WHAT can banks do with their rising volume of surplus liquidity? As Advanced-Deposit ratio has been declining, banks rushed towards Bangladesh Bank's (BB) monetary instrument (known as reverse repo) to generate income. Yet recently, BB switched from using reverse repo to lower-yield 30-day BB bills as its primary instrument to manage surplus liquidity. BB's view is that this shift will incentivise banks to find investment opportunities in productive sectors by lowering their lending rates. Against this background, banks need to make tough choices in three key areas if they want to make productive use of rising surplus liquidity.

PROTECT INTEREST SPREAD OR DEPOSIT GROWTH?

First, if banks take BB's advice and significantly slash lending rates to attract fresh credit, they will have to decide whether or not to pass on lower interest income to their clients through lower deposit rates. Interest-rate spread (difference between lending and deposit rate) remains virtually constant at around 5.0 percent. This relatively large spread is attributable to high non-performing loans (NPL). At present, there is little evidence of an expected reduction in NPL. Indeed NPL actually went up in the first quarter of the current fiscal year, suggesting a reduction in interest rate spread will substantially shrink profit margins. This line of reasoning implies that banks will be tempted to lower deposit rates in line with lower lending rates.

However, reducing deposit rates is likely to divert savings away from banks to alternate financial assets offering significantly higher returns like NSS or Term Deposits offered by non-banking financial institutions. Banks have already felt the brunt of such misaligned interest rates. Recent reduction in bank deposit rates has sharply reduced deposit growth to around 12-13 percent this year from 15-percent (and higher) seen in previous years. Further reduction in deposit growth cannot bode well from a longer-term financial stability perspective. Should banks reduce interest spread, sacrificing profitability, or maintain interest-rate spread and risk lower growth in deposit base?

STOCKS OR RISK-FREE ASSETS?

Second, regulators appear interested in seeing banks increase their stock market exposure. Recently government stated that it would extend deadline for banks to reduce their stock market exposure by another two years. Earlier in January, BB relaxed frequency of banks' stock market exposure reports from daily to weekly. The central bank is currently considering further relaxing this reporting requirement to bi-weekly basis. Given these encouraging initiatives, banks need to decide whether to invest in excess liquidity in listed equities or continue with low-yield BB bills.

Exposure in equities entails higher risk, warranting higher return. It is worth mentioning that as of November 15, the DSEX index is down by 10.5 percent on a year-to-date basis. Profits announced by listed companies in the third quarter of 2015 were generally sluggish. Presence of institutional investors, and the stability they generally bring to an equity market, is still below-par. From such broad perspectives, there is little evidence of a bullish outlook. Yet as of November 15, selected stocks with robust financials from cement, pharmaceutical and FMCG sectors generated annualised return in excess of 13 percent, which is higher than 1-year risk-free rate plus 5 percent risk premium. So the choice of investing excess liquidity in equity market instead of risk-free securities (like BB-bills), essentially comes down to a bank's risk tolerance level. Should banks adopt greater risk and invest prudently in stocks, or resort to 30-day BB bills earning less but avoiding uncertainty?

CONCENTRATION OR DIVERSIFICATION?

Third, banks need to accept the ground reality that foreign lenders are here to stay. Regulators have rightfully eased access to foreign loans since borrowing rate is much lower and international lenders can facilitate much larger loans than domestic banks. Given an outlook of higher presence of international lenders in Bangladesh, banks will have to decide whether or not to reduce dependence on "traditional" corporate clients who will have increasing access to foreign loans. Greater SME (small and medium enterprises) financing, which has strong regulatory support from BB and the government, could be considered.

It is important to note that SMEs are considered relatively high-risk borrowers and often do not have the necessary collateral required by banks. Their financial profiles have potential implications for NPL, asset quality and loan-loss provisioning. They would require closer monitoring, entailing higher cost. Yet, this option would reduce the risk of losing clients to foreign lenders and potentially be a source of sustainable income, provided clients are chosen carefully based on feasibility of the business model and industry outlook. Should banks remain concentrated in urban or reputed corporates and risk losing clients to foreign lenders, or diversify to SME recognising relatively lower credit-worthiness?

As a final remark, these choices will vary between banks depending on their respective interest rates, capital market exposure and concentration in urban corporates. But prompt action in these key areas is certainly necessary if banks want to overcome challenges of rising surplus liquidity and return to a more promising growth trajectory.

The writer currently works as a Macroeconomic Analyst for an organisation in Washington D.C.

Email: shaque4@jhu.edu