Southeast University

Banani, Dhaka

Assignment on Recent Liquidity Crisis of Commercial Banks In Bangladesh

Course: Financial Markets & Institutions Course Code: FIN6143 Submitted to:
Raad Mozib Lalon
Course Instructor School of Business Studies Southeast University

Submitted by:
Ali Haider Mohammadullah ID: 2011110004048 Md. Abu Zafar Rony ID: 2011110004061 Azmul Huda Rubel ID: 2011110004057 Md. Emrul Alam Chowdhury ID: 2011110004055

Date of Submission: 10th September, 2012

1.

INTRODUCTION

Liquidity is a financial term that means the amount of capital that is available for investment. Today, most of this capital is credit, not cash. That's because the large financial institutions that do most investments prefer using borrowed money. High liquidity means there is a lot of capital because interest rates are low, and so capital is easily available. Interest rates are so important in controlling liquidity. These rates really dictate how expensive it is to borrow. Low interest rates mean credit is cheap, so businesses and investors are more likely to borrow. The return on investment only has to be higher than the interest rate, so more investments look good. In this way, high liquidity spurs economic growth. However, a liquidity glut can develop if there is really too much capital looking for too few investments. This is usually a precursor to inflation. As cheap money chases fewer and fewer good ventures-- or houses, or gold, or barrels of oil, or high tech companies -- then the prices of those assets increase. This leads to "irrational exuberance. "Eventually, a liquidity glut means more of this capital becomes invested in bad projects. As the ventures go defunct and don't pay out their promised return, investors are left holding worthless assets. Panic ensues, resulting in a withdrawal of investment money. Prices plummet, as investors scramble madly to sell. This is what happened with mortgage-backed securities during the 2007 Banking Liquidity Crisis. This phase of the business cycle, known as contraction, usually leads to a recession.

2.

ORIGIN OF LIQUIDITY CRISIS

In financial economics, liquidity is a catch-all term that may refer to several different yet closely related concepts. Among other things, it may refer to Asset Market liquidity (the ease with which an asset can be converted into a liquid medium e.g. cash); Funding liquidity (the ease with which borrowers can obtain external funding) Balance Sheet or Accounting liquidity (the health of an institutions balance sheet measured in terms of its cash-like assets). Additionally, some economists define a market to be liquid if it can absorb liquidity - trades (sale of securities by investors to meet sudden needs for cash) without large changes in price. Liquidity Crisis refers to drying up of liquidity, which could reflect a fall in asset prices below their long run fundamental price; or deterioration in external financing conditions; or a reduction in the number of market participants or simply difficulty in trading assets. A negative financial situation characterized by a lack of cash flow. For a single business, a liquidity crisis occurs when the otherwise solvent business does not have the liquid assets (i.e., cash) necessary to meet its short-term obligations, such as repaying its loans, paying its bills and paying its employees. If the liquidity crisis is not solved, the company must declare bankruptcy. An insolvent business can also have a liquidity crisis, but in this case, restoring cash flow will not prevent the business's ultimate bankruptcy. For the economy as a whole, a liquidity crisis means that the two main sources of liquidity in the economy, banks and the commercial paper market, severely reduce the number of loans they make or stop making loans altogether. Because so many companies rely on these loans to meet their short-term obligations, this lack of lending has a ripple effect throughout the economy, causing liquidity crises at a plethora of individual companies, which in turn affects individuals.

3.

MAJOR CAUSES OF LIQUIDITY CRISIS

Liquidity refers to the supply of the means of payments of an economy. In Bangladesh the totality of liquidity is indicated by what is called broad money. A shortage of money restricts demand by making it more difficult to engage in transactions. Investments are particularly susceptible to liquidity, now the main causes of liquidity crisis of banking sector are given below: a) In the recent year, our country has experienced a decline in the value of Tk against US currency which has created has huge liquidity crisis in the banking sector. For this reason our country has failed to collect maximum amount of US dollar required to open letter of credit (LC) for local businessmen to import essential commodities for the country. As a result the importer is facing a severe crisis in their business. The banks need to reserve huge amount of money with the Bangladesh Bank as it is mandatory for them to maintain the CRR and SLR. BB has recently increased the rate of CRR and SLR as a result the problem of liquidity crisis has been aggravated recently. The central bank during last December raised the cash reserve requirement (CRR) by six percent for commercial bank. As the increased percentage of CRR and SLR the commercial bank is facing liquidity problem and for this reason to get rid of the problem this banks are concentrated to generate more deposits. To generate more deposits they have to increase the deposit rate which has an adverse effect in the society Government credit from banking sector that would create extra burden to the countrys banking sector and it creates more liquidity crisis in that sector. the government has already borrowed Tk 110 billion from the countrys banking sector to meet the existing budget deficit during last 10months (July 2010 to April 2011), while last year it repaid Tk 87.92 billion loans. In the recent future the commercial banks will be unable to provide loan to the private sector. If the bankers do not abide by the norms of the central bank and lend out money injudiciously, there arises the problem with liquidity. The abnormal long-term finance and unsatisfactory recovery position of short-, mediumand long-term loans will adversely affect the liquidity situation. The reason of liquidity crisis, if any persisting in the financial sector may be the nonrecovery of loans. The overall percentage of recovery of loan is very alarming. By now the state-owned banks have taken many steps to recover their old loans but could not show any improvement. The state-owned public limited companies should give due consideration to waiver of interest. But the businessmen or traders who failed to repay loans due to various reasons cannot afford to bear the burden of huge interest and suit costs. In yearly period, the commercial banks perform activities of investment banks, and for investment banks to also perform activities of commercial banks (i.e. to borrow short and

b)

c)

d)

e)

f)

g)

h)

to lend long). As a result there is a combination problem of liquidity risk and credit risk and the problem becomes more uncontrollable and severe. i) Relationship of liquidity with the reserve and call money rate: Excess reserve with Bangladesh Bank has been decreased by BDT70 billion in first six months, indicating an active money market.

4.

STEPS TAKEN BY GOVT./BANGLADESH BANK TO RESOLVE THIS PROBLEM

a) Steps taken by Government: The central bank made the deposit insurance mandatory to protect the depositors interests in case if the banks were in trouble like going for liquidation. The central bank though repurchase agreement (repo) is infusing sufficient currency in the money market every day. The central bank injected cash into banks through using Repo (one of two vital instruments to control money supply) to help banks avoid deterioration in liquidity status. Steps Taken by Bangladesh Bank:

b)

In recent years Bangladesh Bank has taken several innovative steps such as inclusive banking, loans to sharecroppers, bank accounts for farmers, solar power and environmental awareness etc. These are no doubt all highly laudable measures; however, they must not be viewed as either substitutes of, or as important as, the core functions of the central bank. It should be

understood that there are other government agencies mandated and better suited to address these issues, but there is none to control the money market, which is exclusively the mandate of Bangladesh Bank. Every additional objective in general requires an additional policy instrument and additional resources to achieve. Bangladesh Bank should take a close look at its strategy and assess what it can realistically achieve given its limited resources. At present CRR ratio is 6% and SLR is 18.5% for all scheduled commercial banks of Bangladesh. If Bangladesh Bank decreases the CRR and SLR then banks will get a huge amount of money which will help to solve the liquidity crisis many part. At last we can say that positive role of Bangladesh Bank, calculative measure of all other banks and a strong bond market can solve the current liquidity crisis in Bangladesh.

5.

STEPS TAKEN BY COMMERCIAL BANKS TO RESOLVE THIS PROBLEM

The Commercial banks have recently launched fund-collection campaigns by offering new saving schemes with higher interest rates in a bid to tackle the prevailing liquidity crisis. They are offering higher interest rates to lure people to keep their savings in the banks. Funds are needed to ward off liquidity crisis the banks are currently facing. A collapse of the countrys capital market has also pushed the banks to go for collecting more deposits. Prime Bank recently offered two fixed deposit schemes-Lakhpoti deposit scheme and Prime millionaire scheme with interest rate ranging up to 13.50 per cent. The bank has also launched a double benefit scheme, which offers double the amount of saving after six years. The new deposit schemes introduced by Standard Bank are Standard Bank regular income programme, three yearly programme, double income plus programme, which offers to return double the amount of saving of five or 10 lakh taka after six years, Lakhpoti Plusof two- to 10-year terms, and Millionaire programme of three- to 13-year terms. Shahjalal Islami Bank has introduced double income scheme, which offers to return double the amount of saving after six years. The bank has also rescheduled its 12existing deposit products by increasing the interest rates to a maximum of 14 percent. BRAC Bank introduced SME fixed deposit scheme in April, which offers payment of interest after three and six months. Eastern Bank launched a new deposit scheme named SME Equity Builder in April, offering to provide monthly interest on the savings amount. NCC Bank has introduced double money scheme, offering a return double the savings amount after six years, special savings scheme of five- or 10-year term with higher interest, and Special Amanat scheme of 3-year tenure, which will provide Tk 1,000 as profit for Tk 1 lakh deposit.

6.

CONCLUSION

Liquidity has become a controversial public issue in recent months. Commercial banks claim that they are suffering from severe liquidity crunch. Business people, especially those associated with the stock market, echo the same view. The central bank of the country (Bangladesh Bank), on the other hand insists that there is no shortage of liquidity in the economy. There is little doubt that poor portfolio management by the commercial banks led to their liquidity crisis. However, the crisis was in the making for more than a year. As the supervisory body of the commercial banks, Bangladesh Bank should have acted sooner to prevent the liquidity crisis from developing and spilling over to the stock market. The timing of the Bangladesh Bank action was also inopportune coming as it did at the year-end closing time of the banks. The crisis underscores the soundness of the old wisdom that central banks should in general avoid tinkering with such blunt instruments as the reserve ratio to achieve their short term policy objectives. Any hike in the reserve ratio impacts more on the weaker banks or banks with liquidity shortages, which may quickly turn an adverse but manageable liquidity position into a crisis situation.

REFERENCES:
http://www.investopedia.com/terms/l/Liquidity-Crisis.asp#axzz25n4ckKz7 http://en.wikipedia.org/wiki/Liquidity_crisis http://opinion.bdnews24.com/2011/04/27/liquidity-is-there-a-shortage/ http://www.scribd.com/doc/99824679/Financial-Institution-Assignment