Banking System: Conceptual

Aspects
TOPIC 1
Introduction to financial systems
• Financial system refers to the holistic collection of financial markets,
financial institutions, financial assets, regulators, regulatory
frameworks, and market participants’ that together ensure the flow of
funds in an economy from the surplus unit to the deficit unit.

• The financial system of Bangladesh is comprised of three broad,

fragmented sectors based on the degree of regulation to which the
sector is subjected to:
• Formal Sector
• Semi-Formal Sector
• Informal Sector
Introduction to financial system
• The formal sector includes all regulated institutions like Banks, Non-Bank
Financial Institutions (FIs), Insurance Companies, Capital Market Intermediaries
like Brokerage Houses, Merchant Banks etc.; Micro Finance Institutions (MFIs).
• The semi formal sector includes those institutions which are regulated
otherwise but do not fall under the jurisdiction of Central Bank, Insurance
Authority, Securities and Exchange Commission or any other enacted financial
regulator. This sector is mainly represented by Specialized Financial Institutions
like House Building Finance Corporation (HBFC), Palli Karma Sahayak
Foundation (PKSF), Samabay Bank, Grameen Bank etc., Non Governmental
Organizations (NGOs and discrete government programs.
• The informal sector includes private intermediaries which are completely
unregulated.
Overview of the Financial System of
Bangladesh
What is a bank?
• A bank can be defined as a financial institution which facilitates the
transmission of funds from surplus units to the deficit units in an
efficient and effective manner.
• From a legal perspective, “Banks’ in Bangladesh are financial
institutions that are formed and regulated under the provisions of the
Bangladesh Bank Order, 1972 and the Bank Company Act, 1991.
• “Banking Company” has been defined in the Bank Company Act-1991 as
any organization which is involved in “Banking business” in Bangladesh.
• Here banking business refers to “the accepting, for the purpose of lending or
investment, of deposits of money from the public, repayable on demand or
otherwise, and withdrawable by cheque, draft, order or otherwise”
Types of Banks
• We can classify or categorize banks using different criterions (ownership,
objective etc.)
• The most common classification of banks is that they can be either
scheduled or non-scheduled.
• Scheduled banks are the banks which are licensed under the bank
company act-1991 and which remain in the list of banks maintained
under the Bangladesh Bank Order, 1972.
• Non-Scheduled Banks are the banks which are established for special
and definite objective and operate under any act/ordinance other than
the BB order, 1972 and Bank Company Act-1991. These banks cannot
perform all functions of scheduled banks.
Scheduled Banks
• The scheduled banks can be further sub-classified into different categories as follows:
1. State Owned Commercial Banks (SOCBs): There are 6 SOCBs which are fully or majorly
owned by the Government of Bangladesh.
2. Specialized Banks (SDBs): 3 specialized banks are now operating which were established for
specific objectives like agricultural or industrial development. These banks are also fully or
majorly owned by the Government of Bangladesh. i.e BKB, RAKUB, Probashi Kalyan Bank
3. Private Commercial Banks (PCBs): There are 43 private commercial banks which are majorly
owned by individuals/the private entities. PCBs can be categorized into two groups:
1. Conventional PCBs: 33 conventional PCBs are now operating in the industry. They perform the
banking functions in conventional fashion i.e interest based operations.
2. Islami Shariah based PCBs: There are 10 Islami Shariah based PCBs in Bangladesh and they execute
banking activities according to Islami Shariah based principles i.e. Profit-Loss Sharing (PLS) mode.
4. Foreign Commercial Banks (FCBs): 9 FCBs are operating in Bangladesh as the branches of the
banks which are incorporated in abroad.
Non-Scheduled banks
• There are now 5 non-scheduled banks in Bangladesh which are:
• Ansar VDP Unnayan Bank,
• Karmashangosthan Bank,
• Grameen Bank,
• Jubilee Bank (undergoing liquidation process),
• Palli Sanchay Bank
Unit vs Branch Banking
• Another classification of banks can be done on the basis of the
number of branches that a bank has.

• Branch Banking: This is prominent in Bangladesh. These are banks which

operate through multiple branches scattered or dispersed over their entire
geographical market.
• Unit Banking: This is not seen in Bangladesh but is quite popular in many
Western countries. Here a bank has only branch and provides the services
through that branch only.
Functions of Banks
• The functions/activities that banks can perform in Bangladesh are
listed in the Bank Company Act-1991.
Functions of Banks
• The functions/activities that banks can perform in Bangladesh are
listed in the Bank Company Act-1991.
Primary activities of a bank
1. Accepting deposits
2. Advancing loans
3. Credit creation – It refers to the expansion of deposits in an economy.
4. Facilitate the payment system in the economy- Banks facilitate transactions
in an economy by providing, maintaining, and developing the payment
system (currency, credit cards, online payment, ATM, CDM, POS machine
etc.).
5. Financing internal and international trade- LC opening, confirmation,
discounting, foreign currency trade etc.
6. Remittance of funds – Inward and outward remittance, student files,
medical files etc.
Primary functions of banks
1. Acceptance of deposits
• Current Deposits
• Savings deposits
• Fixed Deposits

2. Advancing Loans
• Overdraft facilities
• Discounting bills of exchange
• Money at Call
• Term Loans
• Consumer loans
• Miscellaneous advances (project financing, syndicated financing, SME financing, working
capital financing, supply chain financing etc.)
Secondary Functions
• A Bank’s secondary function includes:
• Agency services: A bank may acts as an agent for a principal and provide the
principal with various value added services.
• General Utility services: General services which provide convenience to the
customers. i.e providing locker services, providing advisory service to clients
etc.
Benefits of a robust banking system
• A strong and robust banking system provides various benefits to the
economy and contributes to the economic development of the
nation. These benefits include:
• Maturity intermediation: Bank’s can provide savings/investment conduit for
lenders/borrowers that better reflect the maturity needs of these parties. FI’s
are better capable to manage the risk of maturity mismatch of their assets
and liabilities.
• Denomination intermediation: Banks remove the pronlem of denomination
mismatch through pooling of funds.
• Superior monitoring: FI’s are better equipped to closely monitor the
performance of the borrower thereby better managing default risk. FI’s can
collect more information at a lower average cost due to economies of scale.
Benefits of a robust banking system
• Superior credit assessment: Bank’s possess the expertise required to conduct a
thorough assessment of the creditworthiness of the borrower (issuer). This also
mitigates default risk.
• Credit Allocation: Bank’s are often the main, and at times the only, source of financing
for certain sectors of the economy.
• Transmission of monetary mechanism: Depository financial institutions are the
medium through which the central bank implements/manipulates its monetary policy
to impact the rest of the economy. i.e changing the reserve requirement of banks to
tackle inflation, open market operations etc.
• Payment Services: banks develop and facilitate the network of payment systems used
to make purchases and consumption in the economy.
• Risk Management: Banks may provide risk management services to its clients. i.e
diversification of portfolio
Sources of a Bank’s Income
• Interest income from loans and advances
• Banks try to generate positive spread or net interest income by positively
maximizing the gap between the cost of fund/borrowing and the cost of lending.
• Interest, dividend, and capital gain on Investments
• Banks make significant amount of investments in various money market, capital
market, and government financial instruments. These investments generate return
for the bank in the form of coupon receipts, dividends, and capital gain. Income can
also be generated from FX trading.
• Fees and commissions
• Banks charge fees and commissions for the various services it provides to its
customers. These generate fee income and commission income for the bank.
• Income generated during discounting services
Investment Policy of Banks
Risks faced by Banks
• A depository Institutions and thus a commercial bank is subject to
various types of risks. Some of the common risks include:
1. Interest rate risks:
2. Credit Risk
3. Liquidity risks
4. Technological risks
5. Operational risks
6. Foreign exchange risks
Risks faced by Banks
• A depository Institutions and thus a commercial bank is subject to
various types of risks. Some of the common risks include:
1. Interest rate risks:
2. Credit Risk
3. Liquidity risks
4. Technological risks
5. Operational risks
6. Foreign exchange risks
Interest Rate Risk
•Interest Rate Risk refers to the risk that a change in interest rates will adversely
affect the earnings or the asset value of an organization.
•Interest rate risk mainly arises due to a mismatch between the maturity of an
organizations interest bearing assets and it’s interest bearing liabilities.
•Interest rate risk can be further sub-classified into two categories:
• Refinancing risk: Short term liability but long term asset
• Re-investment risk: Long term liability but short term asset
Interest Rate Risk- Refinancing Risk
Assume that IDLB Bank has borrowed Tk. 100 million in liabilities
financed at 9% per year and the rate that the interest rate resets at
the end of the year. IDLB Bank has used this money to provide loans
to its clients worth $100 million that mature in 2 years at a fixed rate
of 10% per year.
What happens if the interest rate increases to 11% after 1 year?
◦ The cost of refinancing your liabilities increases, but your income from
assets stays the same. Thus, the net interest income is adversely
affected.
Interest Rate Risk- Reinvestment Risk
Assume that HSBB Bank Ltd. Has TK. 100 million in liabilities financed
at 9% per year that mature in 2 years. The FI has made loans of TK.
100 million that mature in 1 years at a rate of 10% per year.
What happens if the interest rate decreases to 8% after 1 year?
◦ The cost of your liabilities stays fixed but in year two your income from
assets decreases.
Credit Risk
• This is the risk that a borrower will not be able to repay the interest and/or
principal amount to the lender resulting in a loss for the lender.
•This too is a major form of risk for Commercial Banks in Bangladesh (high NPL)
as well as for investment banks and securities firm (Non-performing margin
loans).
•Credit risk is of two types:
1. Firm-specific credit risk- The risk of default of the borrowing firm associated with
the specific types of project risk taken by that firm.
2. Systematic credit risk- The risk of default associated with general economy wide or
macro-conditions affecting all the borrowers.
Risks faced by Banks (Depository Financial
Institutions)
• 2. Credit Risk/Default Risk: This is the risk that a bank might not be able to recover the loans that it has
disbursed to its customers. That is the loans might turn into non-performing loans. This reduces the
profitability of the bank and places pressure on the remaining loan portfolio. The Central Bank provides the
Criterion regarding classification of loans as NPL. Some other qualitative criterions are also applicable.

Loan Type Sub-standard Doubtful (Provisioning Bad & Loss

(Provisioning =20%) = 50%) (Provisioning = 100%)
Fixed Term loan >= 6 months but < 9 >=9 months but < 12 >=12 Months
(amount upto 10 Lac) months months
Fixed Term Loan >= 3 Months but < 6 >= 6 months but < 9 >= 9 months
(Amount > 10 Lac) months months

Short term agricultural >= 12 Months but < 36 >=36 Months but < 60 >60 Months
and Micro loans months Months
Other loans >= 3 Months but < 6 >= 6 months but < 9 >= 9 months
months months
Liquidity Risk
• This is the risk of not being able to convert an asset into cash quickly
enough without having to sacrifice the value of the asset.
•FI’s and retail investors both might face liquidity risks/
•For FI’s, liquidity risk could result in reputational risk and may even
generate “runs”.
• Runs may turn liquidity problem into solvency problem.
• Risk of systematic bank panics.
Foreign Exchange Risks
•Foreign Exchange risk refers to the risk that a firms earnings from foreign
denominated asset and the value of these assets might decline due to a change
in the exchange rate.
• Net Long Asset Position – Exposure to foreign denominated assets is greater than
foreign liabilities. Depreciation of foreign currency results in loss.
• Net Short Asset Position – Exposure to foreign denominated assets is less than
exposure to foreign liabilities. Appreciation of foreign currency results in loss.
Country or Sovereign Risk
•Result of loss arising due to changes in the political condition or
policies of foreign government which may impose restrictions on
repayments to foreigners.
•An important characteristics of country risk is that there is a lack of
usual recourse via the court system.
Country or Sovereign Risk
Technological and operational risks.
Risk of direct or indirect loss resulting from inadequate or failed internal
processes, people, and systems or from external events.
◦ Some include reputational and strategic risk
Technology Risk: Technology investment may fail to produce anticipated cost
savings.
Operational Risk: The risk that support systems (often based on new technology)
may break down.
◦ Bank of New York – failed to register incoming payments on Fedwire, but continued
to process outgoing payments
◦ Well’s Fargo – Failure to correctly post deposits to acquired firms account holders –
cost $180 Million
Insolvency Risk
•Risk of insufficient capital to offset sudden decline in value of assets
to liabilities.
•Original cause may be excessive interest rate, market, credit, off-
balance-sheet, technological, FX, sovereign, and liquidity risks.
•It is imperative to ensure sound capital adequacy to protect oneself
against insolvency risk.
Credit Creation
• The basis of credit creation is the bank’s deposits.
• Deposits can be two types:
• Primary deposit
• Derivative or derived deposit
Process of credit creation
Credit creation-Example
Credit creation-Example
Credit creation-Example
Credit creation example
Credit Creation