Whither market mechanism?

Higher lending rate is obviously a barrier to investment; it enhances the cost of doing business. So, there is always a demand for rate cut or lowering the lending rate. To provide the policy support for rate cut, the Bangladesh Bank in April last reduced the Cash Reserve Ratio (CRR) from 6.5 per cent to 5.5 per cent for commercial banks on bi-weekly average basis. This is the standard practice in a mature financial market.

A central bank has a number of tools in its hand to set the direction of interest rates in the market. Banks and financial institutions adjust their own lending and deposit rates accordingly. Central bank's policy rates are considered as benchmarks for the market rates.

Moreover, the government has decided to allow state entities to deposit 50 per cent of their funds with private banks. Earlier it was 25 per cent. The presumption was that it would enhance the liquidity in the banking sector.

The whole scenario, however, changed dramatically in June last when a decision was taken to set the maximum lending rate at 9.0 per cent and deposit rate at 6.0 per cent. The sponsor directors of the private banks declared these interest rates. Both the finance minister and the governor of Bangladesh Bank concurred with such a market-distorting move.

Since then, country's banking sector is going through an unusual pressure to bring down the lending rate to single digit level, ignoring the current market-driven mechanism. But the decision to set the deposit rate at 6.0 per cent and lending rate at 9.0 has not been implemented so far. Some banks are still charging double digit lending rates for different businesses and some are charging single digit lending rates. Though all banks are offering single digit and lower rates for regular savings deposits, some are offering even double digit rates for long-term fixed deposits.

The government has been continuously pushing all the banks to set the maximum lending rates at 9.0 per cent. Last week, Bangladesh Bank again asked the banks to comply with the decision taken last year. In a meeting with the chief executives of the banks, central bank governor and senior officials asked them to implement the decision. Central bank also asked them to take adequate measures to reduce the amount of default loans.

The unique decision to set a single digit lending and deposit rates by the banks completely defies market mechanism. It also ignores the fundamental procedure of setting interest rates by banks and financial institutions. A number of factors are there to determine interest rates.

In a working paper titled 'Single Digit Interest Rate: Bangladesh Perspective', researchers of Bangladesh Bank presented a long list of the factors. They asked the banks to list the factors that they consider while setting the lending and deposit rates. In response to this question, banks have highlighted the number of factors. For setting the interest rates, banks consider the cost of fund, peer banks' rate, market rate, market competition or demand and supply of loanable fund, regulatory compliance, operating cost, assets-liabilities condition, credit risk, monetary policy, money market situation, economic outlook, inflation movement, borrower's financial strength and default loan position. Factors like advance to deposit ratio (ADR), spread and yield rates of government securities significantly affect the deposit rates of the banks. Some banks have also given importance to profit targets of the management and their goal towards the expansion and contraction of the balance sheet, credit policy, non-interest income, tenor of lending and deposit, budget financing, bank projected cash flows and appropriate deposit mix to set their lending and deposit rates.

Moreover, the factors vary from bank to bank and the variation is not unique in Bangladesh. It is a global practice. Bangladesh Bank study showed that for private commercial banks (SCBs), peer banks' rate is a major factor in determining the interest rate. The factor has little to do with the foreign commercial banks in this connection.

Despite being aware of the complex nature of interest rate setting, Bangladesh Bank's move to introduce a 'command regime' in this regard is apparently a misguided approach. This kind of direct or indirect command may distort the movement of the financial market.

In the working paper, the researchers of Bangladesh Bank have tried to estimate a 'plausible range of lending rate'. The outcome of their exercise showed that a range for lending rates in banks varies from 6.20 per cent to 13.0 per cent. According to them: "It means a bank with low cost of fund, low operating cost, low capital charge and low risk factors could set a lending at as low as 6.20 per cent while a bank with high cost of fund, high operating cost, high capital charge and high risk factors would not be able to set its lending rate less than 13.0 per cent." From this, the working paper concludes that setting 9.0 per cent lending rate may not be possible for most of the banks 'unless significant improvement is achieved to mitigate operating cost, capital charge and risk premiums.'

The central bank study, thus gives a clear message that undue intervention to forcefully reduce lending and deposit rates would not work. Experts and economists have already expressed similar opinion.
Instead of dictating the interest rates, the government should focus more on the governance-related areas of the financial sector. This will be an effective intervention to reduce the cost of doing business in the long run.

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