 -39.2 Jul-06 40.3 38.0 53.6 77.2

Aug-06 155.0 167.2 79.1 325.6 Sep-06 97.8 57.6 -41.7 -17.4

Source: Dhaka Stock Exchange

(b) P/E Ratio Table 4.1.3 records the sector wise price-earning (P/E) ratio of DSE shares. The P/E ratio depicts the relationship between market's valuation of a company's shares and the wealth the company. The ratio stays the same if price and earnings increase or decrease by the same margin. If the ratio fluctuates markedly, or stays at a higher or lower than normal, we can argue that recent company performances are no longer the main factor in pricing of a share at the marketplace. Generally, a higher P/E means the company has the potential to improve its fundamentals so that investors may be willing to pay a large multiple of its current earnings to buy the stock. However, from the viewpoint of an investor, a higher P/E is risky because there is possibility that current price does not reflect the company’s fundamentals, rather, non-fundamental factors may support the price rise and hence price may go down substantially in the future.

P/E ratios are higher for firms or sectors as a whole with higher growth prospects. In Table 4.1.3, we can see that highest P/E ratio is for "Cement" sub-sector followed by "Service and Real Estate" in Sept'06. The "Fuel and Power" sector held the highest P/E ratio in both December and June 2006, but declined sharply in Sept'06 because of the decline of price some companies. The P/E ratio declined alarmingly in the calendar year 2006. As per the DSE data, weighted average price earning ratio fell in June’06 as compared to June’05 for most sectors, except "Food and Allied", Fuel and Power" and "miscellaneous". The first two sectors experienced a rise in P/E ratio in last two consecutive fiscal years. P/E ratio of banks fell from 17.94 to 11.26, insurance from 20.97 to 9.94 and pharmaceuticals from 16.65 to 10.24 percent. In June 2006, the P/E ratio of banks fell to 11.26 percent from 17.94 percent in June ’06, before going further up to 14.7 in Sept’06.

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(c) Dividend Yield According to dividend information hypothesis, there exists a positive relationship between the stock returns and dividend (cash) announcement. This is because dividend payment provides information about the future cash flows of a firm, which is consequently reflected in the market price of stock. However, a recent study by Uddin (2003) found that dividend payment did not lead to share prices increase at DSE, rather paying companies lost significant amount of value over a period of 30 days after the dividend announcement. The finding of the study is, however, consistent with dividend tax-effect hypothesis, which links the dividend income with investors’ personal income for tax payment.

Sector-wise average dividend data at the end of June 2006 as compared to June 2005 show that there was an increase in average dividend paid by the banking sector from 3.63 to 5.78 percent, by pharmaceuticals from 19.62 to 21.14 percent, cement from 0.99 to 1.56 percent, jute 2.14 to 3.97 percent and miscellaneous industries from 7.97 percent to 23.24 percent. However, there was rapid decline in average dividend payment by food and allied from 23.02 to 7.78 percent, fuel & power from 32.71 to 7.54 percent tannery from 23.19 to 7.43 percent, engineering from 19.62 to 12.5 percent and insurance from 10.13 to 5.38 and information technology from 9.73 to 4.09 percent. There was marginal increase in average dividend payment of services from 1.79 to 1.89 percent ceramic from 7.94 to 8.22 percent, investment from 12.2 to 12.84 percent, textile from 4.39 from 5.03 percent.

Market Volatility: Risk and Return Stocks are subject to two types of risk: market or systematic risk and non-market risk. Market or systematic risk is the risk that a particular stock's price will be affected by overall stock market movements. Non-market risk, on the other hand, is related to the risk that events specific to a company or its industry will adversely affect the stock's price. Market risk cannot be controlled but non-market risk can be reduced through diversification.

While risk is difficult to measure, a primary but common method of measuring risk is the standard deviation of prices. Standard deviation provides the snapshot as to how far above or below the expected value the actual value is likely to be. Figure 4.3 reports the daily fluctuation of price indexes and turnover at DSE and

Figure 4.1.3: Daily Movement of Price Indexes and Turnover at DSE

1000

1100

1200

1300

1400

1500

1600

1700

1800

1900

2-Ju

l-05

17-Jul-0

5

1-Aug

-05

16-A

ug-0

5

31-A

ug-0

5

15-S

ep-0

5

30-S

ep-0

5

15-O

ct-0

5

30-O

ct-0

5

14-N

ov-0

5

29-N

ov-0

5

14-D

ec-0

5

29-D

ec-0

5

13-Jan

-06

28-Jan

-06

12-F

eb-0

6

27-F

eb-0

6

14-M

ar-0

6

29-M

ar-0

6

13-A

pr-0

6

28-A

pr-0

6

13-M

ay-0

6

28-M

ay-0

6

12-Jun

-06

27-Jun

-06

12-Jul-0

6

27-Jul-0

6

11-A

ug-0

6

26-A

ug-0

6

10-S

ep-0

6

25-S

ep-0

6

DSE

Gen

eral In

dex, D

SE20

, DSI

100.00

300.00

500.00

700.00

Turn

over

(million BD

T)

Turnover (value)DSE20DSE General IndexAll Share Price Index (DSI)

Source: Data from Monthly Review, DSE; Various Issues.

63

Figure 4.1.4: Standard Deviation and Monthly Average of Price Indexes

500.0600.0700.0800.0900.0

1000.01100.01200.01300.01400.01500.01600.01700.01800.01900.02000.0

Jun'0

5Ju

l'05

Aug'05

Sep'0

5

Oct'05

Nov'05

Dec'05

Jan'0

6

Feb'0

6

Mar'

06

Apr'06

May

'06

Jun'0

6Ju

l'06

Aug'06

Sep'0

6

DSI

, DSE

G a

nd D

SE20

8.0

18.0

28.0

38.0

48.0

58.0

DSI

_SD

, DSE

G_S

D a

nd D

SE20

_SD

DSI DSEG DSE20DSI SD DSEG SD DSE20 SD

Source: Data from Monthly Review, DSE; Various Issues. Note: DSI_SD means standard deviation of daily DSI, DSEG_SD means standard deviation of daily

DSEG and DSE20_SD means standard deviation of daily DSE20, on monthly basis

the dotted lines in Figure 4.4 shows the standard deviation of daily price indexes along with monthly average indexes. From both of the figures, it is evident that volatility was quite high during March-June 2006 when the price indexes also showed a declining trend. During FY06 and first quarter of FY07, volatility as measures by standard deviation was highest in July 2005, which is also associated with decline of all share price indexes. Both standard deviations and mean were significantly lower in June 2006 as compared to the June 05. Along with the increase in the monthly average price indexes standard deviation increased in August 2006 but decreased in Sept 06 when DSI and DSEG also declined.

Conclusion Capital market in Bangladesh is largely contributed by the banking industry; in FY06 the most of the top performing companies were banking companies. As a whole, stock markets behaved moderately in FY06 together with some significant developments in the first quarter of FY07. Market turnover got momentum in the first quarter, given the direct listing of Dhaka Electric Supply Company Ltd (DESCO). In terms of price indexes, shares of A, B and G categories played relatively better performance than the blue chips shares listed at DSE in FY06. In view of market volatility and stock return, volatility as measured by standard deviation also found high during a bearish market condition.

References The Financial Express (July 1, 2006), Stock Market 2005-06. (A National Daily in Bangladesh) Uddin, Md. Hamid (2003), Effect of Dividend Announcement on Shareholders’ Value: Evidence from Dhaka Stock Exchange. (FIRST DRAFT 22 November 2003)

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4.1.B Mutual Funds and Asset Management 48

Capital market plays an important role in any economy. A mature and sizeable capital market is perceived across the globe as an indicator of the economic health and prospect of a country as well as an index of the confidence of domestic and global investors. A well-functioning capital market promotes economic growth by efficiently channeling domestic and foreign funds into productive sectors. A large number of investors participates in the capital market through the buying and selling of shares, debentures and mutual funds.

A mutual fund is simply a financial instrument that allows a group of investors to pool their money together with a predetermined investment objective. The mutual fund will have a fund manager who is responsible for investing the pooled money into specific securities (usually stocks or bonds). Investing in a mutual fund means buying shares (or portions) of the mutual fund and become a shareholder of the fund. Mutual funds are one of the best investment instrument ever created because they are cost efficient and very easy to invest.

Mutual Fund in Bangladesh

Mutual funds are usually treated as a means of safe and profitable investment in the capital market. In developed countries, mutual funds are popular investment instruments. More than ten thousand different kinds of mutual funds are actively traded in the US capital market. However, in Bangladesh, there are only 13 listed mutual funds among 270 listed securities in the Dhaka Stock Exchange. As of June 2006, market capitalization of all the mutual funds is worth BDT 1.19 billion, which is rather low (only 0.55 percent) relative to the value of the total market capitalization (BDT 215.42 billion). Mutual funds in Bangladesh can be categorized into two different types based on their operational characteristics - Open-end funds and Closed-end funds. An open-end fund is one that is available for subscription throughout the year without having any maturity period commonly known as “Unit Fund”. Investors can conveniently buy and sell units at Net Asset Value (NAV) related prices. A closed-end fund is known as “Mutual Fund”. It has a stipulated maturity period generally ranging from 3 to 15 years. Investors can invest in the scheme at the time of the initial public issue and thereafter they can buy or sell the units of the scheme on the stock exchanges where they are listed. Among the 13 mutual funds, 8 are managed by government owned Investment Corporation of Bangladesh (ICB), two are managed by ICB Asset Management Company Ltd (AMCL), one is managed by Bangladesh Shilpa Rin Sangstha (BSRS) and remaining two are managed by privately owned Asset and Investment Management Services (AIMS) of Bangladesh Ltd. Two other closed-end mutual funds are under active consideration for immediate flotation by the ICB AMCL. One is specially designed for Non-Resident Bangladeshi namely

48 This section is prepared by Md. Nehal Ahmed and Md. Mainul Islam Chowdhury, Research Economists, PAU

65

“ICB AMCL First NRB Mutual Fund” and the other is “Prime Finance First Mutual Fund”.

ICB Mutual Funds

In Bangladesh, ICB has played a key role in the development of the mutual funds for the sake of investors. ICB has a long history of successfully managing closed-end mutual funds. ICB launched the “First ICB Mutual Fund” on 25 April 1980. Since then the corporation has floated 8 closed-end mutual funds over the years including a total paid-up capital of BDT 175 million. Mutual funds are popular to the investors because these are sources of consistent rate of dividend and scope of capital gain. As on 30 June 2006, more than 30 thousand certificate holders own these funds. Dividends declared on the funds were very attractive ranging from BDT 15 to 210 per certificate for 2005-06. One can invest in such funds through the stock exchanges with which these funds are listed.

ICB AMCL Mutual Funds

ICB AMCL has so far floated two closed-end mutual funds and two open-end mutual funds, which added a new dimension in the country’s stock market through which the small and medium savers get opportunities to invest their savings in a balanced and relatively low risk portfolio. Investors have shown overwhelming interest in all the mutual funds. The aggregate size of these funds is around BDT 600 million. The closed-end mutual funds are, “ICB AMCL First Mutual Fund” and “ICB AMCL Islamic Mutual Fund” each with a capital of BDT 100 million. The latter is governed by the “Islamic Shariah Law” and would cater to the demand of the investors who wish to invest only in shariah based financial products. The open-end mutual funds are “ICB AMCL Unit Fund” and “ICB AMCL Pension Holders' Unit Fund” with initial capital of BDT 300 million and BDT 100 million respectively. The latter one has been introduced only for those who retire from their services under pension or gratuity scheme from government, semi-government, autonomous bodies, sector corporations, nationalized commercial banks, financial institutions and insurance corporations. One can invest in the closed-end mutual funds through the stock exchanges. ICB AMCL Unit Certificates are sold and repurchased on the counters of ICB AMCL Head Office and the branch offices of ICB.

AIMS Mutual Funds

AIMS of Bangladesh Limited was formally inaugurated on August 1999. This is the only registered asset and investment management company of the country under private initiative. AIMS has so far floated two mutual funds (i) AIMS Guaranteed First Mutual Fund; and (ii) Grameen Mutual Fund One.

“AIMS Guaranteed First Mutual Fund” with a fund size of BDT 70 million was launched in 2000 with a 5-year initial tenure and 100 percent capital guarantee. In 2005 the size of the fund was increased through issuance and sale of additional units at par on a pro-rata basis to unit holders whose names appear on the register on 30 June 2005, with a capital guarantee of 50 percent. The size of the fund is

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now BDT 140 million. “Grameen Mutual Fund One” – sponsored by the Grameen Bank – is principally facilitated to micro-saver for investing in the country’s capital market instruments. The size of the fund is BDT 170 million. The following table provides key information related to different mutual funds as of June, 2006.

Table 4.1.5:

(Figure BDT in million) Name Year

of Listing

Share Capital

Cost of Portfolio

Market Value of Portfolio

Net Income

No of Certificate

Holders 1st ICB MF 1980 5 30.94 105.13 133.50 954 2nd ICB MF 1984 5 30.1 27.11 36.00 962 3rd ICB MF 1985 10 39.18 35.22 47.50 2680 4th ICB MF 1986 10 40.26 37.66 52.00 2061 5th ICB MF 1986 15 70.67 68.54 41.29 3789 6th ICB MF 1987 50 87.59 74.89 92.25 9307 7th ICB MF 1995 30 107.61 93.15 51.60 2926 8th ICB MF 1996 50 111.57 94.61 86.00 7323 1st BSRS 1997 50 - - 37.63 - AIMS 1st MF 2000 70 - - 134.40 - ICB AMCL 1st MF 2003 100 - - 192.00 - ICB AMCL Islamic MF

2005 100 - - 90.00 -

Grameen MF one 2005 170 - - 190.40 - Source: ICB Mutual Funds, Annual Report 2005-06

Performance Analysis

Table 4.1.6: (Figure in BDT)

Name Earning Per Share

Closing Price Per

Certificate

Dividend Per

Certificate

Price-Earning Ratio

Dividend Yield (%)

1st ICB MF 203.44 2670 210 13.12 7.87 2nd ICB MF 80.75 720 55 8.92 7.64 3rd ICB MF 52.31 475 52 9.08 10.95 4th ICB MF 71.30 520 48 7.29 9.23 5th ICB MF 40.67 275.25 27 6.77 9.81 6th ICB MF 23.16 184.50 18.5 7.97 10.03 7th ICB MF 20.91 172 16 8.23 9.30 8th ICB MF 21.31 172 15 8.07 8.72 1st BSRS 7.52 75.25 7 10.01 9.30 AIMS 1st MF

0.21 0.96 0.18 4.67 18.75

ICB AMCL 1st MF

19.75 192 16 9.72 8.33

ICB AMCL Islamic MF

5.68 90 5 15.83 5.56

Source: Monthly Review, June 2006, Dhaka Stock Exchange Ltd.

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ICB is the major institutional player and performs a vital role in bringing transparency and stability in the market. ICB has been able to declare attractive Figure 4.1.5:

4

6

FY01 FY02 FY03 FY04 FY05 FY06

8

10

12

14

16

18

20

7th ICB MF 8th ICB MF 1st BSRS AIMS 1st MF

4

FY01 FY02 FY03 FY04 FY05 FY06

5

6

7

8

9

10

11

12

1st ICB MF 2nd ICB MF 3r d ICB MF

4th ICB MF 5th ICB MF 6th ICB MF

Source: Monthly Review, Various Issues, Dhaka Stock Exchange Ltd. dividends on its mutual funds during 2005-06. Among 8 mutual funds managed by ICB, the highest dividend of BDT 210 per certificate was declared on the “First ICB Mutual Fund” with the lowest being BDT 15 per certificate declared on “Eighth ICB Mutual Fund” during the period. In 2005-06 the market prices of all the mutual funds were above their par values, reflecting strong performance of the funds. Apart from ICB, other privately managed mutual funds are also performing well in the market. Among all the mutual funds, price-earning (P/E) ratio is the lowest and dividend yield is the highest for AIMS First Mutual Fund. The following table shows the Earning Per Share (EPS), closing price, dividend, P/E ratio and yield of different mutual funds as of end June, 2006.

As the mutual funds were floated in different times, the portfolios of those funds were built up in different market situations. The cost of portfolios are not equal and usually goes up when the price of stock increases. Portfolio size is another important parameter in order to measure the return performance. As the mutual funds were made up of different sizes, prospect of return on investment from each one varies, depending on the portfolio size. Figure-1 shows the pattern of dividend yield of 12 mutual funds. Of the two, the left panel figure represents the dividend yield of mutual funds over the years that were listed before 1995 and the right one shows the yield of different mutual funds listed after 1995.

Figure-1 indicates that yields of different mutual funds are getting the momentum in FY06. After having a downward trend, which started in FY03, yields bounced back in FY06. The mutual fund is the only vehicle which operates simultaneously both at the demand as well as the supply side of the market. On the supply side, the mutual fund introduces itself as a good and a reliable instrument in the capital

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market for the small but astute investors. Again the demand for blue chip shares increases with the operation of the mutual funds, as mutual fund investment activities takes place primarily in the secondary market through sale and purchase of stocks and bonds.

Conclusion

Mutual funds scheme is a good instrument to mobilize savings and to provide investment opportunities to small savers. Mutual funds have helped to enlarge the investor base of the country. Investors are also getting various tax benefits. As mutual funds are managed and run by professional management team, investing in such funds reduces investment risk and ensures a high level of return and therefore investors are relieved from the emotional stress associated with day-to-day management of individual investment portfolio.

Mutual funds are one of the fastest growing investment instruments throughout the world. In Bangladesh this industry is beginning to receive the status of preferred savings mode. With the wide range of products, the industry is well positioned to meet the investors need even with different risk profiles. SEC’s recent decision to extend pre-emptive right to mutual funds for preferential allotment in public issue will have positive impetus to boost income of the funds. Since mutual funds industry offers long term value, this industry has enormous prospects in Bangladesh.

4.1.C Merchant Banking and Asset Management

Merchant banking under a formal legal framework is a relatively new concept in Bangladesh. Securities and Exchange Commission (SEC) formulated a regulation in 1996 on merchant banking activities namely “SEC (Merchant Banker and Portfolio Manager) Regulations, 1996”. As per the regulations, a merchant bank is allowed to perform four types of operations – issue management, underwriting, portfolio management and corporate advising. The scope of business of a merchant bank has been defined on the basis of its capital base – minimum of BDT 2.5 million for issue management, BDT 10 million for underwriting & issue management and BDT 10 million for portfolio management. To operate as a full-fledged merchant bank (i.e., issue management, underwriting, portfolio management and corporate advising) BDT 20 million is required.

A total of 30 companies are now listed as merchant banks in Bangladesh, of which 23 are full-fledged, 6 are issue managers, and only one is a portfolio manager. Out of 30 merchant banks 3 are commercial banks, 9 are non-banking financial institutions and the rest 18 are solely merchant banks. The role of merchant banks in financial intermediation can be categorized into two broader phase namely primary market making and secondary market making. As primary market making it performs the role of advising, administrative services, underwriting, private placement, and banker of the issue. In case of secondary market making, merchant banks play an important role in the development of the

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capital market for previously issued securities providing a number of merchandising services.

Figure 4.1.6: Composition of Merchant Banks

NBFIs30%

Banks10%

Other Merchant Bank

60%

Source: BLFCA Year Book, 2004

The overall performance of the merchant banks is not very impressive. Most of the merchant banks are engaged only on issue management and underwriting. In case of portfolio management, only three companies are fully operational in the market. The remaining area is untouched mainly because of the limited scope of business in the context of less thriving capital market of Bangladesh, which makes some of the merchant banks become dormant.

From 1999 to 2005, a total of 16 merchant banks were found to be active in issue management. Total income from issue management was BDT 17 million during this period which was 0.5 percent of total issue size. The average income through issue management of these 16 companies was a little over BDT 2 million per year within this period. In case of underwriting, total income of the whole industry is shared between the merchant banks and the commercial banks (conducting merchant banking operation), which causes the former companies to operate within a thin profit margin. The following figure shows the earning trend of merchant banks from issue management and underwriting during the period from 1998 to 2005.

Figure 4.1.7: Income Trend of Merchant Banks from IPOs

0

2

4

6

8

10

12

1998 1999 2000 2001 2002 2003 2004 2005

Tk. i

n M

illio

n

0

200

400

600

800

1000

1200

1400

IPO A

mou

nt (T

k. in

Mill

ion)

Issue Management Income Underwriting Income IPO Amount Source: BLFCA Year Book, 2004

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In reality, merchant banks of Bangladesh operates only in three functional areas i.e., issue management, underwriting and portfolio management (as corporate advising being untouched). Of those, the first two are fee-based business, while the latter one is fund-based. But the cost of fund for merchant banks is much higher than that of the commercial banks. In a step to make merchant banks fully operational, SEC recently amended the Securities and Exchange Commission (merchant banker and portfolio manager) Regulation, 1996, which permits the commercial bankers to conduct the portfolio management business with their own fund. This step was taken as an attempt to help commercial banks to conduct portfolio management more profitably. As a result, all the three companies that are doing portfolio management are the commercial banks. Under the limited scope of business it would be very difficult for other merchant banks to operate competitively as the earning potential for these companies are very restricted.

Active participation of merchant banks is essential in order to expedite the capital market which can accelerate the economic growth of the country. But the major problems faced by the companies are limited scope of business and elevated cost of fund. In order to ensure the sustainability of merchant banks, the scope of business should be diversified. Merchant banks would be able to play a key role in the capital market through their market making activities if it is possible to arrange fund with reduced cost. Government should come up with certain facilities such as creating special fund for merchant banks for their activities in order to facilitate active market operation. 4.1.D Bond: Why Seconday Trading is Absent?

(Write-up on this section is in progress pending data availability)

4.2 Non Bank Financial Institutions (NBFIs)

Non Bank Financial Institutions (NBFIs) in the country have been growing quite rapidly over the last couple of years. Following the issuance of license recently to Ahsania-Malaysia Hajj Investment and Finance Company Limited, total number of NBFIs in the country stood at 29. Though all NBFIs were required to raise their minimum capital requirement (BDT 250 million) thorough IPOs by September 2006 (extended from June 2006), eight (8) companies are yet to float their shares in the market/bourses. Four of those have already submitted necessary documents to Securities and Exchange Commission (SEC) for review while four others are still in the process of doing so.

The major business of most NBFIs is leasing though two NBFIs have focused on housing finance. Lease financing, term lending and housing finance constituted 94 percent of the total financing activities of all NBFIs up to June 2006. The share of leasing and house financing in the total portfolio of NBFIs has been decreased gradually from 59 and 15 percent, respectively in 2002 to 46 and 14 percent,

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respectively in June 2006. The share of loan, on the other hand, has increased from 20 percent to 34 percent during the same period implying increased concentration on term lending. Therefore NBFIs are gradually diversifying their business activity which can be observed in Figure 4.2.1.

Outstanding lease/loan of NBFIs at the end of June 2006 stood at BDT 7.3 billion, which is a 15.50 percent growth (on an annualized basis) over December 2005. Annual average growth over the last four years (2002 – 2005) was 33.89 percent where as growth in 2005 was 27.64 percent. Classified lease/loan at the end of June 2006 increased to 7.18 percent from 6.06 percent in December 2005. Classified loans of their major competitors, namely the PCBs, have also increased from 5.62 percent to 5.98 percent during the same period. Figure 2 shows the total asset of NBFIs and its growth from 2002. Total asset of the industry reached BDT 5.9 million in June 2006 which is a growth of 18.47 percent over December 2005. If considered on an annualized basis this growth is consistent with the annual average growth of 34.91 percent over the last four years.

Figure 4.2.1: Share of Lease, Loan and Housing in Total Financing (outstanding)

0

10

20

30

40

50

60

Perc

ent

2002 2003 2004 2005 2006 (June)

Lease Loan Housing Source: Authors’ calculation from data provided by Financial Institution Department (FID), Bangladesh Bank.

Figure 4.2.2: Total Asset of NBFIs49

0

10000

20000

30000

40000

50000

60000

70000

2002 2003 2004 2005 2006 (June)

BDT

in M

illion

0

10

20

30

40

50

60

70

Percen

t

Total Asset Growth Rate of Total Asset Source: Authors’ calculation from data provided by FID, Bangladesh Bank.

Table 4.1.7 shows weighted average ratios of NBFIs. Current ratio, debt-equity ratio and return on equity (ROE) of the industry are considered as measures of liquidity, risk coverage and profitability respectively.50 The current ratio of the

49 Growth rate of total asset for 2006 is calculated on an annualized basis from half yearly data.

50 Industry wise ratios are calculated taking weighted averages of the ratios of individual firms in the industry. In calculating the industry average one leasing company was not considered as it has a very limited debt (close to zero) and therefore the ratios for this firm is far away from the industry average and can be treated as outliers. Current Ratio = Current Assets/Current Liabilities. The weight is calculated using current asset.

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industry during the first six months of 2006 was 2.66. The ratio had values less than 2 up to 2004 and increased to 2.82 in 2005. The volatility is reduced to 3.72 in 2006 from 6.23 in 2005. Therefore the industry as a whole is well capable of meeting the current debts with their current assets. However, the current ratio of individual firms varied from 0.47 to 16.58. Three firms still have current ratios which are less than one and should concentrate more on their liquidity management. The debt-equity ratio of NBFIs gradually increased from 1.61 in 2002 to 2.94 in June 2006. Though the standard deviation was 2.79, debt-equity ratio of individual firms varied from 0.19 to 12.49. This shows that the NBFIs are gaining more confidence and steadily generating a greater amount of debt. However the percentage of classified loan of NBFIs has also increased in 2006. Therefore NBFIs should carefully monitor the quality of their asset and be more cautious while creating new debt.

Table 4.2.1: Performance Ratios of the NBFIs

Source: Calculated by the author from data provided by the FID, Bangladesh Bank Note: Figures in the parentheses indicate standard deviation.

Year

Current Ratio

Debt-Equity Ratio (times)

Return on Equity (%)

2002 1.98 (2.99)

1.61 (6.16)

6.57 (9.84)

2003 1.91 (4.32)

2.20 (5.30)

10.57 (8.76)

2004 1.81 (3.01)

2.42 (2.98)

16.37 (9.85)

2005 2.83 (6.23)

2.56 (2.46)

14.15 (8.40)

2006 (Jan-June)

2.66 (3.72)

2.94 (2.79)

6.34 (4.61)

Figure 4.2.3: ROEs of NBFIs and PCBs51

0

5

10

15

20

25

2002 2003 2004 2005 2006 (June)

Per

cent

ROE (PCBs) ROE (NBFIs) Source: Calculated by the author from data provided by the FID, Bangladesh Bank and Bangladesh Bank Quarterly

Figure 4.1.10 shows the ROEs of NBFIs and PCBs. Both the curves follow similar pattern from 2003 with ROEs of NBFIs lying a little lower than their competitors’. This may be due to the higher cost of funds incurred by the NBFIs. Weighted average ROEs of the NBFIs stood at 12.68 (on an annualized basis) vis-

Debt-Equity Ratio = Total Debt/Shareholder’s Equity. The weight is calculated using shareholder’s equity. Return on Equity = Net profit after taxes/Shareholder’s Equity. The weight is calculated using shareholder’s equity. 51 All 2006 figures are on an annualized basis.

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à-vis 16.48 in case of the PCBs during the first six months of 2006. ROEs of NBFIs varied widely from 3.51 to 32.49 percent although volatility was much lower compared to the previous year. In 2006, six firms had ROEs which were less than 10 percent and ten firms had ROEs which were greater than 20 percent. Therefore in terms of profitability the NBFIs are continuing to have a strong position.

4.3 Microfinance Institutions52

a) Introduction53

Microfinance Institutions (MFIs) in Bangladesh have been occupying the lion’s share in microcredit market vis-à-vis the government organizations54 involved in this area. As illustrated in the Figure-1 and 2, the contribution of MFIs remained constantly above 80 and 70 percent in terms of disbursement and outstanding loans respectively and exhibited overall upward trends during the period under consideration. This dominance of MFIs over government organizations in microfinance activities may be partly explained by the in-built element of bothersome formalities in any of government operations, which underlines the need for keeping formalities at minimum possible level while trying to reach the poorer section of the society. However, since its last review the microfinance industry of Bangladesh has witnessed three historical events, namely, achievement of Nobel Peace Prize, enactment of Microcredit Regulatory Authority Act (MRAA) and microcredit securitization. This section will be devoted to reviewing mainly those events.

Figure-1: Dominance of MFIs in Terms of Microcredit Disbursement

0

20

40

60

80

100

FY02 FY03 FY04 FY05 FY 06*

Perc

ent

Four big NGOs Govt. organizations

Sources: 1. Bangladesh Economic Review 2006, Ministry of Finance 2.Various issues of Bangladesh Bank Quarterly, Bangladesh Bank.

52 Prepared by Md. Alauddin Majumder, Research Economist, Policy Analysis Unit, Bangladesh Bank. 53 An overview of microfinance industry in Bangladesh can be found in the ‘Fiscal Sector Review’ (volume-1, number-1, February 2006). 54 Government organizations include Nationalized Commercial Banks (NCBs), ministries and other govt. organizations. * Figures of govt. organizations have been estimated on the basis of half yearly actual data.

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Figure-2: Dominance of MFIs in Terms of Outstanding Microcredit

0

20

40

60

80

100

FY02 FY03 FY04 FY05 FY 06*

Perc

ent

Four big NGOs Govt. o rganizations

Sources: 1. Bangladesh Economic Review 2006, Ministry of Finance 2.Various issues of Bangladesh Bank Quarterly, Bangladesh Bank.

b) Winning Nobel Prize The Grameen Bank and its founder Dr. Muhammad Yunus have been awarded Nobel Prize 2006 for peace. They are the first Bangladeshis to have such a prestigious achievement. The Norwegian Nobel Prize Committee was convinced by their excellent performance in innovating effective anti-poverty tools and spreading them around the globe. And hence the prize is the testimony of the fact that Bangladesh is rich with a buoyant microfinance industry. Indeed, the people of Bangladesh are now so much delighted and this is only by virtue of microfinance movement.

c) MRAA MFIs in Bangladesh were left unregulated for a long time since their inception. Although unregulated atmosphere allowed the industry to flourish to a certain extent, many including Nobel laureate Dr. Muhammad Yunus viewed absence of regulatory framework as one of the key impediments to further expansion of the industry, and accordingly raised the demand for a legal framework (Yunus 2003). Responding to the demand the government, with the close cooperation of Bangladesh Bank, undertook huge efforts, which culminated in the enactment of the MRAA on 27 August 2006. The Act, containing 52 articles and 98 sub-articles, mainly focuses on the following points:

i) An authority named Microcredit Regulatory Authority will be established to serve the purpose of the Act.

ii) An executive board consisting of eight members will be responsible for executing the general and administrative tasks of the authority. The board will incorporate the Governor of Bangladesh Bank as ex-officio chairman, six government officials nominated by the government and one executive vice president who will be also the member secretary of the board.

iii) The main responsibilities of the authority include issuance and cancellation of the license for microcredit, overseeing, supervising and facilitating the whole activities of the MFIs etc.

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iv) No MFI is allowed to operate microcredit program without taking license of doing so.

v) The authority will create fund named Depositors Insurance Fund in order to make deposit with MFIs safe and secure for the interest of the depositors.

vi) Each MFI will have to have a reserve fund which cannot be spent without the prior permission of the authority.

vii) The MFIs are not allowed to take deposit from persons other than their members. viii) Any delinquent person will be subject to the punishment of not more than one

year imprisonment or a fine of not more than five lac taka or both.

It is important to note that the Act precluded the proposal of microfinance banks. According to knowledgeable sources the threat of possible financial chaos resulting from the limited controlling capacity of the newly formed authority could be the chief reason for this preclusion. Hopefully, once the authority gets matured it would be easy for it to reconsider the proposal. As far as the sustainability of MFIs and resource mobilization in the rural areas are concerned, the concept of microfinance bank is crucial. The issue of foreign MFIs, one of the key concerns, somehow remained undiscussed in the Act. It is of so importance because in the face of foreign MFIs having edge over the local ones in the competitive environment created by the Act due to their plentiful resources and skills many of the latter may turn out to be away from the market. As a step to cushion the domestic MFIs against such threat a provision of putting some sort of bar to the operation of foreign MFIs seems to be warranted. However, it is too early to make a critical assessment of the Act right now. Necessary amendments are expected to take place in the course of time.

d) Microcredit Securitization by BRAC While securitization is a phenomena occurring numerously in the financial arena, still it exists in the microcrdit framework only in its miniature form. Brac, one of the largest MFIs in Bangladesh, has gone for resorting to structured finance by securitizing its microcredit operation recently. This revolutionary innovation is for the first time in Bangladesh and the second time in the world’s microfinance history.55 Under the securitization deal titled Brac Micro Credit Securitisation Series 1, a total of BDT 12.6 billion will be provided in tranches for Brac against its receivables from microcredit lent to the poor people not reached by formal banking system for over a period of six years. One billion BDT in one tranche will be disbursed every six months with a maturity period of one year. The parties to the deal– Brac, Citigroup Bangladesh, Netherlands Development Finance Company (FMO), and Germany's KfW Entwicklungsbank Bangladesh- signed the agreement on 6 July 2006. The securitization was rated triple-A by the Credit Rating Agency of Bangladesh. A special purpose trust has been created under the agreement. The trust is supposed to purchase all the receivables from Brac and issue certificates to the investors representing beneficial interest in such receivables. According to the agreement, FMO will directly purchase one-third of

55 So far information is available the world’s first microcredit securitization deal took place in the early 2004 between three parties namely i) SHARE, one of the Indian MFIs, ii) the ICIC bank located in India, and iii) the Grameen Foundation USA (Bernasek, Phillips and Ross-----).

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the certificates. Citibank NA will purchase another one-third of the certificates, backed by a guarantee of FMO and counter guarantee of KfW. Apart from this, Citibank NA, Bangladesh, with two other local banks will purchase the remaining one-third of the certificates.56 As stated by the Brac authority, resources will flow from the global financial markets to the doorsteps of nearly 1.2 million households in Bangladesh through the deal. Concerned people see the event of microcredit securitization by Brac as a milestone for the microfinance industry around the world particularly in Bangladesh as it will not only lead to the capacity enhancement of Brac in microcredit operation but also show other MFIs the right direction to proceed on. It is anticipated that if the process of microcredit securitization can go well and unhindered it will open up the opportunity for MFIs to diversify source of fund, reduce on-balance assets and have abundant fund for disbursement. Moreover, expectedly providing AAA rated securities the deal will give a boost to the fixed income security market and thus have profound impact on the country’s capital market. e) Bangladeshi MFIs: still at the Forefront of the Global War against Poverty Bangladeshi MFIs have been remaining at the forefront of the global microfinance movement from the very beginning of the industry. Microfinance Information Exchange (MIX) in its report on ‘Performance in Bangladeshi Microfinance 2005’ comments “Boosted by strong returns and fueled by some of the lowest transactions costs anywhere in microfinance, Bangladeshi MFIs stand at the leading edge of many aspects of global microfinance performance.” Apart from the Nobel Prize achievement of Grameen Bank and its founder, microfinance sector of Bangladesh has got another groundbreaking success recently. According to the MIX’s report titled ‘2005 MIX Global Report 100: MFI League Table’ and presented in the ‘Global Microcredit Summit 2006’, ASA, one of the giant Bangladeshi MFIs, has been adjudged one of the three best MFIs in the world having placed in all the six table constructed on the basis of six areas of performance: Outreach, Scale, Profitability, Efficiency, Productivity and Portfolio Quality.57 Two other best MFIs are FMM Popayán and WWB Cali of Columbia. It is observed from the same report that even though MFIs in Bangladesh are left little bit behind as compared to global standard in terms of profitability, efficiency, productivity and portfolio quality, four among the top five MFIs in outreach category and three among the top 10 MFIs in scale category are Bangladeshi, meaning phenomenal client coverage. In the report, Grameen Bank was shown to be the world’s largest MFI covering more than five million borrowers, followed by BRAC and ASA both reaching over four million borrowers.

f) Conclusion Needless to say, Microfinance industry in Bangladesh has undergone an episodic period in the present calendar year. All the episodes happened in this period may

56 Quoted from the 7 July 2006 issue of ‘The Daily Star’. 57 Number of Bangladeshi MFIs placed in any of the six tables is 10. Out of them respectively 9, 4, 3, 5, 5 and 4 were listed in Outreach, Scale, Profitability, Efficiency, Productivity and Portfolio Quality table.

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be considered as indication of a substantial progress of the industry towards maturity. For the industry, the Nobel Prize achievement and the success reported by MIX will act as sources of inspiration. The enactment of MRAA will refine the industry by ensuring transparency and accountability of the MFIs. And the ever first microcredit securitization in the country will head further innovations and help break up liquidity constraint inherent in the microcredit operation. Now it can obviously be concluded that the MFIs will manifest themselves as vehicles for Bangladesh to be a vital part in the movement for reaching the millennium development goal of halving poverty by 2015.

References

1. Ministry of Finance (2006), Bangladesh Economic Review 2006, Dhaka, 2. Bangladesh Bank (---), Various issues of ‘Bangladesh Bank Quarterly’, Dhaka,

Bangladesh Bank. 3. Government of Bangladesh (2006), Microfinance Regulatory Authority Act 2006, Dhaka, 4. Bernasek, Alexandra, Phillips, Ronnie J. and Michael P. Ross (--------), Globalization

and the Changing Relationship between Economic Development and Capital Markets: Innovations in Funding for Microfinance,

5. MIX (2006), Performance in Bangladeshi Microfinance 2005, MIX. 6. MIX (2006), 2005 MIX Global Report 100: MFI League Table, presented in the ‘Global

Microcredit Summit 2006’ in Halifax, Canada. 7. Yunus, Muhammad, Expanding Microcredit Outreach to Reach the Millennium

Development Goal : Some Issues for Attention, Presented at the International Seminar on "Attacking Poverty with Microcredit" organized by PKSF in Dhaka on January 8-9, 2003.

4.4 Insurance Sector in Bangladesh

Introduction

The emergence of financial conglomerates, providing a range of financial services like banking, securities, derivatives, asset management and insurance are of recent origin which requires understanding. In 1993 a tripartite group of banking, securities and insurance regulators was set up by the Bank for International Settlements (BIS) to consider ways to improve the supervision of financial conglomerates58.In the new economic reality of globalization, insurance companies face a dynamic global business environment.

Till the year 1984, the insurance industry was a government monopoly and is now experiencing cut-throat competition because a number of players have entered

58 Financial conglomerates are defined as a group of companies under common control whose exclusive or predominant activities consist of providing significant services in at least two different financial sectors namely banking, securities, insurance.

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into the Bangladesh market in private sector.59 Earlier only foreign Company, American Life Insurance Company (Alico) started its operation in Bangladesh in 1974. At present, 17 life insurance companies (including Alico) and 43 general insurance companies are doing business in private sector. Besides, one state owned life insurance company, Jibon Bima Corporation (JBC) and one state owned general insurance company, Sadharan Bima Corporation (SBC) in the industry.

Insurance: Life and Non-Life

The industry covers two dimensions viz. Life insurance and General insurance. Life insurance is a financial intermediary which mobilizes people’s savings and invests large amounts of premiums, the General Insurance Companies do not collect savings, yet they raise crores of Taka from premiums. General insurance deals with exposure of risks to goods and property, whereas life insurance is a way to meet the contingencies of physical death and economic death. In case premature death of the assured, the proceeds of policy are paid to the beneficiaries and annuities protect the assured against economic death when lives too long to arrange for his necessities.

In simple language, insurance promises a compensation of monetary loss sustained by a particular person, due to the damage or destruction of a particular piece of property owned by him, provided it happens due to certain courses. In other words, it is perfectly a simple promise to make good the loss.

International Perspective

On a global basis, it is evident that a country with a more developed financial system tends to accumulate more premiums. Insurance penetration as measure of percentage of GDP is very low for Bangladesh compared to other South Asian countries.

Table : Gross premium Income (both life and non-life) as a percentage of GDP

Industry Life Non Life Total Industry

2002 2003 2004 2002 2003 2004 2002 2003 2004Bangladesh 0.29 0.37 0.42 0.18 0.2 0.2 0.47 0.57 0.62

Pakistan 0.24 0.24 0.27 0.39 0.39 0.4 0.63 0.63 0.67Sri Lanka 0.55 0.55 0.63 0.74 0.74 0.86 1.29 1.29 1.49

India 2.59 2.26 2.45 0.67 0.62 0.63 3.26 2.88 3.08Source: Swiss Re Sigma

Insurance Service covered by GATS

Financial services in the GATS include two broad categories of services: 1. Insurance and insurance related services: especially these insurance and insurance related services cover life and non-life insurance, reinsurance, insurance

59 The Insurance Act 1938, Insurance Rules 1958 and Insurance Corporation Act 1973 were amended to allow private sector to operate in the insurance business of the country (Barua, FSR May 2006)

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intermediation, such as brokerage and agency services and services auxiliary to insurance such as consultancy and actuarial services. 2. Banking and other financial services.

Reinsurance

Reinsurance is Reassurance. Reinsurance can also be explained as : 1. A contract of indemnity against liability by which the insurance company procures another insurance to insure against loss or liability by reason of the original insurance 2. Insurance by one insurance company of all or part of a risk accepted by it with another insurance company which agrees to reimburse the insurance company for the portion of the claim insured.The company purchasing insurance is known as the ceding insurer and the company selling insurance is known as the re-insurer.For its own protection, an original insurer arranges for reinsurance with a reinsurer who accepts a part of the risk of loss. It is also defined as : ‘ an agreement between insurance companies under which one accepts all or part of the risk or loss of the other’.

Global reinsurance market is not new to the world of insurance. It started way back in 14th century with a marine reinsurance contract in Geneva and developed itself with the passage of time in demand, supply, modeling, technicality and capacity.World wide the reinsures are becoming strict on technical results of the insurance companies, therefore a disciplinary watch is required on insurance business as it is the base of reinsurance.

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Chapter 5

Financial Market Governance Infrastructure

5.1 The Overall Regulatory Framework for the Financial Sector

(Write-up on this section is in progress pending data availability)

5.2 The Contractual Framework

(Write-up on this section is in progress pending data availability)

5.3 Remittances: Governance and Infrastructure Issues

(Write-up on this section is in progress pending data availability)

5.4 Oversight of Payment and Securities Settlement System60

a) Introduction The payment and securities settlement system of the economy has been reinforced as a result of increasing concentration on oversight activities rendered by concerned authorities. The scenario may be partly explained by the staggering development in the modalities of financial transactions. The electronic mode of payments has sharply occupied a substantial part in the financial structure activities of the country over the recent couple of years.61 The improvement in the indicators of financial depth which occurred in the meantime has been supposedly brought about by the increased oversight of payment and securities settlement system to a certain extent.62 As mentioned in the previous “Financial Sector Review”, Bangladesh Bank and Securities and Exchange Commission (SEC) are

60 Prepared by Md. Alauddin Majumder, Research Economist, PAU. 61 Reportedly the volume of electronic transactions (through debit card, credit card etc.) in the banking sector of

Bangladesh has grown by leaps and bounds from BDT 501350 million in 2001 to BDT 2348260 million in 2005 showing a respectable 47 percent growth in each year (see section 2.2).

62 Market capitalization and broad money (M2) as percentage of GDP are 5.41 and 44 percent respectively in FY06 as against 2.41 and 38 percent in FY03.

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responsible in diverse capacities for overseeing the whole system of payment and securities settlement. Needless to say, the government constantly maintains a cooperative link with both of them so that their courses of actions remain fair and unhindered.

b) Bangladesh Bank’s Actions Being a central bank Bangladesh Bank has the inherent responsibility to oversee the payment system, be it cash or non-cash. In this connection, the following jobs remain within the range of its capacity:

i) Currency in Circulation With a view to keeping monetary and real sector in line Bangladesh Bank as well as the government manages to accommodate currency in circulation in consonant with the increasing economic activities of the country. As seen in the Table 5.4.1, the circulated amount of currency reached BDT 248941 million at the end of FY06, edging higher by about 22 percent over the previous fiscal year. The amount increased at a progressive rate during the period from FY02 to FY06. Of course the currency escalation was warranted by the robust economic growth during the same period.63

ii) Replacement of Soiled and Torn Notes Under its “clean notes policy” Bangladesh Bank has continued to replace soiled and torn notes. Although exact data on note replacement is not available, according to the concerned officials, the Issue Department of Bangladesh Bank made replacement of a significant number of notes in FY06 as done in the previous years.

iii) Actions against Counterfeit Notes Bangladesh Bank has been making a continuous effort to minimize the potential threat to financial system emanating from counterfeiting of notes. In addition to the imposition of suitable security features it maintains intensive collaboration with various legal organs of the government in recovering counterfeit notes and resisting counterfeiting. Table 5.4.1 suggests that amount of counterfeit notes recovered experienced increasing tend over time except for a marginal sliding down in FY04 and FY06 from respective previous fiscal years. This is mainly due to the growing awareness as well as strong legal moves of the overseeing bodies. In addition to that setting up of note counting machine greatly helped in catching counterfeit notes.

iv) Clearing House Bulk of the country’s non-cash payments are continuing to be settled and cleared through the 39 clearing houses.64 It is observed from the Table 5.4.1 that in FY06

63 An estimate made on the basis of Bangladesh Bank data suggests that average yearly growth of Bangladesh

economy was 5.8 percent during the period from FY02 to FY06. 64 Out of these 39 houses 8 are managed by Bangladesh Bank and 31 by Sonali Bank. The clearing house operations are on the verge of being fully automated.

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the clearing houses made settlement of 18.86 million instruments amounting to BDT 3594474 million as against 14.2 million instruments equivalent to BDT 3088046 million in FY05. The table also suggests that the yearly growth of settled amount of payments jumped to as high as 15.5 and 16.4 percent in FY05 and FY06 respectively after remaining steady around moderate 7 percent till FY04, implying augmented oversight actions taken by the Bangladesh Bank.

v) Foreign Currency Clearing As part of its clearing and settlement policy Bangladesh Bank undertakes settlement of non-cash payments in foreign currency by its Foreign Currency Clearing Accounts Section. It is learnt from a discussion with the concerned officials that a healthy amount of foreign currency payments is settled each day through this clearing house. A random check suggests that the amount settled each day ranges from USD 6 to 12 million.

c) Securities and Exchange Commission’s Actions Securities and Exchange Commission (SEC), the apex regulatory institution of the country’s capital market, plays an important role as a watchdog in the settlement of all kinds of securities trading. Close monitoring and supervision of the SEC resulted in the recent rapid evolution of the capital market of Bangladesh. It is seen from the Table 5.4.2 that market capitalization of Dhaka Stock Exchange (DSE) as percentage of GDP jumped from only 2.41 percent in FY03 to 4.88, 6.06 and 5.41percent in FY04, FY05 and FY06 respectively. With a view to eliminating the deficiencies in the security trading process, SEC empowered Central Depository Bangladesh Limited (CDBL) to furnish the delivery, transfer and settlement of securities more efficiently. The SEC often adopts legal to rectify the undue behaviour of the market participants and thus ensuring smooth functioning of the securities settlement system. This is further elaborated below.

Table 5.4.1: Some of Bangladesh Bank's Actions Aiming at Escalating Payment System

(Figures in million BDT)

Action FY02 FY03 FY04 FY05 FY06 Amount cleared and settled

2316798 2487716 2673546 3088046 3594474Clearing house No. of

instruments 12.62 13.84 14.79 14.2 18.86

Currency in circulation (at the end of the FY) 138802 153421 172874 203279 248941

Amount of counterfeit notes recovered 1.2 1.6 1.4 3.8 2.7

Source: Bangladesh Bank

Figure 5.4.2: Evolution of the Bangladesh Capital Market (DSE) (In million BDT)

At the end of Market

capitalizationGDP at current

market priceMarket

cap./GDP (%)

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FY03 72590 3005800 2.41FY04 162369 3329730 4.88FY05 224611 3707070 6.06FY06 225300 4161550 5.41

Source: SEC and Bangladesh Bank

i) CDBL The CDBL ensures speed, perfection and efficiency by dint of its electronic mode of operation. However, all listed companies have not yet become participant of CDBL. According to available statistics, as on September 2006 shares of 101 out of 253 companies and 28 government treasury bills and bonds were traded within the CDBL arrangement, accounting for over 80 percent of market capitalization of DSE (DSE 2006). Most of the remaining companies are not ready at this moment to come under the umbrella of CDBL due to their weak organizational structure. However, their absence in CDBL is not of serious concern as they constitute less than 20 percent of market capitalization and do not pose any significant threat to the financial sector. Moreover, SEC is not unaware of their operation. It is hoped that all the market participants will join the CDBL soon.

ii) Legal Attempt SEC itself as well as the two exchanges (DSE and CSE) with the prior approval of SEC make and amend rules and regulations in line with the changing scenario of the market. It also carries out inspection on a regular basis and occasionally makes investigation and inquiry in response to complaints, if any. As demonstrated by the Table 5.4.3, the SEC took 247 enforcement actions and made 2 orders and 13 notifications during the FY06. Besides, each of DSE and CSE made 2 regulations following the permission of SEC during the same period. The main objective of the legal attempts is to keep all the stakeholders in the capital market on the right track, so that no unwanted situations can emerge during the process of securities settlement.

Table 5.4.3: Number of Legal Moves Taken by SEC, DSE and CSE

Quarter

Enforce- ment action

Legal Case (at the end of quarter)

SEC order

SEC Notification

DSE regulation

CSE regulation

Jul.-Sep. 05 46 117 Oct.-Dec. 05 43 125 Jan.-Mar. 06 42 131 1 13 1Apr.-Jun. 06 116 138 1 2 1Total (FY06) 247 138 2 13 2 2

Source: SEC.

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d) Conclusion A major indication which can be gathered from the facts and figures mentioned above is that the Bangladesh’s economy is getting a good support from the authorities overseeing the country’s payments and securities settlement system in the process of financial deepening, which is very much needed for sustainable development of the economy. Further improvement, however, requires learning lessons from previous bitter experiences such as that of 1996 share scam and observing the systems of other comparable countries, exploring the pitfalls in the existing systems, and making necessary modifications, addition or subtraction in the existing rules and regulation accordingly. Another element of improvement is the adoption of automation. Obviously, automation reduces settlement risk tremendously by stopping all doors of malpractice and enhancing transparency. Present strength of the oversight actions in Bangladesh is magnificently indebted to the automation introduced so far in the Bangladesh Bank, SEC and various government institutions.

ReferencesBangladesh Bank (------), Various issues of Economic Trends, Dhaka, Bangladesh Bank. Securities and Exchange Commission (------), Various issues of Quarterly Review, Dhaka, SEC. Bangladesh Bank (2005), Annual Report 2004-05, Dhaka, Bangladesh Bank.

5.5 Factors Affecting Financial Sector Risk and Stability

(Write-up on this section is in progress pending data availability)

5.6 Financial Market Outlook

(Write-up on this section is in progress pending data availability)

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Chapter 6

The Financial Sector Policy Stance

(Write-up on this section is in progress pending data availability)

• References • Technical Appendixes • Boxes

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