Fixed versus floating lending rate

Banks in Bangladesh generally follow fixed interest rates in their lending and borrowing operations. Asset portfolios of banks commonly have considerable volume of long-term assets, whereas the liability side heavily depends on core and short-term deposits that are exposed to the movements of interest rates. However, banks in the country generally follow a process of adjustment in the deposit and lending rates with changing market interest rates, though not in all instances. In the absence of a unitary benchmark interest rate, there are only a few instances of variable interest-tagged loan products. Practically, the bank-based small financial sector of the country is yet to enforce truly market-based interest rate practices, which is essential for identifying benchmark rates.

Overall, the structure may be termed as segmented interest rates. In case of deposit, rates are of a fixed nature as the depositors do not like uncertainty about expected future return. But the tenure of most of the deposits mobilised by the bank is short (usually less than one year). When a deposit scheme matures, it is renewed at the prevailing rate. As such, most of the deposits are subject to re-pricing within one year. This actually makes the deposit products of a bank rate-sensitive, although they are priced with a fixed rate. Only a small portion of bank deposits are fixed-rate liabilities.

A contrasting picture may be observed in case of lending where a significant portion of loan is given for more than a year. Therefore, pricing is a crucial issue for lending as it involves interest rate risk. Usually, floating rate is observed in many countries while setting the lending rate that actually minimises the interest rate risk. But true floating rate is almost non-existent in the banking sector of Bangladesh. Banks usually offer fixed rate to the borrower, but a condition is imposed on the lending rate that clearly states that rates are subject to change. By putting this condition, banks can change the lending rate whenever it is deemed necessary. Although most of the lending rates seem to be fixed, actually they are floating in nature. This technique is applied by the Bangladeshi banking system to minimise the interest rate risk.

As in other countries, these rates are not tagged with the market-driven interest rates like LIBOR (London Interbank Offered Rate) or of government securities. In Bangladesh, generally treasury department of a bank applies different techniques such as 'rate sensitive gap analysis' or 'duration gap analysis' or 'fund transfer pricing analysis' for measuring the effects of interest rate risks, as identified in the process of discussion with treasury heads. Most of the treasury departments of Bangladeshi banks use the above techniques to measure the impact of fluctuating interest rates in their net income and equity positions. Among these techniques, rate-sensitive gap analysis or duration gap analysis are very popular and widely used by the banks. Fund transfer pricing, though very important, do not get due importance yet because if it's technical difficulties. It is important to note that these types of analyses would be beneficial for minimising interest rate risk only if proper market environment and appropriate risk management products are available in the market. There are only a few instances of interest rate derivative deals here, and Bangladesh is yet to draw true benefits out of derivative products.

There are a few instances when some borrowers were successful in locking their borrowed fund at a fixed rate when the lending rate was very low. In such cases, banks are exposed to interest rate risk that needs to be mitigated. It is also observed that in some cases, banks offer floating interest rate loans to the borrowers. The lending rate is tagged in such cases with the government securities to make it adjustable with time. Such technique helps banks to reduce interest rate risk, as the rates of government securities are used as benchmark rates.

The derivatives market in Bangladesh is still very shallow. Foreign exchange derivatives like Forward and SWAP are available in the market as in most of other developing countries. Most of the banks use these products to minimise their foreign exchange risk exposure. There was a guideline with regard to commodity derivatives, and only a few transactions have occurred so far under commodity derivatives. But interest rate derivatives are almost non-existent. Bangladesh Bank (BB) has given the regulatory guideline on both foreign exchange and interest rate derivative products in its Foreign Exchange Risk Management Guideline. BSEC has also mentioned about derivatives in its directives issued during 2016. The interest rate derivative products are not generally allowed, although the BB guideline provides instruction about the transaction mechanism of interest rate derivative products. BB has allowed these products subject to case-to-case approval.

Currently, the banking sector of the country are engaged in forward transaction of foreign exchange as well as swap transactions for addressing exchange rate risks on a limited scale. Though commodity derivatives were allowed in 2007 to address price risk exposures of traders in the absence of basic cash commodity exchanges, only a few deals were executed with case-to-case permissions from the central bank. The most recent Foreign Exchange Risk Management Guideline of BB explicitly mentions the permissible nature of interest rate derivatives in foreign currencies, and a few transactions have been permitted. The existing foreign currency borrowings by local corporate entities is offering avenues to undertake interest rate swap transactions for addressing the potential trend of growing LIBOR in the near future. BB may think of offering more permission to undertake interest rate swaps in order to address the potential volatile scenario of LIBOR.

Available evidences reveal that the financial and banking market of the country lacks several pre-requisites associated with regulatory, macro and market developments to proliferate such financial products in the country. However, for obtaining greater benefits and ensuring improved growth support, the country cannot keep itself away from the utilisation of bonds, insurance, commodities and equity market developments, as well as derivatives for effective risk management. A good number of countries, including neighbouring India, have already moved forward in the process, where the foundation was laid through introducing interest rate OTC derivatives and later exchange traded tools. Policy and strategic documents as well as targets and work-plans for the development of local currency OTC derivatives are required for tapping the future growth potentials in the area.

Dr. Shah Md. Ahsan Habib is Professor and Director (Training), Bangladesh Institute of Bank Management (BIBM).

ahsan@bibm.org.bd