Size of the non-performing loans is increasing, which increases the provisioning against these loans, which in turn reduces bank profits.
We should not be offended if the response to a question is to say “duh!”. After seeing so many news and views on the plight of the banking business in the media every day, this response in fact makes a lot of sense on the surface.
Everyone knows that most banks are having a hard time managing their finances because of soaring non-performing loans (NPLs). They also probably feel increasingly more vulnerable because the guardian of the financial system appears to be increasing tolerance of deviant behavior on the part of borrowers, known in the financial community as regulatory forbearance. The latest on this front is the setting of yet another precedent for accommodating large business groups to reschedule their loans that were restructured in 2015 on condition of regular repayments. This condition has not been met, yet permission to reschedule and non-performing rescheduled loan has already been granted.
So isn’t the answer rather obvious? Size of the non-performing loans is increasing, which increases the provisioning against these loans, which in turn reduces bank profits. True, but there may be more to it than meets the eye.
Keep in mind, the provisioning shortfall is also increasing. So the increase in the size of NPLs cannot be the full story. Nor is the slowdown in the growth of credit to the private sector because the slowdown happened only in FY19. Private sector credit growth was quite healthy during FY16-18, ranging between 15.7 to 16.9 percent.
A paper by the researchers of the Bangladesh Institute of Bank Management, presented yesterday, has provided another explanation. The operating cost of banks has increased while both the interest and non-interest incomes have shrunk in relation to the total assets of the banks. Increase in NPLs can only partially explain the decline in interest income, because in an accrual based accounting system the interest income on all loans are supposed to be recognized in the income statement while provisioning is supposed to build buffers for default on interest and amortization payments. The cap on interest rates is also not relevant because it is yet to be complied with, as evident from Bangladesh Bank’s repeated advisories on the issue.
The key questions then is why have the interest and non-interest income declined relative to the total assets and why have the operating cost increased?
The spread between the interest rate on advances and on deposits declined from 4.62 percent in July 2018 to 4.15 percent in June 2019. Average deposit rate in June 2019 increased 11 percent relative to the average deposit rate in July 2018 while average rate on advances increased only 0.7 percent during the same period, leading to a 10.2 percent decline in the spread. This decline would usually be construed as an indication of improvement in the efficiency of financial intermediation. Perhaps, not so in this case because the non-interest operating costs have reportedly risen. Unfortunately, we do not have a clear explanation on why the operating costs have increased. Increase in overhead expenses, salaries and bonus payments or what?
We also do not know why non-interest income declined when the trade-GDP ratio increased from nearly 38 percent in FY16 to 39 percent in FY19. Presumably, a lot of fees and charges are earned by providing trade related financial services.
We need to understand the causes of the decline in bank profitability much better to figure what needs to be done by whom to stem the decline in the financial health of the banking system. Recommendations to upgrade technology is well and good, but a little “paracetamolistic” i. e. not necessarily derived from a full diagnosis of the problem.