Project Proposal

on

Nexus among Bank Competition, Efficiency, and Financial Stability:

A Comprehensive Study in Bangladesh

Project Code:

Submitted To:

The Director

SUST Research Centre

Shahjalal University of Science and Technology

Submitted By:

(Dr. Syed Mohammad KhaledRahman)

Associate Professor
Department of Business Administration
and

Mohammad Ashraful Ferdous Chowdhury

Assistant Professor
Department of Business Administration

Shahjalal University of Science and Technology Sylhet.

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1. Project title:

Nexus among Bank Competition, Efficiency, and Financial Stability: A Comprehensive

Study in Bangladesh

2. Type of research: Empirical

3. Field of research: Business

4. Background of the study and Statement of the problem:

The nexus between Bank competition and financial stability is one of the most debatable
issues in the banking literature (Kabir & Worthington 2017, Beck et al., 2010). Theoretically,
competition can enhance the quality of the services, efficiency and finally improves the
financial stability of the country (Fiordelisi & Mare, 2014). However, the empirical studies
are not straightforward. Some of the previous studies found that bank competition increase
volatilities in the soundness of banking sector through excessive risk. For example, OECD
(2010) reports that the Competition has been accused as a major barrier for the soundness of
the banking sector of a country. Too much competition in the banking sector can increase the
probability of default though non-performing loans and also the financial soundness
(measured as z-score). The soundness of banking sector is undoubtedly important for any
country. Nevertheless, the significance and importance of soundness is highly important
when the economy of the country is highly bank driven. As the economy of Bangladesh is
highly bank driven, it is highly important to examine how the bank competition effects on the
financial stability.

In Bangladesh, The two important indicators of financial stabilities: Non-performing

loan (NPL) and Z-score are showing very unhealthy situation 1. The performance of NPL has
become a major concern for the regulators, investors, and policy makers. According to the
latest report Bangladesh Bank data, NPL of banking industry surpass one lac crore taka and it
stood at Tk. 1, 10, 873 crore out of total disbursed loan of Tk. 9, 33, 727 crore up to March,
2019. The amount bad and worthless loan stood at approximately Tk. 37, 000 crore in March
2019. In the previous year NPL was Tk. 93911 crore and in year 2017 it was Tk. 74303 crore
(Prothom Alo, 11/06/2019). In terms of proportion of total loan, NPL ratio was 11.87% in
March 2019, it stood at 9.31% in December 2017, 10.67% in September 2017, 10.13% in
June 2017, and 10.53% in March 2017. In 2016, the NPL ratio was 9.23% in December,
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Z score refers the financial soundness of the banking sector. Higher values reflect higher stability in the
banking sector

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10.34% in September, 10.06% in June and 9.92% in March. The year-end NPL ratio was
8.79% in 2015. It is observed that the NPL ratio is growing with the passage of time
(Chowdhury, 2018).

On the other hand, the Z-score of the banking sector is performing low. For example,
the z score of the banking industry of Bangladesh was 15.69 in 1996 where as the latest Z
score after the financial year 2016 stands only 6.54, which is less than half of the z score of
1996. The figure 1 and figure 2 in the appendix show the trend of the financial soundness
indicators of the banking sector of Bangladesh.

With respect to the supply side of the banking sector of Bangladesh, the numbers of
commercial banks are raising immensely. At present, there are 41 private commercial banks
are operating where 33 are conventional and 8 are Islamic banks. In one hand, the number of
banks is increasing on the other hand the bank soundness indicators are deteriorating. As new
commercial banks are entering into banking industry so it is expected that competition would
increase which ultimately would lead to increased efficiency and reduced NPL. This erratic
behavior of the banking sector provides the motivation for conducting this study with a
special focus on Bangladesh. The proposed study, with special references to Bangladesh, is
an attempt at establishing the causal relationship between bank competition, efficiency and
financial stability.

5. Rationale of the study:

i. Relationship of the objectives to existing relevant knowledge on the research field:

As stated earlier, the literature on the bank competition and financial stability is mixed. Some
studies found a positive, some found negative and some found no impact. The summary of
the prior studies are given below:

Table 1: Review of prior studies

Researchers Main findings

De-Ramon et al. (2018) Based on the data from the UK banking industry over the
period 1994 to 2013, competition lowers stability.
Bashir et 2015 Competition increases NPL
Molyneux and Nguyen-Linh Competition does not increase bank risk-taking.
(2008)
Boyd and De Nicolo (2005) there is a positive relationship between competition and
stability.

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 Kim (2017) Less competition leads to financial fragility.
Albaity (2019) Based on the data from 276 banks across eighteen MENA
countries over the period 2006 to 2015, less competition
leads to less probability of default and high probability of
profitability.
Park (2016) Higher degree of market concentration might have negative
effect on the financial stability of the entire banking system.
Beck et al. (2013) Based on a large sample of 17,055 banks from 79 countries
between1994–2009, authors found that found that a
heterogeneous relationship existed between competition
and bank stability. Furthermore, authors found that the
regulatory quality and institutional factors play a
moderating role in the nexus between bank competition and
financial stability.
Leroy and Lucotte (2017) Based on the European banks over the period 2004–2013,
this study found the more competition stimulates more risk.
However, it still has a positive impact on reducing the
systematic risk of the banking system.
Kasman and Carvallo (2014) More competition is conducive to greater financial stability.
Moyo (2018) Using the bank data from south Africa, the author found a
mixed result. Using the Lerner index, study found that there
is a negative effect of competition on efficiency whilst the
opposite is true when using the Boone indicator.
Kasman and Kasman (2015) Competition has inverse relationship to NPL but positive
impact on Z-score.

With respect to Bangladesh banking sector, a few attempts have been made to explore present
state and causes of NPL and possible remedial measures (see Hossain and Ahamed, 2015;
Lata, 2015; Rifat, 2016). According to ex advisor of caretaker government A. B. Mirza Md.
Azizul Islam, several measures should be taken to curb the NPL such as refraining from
political interference in loan disbursement and collection, ensuring corporate governance in
banks, expediting legal procedures etc. Managing Director of Mutual Trust Bank Mr. Anis A.
Khan opined that special privileges to large loan defaulters such as rescheduling of loan and
lowering of interest rate encourages regular borrowers to become loan defaulters to avail the
special privileges (Prothom Alo, 11/06/2019). However, no research work has been

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conducted for examining the effect of bank competition and bank efficiency on financial
soundness or stability as well as between bank competition and NPL. Moreover, comparison
of this effect between conventional and Islamic bank also is an unexplored area. The purpose
of the present study is to fill this research gap by considering triangular effect of those three
above-mentioned issues.

ii. Significance of the study:

The precondition for the economic growth and development of a country depends on smooth
and efficient flow of saving-investment process. Bangladesh, being a developing country and
with an underdeveloped capital market, mainly depends on the intermediary role of
commercial banks for mobilizing internal saving and providing capital to the investor. Two
important indicators of financial soundness of financial institution are NPL and Z score. Non-
performing loans (NPLs) is deteriorating the capital adequacy of the financial industry to a
large extent. NPL is alarming for the banking industry in Bangladesh for last few decades.
The international standard of NPL is 2% or below but in our country it is more than 5 to 6
times. NPL also has significant impact on economic growth. Government and corporate
financing is required for the purpose of investment in real asset and capital expenditure from
which economic benefit would be generated for a long period of time, which would
ultimately contribute to GDP, national income as well as enhancement of corporate earnings.
Increased corporate earnings lead to corporate expansion, inflated public revenue, and
expenditure. Deficit unit of the economy especially business firms and governments raise
short term and long-term fund from financial markets and institutions. NPL hinders the credit
disbursement capability of commercial banks to a significant extent due to which institutional
investors and capital demanders are not getting fund at their expected level. As a result both
corporate and government investment is declining which ultimately would lead to economic
slowdown.

Moreover, sound and efficient financial system is a prerequisite of attracting direct

foreign investment. It is beneficial for a host country if MNCs raise fund from the local
market. But MNCs of Bangladesh are reluctant to raise fund from local commercial banks
due to high interest rate which is the consequence of NPL. Increase of NPL is an attribute of
financial catastrophe of a country. Excess NPL hampers money circulation in the market,
amount of NPL is blocked until recovery of the loan and interest income from NPL is also
ceased which results reduced debt-servicing capacity of the bank itself. Since the fund is

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blocked and interest income is ceased, the bank neither reinvests the loan amount nor earns
any income from that fund which hampered the banks overall cash flow position. Further,
NPLs weigh on the supply of credit and thus on investment and growth via a number of
channels, such as locking-in bank capital into unviable projects and unproductive activities,
reducing bank profitability, and distorting capital allocation. Higher level of NPL also
damages the system of monetary transmission to the real economy as well as hampers the
financial intermediary role of the financial institutions significantly which would negatively
affect trade and investment in both in and out of the country.

6. Objective of the study:

The main objective of the study is to explore the effect of bank competition and efficiency in
financial stability of the banking sector of Bangladesh. The specific objectives are as follows:

a. To know the present status of banking structure including bank competition, NPL and
Z score of commercial banks in Bangladesh
b. To analyze the significance and direction of relationship among intensity of bank
competition and efficiency and financial stability
c. To examine this above-mentioned triangular effect by considering a comparison
between conventional banks and Islamic banks

7. Methodology:
7.1 Data and sample:
This empirical study will be conducted with a quantitative research approach. Both primary
and secondary data will be used although analysis will be predominantly on secondary data.
This proposed study will consider the annual data from all DSE listed commercial banks of
Bangladesh over the period 2011 to 2018. The financial statements of all banks operating in
Bangladesh will be collected from the annual reports, Fitch connect etc. This study will also
employ the industry specific and macroeconomic variables to examine the impact of bank
competition on the financial stability. The macroeconomic data will be collected from various
secondary databases including the world development indicators, IMF financial statistics
(IFS) database, Heritage foundation etc. This proposed study will also collect the primary
data from the various stakeholders including the expert panels to identify the reasons and
solutions of NPL in the banking sector of Bangladesh. Expert opinion will be sought through
questionnaire and respondent would be one executive from each bank who is a member of

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top management team. Stratified random sampling will be used to select banks where type of
bank is stratification factor.

7.2 Methodologies (Variables and Models Description):

Although the static panel methods would be used as the baseline estimators, this proposed
study will employ the dynamic GMM estimators to examine the impact of bank competition
on the financial stability of the banking sector of Bangladesh. We will employ the dynamic
panel GMM estimator to address the possible endogeneity problem. Another argument for
using the dynamic GMM is the sampled numbers of banks (T) are higher than the number of
years (N). The base model for the proposed study is as follows:
Financial Stability= f {competition, bank specific variables, industry specific variables,
macroeconomic variables}
The above equation financial stability of the banking sector split into two parts:
k l m
Z scorei , j , t=ai+ ∑ β k X + ∑ β l X + ∑ β m X mj ,t + ε i ,t
k l
i ,t j ,t (1)
k=1 l=1 m =1

k l m
NPLi , j ,t =a i+ ∑ β k X ik, t + ∑ β l X lj , t + ∑ β m X mj ,t + ε i ,t (2)
k=1 l=1 m=1

Here, i, j and t subscripts represent bank, country and year, respectively. a i is a constant
term. For both equations Dependent variables are Z-score and NPL, used as proxy for
financial stability, where higher values of Z-score represent the lower probability of bank
default and vice versa. X ik, j , tare the bank-level control variables. X lj ,t is the macroeconomic
variables and ε i , j , tis an error term.. The details of the variable are explained in table 2.

Table 2: Variables Definition

Variable Description Hypothesized

relationship

Dependent variables:

Non-performing The ratio of non-performing loan to total loan. Higher ratio

loan (NPL) indicates the financial disability

Z-score It refers the soundness of the banks. The formula for Z-Score,
Z = (μ+K)/σ

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 Here, μ denotes the bank's average return on assets (ROA), K
is the equity capital in percentage of total assets and σ is the
standard deviation of the ROA. Higher value reflects higher
bank stability and less risk

Independent variables:

Learner Index An indicator for measuring the bank competition of a country. +/-
Higher value indicates less competition in the banking sector.

Boone indicators This is a measure of the degree of competition, computed as +/-

the elasticity of profits to marginal costs.

A. Bank Specific variables

CIR Cost to income ratio. It refers the efficiency of the bank +/-

ACR Asset composition ratio is calculated by Fixed asset to total +/-

asset. It is a proxy for the bank

LA Loans to Assets (LA) are the ratio to indicate the portfolio +/--
mix. It also refers the bank credit exposure.

LLP The ratio of loan loss provision to total assets -

EQASS A measure of banks capital strength in year t, calculated as +/-

equity/total assets.

NIE/TA A measurement for representing the efficiency of management -

relative to asset. It can be calculated as non-interest
expense/total assets.

LNTA The natural logarithm of total assets of the bank in year t. +/-

CR3 CR3 refers the country level bank structure. It is measured by +/-
the concentration of three largest banks in each country. Here
higher values indicate greater market concentration.

B. Macro-economic factors:

LNDP Gross domestic product in Natural logarithm +/-

INFL Inflation rate +

8. Expected Outcome:

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The expected outcome of the proposed study will be as follows:

i. The proposed study will reveal the problems of financial soundness of financial
institutions and underlying causes as well as possible remedies to overcome the
alarming problem of NPL, which would be helpful for financial industry.

ii. As the novelty of the study is unique, the findings of the study will be reference
point for the stakeholders such as bankers, policy makers, institutional investors,
regulators etc.

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 Appendix:

A. Z score of Banks in Bangladesh

Z score
18.00
16.00
14.00
12.00
10.00
Z score
8.00
6.00
4.00
2.00
0.00
96 98 00 02 04 06 08 10 12 14
19 19 20 20 20 20 20 20 20 20

Source: World Bank Development Indicators

B. NPL to Total Loan Ratio of Banks in Bangladesh

Non-performing loan

NPL to total loan ratio

45.00
40.00
35.00
30.00
25.00
20.00
15.00
10.00
5.00
0.00
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18
19 19 20 20 2 0 20 2 0 20 2 0 20 2 0 20 2 0 20 2 0 2 0 20 20 20 2 0 20

Source: World Bank Development Indicators

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