The ‘academic’ view on the 9% interest rate cap: A clarification

When asked about the outcome of the lending rate cap, a reputed senior banker recently said: "In spirit, I support the regulator putting a cap on our lending rate to bring down the cost of doing business and improving our Ease of Doing Business metrics. However, academicians are of the opinion that lending rate cap is contradictory to the spirit of free market economy and financial cost is not the only cost to the business."

The "academic" view is misconstrued

This is amusing. Had it only been just that, it would have warranted no clarification. The problem is it is also not quite right. I assume when he says "academicians" he means economists who teach and do theoretical and empirical economic research. As far as I know, economists in Bangladesh did not express reservations about the interest rate cap on grounds of the "spirit of free market economy" and the other costs of doing business.

The reason is simple. Except some ultra-libertarian economists, I know of no economist in the world, not to speak of Bangladesh, who believes in free markets as an empirically established fact. As the Nobel Laureate Joseph Stiglitz often points out "the invisible hand is invisible because it does not exist". Market interventions are judged based on the extent to which they achieve the intended objective, not whether they are consistent with an undefinable notion such as the "spirit of free market economy".

Interest rate was never in the "getting credit" metric of the (late) Ease of Doing Business report. Moreover, opposing attempts to reduce the cost of doing business in one domain by referring to costs in others is "what aboutism" that takes one into an unhelpful circular debate territory – why this and not that and conversely why that and not this. If the regulator feels that they should start with the cost of credit, so be it.

Unintended consequences were the issue

Nobody ever questioned the good intention of the regulator. Their intention is to widen access to credit for large and small businesses so that they can invest, innovate, and employ more. The question was whether imposition of a 9% cap on lending rate will achieve these objectives. Worse, is it possible that it may in fact defeat them? 

Was the problem really the high cost of credit or structural barriers (collaterals, transaction costs, asymmetric information) to credit access? Was the high cost of credit due to excessive profits arising from market power of some big banks or was it because of high credit risk, risk free rates and operating costs? Will the cap address the root causes, or will it just camouflage the symptoms?

Why do economists think the unintended consequences are likely outcomes of the cap? We started with the assumption that the cap will be binding because the prevailing interest rate on bank credit was in most cases well above the 9% cap. It is reasonable to assume that the willingness to supply loanable funds, other things (such as the cost of funds and credit risk) equal, is positively related with the lending rate. So, when the regulator sets the cap at a level below what the market is willing to bear, the supply of loanable funds decline. At the lower rate the lender will not be willing to make as much additional and renew existing loans as they are at the prevailing higher rate.

A binding cap on the lending rate lowers the optimal loan portfolio size and alters its composition towards lower risk loans. Since they can longer play with the rate, bankers would prefer not lending to market segments where the transaction costs and the risks of providing credit cannot be covered within the cap. As all lenders do this, total loanable funds transacted falls with the curtailing of high cost and risky borrowers. This may partially be alleviated if the lenders can make up the loss in interest earnings by adjusting lending related non-interest fees and charges.

There are other effects to worry about. These are the indirect effects elsewhere in the economy which in turn feedback on the market where the initial change occurred.

In this case the most important indirect effect occurs through the market for deposits. With lower willingness to supply loans it is natural that the banks will themselves be needing less funds at any given rate. This means their demand for all types of deposits will decline, more for high-cost deposits, at existing deposit rates. As this happens the deposit rates will decline, more on the high end. The consequence is a reduction in the cost of funds which in turn can partially offset the initial decline in the supply of loanable funds if total deposits do not fall because the savers have not much elsewhere to go.

Thus, the unintended consequences economists worried about were decreased volume of credit, increase in noninterest charges and fees related to loans and decrease in costs of deposits through both cut in rates and shifts in the composition to low-cost deposits. The reduction in credit volume and curtailing lending to risky opportunities defeats the policy objective of increasing access to credit and thereby boosting investment, innovation and employment.

What did we observe on these fronts?

Growth of credit to the private sector decreased from 9.1% in March 2020 to 8.4% in June 2021 after reaching a historic low of 7.6% the month before. After decreasing 29.7% during July-September, disbursement of total industrial term loans during October-December 2020 decreased by 31.8% compared to the same periods the previous year. During these same quarters, loan disbursements to Cottage, Micro, Small and Medium Enterprise (CMSME) loans decreased by 27.6% and increased 0.68% respectively.

There is no systematically compiled data on non-interest charges and fees related to loans. Banking sector operating profit declined 8% in 2020 relative to 2019 though total non-interest income increased by 24.5% (BB Financial Stability Report 2020). In June 2021, BB set anew the fees for a cluster of banking services including loans. It set ceilings on loan processing fee and fee for repayment ahead of the schedule. BB also waived loan application fees, service charge, loan management fee, monitoring or supervision fees, risk premium or any such fees other than interests. Restrictions such as these are suggestive of at least incipient increases in noninterest charges on loans.

The weighted average deposit rate declined from 5.5% in March 2020 to 5.1% in June and further to 4.1% in June 2021. These declines recently prompted BB to set a floor on the deposit rate based on a three-month average headline inflation rate. The share of almost zero cost demand deposits in total deposits increased from 11.2% in June 2019 to 11.5% in June 2020 and further to 12.3% in June 2021.

Most of what happened in the market for bank credit and deposits in the post 9% cap era are consistent with the predictions from the application of standard demand-supply framework of economic analysis.

Does that mean the economists were right?

Not necessarily! The reason is the conflation of factors causing the changes.

The binding cap assumption was reasonable until Covid forced a sudden reduction in economic activities. The pandemic depressed the demand for credit, increased the inflow of remittances through formal channels and induced liquidity expansion by BB as well as fiscal stimulus through subsidies on interest rates. It is not easy to disentangle the impact of the cap from the effects of all these other changes caused by the pandemic. But a look at the subsequent behavior of the lending rates is instructive.

Average lending rates of scheduled banks fell below 9% in April 2020 when the cap became effective. However, it has declined since to 7.3% through June 2021. The decline occurred for all categories of borrowers – SMEs, large industries, agriculture, and services. The cap cannot explain these declines. Fall in credit demand due to Covid induced disruption in economic activities appears to have taken the teeth out of the cap. The persistent slowdown in credit growth may therefore have little to do with the persistence of the cap.

One factor that escaped attention is the impact of the 9% cap on banks' operating efficiency. According to the reputed banker mentioned earlier "One major strategic move during the trying time was to rein in our operating cost…." There is anecdotal evidence that this happened in case of many banks as they hastened digitization of their systems. Was it due to the cap? While necessity is the mother of invention, profit is the midwife of innovation and adaptation. Why were the banks not exploiting opportunities for cost reduction before being pushed by the cap to do so, if indeed that was the case?

An economist will be inclined to view such a phenomenon as a case of dynamic inefficiency. The extent to which a firm introduces new products or new process depends on market contestability. Firms with significant market power might be complacent because they are under no pressure to adapt new technologies. Competition can stimulate innovation, ex‐ante, but the investor cannot always completely appropriate the benefits ex-post as competitors start copying the innovator. Knowing this everyone waits for the other to move first. The result is no one invests in innovation. If this has indeed been the case in our banking sector, then the regulatory cap could have tipped the balance in favor of adoption of better operating management systems or maybe "social distancing" at work necessitated by Covid did the trick!

Closing thoughts

Economists are generally circumspect in their assessment of interventions such as the interest rate cap. Historically, economic theories have changed as facts changed, not the other way round. If the bankers are aligned with the regulator on the 9% cap in spirit, they should be so in letter as well irrespective of what the academics say. 

A more cunning interpretation of the alignment of spirit with the cap currently may be related to getting 9% on credit disbursed as part of the stimulus packages (with interest subsidies from the government budget at 4.5% and 5% for large and CSMEs respectively) whereas the rates on unsubsidized loans fetch no more than 7.5%!