Non-performing loans, moral hazards, and revisiting depositors’ rights in Bangladesh

Non-performing loans refer to the status of the loans extended by banks and financial institutions that borrowers are not repaying as per the agreed-upon terms. Recently, non-performing loans have reached approximately 9% of total loans, warranting a critical examination of banks' reckless lending activities with depositors' funds in Bangladesh. Although depositors' insurance schemes are crafted to safeguard depositors from risks, they can also create moral hazards that encourage risk-taking by both banks and borrowers. Furthermore, the existing law protects depositors' funds up to a limit only of BDT 100,000. Considering Bangladesh's present socio-economic conditions and a per capita income of $2,284, it is prudent to revisit the law and consider raising the deposit protection cap, as discussed below.

Within any financial system, the pivotal role of banks lies in their ability to provide credit facilities. It is essential for fostering financial inclusivity, stimulating innovation, and driving economic expansion. Banks offer credit facilities through a procedure referred to as credit intermediation, which typically begins with the collection of deposits from individuals, businesses, and various entities. These deposited funds serve as the bank's source of funds. From a legal perspective, any money placed in a bank account constitutes a liability for the bank. This implies that the bank must return the deposited funds promptly upon the depositor's request. Meanwhile, banks use the funds to provide credit facilities with the expectation that the borrowers will pay off the loan as per the agreed terms. Therefore, timely loan repayment is essential in ensuring banks' sound and healthy operation in any financial system.

Nonetheless, banks' function to provide credit carries an inherent predicament embedded in the risk of borrowers' failure to repay loans, liquidity crunch, depositors' loss of confidence in the bank, and bank run, leading to a possible winding up or collapse of banks. To contain the risk of bank failure, the law and prudential regulations require banks to maintain high-quality liquid assets and adequate capital and to deploy provisioning for non-performing loans. The law further requires banks to pay premiums to insure the depositors' funds – a deposit insurance scheme that guarantees the protection of depositors' funds in the event of a bank failure.

Originating in the United States during the Great Depression of the 1930s, deposit insurance aims to protect depositors of failed banks. It is a popular tool to mitigate financial risks in both developed and developing countries. In Bangladesh, the Bank Deposit Insurance Act, 2000 ('Deposit Insurance Act') protects depositors up to BDT 100,000. As per the scheme, if an insured bank fails, Bangladesh Bank will provide each bank depositor with an amount equal to their deposited funds, up to a maximum of BDT 100,000. This amount will not be exceeded even if the individual has multiple accounts in the failed bank and has more than BDT 100,000 as an aggregated amount. While deposit insurance is intended to increase depositors' confidence in the banking system, numerous economists have highlighted that deposit insurance creates a moral hazard by incentivising excessive risk-taking by banks.

To contextualise the moral hazard problem in Bangladesh's banking sector, as per the Deposit Insurance Act, all state-owned commercial banks (such as Sonali Bank, Janata Bank, Agrani Bank, and Rupali Bank) are exempt from paying a risk-based premium even though they could be potentially problematic banks. Recently, all these banks failed to meet the capital adequacy requirements, compelling the central banks to place them under a special plan to improve their liquidity situation.

According to data from Bangladesh Bank, state-owned banks in the country are grappling with a substantial amount of defaulted loans. In addition, on several occasions, significant loan scandals involving state-owned banks resulted in severe capital deficiencies, necessitating liquidity injections by the Bangladesh Bank. For instance, during the fiscal year of 2016-17, Sonali Bank allegedly issued unauthorised loans amounting to $454 million. Janata Bank extended a loan to AnonTex Group that exceeded 25% of the bank's capital base, violating the provisions of the Bank Company Act 1991. Rupali Bank, too, breached the single borrower exposure limit. Given the series of loan scandals, the increase in non-performing loans, and the failure to adhere to prudential regulatory capital standards, the fundamental question arises: Are these banks involved in irresponsible and illicit lending practices using depositors' money, with the expectation that the government will prevent them from failing?

The moral hazard issue is also evident within commercial banks in Bangladesh, where there is typically a reported surplus of liquidity and a high deposit rate despite a significant occurrence of non-performing loans. As of June 2022, banks have disbursed loans amounting to Tk13,98,592 crore, of which BDT 1,25,258 crore is reported as defaulted. Additionally, non-performing loans represent 6.20% of their total loans, amounting to BDT 66,696 crore.

Given the substantial rate of non-performing loans, there is a legitimate concern about whether banks in Bangladesh possess sufficient liquid assets to meet depositors' withdrawal demands. Bangladesh's banking sector has yet to experience a significant crisis, primarily because of the government's commitment to prevent bank failures. The government typically injects liquidity into the banking sector in response to potential shocks. It may make policy decisions that benefit the banks, such as writing off a specific portion of the non-performing loans. However, these actions can inadvertently encourage banks to engage in risky behavior without bearing the consequences thereof.

The lack of development in Bangladesh's capital market presents a significant obstacle, as it restricts banks from diversifying their investment portfolios across various risk categories. For instance, despite having excess liquidity, most commercial banks in Bangladesh refrain from investing in the stock market because of strict provisioning rules implemented in response to the 2010 stock market crash. Hence, banks with surplus funds tend to give big loans. If the loans default, these banks incur losses that encompass depositors' money and the time and effort required for rescheduling and other related activities.

From a consumer behavior standpoint, depositors in Bangladesh tend to keep their money in bank accounts as the only investment option. Due to the lack of a well-regulated capital market, the interest rate on savings, government savings bonds, and interest on fixed savings accounts are some alternatives to increase their wealth. Therefore, depositors will likely lose everything in the event of a bank failure, particularly those with more than BDT 100,000 in their bank accounts.

Bangladesh is now classified as a middle-income nation, with an increasing per capita income and a growing number of people accessing bank accounts. The average deposit has grown over the years. Hence, one must question whether the existing legal safeguards for depositors are sufficient. Last year, a draft law, 'Bank and Financial Institution Deposit Protection Act 2022', was proposed, imposing a higher cap on the insured amount (BDT 200,000). It further introduced deposit insurance up to BDT 100,000 for non-bank financial institutions.

As the primary bank regulator, Bangladesh Bank holds the policy goal of safeguarding the banking system's financial stability, integrity, and robustness. Against the backdrop of the limitations of the current deposit protection framework, central banks are inclined to avoid allowing any bank to die, given the significant responsibility of safeguarding public funds. However, this approach fails to deter banks from participating in hazardous or unlawful lending practices. Therefore, governments must implement effective measures to shield depositors and uphold the system's financial security, viability, and strength.

Sangita Farzana Gazi is a final year Ph.D. candidate in law at the University of Hong Kong and a research fellow at Yale Law School.