Never take financial stability for granted

Decade high inflation in both advanced and emerging market economies forced tightening of global financial conditions to prevent a high-inflation regime getting entrenched. This came into question within its own fort as significant macro-financial vulnerabilities, an unintended consequence of tightening, unravelled in the US and Europe. 

The intended disinflation effect has also materialised, albeit still short. Bangladesh has lived dangerously, with disabled mechanisms for the transmission of tightening, while taking an overt stance for ending policy accommodation of various sorts- monetary, financial, fiscal, and regulatory. There have been some tremors. Financial stability can never be taken for granted.  

Global financial stability risk averted so far

Rapid monetary policy tightening exposed some fault lines in the first half of 2023 in the advanced economies. Higher capital, liquidity, and stress testing since the global financial crisis built resilience to adverse shocks. 

Yet, the failures of significant regional banks in the United States and Europe were eyesores. The revelation of unpreparedness to handle the rapid rise in interest rates on the height of macro and micro prudence shook market confidence. The emergency responses by central banks and financial regulators prevented contagion locally and globally. 2023 is no 2008. 

Geeta Gopinath (IMF) has drawn attention to three uncomfortable truths: inflation is taking too long to get back to target in advanced economies; financial stresses generate tensions between central banks' price and financial stability mandates; and the probabilities of upside inflation risks are higher than before the pandemic. 

Supply shocks in the future could be more frequent (as reminded last week by the Russian withdrawal from The Black Sea Deal), severe, and inflammable. The climate transition could be mildly inflationary. Mixed with financial stability risks, policy makers are navigating under blurry visibility if not blindness.  

Inflation is declining across developed economies. It has declined to 3% in the US and 7.3% in the UK in the year to June 2023, but still above the official 2% target. A fairly optimistic scenario is this may continue without many more increases in interest rates. Pent-up demand has subsided, supply chains are adjusting to a geo-conflict embedded normal, and the US dollar has reversed part of its gains.

Contrary to what many predicted, global crises and escalating geopolitical tensions have not yet begun to reverse globalisation; cross-border trade, capital, information, and people flows have not reversed; and regionalisation is no more than it was before the refracturing of the world economy into rival blocs. That's the good news. 

The bad news is energy and food prices are volatile. Many vulnerable emerging market and low-income economies are at the sharp end of multiple shocks such as the cost-of-living pressure, rising cost of credit, extreme weather, and increasing economic fragmentation. Countries at risk of distress need continued vigilance, policy reforms, and coordinated international support to ensure economic stability. Bangladesh has navigated difficult transitions before but the current one is a different ball game. 

Cracks in local financial stability need attention 

In spite of receding global headwinds, the Bangladesh economy and financial system are showing cracks, rooted in weaker policies and institutions. The economy is on a slowing growth path owing to foreign exchange and energy shortages, incompatible macroeconomic management, and a fragile financial system. Unhealthy balance sheets of banks and corporates are wrong heading credit and investment cycles and dampening the prospects of the economy.

Macro financial vulnerabilities often build up alongside accommodative monetary, fiscal, and regulatory policies. Stress materialises when those policies tighten force majeure to ride the turbulence. How banks' profitability and solvency in Bangladesh evolves in this inflationary, dollar shortage, and regulatory flux will depend on developments in foreign trade, corporate business, the housing market, the CMSMEs, digital competition, and the state of play in financial regulation. 

Credit risks could rise further. Businesses so far have succeeded in negotiating higher output prices while workers have failed to negotiate a commensurate rise in wages. Nominal GDP growth in FY23 is estimated at 11.8%. Private credit demand is weaker despite a near zero real lending rate. 

Bangladesh Bank credit to the public sector has soared. Impediments to inflation pass-through, such as limited ability to pass on cost increases by farmers and CMSMEs or lagging wage increases for workers in the formal and informal sectors, are causing the middle and low income households liquidity and solvency problems. 

The banking system is inadequately buffered. Several large public and private banks are noncompliant on provisioning standards. The rise in the interest rate cap to above 10% may boost banks' net interest income (the difference between interests paid on deposits and other funding and the interests received on loans). 

The Six Month Moving Average Rate on Treasury (SMART) interest rate corridor, now in place, does not promise to be flexible enough to allow passing on cost increases to customers, thus stressing the cost-to-income ratio (operating costs divided by total income) of the banks. Achieving efficiency gains in the years ahead will be shaped considerably by opportunities for technological upgrading and business model re-engineering. 

Banks may still be able to expand the capital position to achieve balance sheet expansion if net interest income outweighs the growing provisions while cost-income ratio is contained. A tall order! 

The banks ought to be prepared for more adverse scenarios in which, for instance, credit losses increase substantially due to the lagged moral hazard effects of on again (for long) and off again (for short) regulatory forbearance. Trust—the foundation of finance—could corrode as a result. Questions about bank executives' accountability and the probity of banking supervision are finding increasing resonance. 

A new law of hope or despair?

The Bank Company (Amendment) Bill 2023, passed in parliament on June 22, is perhaps not even intended to be a game changer. Could it make banking better where currently it matters the most—loan defaults? 

The law defines willful defaulters broadly covering deliberate non-payment of the dues, syphoning off funds to the detriment of the defaulting unit, malfeasance in assets financed, misrepresentation or falsification of records, disposal, or removal of securities without the bank's knowledge, and fraudulent transactions by the borrower. Formally identifying such willful defaulters is in principle not difficult but in practice complicated by the power game. Banks have always known their defaulters of all kinds. The issue is prudent classification and resolution. 

The elephant often escaping the claws of the law is willful default through fraud, insider collusions, and misrepresentation of facts. The devil here will be in the details of the application of the new law. The required criminal proceedings, once detected, are hamstrung by the too big to catch problem (TBCP). Some businesses or sectors are considered so vital to the economy that catching them will cause economic collapse, thus justifying generous bailouts in one form or another. 

We have given this view a chance for years only to relearn from experience the conventional wisdom on the moral hazard it creates. The expectation of government support reduces the incentives for managers and owners to monitor and control risk-taking behaviour. It creates an unfair advantage for the large firms over their smaller rivals who face higher borrowing costs and regulatory burdens. It imposes a large cost on taxpayers who absorb the losses. 

Some last-minute changes in the new law raised a few eyebrows.  The worry is about the emergence of a concentrated financial sector specialised in fraud and risk taking. Protected by its political power, it can be a toxic source of widespread inefficiencies and inequities.

Prioritise the nuts and bolts of regulatory reforms   

A thorough overhaul of regulatory governance to prevent abuse of the penal provisions and attenuate the scope of discretionary powers is overdue. The effectiveness of a policy today depends on the credibility of the commitment to implement that policy in the future. 

Bangladesh is among the classic cases in South Asia currently experiencing circumstances where long-run economic outcomes are the opposite of what the law intended. This has a lot to do with the discretion allowing the policymaker to make case-by-case over period-by-period choices without constraint.

A regulatory regime making the financial and nonfinancial behemoths internalise the spillovers of their behaviour on to the financial system can credibly contain the TBCP problem. Such a regime has high capital requirements to induce intermediaries to self-insure against losses; routine stress tests to ensure capital adequacy even under the most severe adversities; globally compliant asset classification and an effective resolution regime. 

The banks need to be empowered with the Insolvency and Bankruptcy Code to take expeditious and effective steps against willful breaches of the loan contracts. The courts as well as IBC currently do not help speedy resolution of distressed assets. Delays in legal settlements are deliberately planned. There is hardly any accountability for such delays. 

It is not sensible to expect laws to change behaviour when the system has large backdoor escapades of these sorts. Most important for fair play is the vertical and horizontal even handedness of regulatory treatments, a missing norm in the current setting.