The dilemma of interest rate spread

The difference between deposit rate (DR) and lending rate (LR) is known as interest rate spread (IRS). The IRS accounts for banks costs and profits. The two rates - DR and LR - generally move together in the same direction with the spread often narrowing or widening depending on many underlying factors, such as (a) costs of operations, (b) availability of loanable funds, (c) inflation expectations, (d) credit worthiness of potential borrowers, (e) future business and economic outlook (f) financial market (stock market) and (g) political stability.

Some writers in a recent opinion column in another print media argued that the IRS is too high (between 4.25 and 6.0 per cent) and this is so because "interest rate is not market determined". They grieved that Bangladesh Bank's monetary policy statement (January-June 2019) presumed that the interest would be market determined. But that is not happening.  In their opinion piece they argued "It appears that some banks have set their lending rates in tune with their own business interests. A high lending rate is not only a reflection of motivation for high profits, but also a sign of inflationary pressure and loan default risks, as manifested in the high volume of non-performing loans (NPLs) in the banking sector in recent years." In the same column, they argued, "With a view to attracting private investment, there have been initiatives to reduce the difference between lending and deposit rates, termed as interest rate spread, by the central bank".

If I may, I would argue, with reference to the above quoted text that banks are doing what the market forces would require them do. Banks, like other business enterprises, are profit maximisers. However, I may not rule out lack of a more competitive process of interest rate setting by banks. Further, I am not sure how private investment is a function of interest rate spread - it is not.  Private investment is a function of lending rate - not the rate spread. It may be emphasised that role of Bangladesh Bank (BB) is not to pressure banks to lower their lending rates and drive PCBs to bankruptcy. However, BB must guard against non-price competition among banks and facilitate deposit and lending operations.

Banking industry anywhere in the world operates as if they are monopolistic competitive. They have monopoly power to set interest rates on various bank products based on cost, demand, rates set by their competitors.  However, banking in Bangladesh is a distortion - a misrepresentation, if you will - of any well-defined market structure for being a dual system - state-owned commercial banks (SOCBs) and private commercial banks (PCBs), where the former serve as cash cow for government deficit financing in addition to serving the public and the latter serve the public. If the PCBs operate as inefficiently as NCBs, then SOCBs will be non-existent.

People's deposits in various bank products are the primary source of banks' loanable funds. To attract these funds, banks must be charitable to savers in offering higher interest rates in addition to facilitating friendly and faster services. Once DR is set by a bank, LR will depend on how each bank assesses the above  factors.

Empirical evidence from developed economies suggests that LR adjusts differently to DR. Banks may adjust LR asymmetrically, that is, raise their LR faster when rates on government bonds and other investment products are rising and lower DR when rates on those assets are falling.

In the US banks set their prime lending rates (PLRs: Interest rates charged to most creditworthy borrowers) as some "mark-up" relative to deposit rates. This "markup" is approximately 2.5 per cent above the 10-year Treasury bonds. If the "mark-up" becomes too high or low, the market forces will exert pressure on the banking industry to adjust back to some "normal" or equilibrium spread.  The spread depends on several factors:

(1) Information asymmetries between banks and their clients. Once banks and their customers establish some business contracts, it becomes costly for clients to switch to a different lender. As a result, banks may be slow to adjust their rates to declining market rates, causing the spread to widen relative to some equilibrium spread.

(2) Cost of intermediation -- one that facilitates mobilisation of savings, diversification and pooling of risks, and allocation of resources efficiently. Since savings deposits and lending aren't always synchronised, financial intermediaries like banks incur certain unavoidable costs. To recoup those costs, they adjust the interest rates on deposits and loans.

(3) Efficiency of the intermediation process. For example, under healthy competitive environment, the IRS is narrower, includes only transaction cost, while in an imperfect market condition (burdensome regulations), the spread is wider, reflecting inefficiency in operation. 

(4) This inefficiency arises from  inefficiency in the intermediation process of a repressed financial system (as in Bangladesh). This is because in a control policy regime (e.g. BB intervention) credit policies involve substantial administrative costs, and interest rates with set ceilings fail to reflect the true cost of capital. Such a policy regime encourages non-price competition. Secondly, the government sector's reliance on SOCBs to finance its fiscal deficit induces inefficiencies.

(5) In the presence of many nonbank savings products such as NSD (National Savings Directorate) certificates, which pay fixed interest of around 11 per cent, it is not surprising that PCBs face hardships to attract depositors' funds. Therefore, a 6.0 per cent DR appears too low given that it only matches prevailing inflations rate. Paucity of loanable funds at PCBs will tend to push the LR higher, making the IRS wider.   

The scourge of bank looting, loan defaulting, and NPLs are in most part the upshot of the twin dilemma of adverse selection and moral hazard, which arises from the existence of asymmetric information, where one side of an activity (the borrower) has more information about himself/herself than the other side (the lender). This is a pervasive feature of real-world markets, which considerably affect how they operate. George Akerlof, Michael Spence, and Joseph Stiglitz won the 2001 economics Nobel Prize for their path-breaking insights into how markets operate and fail.

Adverse selection occurs when one party engaging in an activity (say, a used car buyer, a banker, a voter, etc.) fails to recognise certain relevant characteristics such as honesty of the other party (used car dealer, borrower, bank director, political candidate etc.). Under conditions of asymmetric information, the former would fall prey to a deception by the latter in an activity they planned to engage in. Hence, when an individual or an institution acts based on less than full information, the consequences of adverse selection sets in.

Moral hazard (undesirable outcome) occurs whenever there are inducements for agents (e.g. borrower, bank director etc.), who cannot be easily observed or monitored, to behave in a manner contrary to what is expected of them after being selected. The source of this moral hazard problem is, as with adverse selection, an asymmetry of information. Examples of both adverse selection and moral hazard in the context of Bangladesh are the colossal amount of bank loan defaults and non-performing loans, and bank looting.

What recourses there're to minimise the consequences of this twin dilemma? When it comes to lending, banks must collect as much credit history of the borrower as possible and, of course, the quality of borrowers' collaterals must be taken into as one of prime considerations. Politicisation of the banking sector must be a taboo. Finally, there is virtually no alternative to a responsible free media and transparency as the foremost resort.

Dr Abdullah A Dewan, formerly a physicist and a nuclear engineer at BAEC, is professor of economics at Eastern Michigan University, USA.

[email protected]