Importance of Financial Sector for Enabling Investment

The financial sector is important for various purposes but here we discuss Importance of Financial Sector for enabling Investment and Mobilizing Savings.

What is the financial sector?

At the beginning of this chapter, were said that the financial services were an important part of the formal series sector. The financial sector plays a critical role in enhancing economic growth.

The financial sector consists of banks, lending institutions, stock markets and other institutions through which savers and investors can channel funds to borrowers who directly invest in productive enterprises.

Importance of Financial Sector

An efficient financial second is important for ensuring that potentially profitable projects are able to find funds for development at the lowest possible cost. To remain efficient, the financial sector has to be able to monitor those who borrow funds and make sure that loans are not wasted in bad investments.

If funds that are made available for investment are wasted and not repaid, other investors will have to pay the proceed by having to pay higher interest rates or funds that for further investments or loans may dry up altogether.

This requires that the financial sector should be able to monitor borrowers/investors on a continuous basis, thereby ensuring that resources are always directed to the most productive and efficient borrowers and the less efficient are forced to return funds or pay bank their loans before they default.

Importance of Financial Sector for Enabling Investment

Importance of Financial Sector for Enabling Investment

How can the financial sector be efficient?

The financial sector can only perform these function if financial institutions have the backing of the state to enforce the repayment of loans or the change of management if a performance of the borrowing enterprise is poor.

To ensure that the legal framework protecting banks and stock market investors can be enforced, the state has to have good regulatory structures in the financial sector so that the state can support financial institutions when they try to monitor and recover their investments if the performance of the borrower is poor.

This requires good courts and procedures through which money can be recovered from poorly performing borrowers. But these procedures also have to be fair and transparent so that borrowers do not feel that an injustice has been done if the bank decides to take action to recover their investments from a poorly performing borrower or if stock market investors try to change the management of a poorly performing company.

The weakness of the Bangladeshi financial system has a lot to do with the inability of financial institutions to enforce the laws protection their investments because of a weak state capacity to enforce the implementation of these laws.

Who is the financial sector in Bangladesh?

The financial system of Bangladesh consists of:

  • The Bangladesh Bank as the central bank, which has the task of regulating the banking sector and lending to other banks if they need short-term loans.
  • 4 nationalized commercial banks (NCB)
  • 5 government-owned specialized banks dealing with agriculture and industry
  • 30 domestic private banks
  • 10 foreign banks
  • 28 non-bank financial institutions

The financial system also embraces insurance companies, stock exchanges (including the Dhaka Stock Exchange (DSE) and co-operative banks.

Source: Banglapedia, Asiatic Society of Bangladesh

Issues (Bad debt)

In 1993, the four nationalized commercial banks dominated the banking system with 63% of total deposits (savings) and 53% of total advances (loans). However, the nationalized banks ran into increasing problems in the 1980s and 1990s because they could not enforce the repayment of money by bad borrowers.

Much of their lending was to enterprises that subsequently did not perform well, but the banks found that they could not rely on the support of this estate to try and recover their loans.

The “bad debts” of the banking system increased rapidly, and Bangladesh is currently facing a serious problem where many of the public sector banks have between a quarter and a third of their loans classified as “non-performing”, which means that the chances of being paid interest on these loans or getting the money back are very low.

The consequence of this has been that banks have become increasingly wary of lending to industrial enterprises for the loan term and this has serious consequences for new enterprises trying to raise money for investment.

Increase in commercial banks and focus on consumer credit

Another consequence has been that the public sector banks have shrunk in terms of their overall business, and the number of commercial banks is rapidly increasing as the private sector is setting up new banks.

The private sector banks are less interested in long-term lending to the industry because they know that they may find it difficult to recover this money given the weak regulatory structure. Instead, the private sector banks have concentrated on lending money for consumer credit (to borrowers who want to buy consumer goods or houses) rather than to industry.

Difficulties for industry

The weakness of the nationalized banks and the different emphasis of the private sector banks has meant that industrial enterprises have found it hard to raise as easily as they could twenty or thirty years ago, and this is one of the shortcomings in the banking sector in Bangladesh.

While the Dhaka Stock Exchange has also grown over this period, it has not been a major source of funding for new enterprises. This is because the stock market is primarily a market for buying and selling shares in existing firm’s rather than raising money for new investments.

Thus, the future of industrial development in Bangladesh depends on whether reforms in the banking sector can be achieved that will enable banks to lend more confidently to manufacturing and industrial enterprises.

Micro-credit

A significant banking innovation in Bangladesh has been the Grameen Bank. The Grameen Bank lends relatively small amounts of money to mainly very poor people, particularly women, and this is why this form of banking is known as micro-credit.

How does it work?

The secret of the Grameen Bank’s success is that has much higher repayment rates of loans than the commercial banks or nationalized banks despite lending to the poorest people in Bangladesh.

It is able to enjoy high repayment rates because instead of lending to an individual, the Grameen Bank first sets up a group of people who collectively guarantee the loan, no-one else in the group will get a loan, so the group has a collective interest in making sure that each individual repays their loans on time.

The Grameen Bank has scored significant successes in making loans available to very poor people to set up small business activities like raising chickens or goats or buying a rickshaw, which has enabled many poor people to escape from poverty.

Why can’t this successful model be used for bigger businesses?

On the other hand, the Grameen Bank model is difficult to replicate for borrowers of big sums of money because if a number of very rich people form a group and collectively guarantee the loans of each individual in the group, it will still be very difficult for the group to ensure that every individual repays.

This is because richer people in Bangladesh and in other countries are able to escape more easily and it is difficult for their friends to ensure that they will actually repay. This explains why the Grameen Bank model has not been scaled up to address the problems of lending to the industrial sector that we discussed earlier.

As a result, the Grameen Bank model is appropriate for dealing with the credit requirements of relatively poorer people, but the credit needs of the industrial and manufacturing sector will have to be dealt with through reforms of the conventional banking system.

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