This is the fourth part in a series that offers a retrospective look at Bangladesh’s financial sector
The financial sector has a number of markets and the prices determined by supply and demand in these markets are returns on asset values, usually interest rates.
For deposit rates and lending rates in the banking sector, competition among banks will determine these rates, subject to any rules that the central bank may establish.
The functioning of the two deposit and loan markets and the interest rates generated are the central issues for the success of the banking sector.
Banks match borrowers and savers by charging a small amount (often called the spread) to do this.
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
A previous article argued that the banking system was the main source of financing for private investment in Bangladesh, so it was concluded that the deposit and advance markets are the most important in the financial sector.
The capital market provides little financing for private investment.
There are four players: banks, central bank, depositors and borrowers.
Two markets, for deposits and for loans; and an intermediary organization, and the banks.
The central bank sets the main rules for banks to follow.
In Bangladesh, there are seven types of banks or quasi-banks:
1. Private banks operate according to Western rules and principles. These make up the bulk of the system. The functioning of these banks is at the heart of the banking sector.
2. Private banks that operate on the principles of Islamic finance. The basic idea is that interest charges are immoral; the loan to a company of a bank of the Islamic system establishes a claim on the profits made by the borrower. The depositors participate in the profits of the bank.
3. Non-bank financial corporations, including leasing companies, housing-oriented companies, all characterized by being allowed to accept only large deposits. Depositors are at greater risk.
4. Private foreign banks. These banks are branches of banks headquartered outside of Bangladesh. They take mostly deposits in current account.
5. State-owned commercial banks. There are five major banks in this category. All of them are insolvent, but depositors rightly believe that the government will always protect their money so that the financial condition of these banks does not discourage many small depositors who value access through the large branch chains that these banks do. have established.
6. Public banks which have a specialized department for loans, for example for agriculture or industry. These banks are relics of the past; they are currently insolvent and subsidized by the government. They contribute little to the financial sector.
7. Micro-credit institutions that receive funds from NGOs, international aid organizations or the government. These organizations provide small loans to households with a large percentage of the portfolio loaned to women. These institutions are characterized by high interest rates [compared to the lending rates of banks] and high recovery rates
Depositors are the general public and companies who have financial resources and prefer to invest safely and return to bank deposits.
The deposit market is pretty straightforward.
A deposit is made regardless of the type, location and bank chosen by the saver.
The bank has a schedule of interest rates for deposits.
However, depositors perceive different levels of risk associated with different banks.
Current regulations require that the interest rate on term deposits held by individuals, unlike businesses, be adjusted monthly to ensure that the deposit rate is greater than or equal to the rate of inflation.
The rate is set at the time of deposit and of course remains unchanged throughout the duration of the contract.
The inflation rate used is the 12-month average of the Consumer Price Index.
Tables 1, 2 and 3 provide an overview of deposits in the banking system in June 2021.
Table 1 compares the deposits of the entire banking system with private banks.
Table 2 breaks down the ownership of deposits at all banks, also showing the share of term deposits in total deposits.
Table 3 covers private banks, including Islamic practice banks [Bangladesh Bank has classified the deposits in Islamic practice banks matching the categories.]
The total deposits amount to Tk 14 trillion, two thirds of which are held in private banks.
Table 2 shows that 82% of deposits are held by the private sector, of which 21% of accounts are held by private non-financial corporations, 6% by financial corporations and 49% by households.
Term deposits represent 45% of total deposits. 50% of term deposits are held by households and 17% by private companies.
Regulation of minimum interest rates
In recent months, the central bank has regulated minimum interest rates on term deposits held by households.
This covers 22% of all deposits and 18% of private bank deposits.
Such restrictions on deposit rates, combined with the likely increase in the rate of inflation, will increase the cost of funds and hence the cost of loans.
In addition, the increase in government borrowing is pushing up the yields on treasury bills and bonds.
This will cause banks to raise rates on other deposits not subject to central bank regulation.
The result will be a larger increase in the interest rates paid to depositors.
But the 9% cap on lending rates preventing higher lending rates despite higher deposit rates will put enormous pressure on private banks to maintain capital requirements and make profits.
State-owned banks are allowed to circumvent the rules usually required to ensure sound banking.
Private banks are subject to stricter rules.
The combination of a rise in deposit rates and a cap on interest rates will cause serious damage to all private banks.
The consequences are repeated in the following article.
The impact of inflation on deposit rates will come slowly.
The increase in international prices combined with the high probability of a small depreciation of the Taka, will lead to higher Taka prices of imports and inflation of domestic prices.
It will take some time for international price increases to influence the CPI.
In addition, it will take at least a year for the increase in the CPI due to external inflation to be fully included in prices, as banks use a 12-month average for the inflation rate.
This leads to a slow rate of increase, but also as inflationary pressures subside, inflation will only decrease slowly.
High interest rates on term deposits should be expected for the next two years assuming rising global inflation can be brought under control.
The purpose of interest rate regulation is to ensure that holders of term deposits earn a positive return.
In fact, the result is not quite as expected by the Bangladesh Bank.
There is a 10% tax on interest income.
A 6% deposit rate actually only pays 5.4%.
If the inflation is 6%, the depositor still faces a constant deterioration in his wealth.
Can the Bangladesh Bank, through monetary policy, reduce the rate of inflation?
In recent years, inflation has been in the range of 5.5-6.5%.
The inability to reduce inflation to a lower level resulted from the growing government deficit.
Define the deficit as the sum of bank credit to the public sector plus increases in the outstanding amount of government-issued cash certificates.
The deficit thus defined increased by 80% from fiscal year 16/17 to fiscal year 20/21.
The CPI rose 21% during this period.
The definition of money (adjusted for receipts) increased by 58%. [This is related to M3 but is not the M3 as defined by Bangladesh Bank.]
To compensate for an increase in external inflation, a substantial reduction in the public deficit would be needed.
Given the strong development program underway, such a reduction is unlikely.
A significant increase in revenue collection will not be achieved. Non-payment of large amounts of foreign loans is unlikely.
It is very likely that:
(1) Global inflation will drive inflation up in Bangladesh.
(2) Deposit rates will increase by 3-5% over the next 12-18 months. They will fall over the next 12 months.
(3) Monetary policy will not be able to prevent external inflation.
(4) Private banks will need capital injections as their capital erodes. Bank dividends will be limited. This effect is in addition to the impact of recognizing bad debt costs incurred during the pandemic.
Forrest Cookson is an economist who was the first president of AmCham and was a consultant for the Bangladesh Bureau of Statistics.