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Paper on Causes of Liquidity Crisis in Bangladesh and Suggestive Remedies Introduction: During the early “liquidity phase” of the financial crisis that began in 2007, many banks – despite adequate capital levels – still experienced difficulties because they did not manage their liquidity in a prudent manner. The crisis again drove home the importance of liquidity to the proper functioning of financial markets and the banking sector. Prior to the crisis, asset markets were buoyant and funding was readily available at low cost. The rapid reversal in market conditions illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended period of time. The banking system came under severe stress, which necessitated central bank action to support both the functioning of money markets and, in some cases, individual institutions. One prerequisite of having a healthy investment climate in an economy is the availability of financing facility for the existing and potential borrowers. The two major sources of financing are the banks and capital market. However, the proportion of bank financing and equity financing differs from country to country. Historically, Bangladesh economy heavily depends on bank dominated financial system. Equity financing from capital markets through issuing new shares is lenient whereas debt financing through issuing corporate bonds is almost nonexistent. This is expected in Bangladesh insofar as banks' loan typically precedes equity and bond financing as the important source of financing. This is quite likely in an economy that evolves from agricultural to more manufacturing and services oriented. Investment and economic growth are highly positively correlated. Growth might result from the quantitative or qualitative changes in factors of production or improvement in technology or a combination of both. The importance of the capital market lies in the fact that it is the primary source of external funds for corporate investment. To flourish investment capital market needs enough liquidity for lending. Liquidity: Liquidity is the risk to a bank's earnings and capital arising from its inability to timely meet obligations when they come due without incurring unacceptable losses. Bank management must ensure that sufficient funds are available at a reasonable cost to meet potential demands from both funds providers and borrowers. 1. Ability of an organization to meet its current financial obligations. In banking, adequate liquidity means being able to meet the needs of depositors wanting to withdraw funds and borrowers wanting to be assured that their credit or cash needs will be met. Liquidity is also measured in terms of debt capacity or borrowing capacity to meet short-term demands for funds. 2. Quality of an asset that is readily convertible into cash, with minimal loss in value. Short-term securities, such as Treasury bills that are easily sold to other investors at relatively narrow


spreads between bid and asked quotes, and in reasonably large trading volumes, are said to be highly liquid. 3. Characteristic of a market where a large amount of securities, futures contracts, and so on, can easily be traded with minimal price distortions occurring. Strong markets are characterized by stable prices and relatively narrow bid-asked spreads. Thin markets have wide spreads and extreme trading volatility. Here are five areas to review to help understand your bank’s liquidity position. 1. Net Non-Core Funding Dependence Ratio - This ratio measures the degree to which the bank is funding longer-term assets (loans, securities that mature in more than one year, etc.) with noncore funding. Non-core funding includes funding that can be very sensitive to changes in interest rates such as brokered deposits, CDs greater than $100,000, and borrowed money. Higher ratios reflect a reliance on funding sources that may not be available in times of financial stress or adverse changes in market conditions. 2. The availability of liquid assets readily convertible to cash without undue loss- Consider Federal funds sold, available for sale securities, loans for sale, etc. 3. Core deposit/asset growth - Are core deposits capable of funding anticipated asset growth? 4. Diversification of funding sources - A bank with strong liquidity has a strong core deposit base, established borrowings lines, and procedures in place for acquiring internet-based or other forms of emergency borrowing. 5. External Forces - Economic conditions, competition, marketing efforts, etc. have a material impact on the need for liquidity going forward. What are some other ways that different banks could have different liquidity positions despite having similar liquidity ratios? • Cash flow from principal and interest payments could vary due to the types of loans on the balance sheet • One bank may have existing relationships and procedures for loan sales • One bank may have a large loan maturing • One bank may be involved in securitizing credits for the bond markets • One bank may have borrowing lines collateralized by the loan portfolio Liquidity is rated based upon, but not limited to, an assessment of the following evaluation factors: • The adequacy of liquidity sources compared to present and future needs • The availability of assets readily convertible to cash without undue loss • Access to money markets and other sources of funding • The level of diversification of funding sources


• The degree of reliance on short-term, volatile sources of funds, including borrowings and brokered deposits, to fund longer-term assets • The trend and stability of deposits • Management’s ability to identify, measure, monitor, and control the institution’s liquidity position, including the effectiveness of funds management strategies, liquidity policies, management information systems, and contingency funding plans Liquidity is a financial term that means the amount of capital that is available for investment. Today, most of this capital is credit, not cash. That's because the large financial institutions that do most investments prefer using borrowed money. High liquidity means there is a lot of capital because interest rates are low, and so capital is easily available. Interest rates so important in controlling liquidity as these rates really dictate how expensive it is to borrow. Low interest rates mean credit is cheap, so businesses and investors are more likely to borrow. The return on investment only has to be higher than the interest rate, so more investments look good. In this way, high liquidity spurs economic growth. However, a liquidity glut can develop if there is really too much capital looking for too few investments. This is usually a precursor to inflation. Eventually, a liquidity glut means more of this capital becomes invested in bad projects. As the ventures go defunct and don't pay out their promised return, investors are left holding worthless assets. Panic ensues, resulting in a withdrawal of investment money. Prices plummet, as investors scramble madly to sell. This phase of the business cycle, known as contraction, usually leads to a recession. Constrained liquidity means there isn't a lot of capital available, or that it's really expensive. Banks and other lenders are hesitant about making loans. It's usually a result of high interest rates. Definition of Liquidity Crisis: For the economy as a whole, a liquidity crisis means that the two main sources of liquidity in the economy, banks and the commercial paper market, severely reduce the number of loans they make or stop making loans altogether. Because so many companies rely on these loans to meet their short-term obligations, this lack of lending has a ripple effect throughout the economy, causing liquidity crises at a plethora of individual companies, which in turn affects individuals. A negative financial situation characterized by a lack of cash flow. For a single business, a liquidity crisis occurs when the otherwise solvent business does not have the liquid assets (i.e., cash) necessary to meet its short-term obligations, such as repaying its loans, paying its bills and paying its employees. If the liquidity crisis is not solved, the company must declare bankruptcy. An insolvent business can also have a liquidity crisis, but in this case, restoring cash flow will not prevent the business's ultimate bankruptcy. For the economy as a whole, a liquidity crisis means that the two main sources of liquidity in the economy, banks and the commercial paper market, severely reduce the number of loans they make or stop making loans altogether. Because so many companies rely on these loans to meet


their short-term obligations, this lack of lending has a ripple effect throughout the economy, causing liquidity crises at a plethora of individual companies, which in turn affects individuals. Liquidity Crisis in Bangladesh: Liquidity crisis, inflation and currency devaluation are matters of intense concern in the financial and economic circles of Bangladesh since the last few months. For vulnerable and largely unstable small economies like ours, a fairly severe financial shock can have devastating effect on their entire economic, political and social structure. Economic disruptions and dislocations can lead to political and social unrests, even, conflict and chaos. Such a scenario is one of our most horrible nightmares. All of these may sound pessimistic but we would much rather be conservative and pessimistic than liberal and optimistic where money is concerned. Money is at the root of much good but also much evil. One endeavors to enhance the good and mitigate the evil. Our present concerns about the state of our "money" have many causes and effects. If one could correctly identify the causes and effects, then one could look for appropriate solutions to the problems. Here looking at the entire complex issue would call for much lengthier deliberations. So, we will here only deal with a few major aspects with a view to facilitating an informed understanding of them. If look at the proposed budget for fiscal 2011-2012, we will see that there is a shortfall of Tk 452 billion between the state's earnings (Tk. 1.23 trillion) and planned expenditures (1.63 trillion). This is the budget deficit and the government fills it up through borrowings both from home and abroad. In this budget, the Annual Development Programs (ADP) is a massive, Tk. 460 billion, 41% of which will be funded from foreign sources, in all probability through borrowings euphemistically termed "project financing" by the Ministry of Planning. Some economists contend that government borrowings, if kept well below 5.0% of the GDP, encourage growth and prevent stagnation. If borrowings exceed the 5.0% mark then it either stokes inflation when the government is spending money or recession when the government is not spending money. If the government cannot properly balance between these two contradictory tendencies, the economy faces severe problems and so some economists contend that the best budget is one which balances earnings and expenditures. Governments borrow for various reasons, in different ways. The recent borrowings of the government are meant to curb inflation, i.e. reduce the amount of money in circulation, resulting a liquidity crisis in private sector banking and financial institutions - that is a shortage of money to lend to businesses and industries. Without credit to operate businesses, import raw materials and machineries, industries cut down on production and cut costs by lying off workers. Without profits for businesses and industries and without jobs and earnings for individuals, there might be less money to be had; the liquidity crisis is further aggravated. Most importantly, there are less goods and services to be had, which


increase the prices of everything; also exports decline reducing the state's earnings. Thus, lack of liquidity leads to recession, at least temporarily. Governments also borrow to fund large infrastructure projects and this may stoke inflation, i.e. there is more money in circulation than the demand for it. Consequently, the real value or purchasing power of money declines. Governments also borrow to fund import of foods and fuel when there is a shortage of such items in the country or when price of these suddenly increases in the international markets and exceeds the planned expenditures on these heads. Governments borrow money either from banks at home and abroad or directly from the citizenry and, in return, they issue bonds, certificates or guarantees which are in effect pieces of paper which purport that the government will return your money after a certain period and will pay you a certain rate of interest for the amount and the period. The state thus incurs a liability which each citizen has to bear, sometime extending over a decade or more. Liquidity Crisis in Financial Institutions: Financial Institutions who act as the Primary Dealers (PDs) of Bangladesh bank are facing acute liquidity crisis as their huge investment remained stuck up in the treasury bonds due to the absence of a vibrant secondary market. PDs bank and non-banking financial institutions (NBFI)’s have bindings to invest in the government bonds but they cannot sell it to the individual persons or other institutions due to the absence of the secondary market. PD financial institutions only can sell the treasury bonds to the non-PD banks, NBFI and life insurance companies. In 2006, government listed the government treasury bonds in the secondary capital market but yet to get responses from the individual investors due to the lower interest rate in the bonds. A primary dealer is a bank or securities broker-dealer that may trade directly with the central bank. Such institutions are required to make bids or offers when Bangladesh Bank conducts open market operations, provide information to its open market trading desk, and to participate actively in government treasury securities auctions. These dealers purchase a vast majority of government treasury securities such as T-bills and Tbonds sold at auction and schedule to resell them to the other financial institutions and public. Liquidity Crisis in Banking Sector: In the recent year, our country has experienced a decline in the value of Tk against US currency which has created has huge liquidity crisis in the banking sector. For this reason our county has failed to collect maximum amount of US dollar required to open letter of credit (LC) for local businessmen to import essential commodities for the country. As a result the importer is facing as ever crisis in their business. The banks need to reserve huge amount of money with the Bangladesh Bank as it is mandatory for them to maintain the CRR and SLR. BB has recently increased the rate of CRR and SLR as


are solving the problem of liquidity crisis has been aggravated recently. The central bank during last December raised the cash reserve requirement (CRR) by six percent for commercial bank. As the increased percentage of CRR and SLR the commercial bank is facing liquidity problem and for this reason to get rid of the problem this banks are concentrated to generate more deposits. To generate more deposits they have to increase the deposit rate which has a adverse effect in the society. Government credit from banking sector that would create extra burden to the country’s banking sector and it creates more liquidity crisis in that sector. the government has already borrowed Tk 110billion from the country’s banking sector to met the existing budget deficit during last 10 months (July 2010 to April 2011), while last year it repaid Tk 87.92 billion loans. In the recent future the commercial banks will be unable to provide loan to the private sector. If the bankers do not abide by the norms of the central bank and lend out money injudiciously, there arises the problem with liquidity. The abnormal long-term finance and unsatisfactory recovery position of short-, medium- and long-term loans will adversely affect the liquidity situation. The liquidity crisis of the banking sector has been accelerated by the increased amount of inflation; thus increasing the price of overall commodities for the general people. To keep peace with this inflationary effect, the people withdraw their savings from the banks and use this fund for their transaction expenditure. As a result the bank faces liquidity crisis. The reason of liquidity crisis, if any persisting in the financial sector, may be the non-recovery of loans. The overall percentage of recovery of loan is very alarming. By now the state-owned banks have taken many steps to recover their old loans but could not show any improvement. The state-owned public limited companies should give due consideration to waiver of interest. But the businessmen or traders who failed to repay loans due to various reasons cannot afford to bear the burden of huge interest and suit costs. In yearly period, the commercial banks perform activities of investment banks, and for investment banks to also perform activities of commercial banks (i.e. to borrow short and to lend long). As a result there is a combination problem of liquidity risk and credit risk and the problem becomes more uncontrollable and severe. Overexposure in deposit-lending ratio, credit to deposit ratio (CDR) is causing the liquidity crisis of the private commercial banks (PCBs). Besides to make windfall profit and engaged in unhealthy competition amongst the banks leading the banking into a deep crisis. Although the Bangladesh Bank (BB) has set June 30 as deadline for bringing down to CDR to a rational level, still many of the private banks are lagging behind to maintain it, according to a BB official. Relationship of liquidity with the reserve and call money rate Excess reserve with Bangladesh Bank has been decreased by BDT70 billion in first six months, indicating an active money market. The excess reserve is hard cash deposited by banks in addition to cash reserve requirements, and it lies idle with the central bank and bears no return. Repo and reverse repo rate were both raised


by 50basis points to 6% and 4% respectively, causing liquidity to drop. Now we will see the graphical presentation of the relationship of the excess reserve and the liquidity of the banks. Call money rate rose to double digit in December 2010 (Figure 2) mainly due to increased demand for fresh funds in the inter-bank money market. The demand for fresh funds was slightly higher on the day following the increment of cash reserve requirement (CRR)by the central bank to curb inflationary pressure on the economy. Under the new rules, the commercial banks will have to maintain a CRR of 6.00% instead of the previous 5.5% with the central bank from their total demand and time liabilities on a bi-weekly basis. Major Causes of Liquidity Crisis in Bangladesh: Causes of liquidity crisis in Bangladesh: Fractional reserve requirements contain key features that determine the possibility of both contagion and systemic banking crisis. Multiple credit and monetary expansion can be produced through small changes in base money via the system of fractional reserve requirements. This is because fractional reserve requirements create an inverted pyramid—i.e., a small reserve base supports a large quantity of deposits and credit. Many countries that have initiated stabilization plans have experienced early stage euphoria. This situation emerges because stabilization generates confidence and the latter attracts capital inflows. Those inflows increase the monetary base and, through fractional reserve requirements, those changes in the base multiply deposits and credit. Conversely, when this phase of increasing capital flows is reversed, the inverted pyramid plays havoc on the system because, in turn, a small reduction in the monetary base reduces credit and money supply by a multiple. In fact, the banking industry is the only business that can “multiply� its output through a relatively small change in its input. More credit can also be produced simply because the public may choose to change its preferences regarding its cash/deposit mix. Contrary to other industries, banking is one of the few where there are often generalized, systemic crises both within and across countries.5 Fractional reserve requirements can actually do more than just multiply. They can also blend. In any ordinary business, the nature of liabilities is no different from assets. In the case of a fractional reserve banking business, however, the (macroeconomic) nature of assets is different from that of liabilities: assets are credit whereas liabilities are money. Due to the system of fractional reserves, banks create money (credit) by means of credit (money) and, vice versa, eliminating credit (money) eliminates money (credit). In this system, money and credit are thus inextricable interwoven. Moreover, in an inflationary context (without payment of interest on demand deposits), fractional reserve requirements expand the deposit taking activities of the banking sector beyond the social optimum. Government Debts: If we look at the expenditure side of the budget, we will find that the largest head is the interest payment on debts, amounting to 11% of all expenditures or Tk. 180 billion or Taka 1125.00 per head irrespectively, for every man, woman and child of our total population of 160 million. This is besides the repayment of the principal, which in fiscal 2011-2012 will amount to US$ 146.80 per capita. This is obviously a heavy burden to bear. If the government had not borrowed so


much, the interests saved could have directly benefited the people or at least the state and the people would not have to bear the burden of "debt servicing". If the debts exceed the 5.0% mark, the state is likely to fall into a "debt trap", i.e. a situation where the payment of one debt leads to incurring of another until the entire system collapses and the state goes bankrupt. This had happened to other countries in the recent past, namely Iceland in 2009 and now Greece is in a similar situation. Imports of Food, Fuel and Fertilizers: During the last one year (2010-2011), the prices of food, fuel and fertilizers have increased manifold in international markets far outstripping our budgetary allocations for these goods. Consequently, the government has borrowed heavily for these imports. That's quite OK, if at the same time the government had not heavily subsidized internal consumption of these items, thereby incurring long-term debts, difficult to pay back. Increased import of machineries: Additionally the year, 2010-2011 saw an increased import of machineries for power generation, a priority sector for development. This import of machineries demanded large amount of foreign currency which also put pressure on the availability of both local and foreign currency. Thus sudden heavy borrowing put a crunch on the money market, particularly on the foreign currency, which is all going out and not coming back at the same rate, leading to a temporary liquidity crisis. This has, in turn, put a recessionary pressure on the entire economy. If the government continues subsidizing consumption of food, fuel and fertilizers at this rate, it cannot sustain the borrowings and the debts. This could lead to a financial and economic crisis at a large proportion. Government Borrowings from the Banking Sector: Control of Money Supply and Banking Credit Under a floating exchange rate regime, control of the money supply is crucial For macroeconomic stability. A large monetary multiplier makes it very difficult to control monetary aggregates. This is because the money supply depends, not only on monetary base, but also on both the cash-deposit ratio and the reserves-deposit ratio. The cash-deposit ratio is determined by the public and is a key variable during banking crises. Normally, it has strong seasonality that introduces “noise� which makes monetary programming difficult. The reserves-deposit ratio is, by contrast, determined by the central bank. When there are multiple reserve requirements (which are common in many countries) the public nonetheless has a strong influence on the resulting weighted aggregate reserve ratio. In relatively stable countries, the weights (which are determined by the public’s portfolio preferences) change little.


The latter, however, is not the case in many developing countries, which have the temptation to use different reserve requirements to control inflation and/or to “develop� chosen regions. With regard to monetary policy, there is an important lag effect between Government borrowing from the banking system has become a matter of concern. Such borrowing is fuelling inflation. People of fixed-income group are passing through a difficult time. Because of lack of balance between income and expenditure, bank loan has become the only source of supplying money to the government. In four and a half months of the current fiscal year, the government has borrowed more than Tk 190 billion, out of which Tk 110 billion have come from Bangladesh Bank. The current fiscal years' borrowing target of the government was Tk 189.75 billion, which has already been exceeded. According to one estimate, if the government borrowing from the banking sector continues at the present rate, it may exceed Tk 300 billion by the end of the fiscal year. The government borrowing from the banking system during the first quarter has stood at Tk 1.25 billion per day. It is learnt that the central bank is printing money to meet the demand. The government is reportedly trying to borrow money even from outside the country. There was a possibility of getting US$1.0 billion budgetary support from the World Bank. The government was also pursuing a $1.0 billion loan from the International Monetary Fund (IMF). The assistance from World Bank and IMF would be of immense value to Bangladesh at this difficult time. But these possibilities have stalled because of the corruption issue in respect of the Padma Bridge project. The government should sort out the matter with the World Bank as soon as possible. It is ridiculous to talk about financing two Padma bridges when we are finding it difficult to meet even the current liabilities. The finance minister has said that the government borrowing will not exceed 5.0 per cent of the GDP. Borrowing money is no solution. The government will have to reduce expenditure. Most of the borrowing from the banking sector is being spent on subsidies. The subsidy is mostly going for fuel and electricity. Fuel subsidy is needed for increased import of fuel for the rental power plants. Subsidy for electricity is needed for buying electricity at a high price from the rental power plants set up without tender. The Power Development Board (PDB) was not a losing concern. The PDB now needs subsidy for buying costly power from the rental power plants and selling the same at a lower price to the consumers. The burden of subsidy is being shifted to the consumers by raising prices of electricity and fuel. The government should go for medium- term power projects to bring down the cost of power generation. The country's foreign exchange reserves was US$9.6 billion on November 20 and it is expected to go down below $8.0 billion by next January after payment to the Asian Clearing Union. The foreign exchange reserve is going down because of excessive rise in import, slowdown in remittances, decline in foreign aid disbursement and sluggish exports. The value of taka is also likely to go down further. It may be noted that a $10 billion reserve is needed to cover the country's import bill for three months. This is a normal requirement. The fuel import cost may increase in the near future due to international price hike. The foreign exchange reserves will be


under pressure to meet this demand. The interest rate earnings from the foreign exchange reserves are also going down because of turmoil in the European markets. The government has advised different agencies to withdraw their deposits to meet expenditures. As a result, there is a rush for withdrawal of bank deposits. This is reducing the availability of funds for the call money market. The rate of interest in the call money market has gone up to 23 per cent from 6.7 per cent. The amount of call money has come down from Tk 5.0 billion to Tk 260-Tk 300 million. There is increasing demand for call money. At a time when the banks are facing a liquidity crisis, the government is urging them to invest more in the capital market. This is contradictory. The International Monetary Fund cautioned that the increased government borrowing from the banking system would create further inflationary pressures. They suggested the central bank to tighten the monetary policy in order to contain inflation. According to the IMF, inflation had soared to a 13-year high of 11.42 per cent in October. The subsidy amount could be 3.4 per cent of GDP, if there is no move to make price adjustments shortly. The energy regulator on November 25 increased the bulk price of electricity for the third time this year by 33.57 per cent. The government's fiscal coordination committee meeting on November 20 discussed the bank borrowing and subsidy issues. It was observed that bank borrowing should be reduced to lower the inflationary pressures. The total budgetary allocation for subsidy is Tk 204.77 billion, but the ministries are now seeking Tk 460 billion. The finance division projected that the probable requirement for subsidy may stand at Tk 350 billion, even after reducing the subsidy demand. The coordination committee meeting found that sales of national savings instruments were lower than expected which resulted in a fall in non-bank borrowing compared to the target. This was due to lowering of interest rates on national savings instruments by the government. The meeting observed that non-NBR revenue collection was less than the target and foreign aid disbursement had also declined, which were the other reasons behind the rise in the government borrowing from the banking sector. The meeting laid emphasis on cutting both government and private sector credit to contain inflation. But credit disbursement to the private sector has already slowed down and there was hardly any scope for further reduction. The committee also discussed ways to ease pressure on the balance of payments situation. The coordination committee also indicated that the government may increase the price of fuel once again, stop financing low priority projects and adopt drastic measures including staff cuts to ease the pressure on the budget. Fertiliser prices may go up to reduce the level of subsidy. The planning ministry will identify less important projects and stop financing them. The finance division estimates that the budget deficit may cross 6.0 per cent of GDP as against the target of 5.0 per cent. The overall situation will require a reduction in the size of the annual development programme (ADP). The planning commission will start this exercise soon. Suggestive Remedies: There are a number of sectors needed to improve to overcome this liquidity crisis.


(i)

Reform Bank Financing System

1. Banks by their nature are not well suited for long term lending. According to a report published by the World Bank in 2008, 69 per cent of lending has a maturity period of less than 3 years in metropolitan areas. The average term for bank loans in non-metropolitan areas was 17 months. After independence, state-owned Bangladesh Shilpa Bank and Bangladesh Shilpa Rin Sangstha were entrusted with the responsibility of providing industrial term loan to meet the long term financing needs of the economy. But, the attempt was not very successful as a significant percentage of credit given through those institutions became non-performing. 2. A major problem in the banking sector is the accumulation of huge amount of nonperforming loan (NPL). The NPL ratio stood at 13.2% as at end-December 2007(BB Annual Report, 200708) which is still very high by any standards, although a downward trend of NPLs is observed in the banking sector for the last couple of years. SCBs and DFIs suffer most from NPL problems as about 30% of loans disbursed by these categories of banks are non-performing. PCBs are doing better in this regard as 5% of their loan is non-performing. In developed countries, the tolerable range of NPL is up to 3%. The performance of the banking sector in the neighboring countries in this regard is also much better than the Bangladesh banking sector. NPL ratios in India, Sri Lanka and Pakistan are 1.9%, 5.6% and 7.7%, respectively. (1) The NPL problem has several damaging effects in the way of optimum utilization of resources. On the supply side, it is limiting the recycling of fund and forcing some banks to follow a very conservative policy which ultimately makes it difficult for a new firm to get required financial assistance. 3. Ideally, interest rate should reflect the risk of the borrower i.e. the more risky borrower should pay a higher interest rate and vice versa. But such a variation is not observed in the interest rate among the borrowers classified in the same sector. Banks' risk analysis of borrowers is mainly reflected in the decision of accepting or rejecting the loan proposal; not so in differentiating interest rate of the credit. The country also lacks an updated, adequate and reliable data base of the business enterprises. However, we might expect the increasing availability of company risk profile with the institutional development of the few number of credit rating agencies that are operating in the country. 4. In many cases, banks assign undue weight to collateral security rather than future cash flow in making credit decision. It becomes difficult ,for some potential entrepreneurs to meet the banks' requirement (The World Bank Report, 2008). As a result, the idea of 'entrepreneurship development' by banks is not practiced or cultured in the Bangladesh banking system. 5. Sound credit management using professional standards is required for insider-loans. Bank management must ensure the same set of standards both for the insider loan and loans granted to others. The issue of loans, given to insider parties, emerged as a matter of concern in the mid 1980s after allowing the operation of private commercial banks in Bangladesh. Although, Bangladesh Bank has adopted various measures for ensuring prudent management of insiderloan, still the banking sector is burdened with a high amount of default loan, granted to the insiders.


6. Although there are wide branching networks of state-owned commercial banks in the country, lending is heavily concentrated in urban areas. Thus, inequitable transfer of funds from the rural areas to the urban areas is evident. Moreover, private commercial banks established since 1990 have very few rural activities. This pattern of urban-based credit portfolio makes the target of equitable development unachievable. Also, there is a disparity between the rural areas and the urban areas in the quality of the banking services offered. In recent years, a number of modern information and communication technology based banking products have been made available mainly in the urban areas. Clients of many non-urban areas do not have access to such products. 7. One of the major problems in the existing financial system is the absence of exit policy. In one way or another, banks are allowed to continue their operations even in the face of severe problems. A number of banks, in the past, continued their operations without meeting the minimum capital requirement and with a substantial amount of defaulted loans. It seems that depositors axe also not aware of varying levels of risk with different banks and do not take their deposit decisions based on the insolvency risk of the bank. This is an example of moral hazard problem where weak banks are not pressurized by the stakeholders, especially, by the depositors to make their operations more sound and efficient which eventually keep Bangladesh banking sector away from having adequate market discipline. 8. One of the major objectives of the regulatory body is to ensure financial stability which, in turn, depends on the compliance with the existing prudent measures by the commercial banks. There are numerous instances of regulatory failures in the banking sector, such as, violations of the provisions relating to the members of the board of directors, amount of shareholding by the directors, etc. Inadequate regulatory compliance and lack of market discipline in the banking sector might be due to incompetence on the part of the regulatory body and/or lack of autonomy of the central bank. Like most other developing countries, there is a sharp difference between legal independence and de facto independence of the central bank in Bangladesh. Thus, it becomes difficult for the central bank to take punitive actions against the wrongdoers within the prevailing overall legal environment of the country. (ii)

Reform Primary Stock Market

Time consuming and hassle in collecting refund amount is a major problem to the investors in the primary market. 90 per cent of the investors consider it as the main problem in the case of IPOs. Investors are skeptical regarding the time and, in some cases, low chance of refunding. It is alleged that issuers in collaboration with banks use the opportunity to hold the money of the unsuccessful investors for several months in order to get undue benefits through reinvestment. Sometimes, investors face problems in getting refunds because their names are not properly written in issuers' book. Moreover, investors get refundable money late because of accusation against them for maintaining multiple BO accounts or making several applications in the same name. Delay in holding draw is another barrier to unsuccessful investors for getting back their money in time. It is understandable that issuers need some time for lottery and allotment process. But 6(six) weeks from the closure of the subscription date, is considered too long for this process


according to thirty-eight per cent respondents. They opined that lottery should be conducted within maximum 3 (three) weeks and the whole process should be completed within one month. Genuine investors face harassments because of multiple BO accounts held by unscrupulous investors. Thirty six per cent respondents concurred on this view. They linked more problems with BO accounts opened at the initial stage of this provision, as fake and multiple BO accounts are opened by some investors. Depositing the entire amount with application is a deterring factor to many investors. Around 26 per cent respondents mentioned that it would be burdensome on them. They added that 20-25 per cent money can be paid during the application time and the remaining amount payable within 10 days after allotment would ease such pressure. Small size of IPOs compared to total capital requirement of the issuers, scarcity of good security and excess premium s are also considered as problems in the primary market. 30 per cent, 22 per cent and 12 per cent of the respondents respectively believed these reasons are the barriers to the flourishing of primary equity market in Bangladesh. (iii) Reform Secondary Stock Market The secondary market experiences unreasonable ups and downs, despite neither any change in the economy nor any earning forecast downshifts by any leading companies. Investors make decisions based on rumors in maximum cases instead of analyzing companyspecific fundamentals. This was conjectured by 70 per cent of the respondents. Small and new investors are pronouncedly affected by rumors. More than one hundred thousand new investors entered the equity market in 2007 and 2008. Most of them depended on rumors as they have no clear access to market information and are not equipped with sophisticated analytical investment tools or techniques. Inadequate brokerage houses, poor services and high brokerage cost are discouraging factors to the secondary market investors. Forty per cent respondents consider these as hurdles in the secondary market. Brokerage houses are confined to major urban areas very sporadically with poor infrastructure. Aspirant investors in many parts of the country are not therefore getting the needed service of brokerage houses. Moreover, quality of brokerage houses is usually assessed by the quality of research produced by the independent research department, which is nearly nonexistent here. Brokerage fees range from 0.5 per cent to 1.0 per cent in Bangladesh. It varies from brokerage house to brokerage house and even investor to investor too. However, this cost is almost at par with other Asian countries. Brokerage fees in Pakistan, Thailand and China are also 1%, 0.64% and 0.56 %, respectively. High volatility, already shown earlier, is a matter of serious concern to 40 per cent respondents. Margin regulations, circuit breakers, price stabilization funds and securities transaction taxes are used to tackle short-term price volatility in different countries. Unfortunately, very little empirical work has been done in Bangladesh on these issues about their practicalities and implications. Dearth of quality securities is, again, considered as an obstacle in the secondary market by 38 per cent of the respondents. This is supported by the number of shares under A-category. In DSE,


only 171 out of total enlisted companies of 293 in 2008 have good fundamentals. Similarly, lack of reliable information and undue interruption by SEC are also causes of concern in the secondary market. Cashing after selling shares is time-consuming and 28 per cent of the respondents are worried about the length of time in settlement process. It requires T 3 days for A, B, G and N category and T 7 days for Z category in Bangladesh. Off and on changes in margin loan ratio destabilize the market. SEC uses margin loan ratio to control market and re-fixes it from time to time. Furthermore, merchant banking division of NBFIs cannot also provide more amount to the investors as they are not allowed to hold exposure (loan to investors, own investments, and commitment for underwriting) more than five times of their paid up capital. Respondents also added that merchant banks sometimes compelled their clients to sell off shares to adjust loans. These reduce their investing capacity. SEC should let merchant banks to lend investors within their own parameters. As loans are collateralized by securities and mark to market system is introduced, banks are capable of lending on the basis of their own norms. However, if the stock price declines to the point where equity drops by a prescribed percentage, the investors may be asked to provide more money to replenish the collateralized value. Insider trading transactions on the basis of undisclosed price sensitive information to public manipulates the market. This is viewed negatively by around 24 per cent respondents. For example, the share price of Popular Life Insurance peaked from TK. 911 ($13.26) to TK. 5000 ($72.78) between June 2007 and March 2008. SEC found insider trading behind this excessive price movement and punished the culprits. However, this is not a common practice. Investors expect that stock market watchdogs should take exemplary actions against insider traders and persons responsible for leaking the sensitive information. An important role of stock market regulators is to ensure that there is transparency to create a level playing field for small, large and institutional investors. 16 per cent respondents are not satisfied with the current status of monitoring supervision, and transparency of the secondary market. They opined that companies' ongoing reporting of financial results is not honest and so called syndicate in price manipulation does exist. Private placement market for corporate securities in Bangladesh has been growing rapidly since 2001. Since the introduction of Credit Bridge Standby Project Facility in 2001, financial institutions emerged as the main issuers of debt instruments through private placement with the consent of the SEC. A total of Tk. 5178.58 million ($75.38m) worth of corporate securities were placed privately between 2001 and 2004. However, issuance of debt instrument was limited to a few blue chip financial institutions and a private commercial bank. Since 2005, corporate units resumed to collect funds by issuing bonds and debentures. Currently, corporate units are more active in collecting debt funds than banks and other financial institutions. However, all except IBBL Mudaraba Perpetual Bond are issued in the private placement market. Conclusion:


The corporate sector heavily relies on indirect financing by procuring bank loans with relative ease and low cost. So liquidity is very important for the development of a developing country like Bangladesh. Direct financing through equity issuance remains limited in scope. Overlapping of regulations, hassles and undue delays in approvals, high cost of issuance, lack of liquidity, high price volatility, etc. inhibit further growth of equity market in Bangladesh. Political instability, high country-specific risk, lack of liquidity and transparency, less sophistication, market shallowness, complex and time-consuming profit repatriation, etc., contribute to an inability to entice foreign equity portfolio investment. Additionally, domestic investors gain sour experience from erratic price behavior, rumors, insider trading and regulatory opaqueness. To overcome liquidity crisis, Bangladesh should pay close attention as well to develop a viable corporate bond market. Currently, Bangladesh is focused on developing a government debt market. This market can be catalyst for developing a corporate bond market through marketbased interest rate, innovation of different debt instruments, appropriate regulations for payment and settlement, insurance, and education.

Causes of Liquidity Crisis in Bangladesh and Suggestive Remedies 2011