OP-ED: Banks and the stock market

This article addresses the question of commercial bank participation in the stock market. The basic conclusion is that commercial banks should not invest in shares of other companies with the possible exception of shares in other financial institutions in which they may have a strategic interest, but excluding other commercial banks. 

The relationship between commercial banks and the stock market has a long history. The argument is simple:  Commercial banks take deposits and make loans; they have a responsibility to protect their depositors who have left their money with the bank. The risks in the share market are of a different nature than of selecting to whom the bank lends money.  

In 1929 the American Stock market collapsed. The banks were weakened by this event and people lost confidence in the safety of their deposits. Extensive withdrawals of deposits led to the closure of many banks. In response to this, in 1933 Congress passed the Glass-Steagall Act. This legislation separated the commercial bank from the investment banks reducing the risk to the commercial bank from the risks of investment banking. Commercial banks complained about these restrictions and in 1999, the legislation was amended essentially removing most of the rules to separate these two types of banks. In 2008-09 the world financial crisis struck. There was widespread belief that the withdrawal of the boundaries was a substantial contributor to the melt down of the financial system. The Dodd-Frank Act led to imposition of new regulations separating investment and commercial banking. In the UK, the regulators introduced what was called “ring fencing” to limit how far a commercial bank could go in finding new forms of financial assets and liabilities. 

There is a continuing battle between banks and regulators with the banks wanting reduced regulations to enable them to take greater risks while regulators worried about potential losses to depositors are leery of permitting commercial banks to drift over into investment banking.

Returning to Bangladesh, in April 2021 the economy is moving towards recovery, but not very rapidly, as exports and investment are unlikely to reach pre-pandemic levels until June 2022. Commercial banks are deferring loan classification as instructed by Bangladesh Bank thus understating the true costs of their operations. The bad loan costs associated with the pandemic are yet to be incorporated in the accounts providing relief to the borrowing company during the recovery period. In addition, the RMG sector borrowed heavily through Bangladesh Bank’s special line of credit to pay workers through the early months of the crisis; these loans are coming due and borrowers will experience considerable difficulty in repaying in the near term. Fortunately, the banks have plenty of liquidity if they wish to restructure these loans. The garment manufactures argue that they are nowhere near full recovery and the assumption behind the government program, that the RMG sector would recover in three months, turned out to be wrong. Of course, the ultimate fate of these loans is uncertain; it is another risk that the banks are facing. All of this points to looming fragility of the banks.   Bangladesh Bank has done a great deal to strengthen the private banks’ position. It can do more.

In this situation Bangladesh Bank should be determined to protect the position of the commercial banks by instructing them to avoid unnecessary risk. There are three steps needed to protect the capital position of the banks: First, no investment in share market, why take on unnecessary risk? Second, no cash dividends should be paid by the banks. The reported profits are fictions due to the suspension of loan classification. What is relevant here is not the Capital now in hand but what would be held if the overdue loans are all booked. No one really knows how much that would be. Third, the central bank should review the condition of the loan portfolios, particularly of the range Tk1 million to Tk50 million where repayment problems are likely to be most severe. Based on this review, work out how the capital adequacy of the banks is likely to evolve during the next 18 months. Bangladesh Bank will confirm what is already in the air, there will be great pressure on the CAR of many private banks. It is foolhardy to require the banks to be involved in the capital market in such conditions.  

In Bangladesh there are commercial banks and merchant banks both requiring licenses. Many banks own or control brokerage houses or merchant banks. The SEC. licenses brokerage houses. The function of margin lending is handled through the brokerages and the merchant banks who obtain the necessary funds from borrowing or from use of their capital. A margin loan allows the investor in stocks to put up say 50% of his own money, borrow 50% from the broker using the stock as collateral [This is the present limit]. If the stock declines in value then when it gets to 50% of the original value the broker sells the stock and pays himself the amount of the loan. In this instance the investor loses his 50%. This is a dangerous game.  When share prices begin to fall this may trigger the brokers selling more shares as margin limits are reached and this may lead to increasing the rate of fall of share prices.  Nevertheless, margin loans are a legitimate instrument.

In the past, there have been instances where the authorities have forced the brokerages and merchant banks to hold onto the shares and not make the margin sale. This is foolish, unprofessional interference attempting to keep the stock prices from falling.  Apart from the fact this is against the law, this never works. The total amount of margin loans is small and the forces driving the fall in the market are not going to be reversed when some national security type decrees that the decline should cease.

The commercial banks are involved in the share market in two ways: First, they are allowed to invest 25% of their capital. Such investments are adjusted every day according to the share prices. If the share price is falling then the bank can investment more to cover what it has lost. This is voluntary but I expect that there is a lot of pressure for the banks to maintain such an investment level. A 10% drop in the share market reduces the bank’s capital by 2.5%. This is a disaster for most banks.

The second channel is the request by Bangladesh bank to each bank to invest 200 crore in the share market. If this is done, the bank does not have to mark the investment to its market value until it sells the shares. Thus, its capital can decline but this is hidden from the investors in the banks.  

What is all this really about? The stock market is a surprise.  The economy was growing very strongly prior to the Pandemic; it has slowed down but is recovering and there is every reason to believe GDP growth will soon be back around 8%. Why is the capital market showing no sign of improvement?

This is a puzzle for the authorities to solve. Bangladesh is a “frontier market”. This is a market not as developed as an emerging market like India; usually a frontier market is rather small, unstable, and lacks liquidity.   

For Bangladesh to develop its capital market, it must attract investors from abroad. This has two effects: the interest of foreign investors is a sign of maturity in the Bangladesh market and directly boosts the market; domestic investors gain confidence in the market, “if the foreigners are investing it should be all right for me to invest.”  

There are three conditions that must be resolved by the SEC if the capital market is to function correctly in financing economic growth. It is important to achieve this as the virtually total reliance on bank lending is not a sound way to manage the financial system of a rapidly growing nation.

What are the conditions?

1. The financial reports and audits of the listed companies are suspect and it is widely believed do not accurately represent the condition of the company. I do not know if this is true but it is certainly a widespread belief among persons working in the financial system. It is also widely believed abroad that one cannot be sure if the audit reports correctly reflect the company’s status.  Even if the quality of audits is just fine, simply saying so will not solve the problem. The SEC must act even if there is no real problem. The accounting profession in Bangladesh has always been very good and offered opportunities for important work with good remuneration. Companies not doing well would pressure their auditor to make things look a little better than they were. If the auditor refused to comply, the company sought out an alternative and easily found someone who would be more flexible. Over time, the quality of audits declined. Audit companies that attempted to maintain their standards found a limited pool of companies ready to engage them. The top audit companies ended up with more and more business with foreign investors. But there were not enough foreign investors.  
2. The second requirement is for the SEC to strengthen the inspection of merchant banks, brokers, and rating agencies. Falling interest rates and reduced spreads cause financial pressure on the merchant banks. There are a large number of brokers and some may not conform with SEC rules. The rating agencies are not taken seriously according to many persons active in the economy. In all cases, the SEC must take a tougher stance and insist that rules be followed. Foreign companies should be allowed into the rating agencies to provide competition. A few reputable foreign companies will create the pressure to maintain standards. The protection of the rating agencies has been a very serious error for the development of the stock market, adding costs but little benefit. In the great financial crisis of 2008-2009, the rating agencies in the US were found to have been deficient contributing to the crisis. There had been insufficient inspection of their work.
3. The third condition is to track and punish market manipulators. If the SEC does not already have available, it can readily procure the computing power, software and expert knowledge needed. Everyone believes that there is market manipulation. The SEC must catch some people and punish them. Without serious investigations, denial is no solution, it makes things worse. Denial of the problems convinces everyone the problem is serious.

When Bangladeshis and foreigners have greater confidence in the share market, then investment will come and the market will grow with the economy.

But manipulation of the share market by forcing banks to invest or blocking margin calls will do no good and much harm. The longer one avoids dealing with the underlying issues the longer it will be before the capital market works to help the economy grow faster.

Actually, things are worse: For the authorities to manipulate the market is a fraud perpetuated on the participants. If the authorities induce false price levels then innocent investors are being tricked into investing and will lose. A private person has committed a crime by manipulating the market.   It is hard to see how the SEC can justify market manipulation to force stock purchases by banks, probably forcing them to lose money.

Conclusion

Bangladesh Bank and the SEC should stop messing around with the stock prices by actions that would be illegal if conducted by a private person.   Commercial banks should not be allowed to invest in the share market except for particular conditions involving a subsidiary.  Banks should not be allowed to pay cash dividends at this time.  Bangladesh Bank is certainly aware of the risks facing the commercial banks.  The next two years pose a great challenge to insure that the banking system gets through the post Pandemic period, caution is the appropriate stance.

Forrest Cookson is an economist who has served as the first president of AmCham and has been a consultant for the Bangladesh Bureau of Statistics.