financial market crisis & proposed financial system

8/3/2019 Financial Market Crisis & proposed financial system

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PHASE I – PREFATORY



Introduction

The economic growth of a nation heavily relies on the channelization of fundsfrom the surplus to the deficit sector, which can be done through the processof intermediation. This intermediation process can be bank-based or market-

based, depending upon the characteristics of a country. For example, in Japan and Germany banks dominate the intermediation process, whereasAnglo-Saxon countries rely more on the market for their financingrequirements (Suzuki et al. 2008). People in developing and underdevelopedcountries are always in a dilemma regarding the development of theirfinancial system. They are not sure whether to go for a bank-based systemor a market-based system. However, before the US financial crisis, market-based systems were considered as superior to bank-based systems. But nowboth the two systems have failed: the bank-based system failed in Japan andthe market-based system failed in the US. Therefore, under the presentscenario it is really difficult to say which one is better, and developing a new

model is not at all an easy job to do, but is not impossible. Looking at thegrassroots of the two systems failure will definitely give some clear insightsinto the development of the future financial system.

Objectives of the Study

The principal objective of the study was to propose a sustainable financialsystem for Bangladesh with reference to the on-going global financial crisis. To accomplish this objective, the following specific objectives were covered:

1. To identify the fundamental reasons of the global financial crisis and

the lessons to be learnt from the global financial crisis;

2. To develop a sustainable financial system for Bangladesh;

3. To suggest a policy framework for the efficient functioning of theproposed financial system.

In order to accomplish the above objectives, the first section of this studyelaborates the existing financial system in Bangladesh and its performance;the second part discusses the fall of Lehman Brothers that bring the panic inglobal financial system and the last part the reasons for and lessons to belearnt from the crisis and proposes a sustainable financial system through

some recommendations.

Methodology of the Study

The present study is based on secondary data. In particular, the studyconcentrates on the existing literature on the global financial crisis in order



to detect the reasons for the crisis and its corresponding remedies. Inaddition, various annual reports were also considered in order to give asnapshot of the existing financial system in Bangladesh and its performance.

The Financial System in Bangladesh – Background

The present structure of the financial system in Bangladesh comprises of various types of banks, insurance companies, and non-bank financialinstitutions. Bangladesh Bank is at the top of the banking system and isaccountable for assuring prudential administration and central bankingactivities for all types of banks operating within the banking industry. On theother hand, the Securities and Exchange Commission (SEC) of Bangladesh isthe regulatory body for stock-market related activities. According to theBangladesh Bank Annual Report (2008-2009), the financial system of Bangladesh consists of 4 state-owned commercial banks, 5 government

owned specialized banks, 30 domestic private commercial banks including 7Islamic banks and 2 denationalized banks, and 9 multinational banks. Thefinancial system of Bangladesh also includes 29 non-bank financialinstitutions, 298 microfinance institutions, 27 insurance companies, and anumber of non-schedule and co-operative banks. Out of 29 non-bankfinancial institutions one is government owned, 15 are domestic private, and13 are established under joint venture with foreign participation.Furthermore, Dhaka Stock Exchange Ltd. (DSE) and Chittagong StockExchange Ltd. (CSE) are the two stock exchanges operating within thefinancial system.Currently, two credit rating companies are also working in Bangladesh: the

Credit Rating Information and Services Ltd (CRISL) and the Credit RatingAgency of Bangladesh Ltd (CRAB). In addition, there are five trustees of asset-backed securities and mutual funds, seven asset managementcompanies, and six security custodians. The process of securitization has notyet geared up in Bangladesh since there are only two cases of asset-backedsecuritization. The first ever asset-backed securities were introduced inBangladesh in November 2004. An amount of BDT 359 million (local currencyof Bangladesh) was floated in the country by the Industrial Promotion andDevelopment Company (IPDC) of Bangladesh, a non-bank financialinstitution. Later, in February 2005 another issue of BDT 190 million wasfloated by another non-bank financial institution, namely the Industrial

Development Leasing Company (IDLC) of Bangladesh (Siddiquee et al. 2006).On the other hand, loan sales by commercial banks and the trading of derivative securities have not yet started in Bangladesh. The government isplanning to initiate the trading of financial derivatives by the end of the year2010.



PHASE II – The Fall



Why did the two systems fail in Japan and in the US?

The Japanese relationship banking system worked very well from the 1950sto the mid-1970s. Under this system, a firm maintains a long-termrelationship with a bank from which it obtains the lion share of its financingrequirements. The main banks also play a corporate monitoring andgovernance role by intervening whenever things go wrong for the firm, andas a result of this the main bank system also refers to a system of corporatefinancing and governance (Aoki and Patrick 1994). But everything started tochange when the government went for deregulation during the 1980s. The

capital structure of Japanese firms underwent a dramatic transformation.Reputed firms with higher profitability and growth opportunities with low riskincreasingly depended on capital markets for their financial resources, whilefirms with lower profitability continued to depend on bank borrowing duringthe 1980s. Strict bank monitoring also induced firms to rely on stock andbond markets. This large shift along with the freedom allowed banks to takebad risks also meant more banks were competing for deposits (Krugman2009). The ultimate outcome was moral hazard and speculative investmentthat led to the financial bubble and its „bursting‟ during the 1990s.On the other hand, the market based system was running successfullybefore 2007 in the US. Everything dramatically changed when the bubbleburst in 2008. Many scholars have been trying to identify the fundamentalcauses of the financial crisis and accordingly give their opinions. According toSolos (2008), excess in financial markets is due to:

(i) The regulators failure to exercise proper control and their inability tounderstand the consequences of financial innovations,



(ii) The excessive use of leverage supported by sophisticated riskmanagement models that can calculate known risk but ignoreuncertainty inherent in reflexivity, and

(iii) The introduction of financial products and mechanisms based onambiguous assumptions. Before the bubble burst borrowers with

less than perfect or no credit history could get a loan.All of these factors led to the formation of financial conglomerates that wereconsidered as organizations too big to fail. But in reality the reverse hashappened. In addition, there is every possibility that conflicts of interest willappear in the bank’s operations in the future whenever these large financialconglomerates actively participate in the underwriting of financialinstruments, financial intermediation, secondary market activities, andmanaging investors funds (Kaufman 2009). They have also induced changesin the perception of liquidity. Before the credit bubble it was treated assomething related to the asset side of the balance sheet, whereas during thecredit bubble it was considered as something relating to the liability side.

Posner (2009) suggests that low interest rates in the early 2000s and thederegulation movement that began in the 1970s in fact laid the foundation of the crisis.Low interest rates made borrowing cheap, and that resulted in low personalsavings rates and high personal debt rates. It also encouraged people topurchase houses and invest in stocks, which led to asset bubbles andconsequent bubble burst. On the other hand, deregulation allowed financialintermediaries like investment banks, money market funds, hedge funds,and commercial banks to offset each other by offering “substitute‟ services.In particular, because of the removal of the Glass-Steagall Act in the US, thecommercial banks extensively relied on short-term credit other than deposits

and real estate investments trusts (REITs), and were involved in lending inaddition to investment banking. As a result, the financial market becamevery competitive and profit margins were squeezed. In response to this,banks tried to reduce risk by securitized debt and credit default swaps whichwere liked by regulatory authorities as tools for spreading risk and therebymaking financial crisis less likely to occur (Zandi 2008). But unfortunatelythis was not true again and almost all of the subsequent losses came frompursuing the flawed trading strategy of borrowing short and investing inlong-term senior mortgage backed securities (Milne 2009). Rating agenciesalso badly misguided the risks and everybody was focusing on meter readingwithout understanding the forces at work (Bryan and Rumelt 2009). As noted

by Shiller (2008: 6), “the housing bubble combined with the incentive systemimplicit in the securitization process amplified moral hazard, furtheremboldening some of the worst actors among mortgage lenders.” The resulting financial turmoil has deepened at an alarming rate and affectsnot only financial, credit, and currency markets but also the real economy. InBangladesh, even though the impact of the financial crisis has not beendirectly felt mainly due to shielding of the economy from the mostimmediate effects of the crisis, the looming economic conditions and



financial market instability in the developed and several emergingeconomies can create adverse impacts on the Bangladesh economy. Nodoubt it is difficult to predict how the financial crisis would affect the poorcountries, but it is relatively safe to conclude that the effects are more likelyto be indirect for Bangladesh since the country has little direct exposure to

the failing US financial institutions and toxic assets in the developed world.Still a developing country like Bangladesh can learn many lessons from theglobal financial crisis and accordingly develop or reshape their financialsystems so that they can avoid the occurrence of financial crises in their ownterritory.

An overview on Lehman Brothers:

The modern Lehman Brothers (founded in 1844 as a dry goods business inAlabama), emerged once more as an independent investment bank in 1994when it was spun off from American Express (e.g. McDonald and Robinson

2009, Rose and Ahuja 2009). Richard Fuld, who had joined Lehman in 1969,was now appointed its President and CEO. Under his leadership, Lehmancontinued to carry out the traditional tasks of an investment bank but alsopushed deeply into the new financial markets that were emerging at thetime. For one thing, it early on became a leader in the subprimesecuritization market.

On September 15, 2008 at 1:45 A.M. Lehman Brothers filed for bankruptcy,something that nearly caused a meltdown of the world’s financial system. Afew days later Bernanke (Fed Chairman) made his famous statement that“we may not have an economy on Monday” (Thomas and Hirsh 2009).

President Bush expressed the same idea, but in his own language, when hesaid, “this sucker could go down” (Mason 2009:28).Commentators agree that the fall of Lehman Brothers changed everything.According to economist Robert Lucas, “Until the Lehman failure the recessionwas pretty typical of the modest downturns of the post-war period…AfterLehman collapsed and the potential for crisis had become a reality, thesituation was completely altered” (Lucas 2009:67). According to Alan Blinder,another well-known economist, “everything fell apart after Lehman…AfterLehman went over the cliff, no financial institution seemed safe. So lendingfroze, and the economy sank like a stone. It was a colossal error, and manypeople said so at the time” (Blinder 2009).

Two months later Henry Paulson, the Treasury Secretary, explained that thefailure of Lehman Brothers had led to a systemic crisis and to theevaporation of confidence in the financial system:We had a system crisis. Credit markets froze and banks substantiallyreduced interbank lending. Confidence was seriously compromisedthroughout our financial system. Our system was on the verge of collapse, a



collapse that would have significantly worsened and prolonged the economicdownturn that was already under way”. (Paulson 2008a)

THE BANKRUPTCY OF LEHMAN BROTHERS:

Solvency should be a simple financial concept: if your assets are worth morethan your liabilities, you are solvent; if not, you are in danger of bankruptcy.But on the afternoon of Friday, September 12, 2008 experts from thecountry’s biggest commercial and investment banks met at the Wall Streetoffices of the Federal Reserve to ponder the fate of Lehman Brothers, andcould not agree whether or not the 157- year-old firm was solvent. Only twodays earlier, Lehman had reported shareholder equity—the measure of solvency—of $28 billion at the end of August. Over the previous nine months,the bank had lost $6 billion but raised more than $10 billion in new capital,leaving it with more reported equity than it had a year earlier. But thisarithmetic reassured hardly anyone outside the investment bank. Fed

officials had been discussing Lehman’s solvency for months, and the stakeswere very high. To resolve the question, the Fed would not rely on Lehman’s$28 billion figures, given questions about whether Lehman was reportingassets at market value. As one New York Fed official wrote to colleagues in July, “Balance-sheet capital isn’t too relevant if you’re suffering a massiverun.” If there is a run, and a firm can only get fire sale prices for assets, evenlarge amounts of capital can disappear almost overnight. The bankersthought Lehman’s real estate assets were overvalued. In light of Lehman’sunreliable valuation methods, the bankers had good reason for their doubts.None of the bankers at the New York Fed that weekend believed the $58billion in real estate assets (excluding real estate held for sale) on Lehman’s

books was an accurate figure. If the assets were worth only half that amount(a likely scenario, given market conditions), then Lehman’s $28 billion inequity would be gone. In a fire sale, some might sell for even less than half their stated value. “What does solvent mean?” JP Morgan CEO Jamie Dimonresponded when the FCIC asked if Lehman had been solvent. “The answer is,I don’t know. I still could not answer that question.” JP Morgan’s Chief RiskOfficer Barry Zubrow testified before the FCIC that “from a pure accountingstandpoint, it was solvent,” although “it obviously was financing its assets ona much leveraged basis with a lot of short-term financing.” Testifying beforethe FCIC, former Lehman Brothers CEO Richard Fuld insisted his firm hadbeen solvent: “There was no capital hole at Lehman Brothers. At the end of

Lehman’s third quarter, we had $28.4 billion of equity capital.” Fed ChairmanBen Bernanke disagreed: “I believe it had a capital hole.” He emphasizedthat New York Federal Reserve Bank President Timothy Geithner, TreasurySecretary Henry Paulson, and SEC Chairman Christopher Cox agreed it was“just way too big a hole. And my own view is it’s very likely that the companywas insolvent, even, not just illiquid.” Others, such as Bank of America CEOKen Lewis, who that week considered acquiring Lehman with governmentsupport, had no doubts either. He told the FCIC that Lehman’s real estate



and other assets had been overvalued by $60 to $70 billion— a message hehad delivered to Paulson a few days before Lehman declared bankruptcy.It had been quite a week; it would be quite a weekend. The debate will

continue over the largest bankruptcy in American history, but nothing willchange the basic facts: a consortium of banks would fail to agree on a

rescue, two last-minute deals would fall through, and the government woulddecide not to rescue this investment bank—for financial reasons, for politicalreasons, for practical reasons, for philosophical reasons, and because, asBernanke told the FCIC, if the government had lent money, “the firm wouldfail, and not only would we be unsuccessful but we would have saddled thetaxpayer with tens of billions of dollars of losses.”

Financial Highlights of Lehman Brothers:

In millions, except per common share and selected data. At or for the year

ended November 30.



Financialinformation

2007 2006 2005 2004 2003

Net Revenues $ 19,257 $ 17,583 $ 14,630 $ 11,576 $ 8,647

Net income $ 4,192 $ 4,007 $ 3,260 $ 2,369 $ 1,699 Total assets $ 691,063 $ 503,545 $ 410,063 $ 357,168 $ 312,061Long-termborrowings

$ 123,150 $ 81,178 $ 53,899 $ 49,365 $ 49,365

Total stockholders’equity

$ 22,490 $ 19,191 $ 16,794 $ 16,794 $ 13,174

Total long-termcapital

$ 145,640 $ 100,369 $ 70,693 $ 64,285 $ 50,369

Per Common Share DataEarnings (diluted) $ 7.26 $ 6.81 $ 5.43 $ 5.43 $ 3.17Dividends declared $ 0.60 $ 0.48 $ 0.48 $ 0.32 $ 0.32

Book value $ 39.44 $ 33.87 $ 28.75 $ 24.66 $ 22.09Closing stock price $ 62.63 $ 73.67 $ 63.00 $ 41.89 $ 36.11

Selected DataReturn on averagecommonstockholders’ equity

20.8% 23.4% 21.6% 17.9% 18.2%

Return on averagetangible commonstockholders’ equity

25.7% 29.1% 27.8% 24.7% 19.2%

Pre-tax margin 31.2% 33.6% 33.0% 30.4% 29.3%Leverage ratio 30.7x 26.2x 24.4x 23.9x 23.7x

Net leverage ratio 16.1x 14.5x 13.6x 13.9x 15.3x

Weighted averagecommon shares(diluted) (inmillions)

568.3 578.4 587.2 581.5 519.7

Employees 28,556 25,936 22,919 19,579 16,188

Assets undermanagement (inbillions)

$ 282 $ 225 $ 175 $ 137 $ 120



During 2008 the position of Lehman worsened and its shares continued to godown. After the fall of Bear Stearns in March 2008, many believed thatLehman was the next investment bank to go. Secretary of the TreasuryHenry Paulson was one of these and he therefore initiated regular contactswith Fuld. He emphasized to Fuld that Lehman was in a very difficult

economic situation and needed to find a buyer. “We pressed him to find abuyer [after June]”, Paulson would later say (Nocera and Andrews 2008).People from the SEC and the Fed were also stationed at Lehman. Contrary towhat is believed, the Fed also started help Lehman with enormous loans andwould do so till its collapse on September 15. Fuld, it appears, did not realizethe seriousness of either what Paulson was saying nor of the situation ingeneral. For one thing, he thought that he had the full backing of Paulson.“We have huge brand with treasury”, as he famously phrased it in e-mail,after a meeting with Paulson on April 12 (Fuld 2008a). From March to theSeptember 13-14 weekend Fuld turned down several opportunities to sellLehman as well as an infusion of capital from Warren Buffett (e.g. Story and

White 2008). Attempts to cut deals with Morgan Stanley, Goldman Sachs andBank of America similarly came to nothing (e.g. Sorkin 2009a). Despite thesefailures, Fuld insists that it was rumours and short selling that brought downLehman, not its huge losses in a deteriorating economy and his own failureto deal with this. “Ultimately what happened to Lehman Brothers”, Fuld latertestified at Congress, “was caused by a lack of confidence” (Fuld 2008b:8).While it seems that Fuld believed that Lehman could weather any storms itfaced during the spring and summer of 2008, investors were gettingincreasingly nervous. While many banks had declared heavy losses andwrite-downs, Lehman had not. In fact, Lehman declared a profit of severalhundred million dollars for the first quarter of 2008. The business press, it

has also been established, was not very critical of Lehman (Starkman 2009).Still, rumours were strong that Lehman was covering up its losses. Someinvestors also started to dig on their own, and what they found made themsuspicious.One of these investors was David Einhorn, the head of a hedge fund calledGreenlight Capital. At a conference for investors in April Einhorn gave aspeech in which he argued that investment banks were dangerous for anumber of reasons. For one thing, he said, they used half of their revenue forcompensation – something that means that its employees had a very strongincentive to increase the leverage of their firm. He ended his speech with afull-blown attack on Lehman. If you calculate its leverage properly, it was

44:1. This means, he explained, that if the assets of Lehman fell by 1 %, thefirm would have lost almost half of its equity. The consequences of this weredramatic: “suddenly, 44 times leverage becomes 80 times leverage andconfidence is lost” (Einhorn 2008a:9). Einhorn also tried to estimateLehman’s losses. He did this by looking very carefully at various categoriesof assets, in which Lehman had invested and which had fallen in value since2007. His conclusion was the following:



Lehman does not provide enough transparency for us to even hazard a guessas to how they have accounted for these items. Lehman responds torequests for improved transparency begrudgingly. I suspect that greatertransparency on these valuations would not inspire market confidence.(Einhorn 2008a:9)

Einhorn, however, was not finished with Lehman. In late May he made asecond public attack on Lehman. This time he announced that his hedgefund was shorting Lehman and he explained the reason for this in detail(Einhorn 2008b:9). He ended on the following note: “My hope is that Mr. Coxand Mr. Bernanke and Mr. Paulson will pay heed to the risks to the financialsystem that Lehman is creating and that they will lead Lehman toward arecapitalization and recognition of its losses – hopefully before taxpayerassistance is required” (Einhorn 2008b:9). That Einhorn had a very good understanding of Lehman’s financial statebecame clear in early June, when Lehman announced a stunning loss of $2.8bn for its second quarter. But even this did not calm investors, who feared

that Lehman had quite a bit more of hidden losses. Rumors grew strong thatLehman was about to collapse. Lehman was not alone in having problem, asthe crisis grew deeper. One major trouble spot was Fannie Mae and FreddieMac, the two semi-official private agencies that together guaranteed some $1.5 trillion in mortgages. On September 7 both of these 17 institutions werenationalized and infused with $ 200 bn in new resources by the Treasury. The U.S. state had once more intervened; and it had again gone far beyondwhat it had done in the past.At this time Fuld was desperately trying to raise capital or to find a buyer. Hecontacted a number of potential investors, including Citigroup, which sentover a team to go through Lehman‟s books (McDonald 2009:281). Lehman‟s

last chance of being bought up disappeared on September 10, when KoreaDevelopment Bank announced that it had decided to withdraw from apossible acquisition. The very same day Lehman also declared a loss of $ 3.9bn and was warned by Standard & Poor that it might be downgraded. The next day Lehman had great difficulty in scraping together the extracollateral of $ 8 bn that JP Morgan Chase now demanded; and it was clearthat the financing of Lehman‟s daily operations was quickly drying up. Theend, in other words, was near. On September 12 a number of the key CEOson Wall Street each got a call from staff members of the Fed, telling them toattend an emergency meeting at 6 pm at the New York Federal ReserveBank. Lehman’s fate was to be decided.



PHASE III – Domestic Sector,Investigation & Recommendation.

Performance of the Banking Sector in Bangladesh:

The banking sector in Bangladesh is very much competitive. All of the banksare operating within a small industry where excessive competition hasalways existed. The prevailing market competition induces the banks todisburse loans without proper screening of the borrowers. According to Islamet al. (1999), “in spite of the liberalizing and privatizing of the banking sectorin the 1980s with a view to increasing efficiency and competition, therobustness of the credit environment deteriorated further because of thelack of effective recourse on borrowers.” All of these banks make disbursed



loans to non-performing loans, which not only badly affects the banks, butalso the entire economy as a whole. The performance of the banks can be judged on the basis of many variables and the non-performing loans to totaldisbursed loans is one of the significant variables that reflects the efficiencyof commercial banks. Tables 1 and 2 give an idea about the non-performing

loan scenario of the banking sector of Bangladesh. According to those twotables, the percentage of non-performing loans to total loans in Bangladeshhas been decreasing over the period from 1998–2007, still the percentagewas significant (13.20%) during the calendar year 2007. In comparison toSouth Asian countries like India and Sri Lanka, Bangladesh has held thehighest percentage of non-performing loans to total loan disbursementsduring recent years. In particular, the percentage was 13.56% in 2005compared to 5.20% for India and 9.60% for Sri Lanka.

Overview of Dhaka Bank Limited:

Bangladesh economy has been experiencing a rapid growth since the '90s.Industrial and agricultural development, international trade, inflow of expatriateBangladeshi workers' remittance, local and foreign investments in construction,communication, power, food processing and service enterprises ushered in an eraof economic activities. Urbanization and lifestyle changes concurrent with theeconomic development created a demand for banking products and services tosupport the new initiatives as well as to channelize consumer investments in aprofitable manner. A group of highly acclaimed businessmen of the countrygrouped together to responded to this need and established Dhaka Bank Limitedin the year 1995. The Bank was incorporated as a public limited company under the Companies

Act. 1994. The Bank started its commercial operation on July 05, 1995 with anauthorized capital of Tk. 1,000 million and paid up capital of Tk. 100 million. Thepaid up capital of the Bank stood at Tk 1,547,402,300 as on December 31, 2007. The total equity (capital and reserves) of the Bank as on December 31, 2007stood at Tk 3,125,688,713.The Bank has 41 branches and 1 Business Centerincluding 2 Offshore Banking Units across the country and a wide network of correspondents all over the world. The Bank has plans to open more branches inthe current fiscal year to expand the network. The Bank has a total number of 50 branches and 1 Off Shore Banking Unit atDEPZ Savar Dhaka, 7 SME Service Centers, 1 Klosk (Business Center) and 1Central Processing Centre as of March 2010. and plans to open more by the

end of 2010 to expand its network. The Bank offers the full range of banking and investment services forpersonal and corporate customers, backed by the latest technology and ateam of highly motivated officers and staff. The Bank has launched OnlineBanking services (i-Banking), joined a countrywide shared ATM network andhas introduced a co-branded credit card. A process is also underway toprovide e-business facility to the bank's clientele through Online and Homebanking solutions.



Financial Highlights of Dhaka Bank Limited:

Credit Rating Agency of Bangladesh Limited (CRAB) has affirmed A1(Pronounced Single A one) rating in the long term and ST-2 rating in theshort term to the Dhaka Bank Limited, (the Bank), based on auditedfinancials up to 31st December 2010 and other relevant information.Commercial Banks rated A1 in the long term belong to “Strong capacity &high quality” cohort. Banks rated “A1” have strong capacity to meet theirfinancial commitments but are somewhat more susceptible to meet adverseeffects of changes in circumstances and economic conditions thanCommercial Banks in higher-rated categories. Such Banks are judged to beof high quality and are subject to low credit risk. Commercial Banks rated inthe short term “ST-2” category are considered to have strong capacity fortimely repayment of obligations. Commercial Banks rated in this categoryare characterized with commendable position in terms of liquidity, internalfund generation, and access to alternative sources of funds.



The rating reflects the Bank’s strength in earning diversity and capitalgeneration as well as operational efficiency. The rating also factors theimprovement in asset quality. On the other hand, principal concerns of theBank are higher loans to deposit ratio, low recovery of classified assets andhigher cost of deposit & borrowing. The Bank also had low profitability and

fluctuation in performance.Figure II: DBL’s Profit After tax and Gross NPL ration pattern.

Profit has increased significantly on the back of increased NIM, sharpincrease in investment income and gradual increase in commission, fees &exchange income. The increased NIM was achieved as the Bank able to passon interest rate decrease to depositors more rapidly than to borrowers. Netprofit margin of the Bank was higher (30.22%) compared to its previousperiod (2009: 2.48%) due to the lower growth of tax expense in 2010. Thesealso resulted in the increased ROAA. Return on risk weighted asset increasedto 1.89% in 2010 from 1.27% in 2009 resulted from the higher growth of PATthan risk weighted assets. The Bank maintained a relatively lower cost toincome ratio (2010: 30.86%) compared to the industry reflecting the better

operational efficiency of the Bank. The Bank’s gross NPL ratio reduced to4.57% in 2010 from 5.57% in 2009 resulted from huge amount of write-off (BDT 1,119.22 million; 1.76% of total loans). However, fresh NPL generationremained high with 4.33% of total loans and advances in 2010. The Bank’scredit portfolio was reasonably diversified having 20.73% of total advancesin textile & garments industry. About 33.90% (2009: 36.13%) of Bank‟s totalloans and advances belonged to the top 50 funded large loans in 2010. TheBank was sufficiently capitalized in the light of regulatory risk weighted



capital adequacy ratio. The Bank issued Tier II redeemable non-convertiblesubordinated bond to increase its capital base in December 2010. As aresult, the risk weighted capital adequacy ratio of the Bank stood at 10.09%against regulatory requirement of 9% under Basel II at the end of 2010.

What Can Bangladesh Do?

There is no doubt that the bank-based system is better than the market-based system for any country in the Asia Pacific region. The culture of Bangladesh is more suited to the relationship-based banking of Japan. Thegovernment can allow banks with sound financial health to patronize aparticular firm under a specific industry with all of the services required tobecome successful. But it is too late to do so. This may be one question todebate since the government has already embraced financial liberalization,which fundamentally caused both the two systems to fail in Japan and in theUS. Another fact is that both the stock exchanges in Bangladesh, namely the

Dhaka Stock Exchange Ltd. (DSE) and the Chittagong Stock Exchange Ltd.(CSE), are in full swing of their operations since the total marketcapitalization of the DSE jumped to BDT 931.03 billion on June 30, 2008 asagainst BDT 475.86 billion at June 30, 2007, showing a 95.66 percentincrease (DSE Annual Report 2007–2008). On the other hand, the marketcapitalization of CSE increased from BDT 56,364 million in 2001 to BDT219,942 million in 2005. In this circumstance, if the government neglects thecapital market and focuses on the bank-based system it may create moreproblems. Therefore, it is better to provide a modified version of the existingfinancial system which will be more sustainable in the future. Before that, itis necessary to highlight the fundamental causes of the global financial crisis

and some recommendations given by various authors regarding the USfinancial crisis.

Causes and Lessons to be learnt from the US FinancialCrisis

There are many reasons that worked together to accelerate the credit bubblein the US and the corresponding bubble burst in 2008. Figure 1 gives some of

the reasons of the crisis. Under the present scenario, it is better toconcentrate on the recommendations given by learned authors, which willprovide some insight about the modification of the existing financial systemin Bangladesh. It will help the government to protect its financial systemfrom financial turmoil.According to Shiller (2009), none of the proposals suggested by the USgovernment after the financial crisis represents a true institutionalinnovation; rather most of them are undertaken from a short-term



perspective without considering the full range of issues. He suggestsincorporating financial innovations with an emphasis on assuring safeguardsfor the society as a whole, of which innovations made by the Grameen Bankof Bangladesh are a good example. They are merely quick fixes that fail toaddress the full scope of the problem. He suggests ensuring the job of

extending innovations of modern financial technology together with effectivesafeguards throughout the society, and that the innovations made by theGrameen Bank of Bangladesh can be an example.

Figure 1: Fundamental Reasons of the US Financial Crisis.



Source: Author

Solos (2008) suggests that a new paradigm, the recognition of reflexivity isrequired, which can be defined as “act of self-reference where an action„bends back on‟ and affects the entity instigating the action.” He alsoargues that the following needs to be done:

The authorities must exercise more vigilance and control during the expansionary phase. This will regulate supply of money and credit creation;

Regulators must reassert control over the use of leverage. It will reduce both the size and the profitability of the financial industry;

A clearing house or exchange must be established for credit default swaps, which will assure submission of existing and future contracts byfulfilling necessary capital structure and margin requirements. Geisst (2009)mentions that a combined effort of the Federal Reserve and the Treasuryshould act together to coordinate fiscal and monetary policies in the US,especially when these involve consumer and mortgage credits. He alsorecommends the following for the betterment of the financial system:



Larger down payment and stronger borrower ratios usually would be sufficient to slow the agencies intermediation;

Change the tax laws regarding capital gains on housing;

The whole issue of complexity in financial design needs to be addressed because that sort of complexity has produced much confusion amonglegislators;

Securitization process needs to be repaired immediately;

European coverage concept of securitization is better than American uncovered one;

Mortgage credit should be included in the category of consumer credit.

Kaufman (2009) calls for an overseer which will look after the issues relatingto capital adequacy, business practices, conflict of interest, and othermeasures with regard to consistency and competitiveness and assureinstitutional set up for the players in the derivative markets. Moreover, hesuggests to spin-off the assets of big conglomerates and they should beunder tight supervision so that it will be possible to ensure that an institutionmay be “too good to fail” rather than current proposition of “too big to fail.”He also criticizes the International Monetary Fund (IMF) and wishes to have amore effective international supervisory body in order to supervise andregulate major financial markets and institutions around the world.

A Proposed Financial System

The financial system of Bangladesh is not yet that complicated and hence itis the right time to reshape the financial environment for the future. Theintroduction of loan sales and other financial derivatives will definitely makethe market more complex. Most of the authors mentioned the proposing of controlled liberalization, since too much freedom can ensure economicprosperity in the short run but not in the long run. Under the current financialsystem in Bangladesh, both the depository and investment intermediariesenjoy a deregulated environment. Bangladesh Bank monitors the bank

market whereas Securities and Exchange Commission (SEC) monitors thestock and bond markets. But the problem is that there is no coordinationamong the two regulatory bodies. There is every possibility that onebusiness organization that takes loans from banks as well as issuingsecurities may not submit the same performance report to a bank and thestock exchange. This anomaly of information remains hidden due to lack of coordination amongst the two regulatory bodies. Even the credit ratingagencies are developing their ratings systems by incorporating quantitative



models without considering the ratings made by the Bangladesh Bank andSEC, although these possess more information about a particular bank orbusiness firm. In this regard, the government of Bangladesh can establish anew entity in the name of a Central Regulatory Authority (CRA) that willmonitor both the banking market and the stock market. This would help to

overcome the existing problem of information asymmetry between the tworegulators by maintaining a central financial database, which is currently notavailable in Bangladesh. Figure 2 outlines the proposed financial system;however the key role of the authority will be to ensure an effectivelysupervised atmosphere under the ongoing liberalized and market-basedregime of the financial system. In order to ensure this the proposed CRA hasto consider the following key factors to uphold a sustainable financialsystem.



Figure 2: Proposed Financial System for Bangladesh

Source: author

Factors to be considered



1. Partial Loan Sale: During the subprime situation banks and other financialinstitutions sold loans and created new loans. In this there was no monitoringfrom a bank‟s perspective. But this is not good at all. There should be someregulation so that banks could not be able to sell the entire loan. This wouldensure the involvement of banks in monitoring borrowers after securitization.

It would also ensure the reporting of loans in a bank‟s balance sheet ratherthan eliminating them from it. The regulators of Bangladesh should considerthis when loan sales start in Bangladesh. It would be better if thegovernment delegates the authority to the proposed Central RegulatoryAuthority (CRA) to implement this partial loan sale arrangement;

2. The Boundary of Doing Business: The removal Glass-Steagall Act was oneof the fundamental reasons for the US financial crisis. It eliminated theboundaries of doing business for financial intermediaries. In Bangladesh asper the law, commercial banks deal with the lending and borrowing of moneyand only a few of them are involved in merchant banking. On the other hand,

investment banks deal with advising, underwriting, and secondary marketactivities. The government should continue this segregation when it initiatesloan sale and derivative trading in the financial market, so that financialinstitutions cannot cross their boundaries and embrace their own downfall bybecoming too big. It is also important to make sure that the securitizationprocess will not become that complex in the future;

3. Credit Rating Reform: The credit rating agencies also misunderstood therisk during the credit bubble in the US. They undertook rating by using theirown quantitative models. They did not incorporate the ratings done by thecentral bank and the SEC. Currently the same thing is also happening in

Bangladesh. But it will be better if the credit rating agencies can incorporatethe comments of the central bank and the SEC regarding an individualborrower or a business firm or a financial institution, since both the centralbank and the SEC has their own ratings;

4. Revisit Deposit Insurance Premium Calculation: So far the rate of depositinsurance premium is the same for all the banks, which is not at all justifiable. This encourages risky banks to take risky investment anddiscourages good banks. At the same time, it is really difficult to introduce anew system. If the central banks charge different banks with different rates,this will badly affect the confidence of the depositors of particular banks.

Therefore, the central bank of Bangladesh should continue with the samerate but can provide other benefits to good banks compared to low-performing banks, so that banks always have the tendency to improve theirperformances.

5. Coordinated Effort : It is always necessary to maintain long-term stability of the entire financial system of a country. Coordinated effort among theregulatory bodies is primarily required to do so. The proposed Central



Regulatory Authority (CRA) will ensure coordination among the Treasury,central bank, and SEC, which will in turn help the government to fix fiscaland monetary policies;

6. Adequate Use of Leverage: Excessive use of “leverage” also accelerated

the US crisis. In order to regulate leverage, sound capital adequacy ratio isan utmost necessity. This capital adequacy ratio should not be determinedfor a long-term basis. It should be monitored on a continuous basis toprevent bad consequences. Again the government of Bangladesh candelegate the authority to the proposed Central Regulatory Authority (CRA) sothat banks use leverage optimally rather than excessively;

7. Controlled-deregulation: It has already been mentioned that deregulationalso laid down the foundation of the US financial crisis. There is obviousdoubt about the future continuation of this long cherished deregulation. Now,it is the right time to go for controlled-deregulation rather than a free form of

deregulation;

8. Interest Rate Monitoring: This is another macroeconomic factor which isrequired to monitor on a continuous basis. The US financial crisis also makesit clear that a low rate of interest is not always good for the economy. Itshould not be fixed for a long period of time. Central Regulatory Authority(CRA) can handle this by consulting with the Treasury and the central bank;

9. Reformation of Reward System: Awarding large bonuses becomes aserious issue after the crisis. This kind of bonus system is also present inBangladesh, predominantly in the private sector. The government should

also consider this with immense prudence and impose some kind of regulation.



Conclusion

The financial crisis will reshape the financial world over years to come. Thefuture sustainability of a country’s financial system largely depends howquickly and smoothly it can adapt to the changing financial environment. It isclear from the crisis that the ongoing regime of financial liberalization cannotprovide guarantees against financial distress. The crisis also urges for theimportance of government intervention to regulate market players to behaveprudently even under the regime of the market-based financial system. This

study aims at developing a sustainable financial system for Bangladesh, withreference to the global financial crisis and proposes to establish a newinstitution CRA capable of generating quality information. The new institutionwill not focus on the administratively regulated financial sector, rather it willensure an effectively supervised financial atmosphere for attainingincentives from market mechanism through innovation and competition,which will not only help to enhance the economic prosperity of the countrybut also to sustain it. The important issue for Bangladesh may be to translatethe current global crisis into an opportunity to step forward under thiscontinuously changing financial atmosphere.

financial market crisis & proposed financial system

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