Governance in the banking system
Governance in the banking system

This is part of a series that provides a retrospective look at Bangladesh’s financial sector

This article reviews the basic governance rules of the banking system.

The banks are busy making loans, collecting deposits and taking in the repayments of loans.

We will use a very simple system for thinking about the bank’s financial position and how the transactions of the bank fit together.

Although all of this is very elementary it is the best framework for thinking about the banking system and its governance.

The bank has three assets: The loans that it has made; its holdings of government securities; and cash either in its vault or in its account at the central bank. The bank has liabilities of which we consider only deposits. The basic accounting equation for the bank is:

Cash+ loans+ government securities = liabilities + equity

The equity is what the bank is worth, its net worth.

Every transaction fits into this equation. A person makes a deposit, then cash increases and liabilities increase.

A loan is made, then loans increase and deposits increase.

A person repays part of a loan.

Cash increases and loans decline.

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

Also Read – Analysis: Interest rates and deposits

Also Read – The state of lending rates – Part 1

Also Read – Analysis: The state of lending rates – Part 2

Also Read – Ever-rising NPLs and bankers’ dilemma

Also Read – The dilemma of handling NPLs

Also Read – A retrospective look at Bangladesh’s exchange rate management

Also Read – Summing up four pertinent issues

The amount of government securities and cash in the central bank must meet certain rules set by the central bank.

We assume these rules are maintained.

At the end of the month salaries are paid: Cash declines 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 being repaid.

We treat this as a special account having the loan account unchanged but opening an account for unpaid interest and a provision account for unpaid principal that is due.

These accounts are liability accounts and equity is reduced by the amount of these two accounts.

The provisions and unpaid interest reduce equity.

At the end of the year these two liability accounts for provisions and for unpaid interest result in lower value of equity and hence less funds available for the payment of dividends.

The central bank enforces three ratios and one important rule: The rule describes how to take provisions and how to decide when unpaid interest due must be taken into the special liability account.

The three ratios are the cash reserve requirement, the statutory liquidity requirement and the capital adequacy requirement.

A bank may reschedule a loan, introducing a new repayment schedule, e.g. giving the borrower two extra years to repay the loan writing a new schedule of repayments.

In this case the bank may demand some repayment be made to make the rescheduling; this goes into cash and raises equity.

The rules of provisioning may enable the provisions to be lifted in which case bank equity increases and the account of provisions declines.

The rescheduling will usually raise the equity of the bank and reduce the provisions for unpaid loans.

A bank may write off a loan.

This means the bank decides it cannot collect the loan and reduces the asset account for loans by the amount of the write off. It also reduces the equity by the amount of the write off.

If the bank has made provisions then it reduces those provisions and the unpaid interest instead of the equity.

It is also permitted by the central bank to take half the value of the equity as part of the write off.

When the loan is written off the borrower is still liable for the amount owed.

The bank sells the collateral and any other assets it can obtain and takes those into cash on the asset side and into equity to balance the fundamental equation.

Finally, the bank can borrow from the central bank or from other banks to help manage its short run affairs.

In all of this the bank has maintained the cash required and the holdings of government securities required.

Of course, the bank can hold more money in the central bank and more government securities than required.

The bank must also handle its provision and unpaid interest as the central bank requires.

This is the way the banking system operates under the scrutiny and certain rules the central bank prescribes.

How the system breaks down

The central bank has one more rule for the commercial bank to follow.

The equity, from the balance sheet must be equal to or greater than a certain fraction of the assets.

The central bank has a complicated set of rules that attaches a number between 0 and 1 to every asset.

Loans to private enterprises have a number 1 attached; loans to the government have the number 0.

The assets are all multiplied by these numbers and added together.

Some off-balance sheet items are included.

Out of this comes a number called the ‘risk weighted assets.”

Equity must equal a prescribed fraction of the risk weighted assets.

The idea here is that if the bank loses money then it is the owners who should pay not the depositors.

The bank should have enough equity that losses are borne by the owners.

This mysterious stew called the risk weighted assets is continually being redefined.

Although this is a rule worked out by central bankers and other experts it is applied by most countries, otherwise one has trouble dealing with banks from other countries.

Problems

The first problem is the banks do not always work out their provisions requirements correctly hence making the equity value of their bank higher than it should be.

The second problem is some banks have such poor loan portfolios that their required provisions would make their bank’s accounts look very bad.

In these cases, the bankers beg the central bank to allow them to only account for part of the provisions.

Central banks should never do this. It hides the condition of the bank from the public.

Worse in some cases the bank is allowed to pay dividends even though it has not made enough money to justify this.

This should never happen.

Having hidden their losses by understating provisions the equity of the bank is now higher than it really is.

It is now easier to claim that there is enough capital. In other words, the bank presents itself as making the required capital when it has not.

The governance system described here is straightforward and works well if implemented.

When the bank fails to maintain the capital requirements then it is given some time, a year at the most to correct this.

The bank does this by bringing additional capital into the bank by selling shares to investors or by existing investors buying additional shares.

However, additional funds enter the bank as cash and equity increases to the required amount.

Owners hate this as either they have to invest more money or the ownership is diluted with new owners. On this point the central bank must be ruthless.

Failure

If the bank is unable to reach capital adequacy, then the central bank must act.

Typically, it will take over the bank, make appropriate loans to help the bank stabilize and introduce new management.

The old management would leave and the Board of Directors would have no say over the operation of the bank.

The new management would do its best to improve the bank’s condition.

Deposits would be encouraged; strong loan collection efforts would be made.

If the new effort is successful then the bank would reissue shares using these to pay for the central bank’s loans made during this adjustment period.

Any surplus would be paid to the original owners of the bank and the bank could continue to operate.

If it was impossible to revive the bank’s financial stability the bank would be closed; the depositors would be paid off according to the deposit insurance.

The original owners of the bank would have lost their investment.

The governance system works very well.

So long as the rules are enforced everyone has an interest in making the banks profitable through making good loans.

Bangladesh Bank has not followed its own rules.

Banks are allowed to avoid booking their actual provisions [encouraging making bad loans.]

Sometimes cash dividends are paid when the bank has actually lost.

Many banks have failed to meet their capital adequacy for protracted periods.

The system has held together as the growth of deposits has been rapid.

It is a Ponzi scheme where incoming deposits are used to pay for the loan losses.

The very excellent Bangladesh Bank staff is fully aware of the condition of the banking system.

The only way to have a sound system is to enforce the system sketched above.

This may mean a few banks are taken over; and if it proves impossible to rescue them, and then close them down.

There are two essential points:

1. There should be no fear of closing down insolvent banks if they cannot be rescued in a legal proper form. Now all bank owners after failing to run their bank correctly refuse to give it up. The state of Bangladesh is far more powerful and important than the reputation of a family or individual.

2. Running a competitive, private banking system where the borrowers repay their loans is the key to a successful economy. Every action by the central bank to move away from the central model outline herein results in economic loss to the Bangladeshi people.

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