The Financial Express

Noi-choi in banking

M. A. Taslim | Published: March 21, 2020 21:42:44

Noi-choi in banking

A process that began many months ago with a promise of the commercial banks to reduce their lending rates to single digits appears to be finally moving to a forced culmination. The commercial banks will be required to set their all loan rates at a maximum of 9.0 per cent by April 01. If this order is implemented it will have essentially reintroduced administered interest rates in the banking sector which an earlier government was forced to abandon in the distant past because of multifarious difficulties. Since then the interest rate was determined by the interaction of market forces.

It is possible for the government to fix any price, such as the price of rice. The market will then determine the quantity supplied (and demanded) and the manner it is produced. If the government attempts to also dictate the quantity sold or how it is to be produced then the stipulations could be unattainable. The market would be distorted and inefficient. Such markets are usually characterised by perpetual shortages. These shortages open up golden opportunities for the government functionaries and business people to engage in shady practices to enrich themselves.

Enforcing a 9.0 per cent interest rate should not be difficult since Bangladesh is a financially closed market, i.e. free flow of financial capital across the border is not permitted, and the average loan rate is currently only slightly above 9.0 per cent.  What affects the bottom line of the banker's balance sheet is not the loan rate itself, but the spread between the loan rate and the cost of funds which must cover all operating costs of the bank as well as provisioning. A bank will have little qualms to set the loan rate at 9.0 per cent if it could borrow funds for 4.0 per cent. However, if the cost of funds is, say, 7.0 per cent then the same bank might be reluctant to lend at less than 11 per cent. In the recent past the interest spread of the banks fluctuated around 4.0 per cent. If this cannot be brought down then the deposit rate has to be set at around 5.0 per cent to reduce the interest rate to 9.0 per cent. The concurrent stipulation of the deposit rate at greater than this rate (6.0 per cent) is simply not consistent with the viability of bank operations.

It is reported that the circular that Bangladesh Bank sent to the commercial banks specified the loan rate ceiling at 9.0 per cent, but did not mention the deposit rate. This leaves room for the banks to adjust to the low loan rate at the expense of the depositors with the implicit approval of the government. It seems the scheme to reduce the loan rate is simply a convenient way to reduce the return of the depositors in order to benefit the business sector. The hardest hit would be those dependent on past savings including pensioners.

If the interest rate prevailing now is the market equilibrium rate, a reduction in the loan rate (as required by noi-choi or 9.0 and 6.0 per cent) would create an excess demand for loan, but bankers would be unwilling to meet the demand fully at the lower rate. The total supply of loans would actually fall contrary to what the government is expecting. The distortion created by the interest rate ceiling will encourage corrupt practices as unsuccessful borrowers seek out loans aggressively.

An assumption that seems to be embedded in this policy is that saving does not respond much to interest rate as there are few alternatives to deposits. There is some danger in basing policy decisions on such an assumption. If savings do respond positively to returns the noi-choi policy could reduce the real deposit rate to negative numbers, and thereby reduce national saving and time deposits. Some of the savings could find way to land and other real assets, and to dubious companies or societies promising high returns, or may escape from the country altogether. It should be noted that during the last several years the deposit and lending rates have declined very substantially, but there has been little increase in business investment. Obviously the main constraint to investment is not the interest rate. None of the surveys conducted by international organisations to estimate indices of such things as investment climate or doing business etc. have found evidence of the interest rate being the major constraint to investment. The government seems to be unwilling or unable to deal with the real causes of loan defaults and low investment.

One outcome of noi-choi would be that it would essentially emasculate the monetary policy of Bangladesh Bank. The principle tool of monetary policy is the interest rate which Bangladesh Bank has some influence on. This derives from its control of the monetary reserves of the country which it can vary through various monetary policy tools. Such variations influence the money supply, which in turn determine the interest rate. When the ceiling of the loan rate is set by the government at 9.0 per cent Bangladesh Bank has to simply ensure it by setting the monetary reserves (and hence the money and credit supply) at the appropriate level. If the interest rate ceiling is less than the optimal rate for the economy Bangladesh Bank can do little to shield it from headwinds by making use of its monetary policy tools since any such attempt would raise the rate above the ceiling. If the market equilibrium rate is less than the ceiling, then it is not a binding constraint and consequently does not have implications for the monetary policy. The economic mayhem that can ensue when the central banks lose control over the monetary policy was witnessed in the aftermath of the great western recession of 2008-09 when the central banks lost control over the interest rate as it fell to near zero level. The low interest did not help business investment as the main problems lay elsewhere.

The banks usually have a slew of loan rates rather than a single rate. The most reliable borrowers of the banks are usually given loans at low rates while the less creditworthy clients have to pay higher rates to cover for the risk premium. This means that if the latter are given loans at 9.0 per cent then the former should be given loans at say 6-8 per cent. This would pose a dilemma for the bankers if they should charge the same rate for all loans. If the best borrowers are currently given loans at around 9.0 per cent, a further reduction will impose costs on them.

It is not clear what motivated the government to aggressively pursue the loan rate ceiling when the average loan rate is falling and is already very close to the stipulated ceiling. What is needed is not restrictions on the financial sector, but rather an improvement in the governance of the banking system. This should be an important function of the government. But it seems to be shying away from its core responsibility and meddling in areas that should be left largely to the financial market. Administered Interest rates were the normal in the era of financial repression, and the experience and lessons of that era should not be overlooked.

M. A. Taslim is Professor of Economics, Independent University, Bangladesh


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