/ Balancing inflation control and banking stability

Bangladesh’s banking sector is undergoing a significant crisis, one that has been exacerbated by past mismanagement, particularly under the previous regime. In recent years, a troubling trend of misappropriation, embezzlement, and money laundering has eroded public confidence. The situation became so dire that early this year, Bangladesh Bank was compelled to inject liquidity into these struggling institutions to prevent a full-fledged banking collapse. However, this cash infusion, in large part through printed money, has placed mounting inflationary pressure on the economy, challenging both consumer welfare and monetary stability.
With the change in political leadership, citizens hoped for improved financial oversight and regulatory discipline. Yet, some argue that recent developments have deepened the chaos, with critics blaming much of this on the central bank’s management. This necessitates a critical examination of the central bank’s monetary policy, its impact on inflation and banking stability, and potential alternative strategies to address these intertwined issues.

Upon assuming office, the Bangladesh Bank governor made several public comments about the financial health of banks under investigation for past misconduct. While intended to inform, these statements inadvertently alarmed depositors, prompting many to withdraw their savings for fear of losing them. This created undue pressure on newly appointed directors at these banks, somewhat hindering efforts to restore stability.
The situation worsened when BB halted liquidity support as part of its anti-inflationary measures. While inflation control is critical, this abrupt withdrawal left already vulnerable banks scrambling for capital. To mitigate the impact, the central bank encouraged solvent banks to lend excess funds to struggling institutions, with the central bank acting as a guarantor. However, this approach has seen limited success, as public trust in Bangladesh Bank’s assurances remains low. Solvent banks, cautious about their depositor bases and potential contagion effects, have responded sluggishly. Only a fraction of distressed banks’ needs has been met by institutions like Sonali Bank, Dutch-Bangla Bank, and City Bank. Consequently, distressed banks have been forced to ration services, further aggravating public dissatisfaction.

To combat inflation, Bangladesh Bank has implemented a contractionary monetary policy—raising policy rates and limiting money supply. While such policies aim to curb consumer demand and slow price increases, they are less effective in economies like Bangladesh, where inflation is driven by supply constraints rather than demand-side pressures. In Bangladesh, most household income is spent on essentials, leaving little room for delayed consumption. Households cannot easily delay or reduce consumption of essential goods, so intertemporal substitution (the postponement of consumption to a future period) is unlikely to occur to any meaningful extent.
In addition, the contractionary policy risks deepening the economic slowdown by raising borrowing costs across the board. Businesses, already facing higher input prices and uncertain demand, are discouraged from taking on additional debt under high interest rates, which can stifle investments and ultimately lead to job losses. This reduction in employment further dampens consumer demand, affecting businesses and slowing GDP growth—a particularly troubling prospect given Bangladesh’s current economic fragility.
Moreover, wealthier individuals, who might otherwise allocate funds to savings or bank deposits, may opt to invest in non-banking assets, such as real estate, gold, or foreign currencies, especially if they lack faith in the sector’s stability. As a result, the intended effect of reducing money in circulation is undermined, while bank deposits decline, further tightening the credit available for real-sector investments. In essence, this policy framework could unintentionally fuel inflationary pressures by constraining the supply side, which is the root cause of the ongoing inflationary spiral in Bangladesh.

BB’s strategy to address liquidity issues by directing solvent banks to lend to distressed banks, with BB as guarantor, presents its own set of complications. Participation of only a few solvent banks, even with BB’s assurances, reflects broader concerns over BB’s credibility and the potential impact on their depositor bases. Given the structural weakness in several of these banks, solvent institutions are understandably hesitant to divert significant funds to their troubled counterparts, fearing a ripple effect that could jeopardise their financial health.
Moreover, this policy inadvertently creates inequality among depositors. Customers of distressed banks receive limited or delayed access to their funds, which can lead them to transfer savings to more stable banks. These solvent banks, however, then end up lending those funds back to the distressed institutions at higher interest rates, thereby introducing a cycle that not only prolongs the distressed banks’ recovery but also reduces returns for depositors across the board. This effectively discourages saving, further reducing the funds available for economic investment and threatens the long-term stability of the banking sector.
Given these challenges, Bangladesh Bank could consider adopting a more targeted and modern approach to monetary policy that focuses on long-term banking sector stability and controlled inflation. One of its immediate priorities should be consistent messaging regarding the financial health of banks. Communication from the Bangladesh Bank governor and other officials should be carefully crafted, and ideally vetted by financial experts, to avoid inadvertently triggering public anxiety. Clear, factual, and reassuring statements are essential to maintaining public trust in the sector.
Traditional contractionary policies may not be suitable for Bangladesh’s unique economic structure. Instead, the central bank could explore quantitative easing (QE), a strategy where the central bank purchases bad assets or non-performing loans (NPLs) from distressed banks. This approach would provide targeted support to banks most in need while allowing BB to inject capital into the financial system without directly increasing money in circulation, thus minimising inflationary risk.
To fund the purchase of bad loans without worsening inflation, the central bank could consider raising the reserve requirement for all banks. By doing so, it can redirect these additional reserves toward buying distressed banks’ bad assets. This approach ensures that the funds injected into struggling banks remain within the banking system, reducing liquidity for speculative activities while simultaneously providing much-needed support to distressed banks.

Bangladesh Bank could work with government agencies and development partners to recover outstanding NPLs and repatriate laundered funds. This would not only boost the banking sector’s balance sheets but also deter future malfeasance. A focused effort on recovering these funds could ease some of the financial burdens on distressed banks and reduce the need for ongoing interventions.
Once inflation stabilises and the banking sector regains credibility, Bangladesh Bank could sell off the bad assets purchased from banks to private investors, either through the share market or direct sales to institutional investors. This would allow Bangladesh Bank to gradually recoup its investments and further reduce money in circulation as the economy strengthens.
The success of these strategies would also depend on broader fiscal discipline across Bangladesh’s government institutions. Addressing inflation and restoring confidence in the banking sector require coordination between monetary and fiscal policies. Bangladesh Bank’s efforts to stabilise the banking sector may be hampered if fiscal policies inadvertently exacerbate inflation, such as through excessive public spending or inefficient tax policies that place an undue burden on certain segments of the population.

Bangladesh’s current monetary policy, focused on traditional contractionary measures, appears misaligned with the economic realities and unique challenges of the country. The interconnected issues of inflation and banking sector instability demand a more nuanced approach—one that goes beyond standard interest rate adjustments and direct liquidity restrictions.
For this approach to succeed, however, it is essential that Bangladesh Bank rebuilds its credibility. Clear, consistent communication is critical, as is a commitment to policies that inspire public confidence in the banking system. The adoption of these alternative measures could help control inflation while ensuring the stability and sustainability of the banking sector, laying a stronger foundation for economic growth. If Bangladesh Bank and the government can work together to implement such reforms, Bangladesh could emerge from this crisis with a more resilient and inclusive financial system, better equipped to serve its people and support long-term development.
Deen Islam is associate professor of economics at the University of Dhaka.

Views expressed in this article are the author’s own.
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