The Financial Express

Interest rate ceiling: How effective is it?

Muhammad Mahmood | Published: February 01, 2020 21:17:55 | Updated: February 01, 2020 21:22:53

Interest rate ceiling: How effective is it?

A decision has been made by the Bangladesh Bank to put a ceiling on (also known as an interest rate cap) the interest rate at 9.0 per cent for borrowers in the manufacturing sector. Interest rate ceilings are generally used for political and economic reasons to provide support to a specific industry or even a sector of the economy. While a variety of methods can be used to put limits on interest rates on lending by financial institutions, the Bangladesh Bank has decided to use the simplest method of putting an upper limit on any loans extended to business enterprises in the manufacturing sector regardless of the size of the firm.

The likely reason for such a market interventionist policy is to channel increased credit supply to the sector which is considered as beneficial to stimulate growth or of strategic importance to the economy or a combination of both.  But in general government may consider what can be considered as market failure in the industry resulting in less than the required level of credit supply for the industry than what would be under a competitive market. Under such circumstances an interest rate cap can be used to force financial resources to flow into that industry. As such interest rate caps are a direct government intervention in the financial market to remedy a perceived market failure.

It is also further argued that banks make excessive profits by charging higher interest rates as reflected in high executive salaries and bonuses and shareholder dividends.  In essence financial institutions use market imperfection resulting from information asymmetry (also called information failure) to their advantage to earn super normal profits which put borrowers at a disadvantage. This is because the seller (the banker here) is typically more knowledgeable about the market conditions than the buyer (the borrower).That also calls for regulating interest rates.

However, the core issue is how high is a high interest rate that would call for the government intervention to put a ceiling on the interest rate. The interest rate is composed of a number of components and a decomposition of those components can provide a better understanding of why the interest rate is considered high or not. Overall, the interest rate charged on lending is composed of cost of funds, profit, risk premium, overhead costs, non-performing loans (NPLs) and taxation.

The cost of funds refers to the cost incurred by financial institutions to borrow funds to lend to their customers. This may involve the interest on deposits or the cost of wholesale funds. Also related to this is the expected rate of inflation (which is an implicit form of taxation for all business enterprises including financial institutions) which can influence the nominal rate of interest. The real rate of interest (nominal rate - inflation rate) in Bangladesh stood at 3.84 per cent in December 2018. However, it must be borne in mind that banks also create money by making loans which powers the economy.

Financial institutions include a profit margin to satisfy shareholders' desire to earn a handsome return on their investment. But the ability to earn excessive profit depend on the market structure - the more concentrated the market structure, the higher the ability to earn excessive profits.

The interest rate also incorporates a risk premium on loans based on the probability that a borrower may fail to repay the loan. Generally, risk premium on lending is reflected in the interest rate charged by banks on loans to private sector customers minus the "risk-free" treasury bill interest rate at which  short-term government securities are issued or traded in the market.  The risk premium on lending in Bangladesh averaged at 5.95 per cent between 2006 and 2018.

The overhead costs broadly have two components. They include the general administration and costs associated with network expansion and new product development. The second one is the cost of credit processing and loan assessment which leads to the issue of information asymmetry.

If borrowers fail to repay the loan, lenders must absorb the cost of bad debt that must be written off at the rate they charge. In Bangladesh non-performing loans (NPL) now stands at 12 per cent which may lead to capital shortfall for many banks in the country.

Finally, the corporate tax rate along with implicit taxation in the form of holding the required reserve requirements with the central bank (in terms of opportunity costs) as well as these reserves are paid at less than market rates by the central bank.

In Bangladesh it appears that the Bangladesh Bank has put emphasis on prioritisation of cost of credit over access to credit. The policy to put an upper limit on the interest rate is premised upon that demand for credit is price inelastic. If the converse were true, there is not much need for an interest rate cap.

In implementing an interest rate ceiling, the central bank is aiming to push out the supply curve to the right and increase access to credit. As the legally binding ceiling is below the market rate of interest, this can affect the market outcome. Now the demand for credit exceeds the supply at the capped rate. This will create a gap between the demand for and the supply of credit which represents a "credit crunch". This simply means credit is not available despite there is demand for it.

The imposition of a ceiling on the interest rate also now has resulted in the ability to extract consumer surplus which in turn creates a larger pool of willing borrowers, many with questionable credit worthiness thus exacerbating the problem of adverse selection as it restricts bank's ability to price discriminate. Any increased lending under such circumstances will only push up NPLs, thus further increasing exposure to risk for banks.

Since the amount of credit on offer at the capped rate will not satisfy the demand, banks with reduced amount of credit must devise ways and means to ration credit using other than the prescribed price. This means banks are likely to institute a number of policy options to deal with the situation of "credit crunch'' resulting from the implementation of the interest rate ceiling.

As the interest rate cap in all probability is unlikely to make a non-zero risk adjustment return as well is unable to recoup their costs of funding and overhead costs, it will not be viable for banks to lend.  Therefore, to comply with the legally binding interest rate ceiling they will resort to increased levels of non-interest fees and charges related to the loans to compensate for the impact of the mandatory interest rate ceiling.  Therefore, while an interest rate ceiling reduces the nominal costs of borrowing, it will not lead to lower overall costs of borrowing. To complicate the situation, the whole interest rate regime will rather become non-transparent making it difficult for borrowers to make any informed decision.

Another likely response from banks to the interest rate ceiling could be to reduce credit extension. As credit supply is highly price elastic, a mandatory lower interest will trigger a reduction in credit supply, thus shifting the credit supply curve to the left. The implications for this is very clear, it is the lower end of the market which will bear the brunt of it and as such, having a negative impact on equity.

Now looking from the macroeconomic perspective, interest rate ceilings will reduce the effectiveness of monetary policy-induced transmission mechanism. If interest rate ceiling rates are linked to the monetary policy-dictated rates, any lower policy rates to stimulate credit growth to stimulate economic activity, the accompanying decline in the capped interest rate would counter the intended effect on credit growth thus also economic activity. Some empirical studies have already found that interest rate ceilings have had adverse effect on GDP (gross domestic product) growth ranging from 0.25 per cent to 0.75 percentage point on an annual basis.

While recognising that there are market failures in credit markets in Bangladesh, the interest rate ceiling is not an effective way to achieve lower long-term interest rates to stimulate investment. The ceiling generally causes sharp decline in bank credit to small and medium enterprises. Also, small banks are likely to be disproportionately hit hard on their profitability. The interest rate ceiling, therefore, causes adverse effects on both growth and equity.

Muhammad Mahmood is an independent economic and political analyst.



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