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Jamal Munshi, Transparency International, 1999
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Non-Bengali entrepreneurs and the public sector nearly monopolized economic activity in the Pakistan era. Of the very few Bengali business professionals active in East Pakistan fewer yet survived the war. Post independence Bangladesh therefore presented a unique set of opportunities and problems for the private sector. The good news was that without the stranglehold of the elite Pakistani business families the field was wide open for the development of a homegrown Bengali private sector; but the bad news was that both a capital base and an entirely new entrepreneurial class would have to be developed out of an economic vacuum.

Capital formation rapidly occurred and the newly nationalized banks, awash in deposits, found themselves with a serious asset management problem because there were few professional entrepreneurial risk takers with business skills and proven track records to whom this capital could be made available under normal and prudent banking practice.

To get the ball rolling, the government of Bangladesh (GOB) relaxed capitalization restrictions on banks and at the same time directed the state-owned banks to disregard normal credit requirements and to reach given loan portfolio targets on a timetable. The anticipated high default rate on these loans was considered to be the price of developing a private sector.

In purely aggregate economic terms the experiment was successful. Liquidity excess soon turned into liquidity crisis as loan portfolios expanded; and thirty years after independence we find that growth in exports, manufacturing, construction, and agriculture is led by a robust private sector that owes its existence at least in part to this risky banking strategy.

However, the price of developing the private sector turned out to be higher than anticipated because of very significant structural inefficiencies that may be enumerated as follows:

  1. First, inexperienced and untrained individuals were at the helm of the nation's banks not only because there was a genuine shortage of trained personnel but also because middle management was populated with labor union influenced promotions and top management consisted of mostly unqualified political appointments.
  2. Second, nationalization compromised accountability and turned banking into a political tool of the Ministry of Finance or MOF. The MOF became the owner, operator, regulator, and watchdog of the entire banking sector.
  3. Third, the GOB financed the losses of state owned factories as "loans" from state owned banks.
  4. Finally, corrupt bankers and political leaders took advantage of these weaknesses and the availability of default-able loans to enrich themselves at the expense of society without providing the risk bearing and private sector development that these defaults were supposed to engender.

After almost three decades of easy credit, the program has developed a degree of inertia and is proving difficult to discontinue. An influential political and financial elite has come to expect default-able loans as a perquisite of political power. The default problem has rendered the domestic banks technically insolvent because almost half of their loan portfolio is in default and they do not have sufficient bank capital to absorb these losses.

Corruption plays a role in the default problem although not all bank corruption is related to defaults, not all defaults are the result of bank irregularities, and not all bank irregularities are symptomatic of corruption. Some of the observed irregularities may be just bad bank management. In other instances it may be difficult to draw a line between outright criminal activities and corruption. It is noted, however, that criminal activity by bank employees is apparently quite common at the nationalized banks.

In this paper we describe documented corrupt practices in banking using a narrow working definition of corruption without addressing bank reform in general. Non-corruption irregularities are excluded from our analysis. In our conclusion we derive broader implications of the data and offer an agency theory framework for corruption and some anti-corruption measures it suggests.


The Architecture of the Banking Industry in Bangladesh

Investment in productive assets by corporations is the primary engine of economic growth in market economies. Household savings flow into such investments through an aggregation and allocation mechanism loosely termed "capital markets". Capital markets consist of securities markets and banks.

In securities markets, corporations raise funds directly from savers by issuing securities to them. Banks on the other hand are financial intermediaries. They collect deposits from savers on one side and make loans to corporations on the other. Securities markets in Bangladesh are not well developed and therefore banks are the primary holders of savings and providers of capital.

Banks pay interest to savers and charge a higher interest to borrowers and make their income from the difference called the "spread". The spread is a useful measure of the efficiency with which banks carry out their capital formation function; the smaller the spread the lower the interest on loans or the higher the interest paid to savers and the more efficient the capital aggregation and allocation function. A well-designed structural and regulatory framework for banks that is supported by a legal, social, and technological infrastructure keeps the spread low. Corruption increases the spread.

Bank Regulation

Governments enact and enforce laws to protect the citizens' deposits in banks as well as to protect banks and their borrowers against fraud by either party on the other. Also, banks create money when they make loans and society regulates this engine of money creation as a way of coordinating overall economic policy.

Deposits are at risk because a run on banks can dry up the liquidity normally held by bankers and also because loan losses can reduce the banks ability to repay depositors unless the bankers themselves have invested sufficient capital to absorb these losses. Banks play an indispensable role in the creation and distribution of wealth in the economy. Bank failures can be ruinous for an economy that depends on banks to provide these functions. Bank regulations are designed to avoid this calamity.

Bangladesh Bank (BB) is the nation's central bank and, along with the Ministry of Finance (MOF), it also serves as registrar and regulator and carries out all the functions of bank supervision and examination. Bank regulation in Bangladesh is expressed in the Bank Companies Act of 1991 and related Acts of Parliament and modified by the Financial Sector Reform Project (FSRP) of 1990-1995, the Commercial Bank Restructuring Project (CBRP) of 1997, and BB circulars and executive orders. The resultant regulatory structure may be described in terms of the common elements of bank regulation as follows:


    1. Chartering of banks
    2. All banks must register with and be chartered by a MOF committee and BB.

    3. Liquidity requirements
    4. Banks must hold 20% of demand and time deposits as cash and marketable securities.

    5. Capital requirements
    6. At least 8% of risk-weighted assets must be financed by owners' equity. This rule replaces the earlier requirement that set bank capital at 6% of deposits.

    7. Safety net for depositors
    8. BB provides deposit insurance for deposits up to 100,000 BDT per account at an insurance premium of 5 basis points per annum.

    9. Disclosure of financial condition
    10. Banks must file periodic financial statements according to published accounting standards and BB makes this information public in an aggregate summary form. Banks must also disclose borrower profiles and the BB uses these to maintain a credit information database for the banks.

    11. Bank examination
    12. BB inspectors review a report submitted by an internal inspection team of each branch of each bank. Both on-site inspection and off-site review are used.

    13. Interest rate restrictions
    14. Restrictions contained in the Companies Act are being phased out by the FSRP

    15. Loan classification and provision for loan losses
    16. This requirement was implemented by the FSRP. Loans must be classified as good, substandard, doubtful, or bad and a specified percentage of each class must be deducted from income as provision for loan losses.

    17. Intervention in bank management

In theory, BB may fire bank directors or seize and close a problem bank. The BB forbids loans without collateral and may become involved in specific loan approvals.

The regulatory structure is inadequate and flawed and banks are generally non compliant. For example, most domestic banks do not meet capital adequacy requirements and the NCB are also short on liquidity. No bank provides deposit insurance. There are no restrictions on asset holdings or on off-balance-sheet activities and there are no "truth in lending" laws. Also absent is an effective policing function to take corrective action when banks are non-compliant. The regulatory system is one that was designed to regulate private sector banks and it does not work in the banking architecture of Bangladesh

The effectiveness of BB in bank examination and supervision is also compromised by structural weaknesses.

  1. First, it is organizationally weak with a poorly trained and poorly paid staff with low morale and without a clear mission.
  2. Second, it is not independent but a political arm of the MOF.
  3. Third, the ownership of nationalized banks by its boss, the MOF, limits its ability to regulate them.
  4. Fourth, it only imposes trivial amounts in fines for violations and lacks a charter to take corrective action or to close insolvent banks.

Some regulatory defects involve a conflict of interest. For example, there is no regulation to prevent

  1. Directors of private sector banks from taking insider loans from their own bank. Bank regulations provide guidelines for insider loans but do not prohibit them. (As of this writing, new regulations are
  2. Businesses controlled by ministers, government bureaucrats, and members of parliament from taking insider loans from state owned banks.
  3. Managers of BB, including the Governor, from being involved in banking in another capacity. Private bankers may become Governor and Governors may go back into private banking.
  4. Managers of NCB from running financial operations of their own.
  5. Non-banking government bureaucrats from ordering state owned banks to make loans
  6. the use of loan forgiveness as a political tool

The need for banking reform in Bangladesh is acknowledged by all concerned parties and is underscored by the formation of the Banking Reform Committee and the implementation of the Financial Services Reform Program and the Commercial Bank Restructuring Project. The agenda for reform has been pushed by donors particularly the World Bank and has placed the GOB in a passive and reactive role.

The GOB is the largest banker in the country and it also controls central banking, bank regulation, and bank supervision. The reform movement imposed on it by donors has implemented loan classification, provision for loan losses, and lending risk analysis procedures but has yet to put forth real structural reforms towards privatization of banks and de-politicization of bank regulation.

Banks in Bangladesh

All domestic banks were nationalized after independence and placed under the direct control of the Ministry of Finance. In addition to state owned banks there exists a significant and growing private sector consisting of both purely domestic banks as well as branches of foreign banks. As of 1999, there were about 50 banks in the country. Most of the banks are in the private sector but most of the assets are held by state owned banks. Banks in Bangladesh are normally grouped into five categories. The banks in each category are as follows:

    1. Nationalized Commercial Banks (NCB): There are four; Sonali, Rupali, Janata, and Agrani. These are depository institutions holding a diversified loan portfolio. They are wholly owned and operated by the GOB.
    2. Development Finance Institutions (DFI): There are five; Krishi, Shilpa, RAKUB, BASIC, and BSRS. They are government agencies that funnel government and donor development funds to specific sectors of the economy. There are therefore four plus five or nine state owned banks (SOB).
    3. Non-Islamic Private Commercial Banks (PCB): These are private sector depository institutions with normal diversified loan portfolios and asset base. Islamic banks (PIB) listed below are normally considered to be part of PCB segment.
    4. Islamic PCB: These are private sector depository institutions that decry interest charges or interest payments and replace them with financial innovations that may be described as a variant of preferred share dividends.
    5. Foreign Commercial Banks (FCB): These are Bangladeshi operations of foreign banks.

State owned banks dominate banking in every sphere except efficiency. In March 1999, these banks accounted for 83% of 270 billion BDT of bank assets and 73% of 6000 bank branches. The state also holds the lion's share of deposits with more than 63% of 60 billion. The DFI and FCB play a relatively minor role with tiny market shares both in terms of assets and deposits.

In the aggregate, domestic banks in Bangladesh carry an astronomical default rate on their loan portfolio. According to the figures provided by the banks more than a third of the loans are uncollectable. The actual condition may be even worse because many bad loans are repeatedly "re-scheduled" and the accounting practice is to restore a rescheduled bad loan to unclassified status until it goes bad again. Bad loans made by state owned banks to state owned enterprises are not normally classified and government bank inspectors tolerate fraudulent accounting by managers of state owned banks. The loan classification system itself is subjective and fuzzy and is the likely cause of wild swings in the data.

The defaults of private sector banks are due mostly to insider loans to bank directors and loans to "sick industries"; and those of the state owned banks are due mostly to corruption and loans to failing state owned enterprises. The amount of defaulted insider loans in the private sector exceeds bank capital invested by insiders by orders of magnitude; therefore these deficiencies are not likely to be overcome without some kind of government bailout. The entire default burden of over 200 billion BDT in bad loans will thus fall on the GOB who will undoubtedly seek relief from donors.

The accounting data are taken from BB publications. Most of the assets of the state-owned banks and almost half of the assets of the banks in the private sector are listed in the BB Bulletin as "Other assets". The figure includes classified loans and pass-through funds from donors. Without this amount the total assets of the banks in Bangladesh is about 70 billion or almost one-fourth of the 270 billion reported; and the market share of the private sector is significantly higher. It appears that the apparent market share of the NCB is supported in large measure by bad loans. Efficiency and performance ratios are also affected; for example these extraordinary items artificially depress bank capitalization ratios. BB does not readily disclose data on income, net bank capital, and loan loss provisions.

The data are also affected by accounting window dressing. For example, it is possible for the NCB to be re-capitalized by the GOB with the proceeds used exclusively to hold government securities. The capitalization ratio is improved although the net transaction is zero. If new capital of $5 invested in a bank with total assets of $100 and bank capital of $5 is returned to the owners as a loan the capitalization ratio of 5% almost doubles and the bank shows a healthy growth in assets.

The nationalized banks are over-staffed and characterized by poor management and inefficient and manual operations. They do not use information technology. They are run more as political and social welfare organizations and as a source of funds for failing state owned enterprises than as a banking business. Non-managerial workers are unionized. The unions are very strong and union leaders are powerful at both the local and the national levels. Union pressure often subverts the managerial decision making process.

The NCB make business loans on the basis of collateral - even physical items such as jewelry - rather than risk analysis, cash flow projections, or the credit rating of the principals. There are a limited number of products and no innovations in asset or liability management, no securitization, no secondary market for loans, and no products designed for rural areas where most of their branches are located.


Exhibit 1: Financial characteristics of banks in Bangladesh. March 1999


Market share of each segment

Total Assets (270 billion BDT) 74% 9% 14% 4%

"Net" Assets (70 billion BDT) 52% 12% 28% 8%

Total Deposits (60 billion BDT) 58% 5% 29% 7%

Loans (50 billion BDT) 51% 17% 26% 6%

Number of branches (6000) 52.8% 19.1% 27.5% 0.6%

Characteristics of each segment NCB DFI PCB FCB All Banks

Cash and Liquid Securities (% of TA) 2% 3% 12% 6% 4%

"Other Assets" (% of TA) 82% 62% 47% 45% 74%

Bank Capital (% of TA) 0.50% 1.68% 1.10% 1.45% 0.68%

Bank Capital (% of net TA) 2.71% 4.92% 2.07% 2.65% 2.60%

Bank Capital (% of Loans) 4.27% 5.56% 3.40% 5.58% 4.02%

Cash (% of Deposits) 13% 22% 27% 14% 18%

Loan default data (% of Loans) NCB DFI PCB FCB All Banks

Classified Loans 40% 63% 33% 4% 39%

Classified as Bad -- -- -- -- 34%




Corruption in Banking

The data for these findings include confidential and sensitive material elicited by TIB from retired public officials and managers. These so called "diagnostic reports" contain inside information and anecdotal evidence and give us insight into the nature and mechanism of corruption. A survey of consumers carried out by the TIB in 1998 provides corroborating evidence for the types of corruption suggested by the diagnostic reports. Of 620 households in the TIB survey of corruption in Bangladesh, 53 had taken out a bank loan and 30 of them used bribery or influence to secure the loan.

This study makes use of TIB's repository of publicly available information on corruption. TIB Internal reports generated by the research staff support the general nature of our findings. Research methods used by the staff include field interviews with public officials and the media and the construction and analysis of a database of newspaper articles on corruption in Bangladesh.

All forms of corruption involve the abuse of a public office for personal gain. These episodes may be either transactional or non-transactional. Transactional corruption involves a transaction between a public sector entity and a private sector entity. The act of corruption subverts this transaction for personal gain by one or both parties either in cash or in kind at the expense of society at large. Power vested in public officials is abused in subverting the transaction. Either party may initiate the subversion of the transaction. The transaction may be for a service that is withheld to extort bribes or for extra-legal considerations.

In non-transactional corruption public officials abuse the power of their office or the access to public resources available through their office for private gain. Non-transactional corruption may be either collusive or non-collusive. Non-collusive corruption is a form of embezzlement. The public official, alone or in concert with other public agencies, diverts public wealth to personal wealth. In the collusive form the public official, as a partner or shareholder, allows a private sector enterprise to raid public resources.

Bribery and influence are complementary and may be applied in tandem; the greater the influence the lower the bribery amount. In the limit, influence prevails without bribery and payments and gifts are given as tips and not as bribes. Influence is gained by way of political party affiliations, positions of power in the public or private sector, through friends and relatives in high places, or by virtue of sustained and mutually beneficial bribery relationships.

Non-cash bribes to bankers have included entertainment and gifts, all expense paid vacations for the family, payment of club bills, high-paying positions in the borrower's firm for the bankers or their family members, allotment of plots in housing development projects, houses or apartments, shares of the borrower's corporation, and offer of admission in schools or universities along with scholarships. A continuation of small gift-giving may be necessary for relationship maintenance and these may include color televisions, refrigerators, jewelry, and dinner parties. In general the acceptance of the gift implies the acceptance of the deal and it creates an expectation on the part of the giver and an obligation on the part of the taker.

Bribery may be driven both by the demand for bribes by government bureaucrats and by the supply of bribes provided primarily by large defaulting business conglomerates. Evidence in TIB diagnostic studies suggests that the supply side plays a significant role in bank corruption. Public officials involved in corruption may include bank managers, the MOF, the Prime Minister's Office (PMO), officials of BB, and members of the Standing Committee of Parliament on the Ministry of Finance. Private sector businesses including banks are the providers of bribes.

It should be noted that in our theoretical construction, insider loans by private banks to their own directors and NCB loans to failing state owned enterprises ordered by the MOF are imperfections in the financial infrastructure but not corruption. Numerous banking irregularities of this nature in Bangladesh underscore the need for banking reform. To this end anti-corruption measures are necessary but not sufficient.

Using our working definition we are able to identify distinct areas of corruption in the banking industry in Bangladesh. They are inferred from operating and financial data and supported by interviews with managers and a survey of consumers. They are described as:


    1. Dictation loans
    2. Fictitious loans
    3. Insider loans to government officials
    4. Diversion of interest payments
    5. Captive government deposits in government banks
    6. Use of bribery to facilitate loans
    7. Use of bribery or influence to subvert the loan approval process
    8. Labor union intervention in loans, procurement, and recruitment
    9. Sale of a forgivable loan
    10. Use of bribery or influence to obtain a "sick industry" classification
    11. Use of bribery or influence to re-schedule loans
    12. Use of influence to waive regulatory restrictions
    13. Use of influence or political power to forestall action on defaulted loans
    14. Bribe demanded by bank officials to release funds
    15. Bribery of external auditors by bank managers
    16. Bribery of BB officials by PCB managers
    17. Technical loopholes in bank regulation
    18. Diversion lf loans



Dictation Loans

In what has been termed a "dictation loan" the normal loan application review process is completely bypassed. Managers of the NCB and the DFI are simply ordered by MOF or higher authorities to make the loan. The amount of the loan is typically more than 100 million BDT. The loan applicant is typically financially powerful and politically well connected and possibly active in the hierarchy of the political party currently in power. Bangladesh law forbids the NCB from acting on behalf of the government but recognizes the power of the government to act on behalf of the NCB.

It is normally assumed by all parties involved that a dictation loan will not be repaid. These cases are described as "willful defaults". In willful defaults no portion of the principal or accrued interest is ever paid and the loans are typically not invested in productive assets. Some may even be converted to hard currency and moved overseas. More than a quarter of the loan defaults of the SOB fall in this category.

The bad loans may be shown on the books as performing assets by recognizing uncollected "interest due" as income and by repeated rescheduling. In some cases the accrued interest and even the principal amount may be forgiven and written off under laws that were designed to assist the private sector in specific cases of economic hardship.

This form of corruption occurs at the highest levels of government. The corrupt officials taking part include Ministers, members of parliament, and leaders of political parties. These officials are accessible only to a very powerful elite. The defaulters are able to maintain their position in the political hierarchy and remain immune to recourse by banks even after committing brazen acts of loan default.

Fictitious Loans

The fictitious loan scam is a form of embezzlement. Managers of state owned banks collude with other government officials to give loans to non-existent entities and then cause these loans to go into default. The GOB creates these opportunities when it sanctions loan disbursement targets for certain sectors. For example, BKB managers in collusion with the Hand Loom Board may invent weaver loans when disbursements for weaver loans falls short of the amount allocated by the GOB.

Insider Loans to Government Officials

Ministers, members of parliament, and other high-ranking government officials are able to take out default-able loans without scrutiny and with impunity from state owned banks by virtue of their position. Donors and not the GOB have been proactive in bank reform because government bureaucrats and elected officials along with their friends are themselves the defaulters. There is a collusive arrangement between them and a "defaulters' lobby" in Parliament.

Captive Deposits

Deposits of SOE and of government agencies such as WASA and DIT are held exclusively by state owned banks by an informal arrangement. These deposits fund corrupt loans that enrich government bureaucrats. Branch managers make substantial "gifts" to the official who holds the fund in order to attract these deposits. In this unusual form of corruption we actually have bribes being paid by one government official to another.

Diversion of Interest Payments

Not all the interest earned by government deposits in government banks is paid to the government agency that made the deposit. The government official in charge of making these deposits conspires with the bank manager to divert interest payments to personal accounts.

Use Of Bribery To Facilitate Loans

For commercial loans a payment of 1-5% of the loan amount to officials of the NCB or DFI can smooth the progress of loan approvals. A portion of the payment may be made at the time of application and the remainder is expected from the first installment of the loan. Bank managers have developed a sophisticated clearance and settlement system for exchange of bribery funds in cases where a manager is transferred before a bribery deal is consummated. The new manager collects the bribes but forwards a percentage to the originator and these cross payments are netted out and a single payment changes hands to close out the transfer accounting.

Even an ideal applicant with good credit and collateral and normal business financing needs but without connections may find it necessary to make a bribery payment. On the supply side the applicant may initiate the bribery transaction to expedite loan processing and to gain extra assurance of its speedy approval. On the demand side bank officials may place barriers to loan processing activities, find faults with the application material, or otherwise resist loan processing until a bribe is paid. The bribery amount in these cases is on the low end of the scale.

Bribery amounts vary in inverse proportion to political influence and the degree of creditworthiness. Minor flaws in the loan application or defects in valuation of collateral or in the credit worthiness of the applicant will normally increase the bribery amount. Specific bribery strategies may apply in extreme cases of non-compliance and these are described under a separate heading. The bribery amount may be decreased by developing a good relationship with the branch manager or by the use of political influence applied at a higher level.

The bribery amount for agricultural loans varies from 2-20%. The larger variation results from a greater cross-section of borrowers. Larger percentages are extorted from uneducated rural applicants. Also, the amount of the bribe for agricultural loans is generally higher than that for commercial loans because the bribe is usually shared with government officials that may be involved in the loan review process. They include the Thana Fisheries Officer, the Thana Livestock Officer, and the Thana BSCIC Officer. Bribes received by Thana level officers percolate up to District and higher levels and neutralize the monitoring function of the administrative hierarchy. ("BSCIC" is a government corporation that provides assistance to cottage industries.)

Use Of Bribery or Influence to Subvert the Loan Review Process

Specific defects in the loan application may be overcome with corresponding bribery strategies. For example, if collateral is insufficient bribery may be used to inflate collateral valuation. Over-invoicing for import financing and valuation of goods according to selling price instead of cost are common applications of this method. Bribery may facilitate the acceptance of uninsured assets as collateral where insurance is required or of photocopies of land title deeds in lieu of the original. In extreme cases, and for equally higher bribe amounts, the bribed banker accepts falsified collateral documents even when no collateral actually exists or accepts cheap imitations when jewelry is pledged.

Bribery also makes it possible for the borrower to use the same physical asset repeatedly as collateral for loans from several NCB. It is said that the same warehouse of goods with "four doors" is sufficient collateral for four loans against the entire warehouse of goods.

Bribery may be applied to falsify credit reports or to otherwise remove unfavorable information from the loan application. In the Lending Risk Analysis (LRA) procedure implemented by the FSRP bribery may be used to alter the input data to create a satisfactory credit rating of the borrower. Conversely, bank managers may alter LRA data to weaken a good credit rating and extort bribes. The LRA, which was introduced as an instrument of transparency, is potentially an efficient tool for bribery.

The bribery transaction normally takes place between the bank manager and the borrower. Influence with higher officials, when available, increases the probability of a successful deal and decreases the bribery amount.

Labor Union Intervention

Labor union leaders, in collusion with the ruling political party, have sufficient power to extort loans from bank managers. Their extortion power is available for sale. Labor leaders may be bribed to influence loan approval. Union leaders use their political power to intervene in other areas of managerial decisions. These include procurement, recruitment, retention, transfers, and promotion.

Sale of a Forgivable Loan

It is reported that rural branch managers of state owned banks charge as much as 50% of agricultural loans in exchange for a promise that the loan will eventually be forgiven by the government. No such forgiveness is actually offered in most cases but a special audit of Agricultural Credit by BB revealed more than 1.6 billion BDT of unauthorized remission of interest payments by branch managers. A local "corruption syndicate" is usually formed to perpetrate the scam. The syndicate may involve the Union Council Chairman, the police, and other local officials.

In a similar scam the farmer's signature or fingerprint is obtained on a loan by telling him that he has been selected for a government grant for an amount that is about 20% of the loan. The loan is quickly approved and the managers of the SOB remove the entire loan amount from the bank and release 20% of it to the farmer who will eventually be asked to repay the entire loan with interest against which he may have unwittingly pledged his assets as collateral.

"Sick Industry" Classification

The MOF and the Ministry of Industries cooperate to provide debt relief and other financing assistance to bail out failing firms in a specific industry that has been identified by the government as a "sick industry". Assistance may include waiver of interest, reduction in principal, repeated rescheduling of overdue loans, or combinations of these. A "sick industry" classification may be purchased with a suitable bribe to the appropriate ministry. Ministries, the PMO, and the Standing Committee of Parliament on Finance may be lobbied and bribed to obtain such a classification. Billions of BDT of NCB loans are written down using this technique.

Loan Re-Scheduling

When a loan becomes classified as a bad loan, all principal and accrued interest may be "paid off" with a new and larger loan if the defaulter deposits a "down payment" which is normally less than 10%. Once "re-scheduled" in this manner the loan is removed from its "classified" status since technically it has been repaid. The new loan made to the same borrower is considered to be a "performing asset", that is, a good and collectable loan generating a steady stream of payments. The transaction helps both defaulter and bank manager. The banker can report a larger portfolio of performing loans and possibly earn an incentive bonus and the borrower gains a temporary reprieve from default.

The defaulter initiates a re-scheduling by paying bribes to NCB managers or by applying influence at a higher level. The influence level and bribe amount are proportional to the amount in default, the number of prior rescheduling episodes, and whether BB is involved. BB does not allow defaulters to re-schedule more than twice. The bribery amount or influence needed for subsequent re-scheduling rises proportionately. There is at least one famous example of a re-scheduling against BB regulations that was made possible with influence from a parliamentary standing committee.

Re-scheduling of insider loans at private banks are internally handled and do not normally involve corruption of public officials unless BB is drawn into the process in a regulatory role. In that case the private bankers may need to make a suitable arrangement with BB officials. Alternately they may apply influence at the MOF to override the applicable BB rules.

Relaxation of Regulatory Restrictions

Many BB rules carry trivial fines and are therefore either not pursued or not contested. In all other cases influence with the MOF, the PMO, or the parliamentary standing committee on finance may be used to waive regulatory restrictions of BB. Cases where corruption is most likely to occur are those that involve restrictions on issuing new loans, classification and re-scheduling of existing loans, provisions for loan losses, bank capital and liquidity requirements, restrictions on insider loans at private banks, and the identification of problem banks by BB inspectors.

A typical case of this nature is initiated when BB proposes punitive action or prohibits new loans or loan rescheduling to a prominent defaulter. The defaulter then lobbies the management of the NCB, the MOF and even the parliamentary standing committee. If the appeal is successful a cease and desist order is sent to BB. The applicable regulations are waived and the matter is settled in favor of the defaulter. In some cases the defaulter is unable to garner universal support and the four government institutions involved, the NCB, the MOF, BB, and the parliamentary standing committee may take opposing sides in the issue.


Funds Withheld

In what appears to be a purely demand side phenomenon, bank managers delay the release of installments on a loan that has already been approved until a satisfactory bribe arrangement has been made.

Bribery of External Auditors and Bank Inspectors

Bank managers may bribe external auditors to hide irregularities in the record and to ensure a favorable audit report. Altering entries for loan classification and the provision for loan losses may hide loan defaults. Bank performance may be exaggerated by showing interest income flowing from defaulted loans or by hiding expenses. Job security, promotion, and incentive bonuses for managers depend on good audit reports.

BB inspectors may be coerced not to question the data submitted to them by the internal bank inspectors or influence may be applied to ensure favorable inspection reports. State owned banks are inspected but are protected from "problem bank" classification by informal policy. However, the punitive action taken by BB in cases of non-compliance is insufficient in most cases to present significant corruption opportunities.

Bribery of BB Officials by PCB Managers

PCB managers may coerce the cooperation of senior officials of the MOF and BB with gifts, bribes, and the offer of lucrative private sector jobs. This method may be used to gain regulatory forbearance with respect to required liquidity, bank capital, loan classification, provision for loan losses, accounting standards, guidelines for insider loans, and exposure of the loan portfolio due to non-diversification.

Technical Loopholes in Bank Regulation

BB guidelines that limit single borrower exposure and insider loans have loopholes. For example, a single borrower loan of ten billion taka may be shown as a diversified portfolio of ten loans of one billion each to firms that exist only on paper and only for the purpose of processing the loan. The technique of loan fragmentation may also be used to get around loan approval limits at each managerial level. Directors of different PCB may "exchange" ownership of insider loans to circumvent restrictions on insider loans.

Diversion of Loans

Willful defaults are related to a well-organized loan diversion scam. NCB managers, the MOF, members of parliament, and even parliamentary standing committees may become party to the conspiracy in exchange for an appropriate payoff or gift. A term loan is taken against what appears to be a legitimate project but is actually a worthless shell. The proceeds from the loan are diverted to overseas banks or to illegal business activities such as smuggling. The project itself is a loser by design. The borrower defaults on the loan and gives up the assets of the dummy project to the bank, which is able to recover only a small portion of the amount in default. Ironically, the actual investment made in the smuggling business with the bank’s funds may be very profitable but these profits are well beyond the reach of the bank.


A Theoretical Framework for Corruption in Banking

In 1999, the average interest paid by bankers to savers in Bangladesh was 7%. With the average interest charged on loans at 14%, the interest rate spread was a staggering 7%, well above the 1% to 2% found in economies with well-designed banking systems.

The capital removed from the system by corruption is an economic loss in that it was not invested in profitable new projects and therefore did not generate new wealth for the economy. What’s worse, the loss to bankers is made up by higher cost of capital to good businesses that do invest in profitable projects and the higher cost of capital borne by these businesses decreases their ability to create wealth. At the same time bankers are forced to increase their spread to cope with the heightened risk of lending. The result is an inefficient capital market and lost economic wealth.

Banks create money when they make loans and the business borrowers generate wealth when they invest the funds in profitable productive assets. When business loans are diverted for personal use the increase in money is not matched by new production. Loan defaults can cause inflation.

Bangladesh has been able to endure a high cost of capital imposed on it by a corrupt banking system because of an abundance of profitable projects in which entrepreneurs may invest. It is generally true of emerging economies that projects with very high internal rates of return are available to business. The economy is able to grow even at a high cost of capital. For continued economic growth, however, the country will need to lower the cost of capital and it cannot do that and continue to absorb frictional losses of the magnitude being imposed on it by a corrupt and inefficient banking system.

We model these losses as agency costs and relate these costs to weaknesses in the architecture of capital markets in Bangladesh. High agency costs in the banking sector may be ascribed to poorly developed securities markets, poorly managed banks, conflicts of interest at the MOF which is simultaneously a banker and bank regulator, a weak and politicized central bank that is charged with bank supervision and examination, and a cultural primacy of personal connections over objective procedure. The influence of the MOF and the parliamentary standing committee on finance rises above the law and this power is a source of corruption in banking.

Agency Theory And The Moral Hazard Of Banking

Bankers are creditors to corporations. Corporations are imperfect agents of banks. They are charged with investing debt funds in profitable low risk projects. Banks incur agency costs in this relationship because the debtor can view the loan as a call option to buy the firm. The option will be exercised, and the loan repaid, if the firm is worth more than the loan. Otherwise it is optimal for the corporation to default. The riskier the project the greater is the value of debt funding to shareholders because the option contract limits their downside exposure while they benefit from the upside potential of risk. Therefore firms tend to seek debt funding for risky projects and this tendency imposes an agency cost on banking because those more likely to default are more likely to seek loans. This conflict is an imperfection that interferes with the capital allocation function of banking.

Well-designed banking systems are able to reduce these costs by qualifying the borrowers and by careful selection and diversification of project risk. Additional discipline may be enforced by a debt contract that limits the firm's ability to make decisions that would be detrimental to the bank. This agency cost increases the interest rate on loans and therefore the cost of capital to firms. Successful monitoring and discipline reduces the cost of capital.

On the other side of the ledger, bankers are imperfect agents of depositors as custodians of their savings. Bank depositors seek safety and liquidity of their savings while banks seek to maximize earnings from investing. Conflicts arise because maintaining liquidity is costly to banks in terms of lost earnings. Also, bankers want to leverage their equity with deposits while depositors want to be protected from bank failures by a large cushion of bank capital. This conflict is an imperfection that interferes with the capital formation function of banking. The demand for deposit liquidity and bank capital limits the rate of interest conservative bankers can pay to savers and attract deposits. Likewise, aggressive banking that results in bank failures increases the perceived riskiness of bank deposits and retards capital formation.

Monitoring and discipline may be used to reduce these agency costs. Regulators, acting on behalf of depositors, may impose and enforce minimum bank capital and liquidity standards as well as deposit insurance. Market forces also work to reward good managers that are able to balance risk and return and attract deposits. Banks, borrowers, and depositors rely on a financial and regulatory infrastructure that disciplines borrowers' use of debt funds and bankers' use of deposits. An infrastructure that is defective or corrupt produces a sub-optimal banking system.

Personal connections and relationship building are important in the socio-cultural makeup of Bangladesh and consistent with the observed modes of corruption. Connection networks are normally large and operational contacts may be more than one node removed. Membership in the network is informal but it implies an obligation to help and more so to reciprocate.

For example, to buy a train ticket, one may call a contact at the railway department rather than take a trip to the station even when no irregularity in the transaction is sought. However, the connection approach offers a greater opportunity for corruption. Individuals with contacts in the railway department are more likely to take the train and less likely to be bound by normal railway procedures; and those with connections in banking are more likely to take out loans and less likely to repay them.

In this cultural context, rules and procedures apply to the unprivileged and differentiate the privileged. At NCB branches the unprivileged queue at teller windows while the privileged sip tea in the manager's office as clerks scurry to complete their transaction. Obligations to the connection network interfere with the agency roles of elected officials and government bureaucrats and increase moral hazard, adverse selection, and agency costs. Agency costs are higher when banking and regulatory systems are designed with incompatible cultural assumptions.

Bank managers of state owned banks are accountable to the MOF, which is at once the only shareholder and the primary debt-holder. Thus no agency conflict can exist among shareholders, debt-holders, and managers in the manner of a publicly held private sector corporation. But agency problems do exist; and they arise from external sources.

The MOF is an agent of the people, an agent of the political party in power, and also an agent of connection networks. Connection networks exert the most discipline and therefore suffer the least agency cost while the people exert the least discipline, suffer the highest agency cost, and incur the highest monitoring costs.

It is difficult for the people to monitor the MOF because the regulatory structure does not contain sufficiently independent instruments of discipline. Bank supervision and examination are carried out by BB which is itself an agent of the MOF and of the same political party. Members of parliament, the Bureau of Anti-Corruption, the Judiciary, and the Police, that might have served as monitoring devices for the people are also agents of the political party that controls MOF and they have their own connection clients. The parliament's Standing Committee on Finance is the people's oversight agent that is supposed to discipline the MOF but it too is subject to stronger agency relationships to political parties and connection networks.

The people therefore rely on monitoring devices that are external to the government. The media provides a certain amount of monitoring but the only real discipline has come from donors, particularly the World Bank. These extra-governmental agencies have pressed for and implemented the only accountability and transparency measures that have ever been adopted.

The inability of the GOB to run banks is related to its other business interests. In addition to banks, the GOB also owns and operates textile mills, sugar mills, steel mills, utilities, hotels, road and river transport businesses, an airline, a railroad, an oil refinery, and other ventures none of which is profitable. Their losses, estimated to be in excess of a billion USD, are financed by the GOB's own banks.

The people's ability to monitor banks can be improved if the GOB gets out of the banking business and concentrates on setting policy and designing and enforcing appropriate regulation. Ideally the type of regulation implemented would be culturally relevant and designed specifically to control loopholes and bribery opportunities. Insider loans to bank directors is a loophole that is tolerated to improve board quality but the theoretical loss in board quality of private banks would probably be an acceptable monitoring cost for society. The people must have access to a monitoring device with which to discipline banks and bank regulators within the context of the agency matrix described. Reduction in allowable discretion of public offices subject to large agency costs may result in sub-optimal decisions in many cases but it may be optimal for the people to absorb these as monitoring costs.

The degree of imperfection in agency is a societal characteristic and possibly related to cultural variables. The form and degree of regulation that is appropriate for a given society is therefore a function of the same cultural variables. The degree of regulation must be optimized in bribery economies because regulation itself breeds corruption by creating bribery opportunities. The cost of excess regulation is higher in the presence of corruption than otherwise.

The Corruption Premium of the Interest Rate

Corruption increases the risk of lending and thereby increases the risk premium of the interest rate to all borrowers. We may term the increase in the risk premium that is due to corruption as a "corruption premium". The corruption premium is a direct measure of the impact of corruption on banking. The corruption premium retards economic growth and increases poverty. The key linkage is the cost of capital. As the corruption premium rises so does the cost of capital to corporations which must compensate for the increase by not investing in marginal projects, by raising prices, or by lowering wages, or by a combination of these. Corruption in banking impacts all economic actors even if they are not directly involved in banking.

Very few Bangladeshis have bank accounts and fewer yet have credit or debit cards. Businesses do not accept checks and the handful that accept credit cards cater mostly to foreigners. The vast majority of the citizens have never taken out a bank loan nor enjoyed any form of credit that would show up as economic data. The securities industry is even more exclusive and caters only to a very select club of urban investors and entrepreneurs.

The economy is primarily a cash economy. Most citizens get paid in cash and make all their purchases in cash. They save what they can in cash or jewelry and invest what they can in cattle or land for which they pay in cash or kind. The vast hinterland remains mostly untouched by the formal financial infrastructure and hidden from the macro economic figures and statistics we use to characterize the country. Therefore, it would appear, that citizens of this economy would be immune to bank corruption.

But Bangladesh is also characterized by extreme concentration of wealth. The banks deal with a larger percentage of the wealth than would be apparent from the small percentage of the population that uses banks. The business activities of the very wealthy affect a large cross section of the people. For example, a transport business may use a bank loan to finance a bus. The interest rate on the loan may contain 5 percentage points of corruption premium. The higher loan payments due to the corruption premium will make it necessary for the bus company to charge higher fares or pay lower salaries or both. An individual from the cash economy hinterland who has nothing to do with banking ends up paying more for transport because of corruption in banking.

In fact, because of the corruption premium there will be fewer transport businesses and fewer buses. In general there will be a lower level of business activity and a lower level of wealth generation by entrepreneurs. Therefore there will be fewer goods and services and at higher prices. Likewise, there will be fewer jobs and at lower wages. The common workingman ends up paying for corruption in terms of lost wages and higher prices.

Corruption is a wealth transfer engine that moves wealth from the poor to the rich and distorts income distribution. There is a non-linear relationship between corruption and income distribution. Distortions in income distribution cause corruption and corruption causes distortions in income distribution.

Risk-based lending may be used as an antidote to lessen the burden of corruption on the common citizen and the poor. The innovation may also act as an anti-corruption mechanism by increasing the cost of rent seeking.