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During the past few months the banking system suffered from a shortage of funds. This was manifest through a slowdown of deposit growth. Deposit growth had been 12-13 per cent per annum over the three years 2015-2017. During the past year the annualised growth rate declined steadily from 12.6 per cent to 5.3 per cent per annum [by quarter, with the last quarter ending in the latest data for April 2018]. This decline in the rate of increase of deposits seems to be a result of a loss of confidence in the banking sector. The growth of gross domestic product (GDP) was strong, net sales of National Savings Certificates slowed down, while remittances and export proceeds increased. Holdings of cash (Taka) increased more rapidly than deposits.
The loss of confidence in the banks arose from the run on The Farmer's Bank. That run was triggered by the central bank's public criticisms (illegal under the Bangladesh Bank Order) and the withdrawal of Government deposits, both actions that eroded public confidence in one bank that quickly spread to other banks. Broad money growth slowed sharply with Government borrowings from the banking system declining and foreign exchange reserves stagnating. Bangladesh Bank (BB) took no action to offset the squeeze on deposits resulting in what was called a liquidity crisis. Banks increased lending rates in the face of this shortage of funds for lending. Deposit rates also increased in response to the need for more funds. Some steps were taken or at least talked about to ease the liquidity crisis. The Government seemed to agree to the request of the Bangladesh Association of Banks (BAB) for more Government deposits to be placed in private banks. There was also some temporary relief in the central bank's use of the deposit to loan ratio as an instrument of monetary policy. But these actions seemed to have little impact and the banks continued to feel that there was a shortage of funds available for lending. The appropriate action was to increase lending to the banks by BB as "lender of last resort" insuring adequate liquidity and enabling BB to achieve its monetary policy targets.
The discussions and arguments over interest rates are very confused and confusing. The actions by BAB aimed at interfering in the setting of interest rates and apparently getting the banks to act in unison to control interest rates is remarkable. First, it is probably not legal. This is an action by private companies to fix prices. Where was the central bank in all of this?
BB intervention in financial markets to directly control lending rates is a serious backward step. One of the key policies in the Financial Sector Reform Project is to allow interest rates to be determined by market conditions. When market conditions tighten in credit markets, interest rates increase. The current effort by the central bank to simultaneously reduce credit availability while trying to prevent interest rates from rising makes no sense. A monetary policy aimed at lowering inflation by reducing the money supply growth is going to drive up interest rates, reducing the demand for credit. This is what monetary policy is about! The central bank should be delighted to see interest rates increase, supporting the anti-inflationary policy, not rushing about trying to prevent this increase.
DEPOSIT RATES: There are many kinds of deposits. The average rate calculated by BB has been around 5.0 per cent for the past two years. When the statement is made that the deposit rate is 6.0 per cent, what type of deposit are we talking about? There is one thing that one can conclude: With a 10 per cent tax and an inflation rate of 5.5 per cent a 6.0 per cent deposit rate earns nothing. Any deposit rate less than 6.0 per cent reduces deposit value. One does not know what this announcement about deposit rate really means. One should note that time deposits are contracts and cannot be changed at the whim of the bank. When fixed deposits mature, then the depositor can decide if he likes the new rate. It appears that the BAB statement indicates that there is little change in deposit rates. But deposit rates are actually too low with the present inflation rate. Saving should be encouraged by the Government.
LENDING RATES: The most important point about lending rates is that these must be linked to what they cost to provide. The arithmetic for the cost of lending is simple. We consider the average loan: For private banks: cost of funds 6.0 per cent [average deposit rate plus correction for the cash reserve requirement and the statutory liquidity requirement]; cost of operations, net of fees -1.0 per cent; return on capital 3.0 per cent [Taking account of capital adequacy 10 per cent, target return on equity 20 per cent, tax rate 38 per cent (.1)(.2)/.62=.032]; bad loans -7.0 per cent [Private banks 6.0 per cent non-performing loans plus allowance of 1.0 per cent.]. Result: interest rate is 15 per cent. For good borrowers that have repaid on time the cost of bad loans can be reduced to 2.0 per cent [unfortunately there are few borrowers in this category.] Then the cost of lending is 10 per cent; but for risky borrowers it is 16-17 per cent. To reduce the average lending rates to single digits, one needs to get the cost of funds down below 4.0 per cent and the bad loans costs to 4.0 per cent. To reduce the cost of funds to 4.0 per cent means an inflation rate of 2.0-3.0 per cent. To reduce the cost of funds to 4.0 per cent means a revolution in loan recovery that would take years to achieve. 9.0 per cent lending for the average borrower is a myth, such a position cannot be sustained.
Of course, in reality it is not a myth. Suppose the banks do lend at 9.0 per cent on the average, what happens? The financial position of the private banks will continue to deteriorate as they are not covering their costs. The bad loan costs mount up although this can be concealed with rapid growth of lending. But when the evil day of slow deposit growth and slow lending comes, then all of this is exposed. Banks are in serious trouble and cry for help. One cry is "do not make me take the provisions" or "ease up on the classification rules." Forcing banks to lend below cost is dangerous and leads to serious difficulties. Any business must cover its costs of their product to stay solvent. At a 9.0 per cent lending rate private banks cannot do so.
For government banks the required lending rate to cover costs is much higher since the bad debt cost is of the order of 20 per cent. The cost of funds is lower and perhaps the banks do not want to earn profits. But anyway you manipulate the numbers, state-owned banks need lending rates of at least 20 per cent to cover their costs. That is impossible, so the government banks are doomed to lose money and have their capital eroded. This is the story of the past twenty-five years.
Any attempt to force the average lending rate or even the rate for best borrowers to 9.0 per cent at the present inflation rate and present levels of loan recovery is a disaster for the banking system. The Government subsidises the state-owned commercial banks but private bans must be profitable. They cannot be at a 9.0 per cent lending rate.
HOW CONTROLLED LENDING RATES WORKS: When the banks perceive a strong demand for credit and they do not have the resources to meet these credit demands, how does the bank decide who should get a loan and who should not? The market approach allows the interest rate to increase so that the demand for credit equals the availability of funds. The individual bank manages by going to the interbank money market as necessary to replenish funds and this drives up the cost of funds. But if the authorities try to control the interest rate than the choice of who gets credit and who does not, shifts to administrative choices by the commercial bank. This encourages corruption. This credit rationing could also be based on the bank staff deciding which loans are better than others (better here means more likely to be repaid). The bank staff do not have all the information available to the borrower and have difficulty making such choices. The bank staff choices will be less efficient than selection through an increased interest rate that causes some potential borrowers to withdraw from the market. The borrower is in a better position to decide if he can handle the higher interest rate. The point is that the paper lending rate may be different from the actual rate or the credit rationing reduces the average return to investment by choosing poorer projects, harming economic growth. Bankers understand this point very well. Encouraging credit rationing is a very bad idea. But that is what intervention to achieve direct control over interest rate means.
Attempts to regulate lower interest rates are imperilled. As happens so often market prices break through attempts to control them. In 1989-90 it was clear that the control of interest rates by Bangladesh Bank was an illusion; actual interest paid by borrowers was much higher and responded to supply and demand. The central bank could only pretend to control interest rates. Nothing had changed.
Why would the central bank intervene to try to distort interest rates? If you tighten monetary policy then you want higher rates. Higher rates help to moderate inflation. But higher rates tend to reduce borrowing. If higher interest rates do not slow private borrowing the implication is many borrowers are indifferent to the interest rate believing that they are able to sidestep repayment or expect to negotiate interest rates down. When companies are indifferent to the interest rate then it signals that they believe they will end up paying a lower rate.
The central bank cannot directly control lending rates and should avoid trying to do so. If it wants to lower interest rates it should increase the flow of credit to the banks. That will lower interest rates to some extent, but will increase the inflation rate.
There is another important point that has not been discussed. All borrowers should not be eligible for the same lending rate. Good borrowers with a track record of repaying their loans should receive a lower lending rate. This directs credit towards the most productive enterprises. Are the recent promises by the BAB to have single digit rates apply to all borrowers or to just the lowest risk? Most borrowers will be in the higher risk categories. So the implication is that if the BAB promise applies to the average loan then good borrowers should receive significantly lower rates. Unfortunately, this point is often forgotten and the good borrowers pay a higher rate than they should and the bad borrowers a lower rate. The result is the good companies are penalised and weak ones subsidised. This slows down economic growth and encourages non-repayment of loans.
The argument in brief is that the attempt to control interest rates by direct intervention is a wrong policy that will result in poorer quality investments, increased corruption, a weaker banking system, and slower economic growth.
To have lower interest rates there are two things that are needed: Reduce the rate of inflation and improve loan collection. Lower inflation means lower deposit rates and improved loan collection reduces the cost of covering bad loans.
Dr Forrest Cookson is an economist. [email protected]