Bangladesh Bank (BB) in its recent monetary policy expressed concern about higher domestic inflation expectation following higher than target private sector credit growth (19.1 per cent in November 2017 and 18.1 per cent in December 2017 against 16.2 per cent target). As a result of that and in order to contain annual average inflation within target rate (6.0 per cent; actual was 5.7 per cent in December 2017), BB has already reduced Advance-Deposit Ratio (ADR) for traditional banks from 85.0 per cent to 83.5 per cent, a reduction of 1.5 per cent as against 4.5 per cent ADR reduction earlier anticipated by the Association of Bankers, Bangladesh (ABB).
Accordingly, before declaration of the monetary policy for January-June 2018 and reduction of ADR by 1.5 per cent, ABB expressed serious concerns about reduction of ADR and in a recent letter, ABB suggested BB not to do so without giving 12 months' time, if at all BB wants to do that. BB has apparently reduced the ADR, in order to contain inflation within target (6.0 per cent) after recent higher than target private sector credit growth. ABB, among others, has argued that it will increase cost of deposits and, in turn, cost of loans. It argued in the letter that: (1) "this will then force the banks to re-price their loan books and interest will start rising, putting upward pressure on inflation". ABB has made few other arguments in the letter, notable among them is: (2) General Provision (GP) requirement for off-balance sheet exposure (OBE) should be in line with funded GP requirement.
The first part of the first argument ("this will then force the banks to re-price their loan books and interest will start rising") is valid; definitely such a move will raise interest rates on deposits and loans across the market. However, the second part of the argument ("putting upward pressure on inflation") is invalid; a higher interest rate across the market will reduce supply of money resulting in reduction in aggregate demand and inflation. Though higher interest rate may add some cost-push inflation here and there, yet reduced money supply and reduced aggregate demand across the market will more than sufficiently offset that impact reducing or containing inflation as a whole. Here the whole purpose of BB is to reduce inflation by reducing supply of money and aggregate demand. Reducing ADR is just one of the tools that may be used by BB to attain its objective of containing inflation within a target limit (6.0 per cent).
Possibly because of avoiding a hard landing, BB has reduced the ADR by only 1.5 per cent as against 4.5 per cent earlier anticipated by ABB. However, BB should foresee such higher than target credit growth or other factors contributing to higher inflation, well in advance and should take policy measures, including reduction of ADR, gradually and well in advance, enabling a soft landing for the economy and banking companies in term of Asset-Liability management. Such well-timed measure is essential on the part of BB because monetary policy measures take two to three quarters to feed into the economic system to get the intended results even in a developed country like the USA (having highly efficient market and communication system), and in a country like Bangladesh naturally it takes a longer time. Reducing 4.5 per cent ADR in one go, after allowing credit growth beyond target limit for a considerable period would force the banking companies or, for that matter, the economy to have a hard landing which is the last thing a central bank may desire.
Now if there is a conflict between two objectives i.e. containing inflation within a maximum limit (6.0 per cent) and attaining gross domestic product (GDP) growth of minimum 7.0 per cent, what will BB do? In such a case, BB (as a central bank) should give higher priority to containing inflation rather than GDP growth, because higher than target inflation, other factors remaining constant, will create uncertainly for both the investors and the consumers, reducing investments, production, employments and consumption (higher inflation will also directly reduce purchasing power of the consumers) resulting in lower aggregate demand thus lower employment and GDP growth in the medium and long term - that is the mainstream opinion and experience of economists, central bankers and policy makers worldwide. This view was also stressed by Dr. Chakravarthi Rangarajan, a former governor of Reserve Bank of India (RBI) in a recent speech at Bangladesh Institute of Bank Management (BIBM), Dhaka while he mentioned that "among the various objectives such as price stability, growth and financial stability, the dominant objective for central banks, particularly in developing economies, must be price stability".
If and when a central bank fails to contain inflation within or around the target, that erodes its credibility in its intention and ability to contain inflation adding further uncertainty in the market that is not at all favourable for employment and GDP growth. Inflation beyond tolerable limit is considered one of the greatest enemies of employment and GDP growth in the long term. Higher than target inflation may also reduce a country's competitiveness , by making its exports relatively expensive and imports relatively cheaper adversely impacting net exports, balance of payments and GDP growth. Price stability is also preferred by central banks for stable financial and payment system. No one will argue that higher than tolerable inflation rate, resulting from loose monetary policy or excessive credit growth or money supply, is favourable for a stable financial and payment system.
Therefore, if BB considers and estimates that inflation is going to shoot over its target rate (6.0 per cent) then it should take whatever monetary policy measures necessary to contain inflation and essentially prioritising inflation targeting rather than GDP growth rate. If inflation can be contained by BB consistently within or around the target, then, other things remaining constant, employment growth or, for that matter, GDP growth will take care of itself in the long term.
The second point raised by ABB is that GP for off-balance sheet exposure should be in line with GP requirements against funded exposure of same kind of credits (e.g. corporate loans, small and medium enterprise loans). It is a valid point.
However, the argument of BB for reducing GP requirement for small and medium enterprise (SME) loan portfolio to 0.25 per cent as against GP requirement of 1.0 per cent against corporate loan portfolio, that it will encourage SME lending by banks, is invalid. Here the argument of BB is very weak. One quarter (0.25) per cent GP against SME loan portfolio as compared to 1.0 per cent GP requirement against corporate loan portfolio cannot be justified, firstly, because even BB itself recognises that the inherent credit risk in the SME portfolio is higher than that in corporate loan portfolio, that is evident in the circular of BB (2012) in which it imposed 5.0 per cent interest spread capping (a wrong policy itself, essentially because, here incentives are biased against competitive & efficient deposit management as well as developing & providing modern , innovative and digital banking products & services) between deposit rate and lending rate excluding SME and credit card. That means, BB allowed more than 5.0 per cent spread in case of SME lending, not in case of corporate lending, because BB assumed (rightly) that the inherent credit risk in SME loan portfolio is higher warranting higher risk premium thus higher interest rate. In fact, at that time (2012) SME lending was bracketed with very high risk credit card lending.
Subsequently (2015), considering SME as a preferred sector, in order to encouraging SME lending by banking companies , 5.0 per cent interest spread has been also imposed by BB on SME lending, which can create a mismatch between perceived risk and return discouraging the banking companies from extending more loans to SME sector to the extent desired by BB or required for necessary employment and GDP growth, unless they are forced by imposing a floor for SME lending as a percentage of total loan portfolio of a bank.
However, encouraging lending to a particular sector/segment -- (in this case, SME) preferred by BB or government of Bangladesh (GOB) -- has nothing to do with maintaining lower or no GP. There are other effective ways for encouraging or forcing the banks, if that is required for the national economy, to increase their lending to a particular segment (SME). As for example, it may be that a minimum percentage (say 25 to 50 per cent) of total loan portfolio should be in the SME sector.
There is only one right criterion in the banking world for determining provision requirement against any individual loan or loan portfolio, on the balance sheet date, that is credit risk associated with the individual loan or loan portfolio in terms of probability of recovery based on objective criterion and/or qualitative judgment. Specific provisions are made against identified & specific loans depending on probability of recovery on a given date. In term of probability of recovery, individual loans in any loan portfolio can be divided into three parts. The first part is where the bank management is confident beyond any reasonable doubt that a loan in question is recoverable as per its existing terms & conditions in normal course of business - in this case no specific provision is necessary. The second part is where the bank management is confident beyond any reasonable doubt that the loan in question is not recoverable fully or partly (if there is some recoverable security) - where full provision (net of any probable recovery from, say, sale of securities) is essential. Finally, the third part is where there is reasonable doubt as to the recovery of a loan but probability of recovery is not zero per cent; in such cases also, provisions should be made to the extent of probable losses on the basis of conservative accounting principle. If there is 50 per cent probability of non-recovery then at least 50 per cent provision should be made. BB's specific provision requirement in its classification policy, in general, is designed in that line.
Now coming to GP, primarily it is maintained to cover unforeseen credit losses which are not yet specifically identified but inherently exist in a loan portfolio. Some of the loans in a bank's portfolio will be eventually irrecoverable despite having the best possible credit risk management in place, essentially because future is always uncertain depending on many external and internal factors, most of which are beyond the perception and control of the bank management. GP should be based on past experience of loss which may be extrapolated for future probable loss in a loan portfolio. As for example, if actual annual average loan loss (write-offs) in SME portfolio has been 2.0 per cent of total portfolio in the past few years, then 2.0 per cent GP should be maintained against SME portfolio unless there is strong reasons to justify that future probable loss would be significantly lower or higher than the past.
If one agrees with the fact that inherent credit risk in SME lending is higher than corporate lending, then GP against SME should be more than 1.0 per cent, even 1.0 per cent GP requirement equal to that of corporate lending is not sufficient. Otherwise in the short term, because of lower GP requirement banks may increase their lending in SME portfolio, their short-term profit may be higher but in the long term eventually, it will have to recognise much higher actual credit losses, creating a huge hole in the balance sheet of a bank having a large portfolio of SME loan - which in extreme cases may endanger the solvency of the bank. In order to justify 0.25 per cent GP requirement against SME loan portfolio, one has to justify that, in general, credit risk inherent in SME loan portfolio is four times less than credit risk inherent in corporate lending portfolio.
There is another inadequate provision requirement against 'short term agricultural and micro-credits' (STAMC), where 5.0 per cent provision is required against substandard STAMC (over due for 12 months or more) and doubtful STAMC (overdue for 36 months or more but less than 60 months). One hundred (100) per cent provision (95 per cent is made after 60 months) is required for bad/loss STAMC (overdue for 60 months or more). In 1989, when for the first time classification & provision policy was formulated by BB, then a loan was classified as bad/loss after becoming overdue for 60 months, now for almost all other loans the time limit is only nine months. Whether a STAMC will be eventually recovered or not that is mostly and practically determined in maximum 12 months' time, because usually such loans are taken for cultivation of a seasonal crop that can take at best a few months time. Such an exceedingly inadequate provisioning policy has created huge unrecognised loss, overstated profit, asset and capital or understated capital shortfall in the balance sheet of banks like Bangladesh Krishi Bank (BKB) having very large STAMC portfolio.
Khan Tariqul Islam FCA can be reached at e-mail: [email protected]
