Interest rate controls: A risky bet
A government-imposed control on rates of interest, slated to come into force in Bangladesh from 1 April 2020, is going to distort market forces. Observers believe borrowers will gain to the detriment of both depositors and shareholders. Other arguments can be marshalled against subsidization of capital which we apprehend will hurt an already precarious banking system.
Price controls are unheard of in factor markets. By giving a pass to land, labour and machinery, why the government has chosen to home in on capital for manipulation is unclear. Let us, for a moment, forget about costly payday loans against which governments around the world have rightly imposed tough regulations.
Savers view interest as a reward for waiting and not consuming. Borrowers see it as the necessary cost of an essential input. So, careful and intricate reasoning undergird this cost-benefit structure.
The bank rate set by Bangladesh Bank together with repo and reverse repo rates influence short-term rates in the financial system. Long term interest rates, on the other hand, tend to track the economy’s trend growth rate. In light of the nuances involved authorities should think twice before issuing a fatwa on interest rates.
When a similar experiment was conducted in Kenya in the fourth quarter of 2016 where the central bank imposed a ceiling on lending rates, and a floor of deposit rates, a number of adverse effects were seen. Firstly, the stock of credit to SMEs dropped by around 10 percent in just one year. In contrast, lending to other types of borrowers (such as households or large corporates) continued to increase at a rate similar to the one prevailing before the introduction of the caps.
Secondly, stock of credit of small banks declined by about 5 per cent in 12 months. This was because the business model of smaller banks was to lend high-cost money to SMEs.
However, medium- and large-sized banks continued to achieve moderate credit growth. Thirdly, a shift of credit away from the private and towards the public sector was noticed. Overall, the volume of credit going to the private sector climbed down.
Apart from the time value of money, inflation,and default risk, administration expenses have to be factored into the interest rate for money lent out. Time value of money, an important concept in finance, is the opportunity cost of having, or not having, money in hand.
Secondly, unless one fails to recoup about 6% from lending in Bangladesh inflation will eat up some of the yield. Thirdly, there is a risk that borrowers will fail to pay interest or principal or both. Fourthly, administration costs(as a percentage of loan volume) depend on the particular circumstances of the bank.
Borrowers will be eager for the suddenly cheaper money. However, depositors would flee from reduced yields on their deposits. Banks will suffer the double whammy of leaner net interest income (NII) and reduced volumes. As a consequence, net operating income will be squeezed bringing down dividends. With lesser retained earnings banks may have to discard automation projects. Credit ratings of affected banks may worsen. Stock valuation will suffer to the detriment of individual portfolios.
In order to compensate for falling interest margin banks may be tempted to charge fees thus making the real cost of borrowing opaque. Productivity of bank officers will fall in tandem with reduced volume of loans.
In this see-saw game the financial sector is put at a disadvantage vis-a-vis the real sector. The government should concentrate on correcting factors that drag down Bangladesh’s ‘ease of doing business’ score rather than go for a risky experiment. Investors abhor uncertainty.
* Raihan Amin is visiting faculty, University of Asia Pacific