Should all loans come under 6-9pc ceiling?

The government of Bangladesh has taken policy decision to put a cap on lending and deposit rates effective from April 01, 2020. Accordingly, the lending rate offered by scheduled banks should not exceed 9.0 per cent and the deposit rate should not exceed 6.0 per cent.

In essence, this financial sector reform-measure by Bangladesh Bank compels the scheduled banks to set their interest rates within the said range. Before examining the decision of market cap on interest rates, it is imperative to evaluate the banking tendency of spread and current situation of non-performing loans (NPL) and its recovery.

Bangladesh has the highest interest rate spread in South Asia, which directly affects the market setting of deposit rates and lending rates.

The recent rise in NPL has triggered an alarming situation in the banking industry, which has been identified as one of key factors for promoting the market cap on interest rates. As of September 2019, the cumulative amount of NPL stood at Tk 1.16288 trillion, which was Tk 993.71 billion at the end of September 2018.

Implementation of the proposed interest rate ceiling may generally speed up industrialisation in some areas, but will adversely affect small and medium-sized enterprise (SME) sector.

The issue of bringing down the lending rate to a single digit has been a significant concern of the country's banking industry for quite some time. Although it is essential to bring down the lending rate to pick up the pace of industrialisation and private investment, the market cap on interest rates should have been given on the basis of criteria of different loans instead of treating them in the same manner. As the lending rate varies with loan category and even with banks, the components involved with the lending rate also vary with loan types.

Policymakers may take into consideration these loan categories before pushing the same policy for all the loans. They may put emphasis on the lending rate in terms of components that make up the rate of lending of any financial institution.

The interest rate charged on loans is the sum of cost of funds, overhead costs (e.g., administrative costs of the bank as well as costs of processing loans), taxes, profits, and risk premium of the banks for bearing risks of the utilisation of funds.

A major problem that may arise out of putting the single cap across all types of loans is the chance of loan dislocation from high or small risk loan products. A number of countries use a relative cap link to set interest rates in which the past average (i.e. for six months) interest rates of the market, is used.

Countries such as Vietnam have applied multiple interest rates' cap for agriculture and rural sector loans. Similarly, Bolivia has set different interest rates for its social housing, agriculture, manufacturing, mining, and tourism sectors.

However, adopting the proposed interest rates can be beneficial to the economy in the following areas:

* Additional investment will be encouraged since the borrowing cost will be cheaper than before.

* The banking industry will move to an equilibrium point where risk exposure relating to cost of fund and lending rate would have been minimised.

* The lower market ceiling on interest rates can induce the banks to recheck their operational efficiency. In such a scenario, banks will have to reduce their operating cost to maximise profit.

* Interest rate caps can help safeguard public interest by offering a fair interest rate to everyone.

* The proportion of non-performing loans to total disbursed loans can be reduced if the number of quality loans disbursed for investment purposes increases. In this case, the lower lending rate can increase the chance of lowering bad loans if and when potential loans are disbursed with good judgment and maintaining strict monitoring afterward.

* Reduction in lending rates will increase consumption of households as consumers will pay less to finance their use. Lower required payments encourage consumers from buying durable goods on credit such as cars, white goods, etc. which increase consumption.

* Higher aggregate demand through higher consumption and investment leads to a higher demand for labour. More employment opportunities will be created which will boost the economy.

* The intended ceiling on the interest rates will act eventually as a stimulus for corporate and institutional borrowers and depositors. As around 70 per cent of the loans and advances are disbursed among corporate and institutional borrowers, it provides more bargaining power to such borrowers to ask for more return from the corporate deposits or investments. Thus the mentality of institutional and corporate depositors can be altered upon implementation of the market cap.

The inclusion of all types of loans into the bracket of 6.0-9.0 per cent also brings up the issue of loan mistreatment in view of different risks involved in managing them.

The SME sector loans require engagement of additional workforce for an individualised loan facility that impels banks to bear a high level of risk and cost. This high level of risk premium involved in the SME sector loans cannot be capitalised, should the 6.0-9.0 per cent loan cap be implemented. According to the central bank data, average interest rate on SME loans was around 10 per cent in 2019, which is around 1.5-2 per cent higher than the other loans. If the 6.0-9.0 per cent market cap on interest rates is implemented, banks will take a hit on their profit. This is due to the fact that approximate 20 per cent of the country's loans of scheduled banks has been disbursed for the SMEs. The interest rate bracket will leave serious negative effects on SME loans.

There will be challenges that have to be faced by the banking industry.

* An initial liquidity crisis may arise due to lower deposit rates since depositors would presumably feel reluctant to keep their money at such low yield. Instead, deposit funds may be diverted to unproductive sectors which bear a high level of uncertainty due to narrow investment opportunities persisting in Bangladesh.

* By employing a similar market cap on all loan categories, it may be difficult for the banks to sustain appropriate provisions for small loans to riskier borrowings.

* Low-interest rate caps, such as the intended 9.0 per cent for all loan categories, can force the lenders to stop expanding loans for SME and other risky ventures.

* Banking profit will take a hit if all loan categories are kept under the same interest rate bracket. In the process, the taxable income of banks will come down, which may negatively impact the revenue earnings of the government.

* Many researchers apprehend difficulty in matching demand and supply of funds if the initial liquidity crisis follows. This is because of hastiness of the approach to put a cap on every category of loan at a time.

* Several banks may face the problem of non-zero risk-adjusted returns where it will not be very easy to provide individual loans due to the extremely low-interest-rate ceiling.

* Banks may withdraw loan facilities from remote corners of the country due to high monitoring costs and instead provide loans only to urban areas where the monitoring cost is less.

* Lower interest rates may adversely affect the exchange rate, however, making exports more competitive.

* The lower lending rates encourage the consumer with more spending; therefore, there will be a hike in cost of imports. It will negatively affect the current account of Bangladesh.

The significant challenges that will be faced upon implementation of the market cap of 6.0-9.0 per cent comprise the current situation of alternative investment and implementation of policy in every bank at the same time. However, let's try to offer some solutions to policymakers for properly implementing the market cap on the interest rates:

* Multiple interest rates caps should be introduced for different categories of loan, such as corporate, SME, and consumer loans.

* Already disbursed short-term loans should also be allowed to carry on at their original lending rates. Newly created and disbursed loans, on the contrary, should be allowed to avail at the 9.0 per cent ceiling effective from April 01, 2020.

* New investment opportunities need to be created aside from capital market investment for making the economy more productive where investments can be liquidated or converted into another form of investment.

* Monitoring cells should be formed by Bangladesh Bank to routinely follow up the process of implementation of the market cap of 6.0-9.0 per cent in every bank.

* Information asymmetry on rates of different banks should be alleviated in order to ensure free-market interest rates (at least) within the interest rates ceiling.

* The national savings certificate rates should be adjusted with newly proposed deposit interest rates giving appropriate considerations to provide a particular scheme for senior citizens, pensioners, physically challenged people and women with low income.

* It is essential to follow up implementation of the government policy of putting 50 per cent of the government fund in all autonomous financial institutions.

* Willful defaulters should be identified and quicker legal action be taken to discourage other bad borrowers from seeking loans. Recovery of defaulted loans should be accelerated because without higher recovery rate, the already lent loans will remain unutilised.

* The banking services through agent banking, mobile banking and banking booths and sub-branches should continuously be expanded to achieve the goal of cashless economy concept in the long run.

* Consumer financial literacy should be promoted to protect borrowers from destructive lending and banks should enhance transparency of non-interest charges to assess the overall cost of loans of borrower.

* Lastly, there should be at least a 1.0 per cent variation in interest rate on deposits between the state-owned and private commercial banks as against the already proposed gap of 0.5 per cent.

If the above recommendations are adopted, the market regulations to be imposed by the central bank will have a positive effect on the banking sector. On the contrary, it will be a formidable task for Bangladesh Bank to tackle unsettled issues of NPL and its slow recovery if the proposed policy is not followed by all the banks. Needless to mention that the high rise in bad loans has already polluted the lending environment of the banking industry, which can be further affected if every bank does not operate under the same interest-rate ceiling.

Dr. Syed Md. Aminul Karim is a former Member, Tax Policy, at National Board of Revenue.

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Dr. Md. Ariful Islam is a banker working at Mutual Trust Bank Ltd

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