Fazlur Rahman: Bangladesh’s financial system is currently under unprecedented strain. The banking sector is facing significant distress, and as a result, the money market has become largely short-term in orientation. Over time, the capital market has also weakened and become disconnected from the real economy.
As of 2025, a combination of high non-performing loans (NPLs), liquidity shortages, declining investor confidence, and erosion of public trust is threatening the core stability of the financial sector. In this context, the capital market is no longer a parallel or optional avenue—it must now assume a central role in economic repair and structural reform.
This paper proposes a strategy focused on market-based solutions—specifically, the use of long-term bonds and convertible instruments issued through the capital market—to recapitalize vulnerable banks, especially those burdened with illiquid deposits caused by NPL-induced shortfalls.
State of the Banking Sector: Fragile and Overburdened
• Officially reported NPLs exceed 20%, but independent studies suggest actual rates are above 70% in some banks.
• Capital adequacy ratios have fallen significantly below Basel thresholds for several institutions. Profitability is under immense pressure due to rising costs and increased provisioning requirements.
• Depositor confidence—particularly in private and specialized banks—is weakening due to delayed withdrawals, lack of transparency, and negative media coverage.
• Bangladesh Bank’s ability to inject liquidity via repo or refinance lines is limited, given inflationary pressures and declining foreign reserves.
The Role of Capital Market Instruments in Bank Recapitalization
1. Long-Term Deposit-Backed Bonds to Replace Illiquid Deposits
Proposed Mechanism:
• Banks may issue “Deposit Compensation Bonds” or “Loss Absorption Bonds” through the BSEC, under special regulatory exemptions.
• These bonds would be offered to depositors, particularly those whose funds are trapped due to NPL-related illiquidity.
• Bonds may carry a maturity of 5–10 years, offer fixed or inflation-indexed returns, and remain non-redeemable before maturity (except in emergencies).
• Listing these bonds on the DSE would provide optional secondary market liquidity.
Benefits:
• Alleviates immediate withdrawal pressure and prevents bank runs.
• Converts unstable, short-term liabilities into structured, long-term funding.
• Improves Liquidity Coverage Ratio (LCR) and lowers cost of funds for banks.
2. Convertible Bonds to Strengthen Capital Base and Governance
Banks can issue convertible bonds—hybrid instruments that begin as debt and convert into equity if triggered by specific conditions such as:
• Capital levels falling below a set threshold;
• Negative profitability for two consecutive years;
• Failure in regulatory stress testing.
Conversion Scenario:
• Bondholders (including depositors or institutional investors) would receive shares, thereby becoming equity stakeholders.
• Over time, this would dilute concentrated ownership, enhance governance diversity, and encourage better risk management practices.
Precedent:
• Basel III-compliant Additional Tier 1 (AT1) Bonds or Contingent Convertible Bonds (CoCos) are successfully used in Europe and India.
Strategic Advantages for Bangladesh
Capital infusion– Enables banks to meet Basel III capital requirements without government bailouts.
Deposit Management– Converts high-risk deposits into structured long-term liabilities.
Market Discipline– Equity conversion encourages transparency and board-level reform.
Liquidity Relief– Eases withdrawal pressure and restores depositor confidence.
Secondary Market Depth- Listed bonds expand the capital market and create pricing benchmarks.
Regulatory and Implementation Considerations
A coordinated framework is essential, involving Bangladesh Bank, BSEC, and the Ministry of Finance:
A. Regulatory Enablement
• Amend the Bank Company Act and BSEC Act to allow deposit-backed bonds and conditional convertibles.
• Introduce fast-track issuance and listing procedures tailored for banking instruments.
B. Investor Protection
• Ensure robust disclosures, independent valuations of conversion terms, and enforce listing compliance.
• Establish a Bondholder Protection Trust to safeguard retail investor interests.
C. Incentives
• Provide tax incentives on bond yields.
• Allow banks to treat these instruments as Tier 1 or Tier 2 capital, depending on structure.
D. Pilot Program
• Launch with state-owned or high-risk banks under a supervised pilot model.
• Use early success to attract private capital and institutional investment.
Capital Market Synergy: From Reactive Fix to Proactive Reform
This approach elevates the capital market from a passive bystander to an active driver of economic stability. With innovation and discipline, the capital market can serve as a strategic policy tool to:
• Recapitalize banks without overwhelming the national budget;
• Mobilize long-term domestic savings from households and institutions;
• Enhance market depth through hybrid instruments;
• Restore public trust in the formal financial system.
Conclusion: A New Financial Architecture for Bangladesh
The current banking crisis in Bangladesh cannot be resolved through bailouts, moral persuasion, or liquidity injections alone. Structural, market-based solutions are necessary to create a resilient and transparent financial system.
Capital market instruments—particularly long-term deposit-backed and equity-convertible bonds—offer a viable path to recapitalize banks, protect depositors, and reduce the fiscal burden.
If implemented boldly and managed prudently, this model could position Bangladesh as a regional leader in financial innovation, regulatory reform, and sustainable market development.
