Outlook for the Banking Sector in 2010

A less than exciting year 2009 for the banking sector
Despite a late-year rally, Bangladeshi commercial banks had a lackluster performance in 2009. Although most banks improved their profit figures, the spectacular growth in yester years stalled during 2009. In the backdrop of over 30% loan and deposit growth even by the average bank in previous years, loan growth for the industry slowed down to about 15% in 2009. Despite a more favorable political climate, investment did not pick up during the year.

Overhang of the commodity price adjustment…
During the first half of the year, large trading houses (that are also the largest corporate clients of banks), were stuck with large positions in commodities acquired at high prices during 2008. As commodity prices retreated, both these corporate clients and their banks were cautious in making large investments in commodities. As a result, commodities and raw materials import decreased by as much as 20% compared to last year.

Global recession and crisis of confidence …
Although publicly adorning a brave face, no one in the business community really believes that Bangladesh will remain unscathed during the global recession. Because of low connectivity with global economy and catering to the lower-end of the western consumer market, the effect has been delayed and subdued so far. However, not knowing the extent and the duration of the recession, businesses are not very excited about making new investments, especially in textiles and readymade garments (RMG) that are the main drivers of export. Although domestic demand has improved, the questionable outlook for remittance, agriculture and export earning did not provide enough incentive to invest.

Lingering infrastructure problems…
The country currently faces a 25% shortfall in electricity generation (5,000MW of demand as opposed to 3,800 MW of supply) simply to supply current connections. As much as 50% of the country still does not have access to electricity. Due to lack of new supply of natural gas, new gas connection has been withheld for almost six months. Although road and port services have improved, they are still inadequate to open up new industrial zones. No entrepreneur would be excited about the prospect of less than 50% capacity utilization because of lack of such essential services.

Heaps of excess liquidity…
As of September 2009, the banking system had idle liquidity of BDT 340 billion. This was an improvement over liquidity in June 2009, which was BDT 350 billion. In one year since June 2008 when excess cash in the system was BDT 130 billion, liquidity went up by 170%. This resulted from a confluence of factors including lack in investment and monetization of incoming forex. As a result of excess liquidity, inflation rate after an initial cooling down is on the rise again. Another concern is the expansion of credit in absence of industrial, commercial and agricultural lending; in such a scenario credit may find way into excessive consumption or the capital markets, which may create bubbles. Banks removed some liquidity from the market, but instead of going into lending, some of it found way into government securities. Although banks tried to reduce the speed in deposit taking, this idle liquidity still put pressure in their interest burden. The squeeze in profitability may be further felt in 2010 if investment does not accelerate.

Priming the pumps…
A number of large business houses were affected by the crackdown on corruption during 2007-2008. The necessary adjustment for them with a new political environment may have lingered the slow investment climate. The construction sector was especially affected as investment of undeclared funds in real estate was closely scrutinized. Besides, government development projects through the annual development programs (ADP) remained slow and achieved an implementation rate of only 60%.
Model of large corporate-based lending is challenged…
In excess of 30 banks are vying for the business of the same handful of corporate clients. Growth in earning of most banks suffered as large corporate clients stopped borrowing. This accentuates the lack of loan and income diversification by most banks. It is not surprising that more and more banks are vying for the missing middle (the SME sector) where some banks have commanding lead.

Capital markets, the savior…
A saving grace for the banks was the strong rally in the capital markets. Banks with large exposure in the capital markets gained windfall profits in three ways; through appreciation of their proprietary portfolios, by collecting trading commission from an increasingly active market, and by lending in margin to retail investors with unbelievable spreads (thanks to plummeting money market rates). In a banking industry with limited service offering, fees and commissions for some banks exceeded 30% of their operating profit. A growth in the breadth and depth of the capital market would most definitely favor the first-mover banks, but current growth in commission income may have gotten ahead of itself in a shallow market. Another issue of importance is the directive by the central bank to create separate subsidiaries for merchant banking and brokerage businesses. Banks may be constrained in margin lending because of a limit on the capitalization of subsidiaries. This may subsequently reduce the interest income from securities business.

Outlook for 2010: more permissive regulatory environment
Some of the structural problems would remain for the banking sector in 2010. Infrastructure problems do not go away overnight and global recession may eventually take its toll on remittances and RMG export. Despite the hitherto resilience of the domestic sector, the outlook for agriculture (the largest driver of the domestic economy) remains less than certain this year. On top of the macroeconomic variables, the banking sector will deal with a number of regulatory and structural issues.

A liberal monetary policy…
Bangladesh Bank (BB) implied that it would continue the current liberal monetary policy to promote what the new Governor has termed an “Inclusive Growth”. In balancing between growth imperative and inflation fears, the bank seems ready to side with growth. BB has targeted over 16.7% growth in private credit-flow in 2010. BB has either eased or has hinted at easing its monetary instrument tools and such as repurchase (Repo) and outright transactions in government securities (Open Market Operations).

Exchange rate intervention…
Foreign exchange reserve continues to improve, mainly supported by strong remittance flow. Current reserve at over USD 10.5 billion is highest in the history. The high foreign exchange reserve also illustrates the lack of economic activity, especially the significant reduction in raw materials and machinery imports. As excess supply of forex forces appreciation of the BDT and poses a threat to the export sector, BB made several soft interventions in the market by purchasing USD from banks. In the past two years, BDT has traded within a very narrow band, partially because of interventions by the BB. Despite increasing remittance in the latest months, BB has managed to monetize the forex without significant increase in inflation. Picking up of investment and reduction in remittance (both of which look realistic) may ease need for interventions before any significant effect in inflation.

Managing lending and borrowing rates…
BB has held the view that interest rate spread in the country is excessive and should be brought down below 5% in order to increase credit flow. Spread in Bangladesh averages 5.0% - 5.5% whereas in neighboring India the range is 4.5% - 5.0%, a full 100 bps less. Instead of moral-suasion that has been the practice of the central bank, it directed all banks in April 2009 to put a ceiling of 13% on lending rates (except for consumer loan, small enterprises and some trade financing). Consequently, Bank associations as a group have decided to lower deposit rates, trying to effectively maintain the spreads. There are a few consequences of this dance; first to maintain profitability, banks may favor higher rate higher risk consumer loans; second, investors chasing yield enter the stock market and drive up price-levels. Neither of these are desirable outcome. Weaker banks may break rank with the associations by offering higher deposit rates in order to compete for deposits.

Central-bank’s vision of “Inclusive Growth”…
The current central bank governor has set out a vision for the central bank that is true to his development finance background. In his view, a "broad-based, inclusive, socially and environmentally responsible economic growth is viewed by Bangladesh Bank as the way forward in strengthening domestic demand and intra-regional trade." He set out a target of 25% of lending portfolio of banks to be directed to agro-related businesses. There are other directives encouraging lending to SME, women-entrepreneurs and socially-responsible businesses. While none of this conflicts with the principal objectives of banks, which is lending to profitable businesses, banks may be challenged to meet all of these directives and still maintain profitability in a slow-investment environment.

Rescheduling may hide the true story of NPLs…
BB has given a wide discretion to banks allowing rescheduling of defaulted loans to export-oriented sectors within June 2010 without any down-payment. An even more curious step was to allow rescheduling of defaulted loans by businesses of 30+ people who have been “unduly harassed” by the past caretaker government. As defaulters start taking advantage of these benefits, NPL percentage of banks may decline without any real change in the asset quality. Earning quality may also be distorted as provisioning is reduced. In the first half of 2009, NPL growth of foreign banks exceeded the sectoral average, which was surprising given the more stringent lending criteria of such banks. Regularizing of defaulted loans by rescheduling may hide the true picture of bank-asset quality.

Discipline in the banking sector…
Over the years, the central bank has done a good job of bank supervision. Its success is evident in the lowering of NPL for the entire banking sector including the state-owned banks (came down from over 40% in the 1980s to less than 11% currently), ensuring better corporate governance by imposing strict guidelines for the appointment of management and boards, taking decisive steps in handling troubled banks, improving the Credit Information Bureau (CIB), and lastly using a carrot and stick policy for chronic loan-defaulters. Some recent policy decisions by the Ministry of Finance and BB appear to be at odds with the previous track-record. We hope that such relaxation is part of the government’s stimulus plan and a selective relief does not escalate moral hazard.

Long-term outlook for investment in bank stocks
Despite current challenges, the banking sector remains one of the most attractive investment choices in the Bangladesh capital market. It already constitutes about 30%of the total market capitalization of the DSE. The banking sector experienced a late year rally in 2009. However, the banking sector is still in its initial stage of growth in Bangladesh, and opportunities exist for selective investment in the banking sector.

Banks give an exposure to the entire economy…
While there is a debate on a realistic date for Bangladesh’s elevation to the mid-income country group, there is no doubt about the prospect for above-average growth rate. The financial system in this country is still bank-based, and banks would finance most development activities in the near-future. In the absence of a broad-based capital market, banks provide best exposure to the country’s economic growth.

A large unbanked population will drive further growth…
Banks have achieved more than 30% asset growth on average in the last five years, compared to less than 20% growth in India and China, two Asian giants. Still, only 25% of the country’s population has access to banking services. According to a report published by the World Bank on “Access to Finance”, only 23% of the bankable population has a deposit account whereas only about 6% of the people have a loan account. In comparison, the numbers are 94% and 23% respectively in neighboring Sri Lanka (India falls in between). The global benchmarks for these numbers are 150% and 50%, respectively. Bangladesh Bank is preparing a strategic plan that targets inclusion of a broader population in the banking network, which would help expanding banks’ revenue-base.

Limited product range leaves room for diversification…
Until recently banks focused largely on conventional lending. In an environment of big interest rate spread, they did not have an incentive for product diversification. As businesses and consumers become more mature, innovative banks will bring new products to the market to meet their demand. This creates an opportunity for differentiation. Although a number of banks have nibbled in the capital markets, they have only scratched the surface. As income level improves and wealth is created, there would be huge need for wealth management and other fee-based services. On the supply side, as businesses look for innovative financing, an opportunity awaits banks in merchant banking. Banks need to take a long-term view and make the effort to develop skilled staff.

Investor-base and liquidity…
Because of dilution over the last two decades, banks have a large and diversified investor base. Consequently, the banking sector offers the most fundamentally-driven investment vehicle, where price manipulation is minimal. There is ample liquidity in the market for most banks. It is also the best regulated sector under the supervision of a fairly competent central bank. Improvement in disclosures and financial statements attests to improving governance. Few other industry sectors in the Bangladesh capital market have these characteristics.

A more competitive environment…
An environment of windfall profit for banks comes to an end as investment slows down, rates reduce, competition for deposits intensifies and other savings instruments emerge that compete with plain vanilla fixed deposits. In a more competitive environment, only better-capitalized and better managed banks offer good return prospects. Management quality, vision, investment in technology, focus on operating efficiency, and ability to develop niche markets will separate the men from the boys in the future.