Macro-Financial Context and Structural Intermediation

The banking sector operates at the core of the domestic financial system, bearing the predominant burden of resource mobilization and credit intermediation in the absence of deep, liquid capital markets. The structural footprint of financial intermediation is reflected in the ratio of broad money (M2) to gross domestic product, which stood at 51.2 percent according to the World Bank WDI 2023 data. This aggregate highlights both the central role of commercial banks in domestic liquidity creation and the relative shallowness of non-bank financial alternatives. At this level of broad money penetration, systemic stability is almost entirely synonymous with the solvency and liquidity of the scheduled banking institutions. Disruptions in bank credit distribution or severe impairments to institutional balance sheets directly translate into macroeconomic slowdowns, given that corporate entities, small and medium enterprises, and public agencies rely on banking lines for both working capital and long-term capital formation.

Macroeconomic management has faced severe cross-currents characterized by persistent inflation pressures, balance of payments adjustments, and a tightening domestic liquidity environment. Monetary authorities have pursued a restrictive posture designed to curb aggregate demand and stabilize domestic prices. The central bank policy rate serves as the primary operational anchor, with the Bangladesh Bank repo rate positioned at 10.0 percent as established in October 2024. This contractionary setting is designed to raise the nominal cost of central bank refinancing, compress excess systemic liquidity, and discourage speculative import financing. However, the transmission of this elevated policy rate through the broader financial architecture faces structural frictions arising from legacy portfolio misallocations, uneven liquidity distribution across scheduled banks, and institutional governance deficits.

External stability forms a critical counterpart to domestic liquidity conditions. Foreign exchange reserves, recorded under the International Monetary Fund Balance of Payments and International Investment Position Manual (IMF BPM6) methodology, stood at USD 31.07 billion as of December 2024. These reserve holdings represent an indispensable cushion against external liquidity shocks, import payment pressures, and exchange market volatility. The maintenance of this reserve buffer under standardized, gross-verifiable accounting metrics has restored an essential measure of transparency to the country's external balance sheet. Nonetheless, protecting this reserve position while accommodating essential commercial imports requires careful liquidity coordination between the central bank and authorized foreign exchange dealers, directly influencing domestic money supply dynamics and interbank settlement conditions.

Asset Quality Realignment and Capital Depletion

The defining operational reality of the financial sector is the profound deterioration in reported asset quality following the transition toward authentic prudential standards. The systemic non-performing loan ratio reached 35.73 percent following the Bangladesh Bank Basel III reclassification implemented in late 2025. This sharp elevation in non-performing assets reflects the dismantling of prolonged regulatory forbearance mechanisms, subjective classification concessions, and artificial loan-restructuring programs that historically masked underlying portfolio distress. By enforcing rigorous, standard-aligned criteria regarding overdue classifications, default triggers, and the continuous monitoring of restructured facilities, the regulatory framework has exposed decades of accumulated capital misallocation and unserviced liabilities.

The scale of this non-performing asset burden fundamentally alters the capital structure and operational viability of scheduled banks. At a non-performing loan level of 35.73 percent, the banking system faces acute impairment provisioning requirements that outstrip the pre-provision operating profits of numerous institutions. The required accumulation of specific and general provisions against classified facilities directly absorbs core regulatory capital. Consequently, Tier 1 capital adequacy ratios across multiple peer groups, most notably within the state-owned commercial banks and several distressed private commercial banks, have undergone severe erosion. Capital deficits now curtail the capacity of these institutions to expand risk-weighted assets, effectively choking off credit delivery to productive sectors of the real economy.

The persistence of unviable assets on bank balance sheets generates substantial liquidity deadweight. Distressed advances generate zero cash flow while absorbing scarce administrative and legal resources. Furthermore, non-accrual requirements prevent banks from recognizing fictitious interest income on delinquent facilities, curtailing reported revenues and exacerbating underlying solvency pressures. The institutional landscape has consequently fragmented into a segmented market. A cohort of well-managed, governance-compliant private commercial banks retains solvency, liquid deposit bases, and international correspondent relationships. Conversely, a broad perimeter of chronically distressed banks remains burdened by toxic assets, negative equity positions, and heavy dependence on exceptional central bank liquidity support facilities.

Pricing Structures, Margins, and Credit Transmission Distortions

The pricing of credit throughout the scheduled banking sector reflects the tension between tightening monetary policy, administrative inertia, and heightened counterparty risk. The weighted average lending rate across scheduled banks was recorded at 11.84 percent as of December 2024. When viewed alongside the central bank policy stance, where the Bangladesh Bank repo rate stood at 10.0 percent as of October 2024, the effective margin between central bank refinancing costs and commercial lending rates appears exceptionally compressed. In an unconstrained, risk-sensitive credit market, elevated sovereign refinancing rates combined with a systemic non-performing loan ratio of 35.73 percent would command a substantial risk premium across lending portfolios.

The compressed spread between the repo rate of 10.0 percent and the weighted average lending rate of 11.84 percent highlights severe rigidities in the credit pricing mechanism. First, commercial banks face elevated cost-of-funds pressures as intense competition for stable retail and corporate deposits drives term deposit rates upward toward the policy rate floor. Second, high default volumes restrict the pool of performing assets capable of cross-subsidizing operational costs and provisioning shortfalls. Consequently, banks cannot expand the nominal lending rate sufficiently to clear the market without pushing borrowing costs beyond the debt-service capacity of marginal, high-integrity corporate and SME borrowers.

This dynamic induces severe credit rationing and adverse selection. Because lenders cannot price high-risk exposures accurately without encountering borrower default, scheduled banks systematically retreat from extension of new credit lines. Loan origination becomes heavily biased toward large conglomerates possessing extensive collateral, public sector entities, or state-guaranteed obligations. Dynamic, productive enterprises, particularly emerging export-oriented manufacturers and domestic supply-chain components, face restricted access to formal working capital lines. Furthermore, the transmission of monetary policy becomes asymmetric. While policy rate hikes immediately escalate the marginal cost of interbank and central bank borrowing, retail and corporate credit pricing responds slowly, blunting the effectiveness of monetary tightening in dampening aggregate demand while disproportionately penalizing sound, dependent enterprises.

Structural Vulnerabilities and Systemic Solvency Risks

Beyond immediate pricing and liquidity frictions, the financial system confronts profound institutional vulnerabilities rooted in systemic governance failures and deficient legal enforcement mechanisms. The escalation of the non-performing loan ratio to 35.73 percent in late 2025 is not merely a reflection of macroeconomic headwinds or global commodity cycles; it represents the crystallisation of persistent governance deficits. Historically, aggressive connected lending, insider board interference, systemic collateral misvaluation, and regulatory forbearance enabled chronically distressed borrowers to roll over bad debts indefinitely. The institutional architecture failed to enforce timely collateral seizure, leaving lenders with nominal, illiquid security that cannot be quickly liquidated through legal proceedings.

The insolvency and debt-recovery framework remains an acute operational bottleneck. The Money Loan Court system (Artha Rin Adalat) and general civil litigation processes suffer from protracted judicial backlogs, frequent procedural stays, and extensive writ petitions filed by defaulted borrowers. Debtors have routinely exploited procedural loopholes to obtain legal stay orders that halt asset recovery, stay default classifications, and prevent banks from initiating bankruptcy proceedings. Consequently, the actual recovery rate on classified loans remains low, entrenching capital lockups and encouraging strategic default behavior across the corporate sector.

The sovereign-bank nexus further amplifies these systemic vulnerabilities. State-owned commercial banks, which shoulder an outsized share of total classified loans, maintain extensive exposures to loss-making state-owned enterprises and public procurement agencies. Because these institutions lack autonomous capital generation capabilities, their capital shortfalls constitute large contingent fiscal liabilities for the government. Repeated sovereign recapitalizations using public resources have historically created moral hazard without remedying the underlying operational and underwriting weaknesses. Moreover, high domestic government borrowing through the issuance of sovereign treasury bills and bonds has absorbed substantial commercial bank liquidity, crowding out private sector borrowers and tying bank asset portfolios directly to sovereign fiscal performance.

External financing relationships also face increasing scrutiny. Although gross foreign exchange reserves stood at USD 31.07 billion under IMF BPM6 accounting in December 2024, maintaining trade credit lines and foreign currency settlement channels requires constant foreign counterpart confidence. Elevated domestic non-performing loan ratios and institutional capital deficiencies elevate perceived country counterparty risk among international correspondent banks. This friction manifests in demands for higher confirmation fees on commercial letters of credit, reduced access to uncommitted trade finance lines, and heightened reliance on cash-backed transactions, ultimately raising the transaction costs of external trade and constraining the domestic industrial supply chain.

Policy Levers, Sequencing, and Resolution Strategies

Stabilizing the domestic banking sector and re-establishing functional credit intermediation requires a rigorous, non-discretionary policy roadmap. Policy intervention must be sequenced logically to prevent disorderly institutional failure while progressively cleansing distressed balance sheets and safeguarding financial stability.

Diagnostic Verification and Capital Triage

The essential initial phase requires completing granular, third-party asset quality reviews across all scheduled banks, utilizing the rigorous classification criteria introduced through the late 2025 Basel III realignment. The central bank must establish an unambiguous triage perimeter categorizing institutions into three distinct operational groups:

• Fundamentally sound banks that possess adequate regulatory capital buffers, disciplined underwriting practices, and low default exposures. These entities require standard supervisory oversight and full access to market-based operational facilities.
• Under-capitalized but fundamentally viable banks that demonstrate viable core franchises, sound retail deposit bases, and localized balance sheet impairments. These institutions must be placed under structured, legally binding Prompt Corrective Action (PCA) frameworks, requiring mandatory asset disposals, cost rationalization, dividend moratoriums, and shareholder capital injections within defined compliance horizons.
• Structurally insolvent institutions with pervasive governance failures, negative net worth, and non-performing asset ratios that eliminate all regulatory capital. For this group, forbearance must cease entirely; central bank intervention, board displacement, operational restructuring, orderly merger, or resolution through specialized resolution frameworks must be executed without regulatory hesitation.

Structural Resolution of Non-Performing Portfolios

Addressing the non-performing loan ratio of 35.73 percent requires removing impaired facilities from the core banking system to unfreeze institutional balance sheets. Continued retention of legacy toxic assets inside commercial banks blocks new lending and distorts institutional governance. Policymakers must deploy specialized institutional mechanisms:

• The legal and regulatory operationalization of a national asset management framework, establishing clear procedures for the acquisition, management, and liquidation of bad debts. This entity must operate under strict, independent commercial governance, purchasing classified assets at realistic, discounted market valuations rather than inflated book values to avoid passing private commercial losses onto the sovereign balance sheet.
• Targeted legal reforms to accelerate judicial resolution under the Money Loan Courts, including restricting the grounds for interlocutory appeals, capping the duration of procedural stays, establishing dedicated commercial benches, and modernizing bankruptcy legislation to allow for expedited corporate restructuring and asset liquidation.
• Disincentivizing strategic default through stringent personal liability rules, rigorous cross-collateralization enforcement, and total exclusion of persistent default actors from formal financial services, public procurement bidding, and corporate board directorships.

Liquidity Anchoring and Monetary Harmonization

Monetary policy operations must remain calibrated to macro-financial realities, preserving liquidity stability without exacerbating moral hazard:

• The central bank repo rate, positioned at 10.0 percent as of October 2024, must continue to act as an uncompromised anchor for aggregate domestic liquidity management. Refinancing access through standing liquidity facilities must carry strict collateral requirements to prevent unviable banks from funding delinquent balance sheets through central bank credit expansion.
• Commercial lending rates must remain fully market-determined. The compressed relationship reflected in the weighted average lending rate of 11.84 percent as of December 2024 demonstrates that artificial pricing constraints undermine institutional profitability and distort risk assessment. Commercial lenders must possess operational freedom to price credit according to counterparty risk, creating realistic incentives for sound borrowers and discouraging speculative exposure.
• Foreign exchange liquidity must be managed to defend the reserve baseline of USD 31.07 billion established under IMF BPM6 accounting in December 2024. Central bank interventions in foreign currency markets must be strictly confined to smoothing disorderly market volatility rather than defending unsustainable exchange rate levels, ensuring that foreign exchange allocation is driven by market clearing prices and genuine balance of payments equilibrium.

Governance Architecture and Regulatory Autonomy

The lasting restoration of the financial system requires a fundamental restructuring of regulatory and institutional governance:

• Complete operational independence for Bangladesh Bank in executing supervisory oversight, licensing, enforcement, and resolution protocols. Regulatory mandates must be applied symmetrically across both private commercial institutions and state-owned commercial banks, abolishing dual-regulatory structures and discretionary exemptions.
• Enforcing strict limits on single-borrower and connected-group exposures, supported by centralized, real-time registry oversight to eliminate hidden cross-holdings, undisclosed related-party credit extensions, and circular corporate financing.
• Depoliticizing the board appointments, executive management selections, and credit sanctioning committees within state-owned commercial banks, instituting professional fit-and-proper criteria enforced rigorously by independent supervisory bodies.

The banking sector stands at an unprecedented structural juncture. The recognition of reality reflected in the late 2025 non-performing loan ratio of 35.73 percent has removed the veil of regulatory forbearance. Resolving the resulting institutional insolvency, re-establishing real positive interest rate spreads above the 10.0 percent policy floor, protecting the USD 31.07 billion reserve buffer, and re-anchoring broad money intermediation beyond its 51.2 percent baseline are the unavoidable structural prerequisites for macroeconomic stability and durable economic expansion.