This is part of a series that offers a retrospective look at Bangladesh’s financial sector
This article reviews the fundamental rules of governance of the banking system.
Banks are busy making loans, collecting deposits and collecting loan repayments.
We will use a very simple system to think about the financial situation of the bank and how the transactions of the bank are articulated.
Although all of this is very basic, it is the best framework for thinking about the banking system and its governance.
The bank has three assets: The loans it has granted; its holdings of government securities; and cash either in his safe or in his account at the central bank. The bank has liabilities of which we only consider deposits. The basic accounting equation for the bank is:
Cash + loans + government securities = liabilities + equity
Equity is what the bank is worth, its equity.
Every transaction fits into this equation. A person makes a deposit and then the cash goes up and the liabilities go up.
A loan is made, then the loans go up and the deposits go up.
A person repays part of a loan.
Liquidity is increasing and loans are decreasing.
Also Read – A Retrospective Look at Bangladesh’s Financial Sector
Also Read – A Retrospective Look at Bangladesh’s Financial Sector: Part 2
Also Read – A Retrospective Look at Bangladesh’s Financial Sector: Part 3
Read also – Analysis: Interest rates and deposits
Read also – The state of lending rates – Part 1
Read also – Analysis: The state of lending rates – Part 2
Read also – Ever higher NPLs and bankers’ dilemma
Read also – The dilemma of NPL management
Also Read – A Retrospective Look at Exchange Rate Management in Bangladesh
Also Read – Summarizing Four Relevant Problems
The amount of government securities and central bank liquidity must comply with certain rules set by the central bank.
We assume that these rules are maintained.
At the end of the month salaries are paid: Decreases in cash flow and equity [the balancing item] decreases. At the end of the year, the owners decide to pay themselves a dividend and reduce cash and equity.
The loan officer reports that a loan is not repaid.
We treat this as a special account having the loan account unchanged but opening an account for unpaid interest and an allowance account for the principal unpaid that is due.
These accounts are liability accounts and shareholders’ equity is reduced by the amount of these two accounts.
Provisions and unpaid interest reduce equity.
At the end of the year, these two liability accounts for provisions and for unpaid interest result in a decrease in the value of equity and therefore less funds available for the payment of dividends.
The central bank applies three ratios and one important rule: the rule describes how to take provisions and how to decide when unpaid interest due should be charged to the special liability account.
The three ratios are the cash reserve requirement, the legal liquidity requirement and the capital requirement.
A bank can reschedule a loan by introducing a new repayment schedule, such as giving the borrower two more years to repay the loan by writing a new repayment schedule.
In this case, the bank may require a certain reimbursement to effect the rescheduling; it goes in cash and raises equity.
Provisioning rules may allow provisions to be lifted in which case bank equity increases and the provision account decreases.
Rescheduling will generally increase the bank’s equity and reduce the provisions for delinquent loans.
A bank can cancel a loan.
This means that the bank decides that it cannot collect the loan and reduces the asset account for loans by the write-off amount. It also reduces equity by the amount of the write-off.
If the bank has made provisions, it reduces those provisions and unpaid interest instead of equity.
It is also allowed by the central bank to take half of the equity value as part of the write-off.
When the loan is written off, the borrower is still responsible for the amount owed.
The bank sells the collateral and all the other assets it can get and takes them in cash on the asset side and in equity to balance the fundamental equation.
Finally, the bank can borrow from the central bank or other banks to help it run its affairs in the short term.
In all this, the bank maintained the necessary liquidity and the required government securities holdings.
Of course, the bank can hold more money in the central bank and more government securities than necessary.
The bank must also manage its provision and unpaid interest as required by the central bank.
This is how the banking system operates under the control and certain rules prescribed by the central bank.
How the system breaks down
The central bank has one more rule that the commercial bank must follow.
Equity, from the balance sheet, must be equal to or greater than a certain fraction of the assets.
The central bank has a complex set of rules that associates a number between 0 and 1 with each asset.
Loans to private companies have a number 1 attached; government loans are numbered 0.
The assets are all multiplied by these numbers and added up.
Certain off-balance sheet items are included.
From this comes a number called ârisk-weighted assetsâ.
Equity should equal a prescribed fraction of risk-weighted assets.
The idea here is that if the bank loses money, the owners should pay, not the depositors.
The bank must have sufficient equity so that the losses are borne by the owners.
This mysterious stew called risk-weighted assets is continually being redefined.
Although this is a rule developed by central bankers and other experts, it is applied by most countries, otherwise it is difficult to deal with banks in other countries.
The first problem is that banks do not always calculate their provision needs correctly, which makes their bank’s equity value higher than it should be.
The second problem is that some banks have such poor loan portfolios that the required provisions would make their bank’s accounts very bad.
In these cases, the bankers plead with the central bank to allow them to recognize only part of the provisions.
Central banks should never do this. He hides the state of the bank from the public.
Worse, in some cases the bank is allowed to pay dividends even if it hasn’t earned enough money to justify it.
It should never happen.
After hiding their losses by underestimating provisions, the bank’s equity is now higher than it actually is.
It is now easier to pretend that there is enough capital. In other words, the bank presents itself as realizing the required capital when it has not.
The governance system described here is simple and works well if implemented.
When the bank fails to maintain capital requirements, it has a certain amount of time, up to a year, to remedy the situation.
The bank does this by providing additional capital to the bank by selling shares to investors or buying additional shares from existing investors.
However, additional funds flow into the bank as liquidity and equity increases to the required amount.
Homeowners hate this because they either have to invest more money or the property is diluted with new owners. On this point the central bank must be ruthless.
If the bank is unable to achieve capital adequacy, then the central bank must act.
As a rule, he will take over the bank, make appropriate loans to help the bank stabilize and introduce a new direction.
The old management would leave and the board would have no say in how the bank operates.
The new management would do their best to improve the situation of the bank.
Deposits would be encouraged; major loan recovery efforts would be made.
If the new effort is successful, the bank will reissue stocks using them to pay off central bank loans made during this adjustment period.
Any excess would be paid to the original owners of the bank and the bank could continue to operate.
If it was not possible to restore the financial stability of the bank, the bank would be closed; depositors would be reimbursed in accordance with deposit insurance.
The original owners of the bank would have lost their investment.
The governance system works very well.
As long as the rules are applied, everyone has an interest in making the banks profitable by making good loans.
Bangladesh Bank did not follow its own rules.
Banks are allowed to avoid posting their actual provisions [encouraging making bad loans.]
Sometimes cash dividends are paid when the bank has actually lost.
Many banks have failed to achieve capital adequacy for extended periods of time.
The system held up because the growth of deposits was rapid.
It is a Ponzi scheme where incoming deposits are used to pay off loan losses.
The excellent staff of the Bangladesh Bank are fully aware of the state of the banking system.
The only way to have a sound system is to apply the system outlined above.
This may mean that a few banks are supported; and if it proves impossible to save them, then close them.
There are two essential points:
1. There is no need to fear closing insolvent banks if they cannot be rescued in an appropriate legal form. Now all bank owners, after failing to properly manage their bank, refuse to give it up. The state of Bangladesh is far more powerful and important than the reputation of a family or an individual.
2. Managing a competitive private banking system where borrowers repay their loans is the key to a prosperous economy. Every move by the central bank to move away from the central model described here results in economic loss for the Bangladeshi people.
Forrest Cookson is an economist who was the first chairman of AmCham and was a consultant for the Bangladesh Bureau of Statistics