CORRUPTION IN BANKING: A CASE STUDY

Jamal Munshi, Transparency International, 1999

All rights reserved
Introduction
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
All banks must register with and be chartered by a MOF committee and BB.
2. Liquidity requirements
Banks must hold 20% of demand and time deposits as cash and marketable
securities.
3. Capital requirements
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.
4. Safety net for depositors
BB provides deposit insurance for deposits up to 100,000 BDT per account at an
insurance premium of 5 basis points per annum.
5. Disclosure of financial condition
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.
6. Bank examination
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.
7. Interest rate restrictions
Restrictions contained in the Companies Act are being phased out by the FSRP
8. Loan classification and provision for loan losses
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.
9. 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
NCB DFI PCB FCB
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 banks 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.
Whats 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