Caps on interest rates: A puzzling move

Syed Ashraf Ali   | Published: June 27, 2018 22:07:20 | Updated: July 02, 2018 21:29:06

The recent announcement by the private sector commercial banks to put caps on interest rates--6 per cent on deposits and 9 per cent on loans--would certainly be welcomed by the banks' borrowers who have long been groaning, so to say, under the heavy weights of high interest rates ranging from anything to well up to 16 per cent per annum. The lower costs of money should promote investment, especially in the fringe sectors from which the investors have so long shied away due to high costs of borrowed money. The low interest rate on deposits will similarly drive the depositors from the safety of fixed deposits to investment in the productive sectors such as real estates, industrial enterprises and capital market.

The move looks like a demonstration of bank owners' gratitude in exchange of a series of privileges provided by the government beginning with increase of the number of family members of the sponsors and directors from 2 to 4 who can sit on the Board and  enhancement of the tenure of the Directors and the Chairpersons. Quickly on the heel of these privileges, Bangladesh Bank lowered their requirements of keeping cash (Cash Reserve ratio) with the central bank in addition to slashing their advance-deposit ratio. The icing on the cake turned out to be reduction of corporate tax by 2.5 per cent that would save them an estimated 3.0 billion taka this fiscal year.

The caps on lending and deposit rates are seen more as a move to appease the government without a realistic assessment of the factors impinging on interest rates on loans and deposits. Perhaps the bank owners did not do their arithmetic right in setting the caps uniformly across the entire banking sector populated by a legion of 57 banks with diverse financial strength, reputation and ability to absorb the shocks that the caps imply. It goes without saying that the weaker ones will find the going real hard and may even be choked to death in a fiercely competitive environment.

From a conceptual perspective, the move to a regime of dictated interest rates looks like a complete U-turn on the financial highway laboriously built since 1990, under a long drawn financial sector reform programme-- a level playing ground for operation of a free market economy. It may be recalled that prior to 1990, Bangladesh Bank dictated interest rates on lending for different sectors with concessional rates for priority sectors like agriculture, exports and small-scale industries but compensated the banks by way of cheap refinance and rediscount facility or subsidy.     

Turning to the logic behind the move to put caps on interest rates, we may point out that a bank's lending rates are mainly influenced by the cost of funds, administrative costs, its profit margin and costs attributed to bad loans, euphemistically called 'nonperforming loans. The cost of fund in Bangladesh tends to be high on account of stiff competition among the fast growing number of banks and financial institutions scrambling for deposits. Another stumbling block is the alternative channel of investment kept ajar by the government through its savings instruments. The ridiculously high yields of these saving instruments serve as a benchmark for the bank to construct their deposit rates. The governments everywhere borrow from public and the institutional investors at the cheapest costs. One reason in favour of high interest rates of savings instruments frequently heard is that these serve as support for the people in their old age. I read a report sometime back that a survey done by a think tank revealed that at least 80 per cent of the savings instruments are held by richer sections of the society. What is forgotten is that the people with money to invest are certainly better off than those who, as the saying goes, live from hand to mouth. In the final analysis, the high costs of borrowing money through savings instruments are borne by rich and poor alike through budgetary allocation for debt servicing; some elements of tax are embedded even in the loin cloth the poor people wear. 

One critical element that has direct bearing on a bank's lending rates is the ratio of non-performing loans in their loan portfolio. Unfortunately, the ratio of non-performing loans has broken loose from its moorings on account of poor loan management, legal complications and dilatory process for recovery of dues from the recalcitrant borrowers. If we throw in this mix the money stolen by fly-by-night characters through loan scams, proportion of NPL would shoot further up the sky. According to the Bangladesh Bank's Annual Report for FY 2016-17, the following are the NPL ratios by types of banks on June 30, 2017.

Leaving aside the intractable government-owned banks and DFIs, we can turn our attention to the private sector banks which are now the key players in the sphere of financial intermediation and find out how they would operate their lending activities with a thin spread of 3 per cent between the deposit rate and the lending rate. The cost of funds across the banking system in the private sector would range between 5 and 6 per cent. The loss of revenue for writing off bad loans would be at least 3 per cent (about 50 per cent of the NPL). The administrative cost is estimated to be around 2 per cent. The bank would like to load a profit margin of something like 0.5 per cent.  All these elements add up to 10.5 per cent under the best of circumstances for a reputed bank. The weaker ones will need a bigger cushion to keep their nose above the turbulent waters of the financial sector.

The government is obviously concerned with availability of cheap money to stimulate investment. This objective can better be achieved by way of infusion of additional money in the economy through the age-old system of central bank's money market operation at low interest rates. This will automatically lead to lowering the banks' cost of funds; the competition for finding the borrowers will force down the lending rate. It may be noted that American Federal Reserve Bank maintained a cheap money policy for long ten years to stimulate investment in the wake of financial meltdown of 2007-8.

The bottom line of this discussion is that the banks should be left to determine their own interest rates and Bangladesh Bank should keep its discount window open for supply of money at cheap rates.

We have left out state-owned commercial banks (SOCBs) from our discussion. They are dead anyway but somehow breathing with life support from tax payers' money. Any cap on their lending rates would be meaningless. Given the ratio of 26.8 per cent non-performing loans in the loan portfolio of SOCBs and 23.8 of the DFIs, a cap of perhaps 20 per cent on their lending rates will not stop the bleeding of public money. A major surgery is needed but, I guess no one will take that risk in this election year. We wait with bated breath that the present government which has achieved spectacular success in terms of economic progress, improved social indicators, political stability, successful diplomatic manoeuvres and suppression of terrorism will address the problems of banking sector when they begin the next term with a new set of financial managers.   

Syed Ashraf Ali  is a former banker.





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