Banking Stress: Ring-Fence the Bad Loans Before the Credit Squeeze Stalls Investment

Diagnosis

The banking system is under acute, tier-one stress on three fronts at once, as the curated problem note records: a non-performing loan (NPL) surge, a spread blow-out (the gap between deposit and lending rates widening), and a private-credit collapse. These are not three separate problems. They are one feedback loop. Rising bad loans erode bank capital and force banks to price risk higher, which blows out the spread. The wider spread and capital scarcity then choke off new lending to private firms, which slows the economy and pushes still more borrowers into default. Left alone, the loop tightens on itself.

The horizon is short, which means the window to break the loop with credible action is now, not after the next budget cycle. This is a macro-financial event, not a slow structural drift. The danger of inaction is a credit freeze that starves working capital from otherwise viable firms, converting a balance-sheet problem inside banks into a real-economy contraction.

Recommended actions

1. Force honest loss recognition and uniform NPL classification. Owner: Bangladesh Bank, through a binding prudential circular tightening loan-classification and provisioning rules and ending forbearance and ever-greening. Mechanism: a supervisory circular plus on-site asset-quality inspection of the largest exposures. Observable signal it is working: reported NPLs rise initially (the hidden stock surfaces) and then the rate of new NPL formation slows quarter over quarter.
2. Recapitalize the weakest banks with conditions, not blank cheques. Owner: Ministry of Finance, with the Internal Resources Division sizing the fiscal cost and Bangladesh Bank verifying capital shortfalls. Mechanism: a conditional recapitalization line in the budget tied to governance reform, board changes, and lending-discipline covenants, not open-ended state injections. Observable signal: recapitalized banks meet capital-adequacy thresholds and the share of system assets held by undercapitalized banks falls.
3. Compress the spread by restoring competition and resolution, not by capping rates. Owner: Bangladesh Bank. Mechanism: stand up a credible distressed-asset resolution track (an asset-management vehicle or court-backed workout process) so banks can move bad loans off their books and re-price new lending to healthy borrowers. Observable signal: the deposit-to-lending spread narrows while credit growth turns positive, showing the narrowing comes from resolution rather than suppressed deposit rates.
4. Protect the flow of credit to productive private firms during the cleanup. Owner: Ministry of Finance with Bangladesh Bank. Mechanism: a targeted, time-bound refinancing window for working capital to small and medium enterprises and exporters, ring-fenced from the troubled-asset cleanup so deleveraging does not indiscriminately cut off solvent borrowers. Observable signal: private-sector credit growth recovers without a parallel rise in fresh defaults.
5. Coordinate banking and capital-market stress so one does not detonate the other. Owner: Ministry of Finance convening Bangladesh Bank, the Bangladesh Securities and Exchange Commission, and the General Economics Division. Mechanism: a standing financial-stability coordination cell that watches bank equity, listed-bank disclosures, and macro forecasts together. Observable signal: a single published stress dashboard and a pre-agreed escalation protocol.

Sequencing (first 12 months)

Start with loss recognition (action 1). Nothing else is credible until the true size of the NPL stock is on the table, and an honest number is what unlocks correctly sized recapitalization and resolution. In parallel, MoF and IRD size the fiscal cost so the recapitalization line (action 2) can be built into the budget. Once the bad-asset stock is visible and capital gaps are funded, stand up the resolution track and the SME refinancing window together (actions 3 and 4) so the spread can compress without freezing credit. The coordination cell (action 5) should be convened from day one to govern the whole sequence.

Risks and constraints

The binding constraint is fiscal: recapitalization competes with every other budget priority, and the Internal Resources Division must find the space without crowding out essential spending. The second constraint is political. Honest loss recognition surfaces losses tied to influential borrowers and to state banks, so forbearance is the path of least resistance. If Bangladesh Bank's classification circular is diluted under pressure, the entire sequence fails at step one. The third risk is moral hazard: recapitalization without enforceable conditions simply funds the next cycle of bad lending.

Bottom line

Bangladesh's banking stress is a single self-reinforcing loop of bad loans, widening spreads, and collapsing private credit, and breaking it requires honest loss recognition first, conditional recapitalization second, and protected credit flow throughout. The Ministry of Finance and Bangladesh Bank have a short window to act before a balance-sheet problem inside banks becomes a contraction in the real economy.