Finance: Research, Policy and Anecdotes

I am on my way back from Dhaka, where I attended a workshop on Institutional Diagnostics in Bangladesh, commenting on a paper on the “Political Economy of Private Bank Governance in Bangladesh”.   Bangladesh’s financial system is very much in line with its status as a lower-middle income country, dominated by banks, with a large share of government-owned banks. Non-performing loans are high and one can argue that it not quite fulfilling its role in pushing the economic development and transformation (including export diversification) of Bangladesh further. But what holds financial sector development back. If one considers the policies that international experience has shown to be conducive for financial sector development – macro-stability, contractual framework – one sees there is volatility and there are many gaps in the institutional framework. But what are the political constraints to addressing these gaps.

It was my third visit to Dhaka; the first time was in 2006, while at the World Bank, when I was asked to write a background paper for the Country Economic Memorandum on the challenges facing the financial sector.   Some readers might not be surprised, but the challenges to which I pointed in 2006 are still around. In addition to the ones mentioned above, the regulatory framework has been anything but conducive for the development of a thriving banking system – heavy-handed regulation, on the one hand, though often not enforced; bank licenses awarded as political favours and regulatory forbearance resulting in fragile private banks never going out of business.  What has changed over the past 13 years is that the independence of the central bank and thus supervision has been further undermined, increasing political and regulatory capture. The political background to this is a shift from a competitive political system (where the main two parties alternated in power) to a political system dominated by one party.

What are the solutions? The literature tells us what to do, but these reforms might encounter strong political constraints! Privatization of state-owned banks – politically difficult and not necessarily a solution as regulatory forbearance vis-à-vis private banks and the political “sale” of bank licenses show. Strengthening the independence of the central bank; this has worked in many countries but given the record of political appointees at Bangladesh Bank, it might be difficult to turn de jure into de facto independence.

There are no panaceas but the need to think outside the box.  Two suggestion I have made are: first, a stronger role for foreign banks. Foreign banks are more immune to political pressure and can help break the link between politicians, bankers and borrowers. The experience of Central and Eastern Europe has shown the transformational role foreign banks can have. Yes, there are worries that foreign banks might ignore the low-end of the market (as shown by Atif Mian in his paper on Pakistan), but this might be somewhat less of a concern in Bangladesh given a thriving microfinance industry that is eager to move up-market. It is important to note, however, that the benefits of foreign bank entry for host economies can only be reaped when the institutional infrastructure surpasses a minimum quality threshold. Second, strengthening private monitors. Accounting and auditing companies seem to be struggling; given regulatory forbearance, market discipline is very limited. However, it seems that the print media still have an important role to play, but more players would be better. Establishing an independent FCA-style institution might be useful. Strengthening banks’ disclosure requirements (and making CEOs liable for complying with them) might help as well. 

Ultimately, it is difficult to address financial sector and institutional reforms outside the political space.  Increasing the share of people with a stake in such reforms and creating coalitions that benefit from such reforms can help.

Overview