Financial stability of the banking sector in the context of the multiwave pandemic

Covid-19 pandemic is affecting every aspect of our lives. The banking sector is not an exception. It now faces unprecedented uncertainties in business activities. 

The declining economic activities will impact credit quality, loan demand, deposit growth, fee income, etc. Banks are relentlessly trying their best to ensure effective risk management so that the ultimate target i.e. financial stability, can be achieved. But multiple waves of the Covid-19 have changed the total scenario for the worse. 

Bangladesh's is a bank-based financial system. As such, any disruption and instability in the economic and business activity have notable implications for the banking industry. Our banking sector has been adopting sophisticated risk-management practices in many instances, based on their risk exposures. 

However, these initiatives for managing various risks are not sufficient to cover the crisis arising from the multiple waves of the Covid-19 pandemic. The situation demands specific and purpose-driven risk management initiatives as observed in the global cases. One such initiative might be changing the mindset of the board and top management for achieving effective risk management.

Nahal Ahmed/TBS Sketch

Are we prepared to handle credit risk, market risk, operational risk and liquidity risk, as these are the major risk factors under Basel-III capital framework? It is to be noted that these risk factors are also responsible for declining financial stability. 

In the context of Covid-19, credit risk is the most significant risk for the banks in Bangladesh. No doubt, businesses are seriously disrupted and most of the borrowers are either defaulting or experiencing a decline in their credit rating. 

As such, the banks are facing a challenging situation to maintain their asset portfolio. The government and the Bangladesh Bank have declared a number of stimulus packages to be implemented through banks for helping the corona-affected businesses so that economic activities can be revived. 

However, successful implementation of stimulus packages largely depends on commercial banks, as the risk of adverse selection of borrowers lies with the banks. In addition, stimulus packages may not be able to stop the rising non-performing loans (NPLs) unless banks are able to stop the moral hazard problem. 

The operational risk, the second most crucial component for banks after the credit risk, has a significant impact on the banking business due to this corona crisis. Banks are facing severe difficulty in ensuring business continuity during the crisis. Banks should have tested business continuity planning (BCP) to ensure regular business operation while minimising the risk of contamination of their employees and customers. 

Work from home is a new phenomenon for the bank employees in this pandemic. Banks are now extensively dependent on the digital platform for providing various banking services to their customers. 
This excessive reliance on the digital platform creates opportunities for fraudsters to perform criminal activities, which is a big threat, both for the banks as well as for their customers. 

With regards to market risk, the banking sector of Bangladesh is in a suitable position as the weight of market risk components in the total risks is relatively low - contributing to less than 3% of the total risk basket. 

In terms of liquidity management, Bangladesh Bank has been actively working in response to the increasingly challenging circumstances. BB responded to the market needs with several efforts of liquidity injection and due to their efforts the market is now flooded with excess liquidity, as observed from the market data. Now this excess liquidity becomes a problem for the banking sector. 

We know that Basel-III is a comprehensive risk-based capital management framework for promoting a resilient banking system. The goal of the Basel-III regulation is to increase the financial stability of the banks in order to withstand future economic and financial crises. 

The Covid-19 pandemic has changed the whole scenario and puts downward pressure on the capital of the banks. From the global financial crisis we learned that the crisis in the financial sector has a spillover effect on the real economy. 

As the duration of the pandemic is unpredictable, it is important to undertake necessary initiatives to mitigate the impact of Covid-19 on capital, for avoiding uncertainties in the financial sector so that adverse effects on the real economy can be minimised. 

Considering the evolving nature of Covid-19, maintaining appropriate Capital to Risk-weighted Asset Ratio (CRAR) is essential to ensure the financial stability of individual banks as well as the overall financial sector. 

Banks are required to maintain a minimum CRAR of 12.5% in the form of capital to fulfil risk-based capital adequacy (RBCA) guidelines of Bangladesh Bank. However, Covid-19 posed a serious threat to the compliance of capital management guidelines. 

Most of the businesses are affected badly due to the Covid-19 pandemic, which will ultimately affect their repayment to banks. As a result of this, either the quality of the bank borrowing will decline or the loan will become delinquent. 

The resulting impacts are declined income, increased provisioning, increased risk-weighted asset (RWA), and increased capital requirement. The obvious outcome of this scenario is the weak resiliency of the banking sector. 

A similar picture may also arise in case of operational risk and market risk, as the occurrence of such risk has increased manifold during the Covid-19. Bangladesh Bank performs stress tests on commercial banks on a quarterly basis to assess the financial stability of the banking sector under crisis scenarios. 

The pre-covid-19 result of the test has not been encouraging, as a good number of banks failed to qualify the test (Financial Stability Report). As such, it is highly likely that post-covid-19 financial stability will also decline due to the pandemic. 
Ensuring financial stability is a regulatory mandate of the central bank and our central bank has been doing the task effectively for the last few years. But in the context of the Covid-19 pandemic, the question may arise whether this is the right time to concentrate on the stability issues. 

We all know that the Bangladesh Bank is actively working to rebuild the Covid-19 affected economy of the country by undertaking various initiatives. All these efforts are to boost up the businesses and economic activities of the country so that life and livelihood can be continued. 

Although ensuring financial stability is a regulatory mandate of the central bank, multiple waves of Covid-19 may create opportunity for regulatory lapses in ensuring financial stability as Bangladesh Bank is burdened with other important issues. Here lies the importance of self-regulation where individual banks should focus on rebuilding their stability and consumers' confidence on their own and not by looking for the regulatory instructions. 

Commercial banks should conduct regular stress tests proactively to assess their financial position in a crisis scenario like Covid-19. This will help them to formulate contingency strategies so that they can protect themselves from any potentially damaging effects and can sustain in the market. But these initiatives require strong commitment and involvement of the Board and top level management. 

From the global practices we know that an effective risk management programme starts from the Board and top management. However, in the case of Bangladesh, the scenario is somewhat different where risk management is perceived solely as a regulatory mandate; rather than as an important means of enhancing competitiveness and performance. 

Banks are yet to be habituated to risk-focused culture and the mindset of the Board and top management are less supportive to such efforts. It is time when all the Board members should be the part of the risk committee for facilitating better risk management. This is important as banks with a strong culture of risk management are less likely to experience potentially damaging risk events like Covid-19 and are better placed to deal effectively with those events that do occur. 

This will not only add value to risk management efforts of banks to deal with the multiple waves of the pandemic but also ensure the financial stability of the banking sector. 

Professor Md. Nehal Ahmed is Director, Bangladesh Institute of Bank Management (BIBM). He can be reached at [email protected]