Legal framework of banking sector must be reformed

On June 4, Bangladesh Bank informed the chairmen and managing directors of five Shariah-based banks in a special meeting that it intends to merge them into a single, stronger Islamic bank. The five banks in question are First Security Islami Bank, Global Islami Bank, Union Bank, Social Islami Bank, and EXIM Bank. It is worth noting that toward the end of the last Awami League government’s tenure, an initial attempt was made to merge EXIM Bank with Padma Bank to form a new entity, but that initiative was halted due to political changes.

Bangladesh Bank is now revisiting that plan. The five banks slated for merger have a combined total of 779 branches, over 15,000 employees, and approximately 9.2 million customers. Their total deposits stand at BDT 1.45 trillion, while they have disbursed BDT 2.15 trillion in loans. Until the merger process is completed, all employees except top executives will remain in their positions. Decisions regarding their future will be made once the merger is finalized, which may take up to three years. These banks are owned by individuals known to be closely aligned with the previous government, including the controversial S. Alam Group, which has ownership stakes in multiple banks.

During the previous government, the banking sector arguably suffered the most damage among all sectors of the economy. The rampant approval of licenses to politically loyal individuals led to an excess of banks, far exceeding the market’s actual demand. As a result, many of these banks have become unsustainable. Political considerations often prevented effective corrective actions. The current interim government has taken the commendable step of addressing these challenges by initiating the merger of weak banks. However, mergers alone cannot resolve the sector’s deep-rooted problems. Alongside reducing the number of banks, it is crucial to modernize and reform the regulatory and operational frameworks.

The banking sector experienced significant setbacks during A H M Mustafa Kamal’s tenure as Finance Minister. He introduced changes to globally accepted banking laws in a way that undermined governance. Consequently, the sector became a hotbed of financial misappropriation. It is worth mentioning that among all the finance ministers since Bangladesh's independence, A H M Mustafa Kamal is the only one with a direct business background. This background likely influenced the reforms he introduced, which often favored defaulters and irresponsible borrowers.

Soon after assuming office, Kamal declared that not a single taka would be added to the total volume of defaulted loans—a statement that initially sparked optimism. But it didn’t take long for the implications of his policies to become clear. He manipulated global-standard banking regulations to understate the volume of non-performing loans (NPLs), even when loan repayments were not made.

One notable change was the extension of the loan classification period. Previously, a loan would be classified as defaulted the day after a scheduled repayment was missed. Under the new regulation, a three-month grace period was allowed before the loan would be officially classified as non-performing.

Previously, writing off a bad loan required five years of NPL status, a lawsuit filed in the appropriate court, and 100% provisioning. The write-off didn’t mean the bank forfeited its claim but rather transferred it to a separate accounting treatment. Under Kamal’s reforms, loans could be written off after just two years of default. For loans below BDT 500,000, the legal case requirement was waived, and the 100% provisioning rule was relaxed—greatly weakening the safeguards against financial abuse. This allowed many borrowers to write off their defaulted loans with little resistance.

In the past, a loan account could only be rescheduled a maximum of three times, with each rescheduling requiring increasingly larger down payments—10%, 20%, and 30%, respectively. However, under Kamal’s policy, loans could be rescheduled for up to 10 years with only a 2% down payment and a one-year grace period. About 38,000 individuals and entities took advantage of this. During the post-2014 political unrest and arson attacks, certain government-aligned groups used the situation as a pretext to restructure loans worth BDT 500 crore and above, with minimal down payments, for a 12-year period. In total, 11 conglomerates regularized around BDT 150 billion in bad loans. Yet most of these eventually turned into defaults again.

Previously, no more than two directors from the same family could be appointed to a private bank, serving a maximum of two terms (six years total). The law was amended to allow four family members to serve three consecutive terms (nine years), making it easier for families to dominate bank management. Following pressure from the International Monetary Fund (IMF), this was scaled back to three family members in later reforms.

One of the most controversial changes came just before the end of the previous government's tenure. Previously, if one enterprise of a business group defaulted on a loan, its other enterprises became ineligible for fresh bank loans. This rule was changed so that even if one enterprise defaulted, others under the same group could still borrow—essentially encouraging willful default.

In favor of government-aligned business groups, the maximum interest rate on bank loans was capped at 9% for an extended period. Following the inflationary surge caused by the Russia-Ukraine war, central banks in many countries raised policy rates to tighten money supply and control inflation. Bangladesh Bank raised its policy rate multiple times—from 5% to 10%. But the lending rate remained capped at 9% until recently, making loans effectively cheaper and encouraging irresponsible borrowing and capital flight, even abroad.

At one point, the central bank set the private sector credit growth target at 14.1%, but it actually reached 14.7%. However, during that same period, imports of capital machinery dropped by 76%, and imports of raw and intermediate goods declined by 14%. This raises a serious question: where did all the credit go? Recently, the lending rate has been made market-based, and as a result, private sector credit growth has dropped below 7%. Some business groups that own multiple banks used the banking system to launder massive sums of money abroad.

Bangladesh Bank also kept the exchange rate of foreign currencies artificially low for a long time—setting the USD rate at BDT 110 when it was trading at BDT 122–123 in the curb market. Once the crawling peg system was adopted, the official rate rose by BDT 7 overnight. Critics had warned that a market-based exchange rate would lead to sharp depreciation of the taka. But when the IMF-recommended system was finally implemented, no such disruption occurred. The dollar still trades around BDT 122–123.

Fixing the exchange rate adversely affected remittance inflows. Since allowing market-based rates, remittance inflows through official channels have increased significantly. In the first ten months of the current fiscal year, Bangladesh received $25 billion in remittances—the highest ever for a single fiscal year. In April alone, the country received $3.29 billion—the highest monthly remittance in its history. The ongoing high inflation in the domestic economy is largely the result of the flawed policies of the previous government.

Bangladesh Bank is trying to address these challenges by merging weak banks. But without restoring the legal and regulatory framework to global standards—and strengthening it further, if necessary—the underlying problems will persist. Structural reforms and honest governance, not just mergers or acquisitions, are key to solving the crisis in the banking sector. Understanding this reality is essential to making meaningful progress.

M A Khaleque is a retired banker and writes on economic issues.