The Covid-19 pandemic poses a significant threat to the sustainability of financial institutions, particularly banks. It would be worse in developing and emerging economies, where financial systems are weak.
Banks traditionally deal with a wide range of risks and the pandemic is going to deepen and widen them. This is likely to be worse particularly in developing countries where banks serve millions of individuals and firms with relatively lesser financial and economic capacity under a weaker policy environment and aggressive market competition. In developing countries like Bangladesh, Covid-19 could produce a complex and interrelated set of impacts; for example, increased stress on asset quality and values, liquidity crunch due to decreased savings, increased deposit withdrawals and heavy government borrowing, decreased availability of loanable funds to the private sector, increased default rates, downward pressure on market interest rates, and depression in new loan demand. The impacts would lower returns from banks' existing loans, increase the size of non-performing assets, and damage capital adequacy, which in turn could trigger contagious bank-run. As such banks are likely to see increases in a wide range of risks such as credit risk, liquidity risk, market risk, and interest rate risk. Since in countries like Bangladesh, banks are the engine of economic growth and serve as the dominant source for both long-term and short-term capital financing, the pandemic's threat to the performance, survival, and growth of banks would hurt the economy at its core.
Among all, the direst consequences of the pandemic, especially for banks in Bangladesh, are likely to arise through increases in default rates and non-performing loans. This is particularly because the banking sector in Bangladesh is already overburdened with a high default rate and non-performing loan/asset (NPL) ratio. A growing discussion among researchers and policymakers strongly suggest that two sectors are likely to embrace the biggest hits of the pandemic - one is the ready-made garment (RMG) and the other is the small and medium enterprises (SMEs). Bankers are increasingly worried about the possible size of NPL increases that are likely to arise due to defaults of RMG and SME sector loans induced by the Covid-19 led economic slowdown at the national and global levels.
Given this fact, in our latest research we explore the likely impacts of the Covid-19 driven NPL shocks (i.e., NPL increases) arising from the RMG and SME sectors on banks' value of risk-weighted assets (RWA), interest income (INT), and capital adequacy ratio (CAR) using a Bangladesh Bank designed and prescribed NPL stress testing model. Needless to say, the ultimate impact of all is translated into alterations in the CAR of banks. In the research we consider the 30 publicly-listed commercial banks which represent about 50 per cent of the total number of banks. The unlisted banks are excluded due to necessary data unavailability. According to Bangladesh Bank data, the banking sector has a loan exposure of about 33 per cent to the RMG and the SME sectors combined as of 2017. This means if NPL were to increase from these two sectors, it would go up by a maximum 33 per cent under an extreme scenario. Based on this consideration in our research, we produce 33 scenarios of impacts of NPL increases by 1 to 33 per cent on RWA, INT, and CAR of each of the 30 banks considered. We also produce sectoral impacts by averaging the bank-wise quantitative impacts across all banks using weighted and simple average methods. Considering the length and complexity of discussion and that all effects in the end are to affect capital adequacy (CAR) of banks, we discuss the key findings of only CAR impacts in this article.
According to BASEL-III guidelines and Bangladesh Bank regulations, all banks are required to maintain a minimum CAR of 10 per cent without a buffer and 12.5 per cent with an extra capital conservation buffer. While a minimum 10 per cent CAR requirement is minimum for banks in Bangladesh, a 12.5 per cent buffer is generally intended to protect banks from unexpected shock in the credit market. Based on the estimated scenario-based impacts of NPL shock on CAR, Figure 1 shows that a 10 per cent NPL shock or increase will force CARs of all 30 banks to go down to below the minimum requirement of 10 per cent. On the other hand, only a 7 per cent NPL increase will force CARs to go below 12.5 per cent. The findings warn of a deeper systemic crisis, considering that the average CAR of the 30 banks is already about 9 per cent according to the pre-pandemic level data of 2018.
In fact, a 7 to 10 per cent NPL shock is very much possible due to the Covid-19 pandemic and it can be explained by considering just the case of the RMG sector. According to Bangladesh Bank data, the share of outstanding loans in RMG & Textiles industries stands at about 13.37 per cent as of 2016 (about US$ 1050 million). The Bangladesh Garment Manufacturer and Exporters Association (BGMEA) reports that orders worth about US$ 3.15 billion (or US$ 3150 million in 1,134 factories) are cancelled or delayed as of April 2020 due to the pandemic (UNB, 2020). Assuming the loan exposure remains the same, Table 2 shows different scenarios of NPL shocks that could generate from the permanent loss of revenue from the RMG order cancellations and delays during the Covid-19 pandemic.
Table 1 shows that if only 5 per cent of the total value (i.e., revenue) of orders cancelled in the RMG & textiles industries are backed or financed by or constitute a bank credit and if the 5 per cent is permanently lost due to the resulting borrower defaults, it could generate an NPL shock of about 15 per cent. Similarly, a 10 per cent would generate a 30 per cent NPL shock and a 20 per cent could eat up about 60 per cent of the total loan outstanding in the sectors. At the extreme end, if one-third (33 per cent) of the total order value cancelled is backed or financed by bank credit and it is lost permanently due to borrower defaults, it could eat up about 100 per cent of the total outstanding loan. Overall, Table-2 suggests that the amount of loss in the value of export orders has a multiplier effect on NPLs in the banking sector. In other words, a 1 per cent of permanently lost order value could generate about 3 per cent NPL increases. In Figure 1, we showed that a 10 per cent NPL shock would drag CAR of all banks to below the minimum requirement of 10 per cent. Considering the multiplier effect, it will require a permanent loss of just over 3 per cent values of the delayed or cancelled RMG & textiles export orders. A default equivalent to a merely 3 per cent of the order value is very much possible since almost all of the export orders are directly or indirectly backed or financed by bank's short-term and trade financing mechanisms. Banking sector data show that about 100 per ent of the RMG exporters utilise different types of short-term and trade financing products to facilitate their exports. All findings considered, the CAR effects produced by our research display a worrisome picture for the banking sector's stability in Bangladesh. In addition to the bank-level estimates, we find that a 13 per cent or more sector-wide NPL shock could push overall sectoral CAR to go zero to negative.
Although detailed analyses of all results of our research cannot been reported in this article due to length and complexity considerations, there are other findings from our work that need at least a mention. For example, our estimates show that all banks are likely to see a fall in risk-weighted asset (RWA) value and interest income (INT) more or less, resulting in a sector-wide decline of the both. At the sectoral level, the average fall in RWA value ranges from 1 to 31 per cent based on the magnitude of NPL increase scenarios. On the other hand, interest incomes could fall by about 0.2 to 6 per cent across all banks, which at the sectoral average level could range from about 0.3 to 4.5 per cent across the scenarios estimated. Our results also show that the decline in all three dimensions -- CAR, RWA, and INT -- are likely to be disproportionately bigger for larger NPL shocks, and that larger banks are relatively more vulnerable compared to the smaller ones.
Overall, our research rings a critical warning bell for all. As our banks are already crippled with rising NPLs, any further shock due to Covid-19 slowdown, particularly from the RMG and SME sectors, will force most banks to face a substantial fall in capital adequacy, alongside declines in asset values and interest incomes. And a persistence of such stress for a longer period may put the entire banking sector in a sustainability crisis and may trigger bank runs. The banking sector needs to safeguard itself with all possible measures. Generally, large banks in Bangladesh have a larger loan exposure to the RMG and SME sectors and therefore, they have a higher chance of seeing larger NPL shocks. Given our findings, we urge particularly larger banks to take all-out measures to guard themselves from large NPL shocks. We also call Bangladesh Bank for immediate, phase-wise, and innovation-driven policy measures with a long-term approach to prevent an imminent banking sector crisis in Bangladesh.
Dr Suborna Barua and Bipasha Barua are Assistant Professors in the Department of International Business and the Department of Banking and Insurance respectively at University of Dhaka firstname.lastname@example.org. For detailed assessments, interested readers may read the full paper at: https://ssrn.com/abstract=3646961