What banks should do to conform to regulations on deposit and lending rates

Bangladesh is a bank-based financial system. The main task of a bank is to play the role of a financial intermediary between depositors and borrowers. Banks pay an interest rate to depositors for their fund, which is known as the cost of deposit. Similarly, the bank charges an interest rate from the borrowers to cover funding cost, operating cost and profit margin. 

The difference is known as the spread. This is a common practice in the banking system, and common knowledge. 

However, a debate started when the Bangladesh Bank issued a circular regarding the rationalisation of interest rates on deposits on 8 August (BRPD Circular No. 17). Before this, Bangladesh Bank issued a circular on 24 February last year, where the lending rate ceiling was fixed at a maximum of 9% (BRPD Circular No. 03). 

A question may arise about such fixation of interest rate by the central bank, especially, in the context of an open market economy.  

The most significant change during the last three years we have observed is in the case of the weighted average lending rate. The lending rate was around 10% in June 2018, which reached 7.3% in June 2021, well below the regulatory ceiling of 9%. This change was expected as a result of the implementation of a cap on the lending rate on 1 April, 2020. 

The outcome is encouraging for borrowers as they were demanding a single-digit lending rate to boost business activity and economic growth - a critical measure to recover from the economic damage caused by the Covid-19 pandemic. But the regulatory ceiling is not the only reason for the declining lending rate. 

The recent reduction of the deposit rate due to the implementation of a 9% lending rate is a concerning issue for the depositor. The rate is now lower than the inflation, which produces a negative real return (Real Return = Nominal Return – Inflation) for the depositor. 

Covid-19 pandemic continues to significantly impact credit demand, which created surplus liquidity in the banking sector. This excess liquidity pressure is so immense that the banks were bound to reduce the lending rate well below the regulatory ceiling. 

On the contrary, deposits have increased significantly during this period (14.34% year-on-year growth). A simple demand-supply theory, where excess supply reduces price, is at play here. At the moment, the banking sector is experiencing this and the ultimate result is a declining weighted average deposit rate, which reached 4.13% in June 2021. 

The reality, however, is grimmer. The deposit rate, for a significant number of banks, is even below 4% because some of the financially weak banks are offering a high deposit interest rate. Eventually, banks are shifting their lending rate burden on the depositors, keeping their spread and profit unchanged. 

TBS Sketch of Md. Nehal Ahmed

However, this was not the motivation behind Bangladesh Bank fixing the lending cap. Banks should think of different ways to solve this problem. One concerning issue for the banks might be the erosion of excess liquidity due to the high demand for a loan once the Covid-19 debacle subsides. 

When talking about deposit rates, it is imperative to focus on one vital aspect of the banks' balance sheet. Depositors are the major source of funds and approximately 90% of the assets of a bank are sourced from depositors' funds. However, depositors are still the lesser prioritised customer group in the banking system. 

Looking at the last three years, it can be observed that there continues to be a strong pressure, from a group of 'borrowers,' for reducing the lending rate to a single-digit. They were successful in attaining their demand. 

The shareholders are also getting a very good return from the banks, with some exceptions. That's why the intervention by the central bank was necessary, as someone must speak in favour of the depositors. Also, this was a mandate from the regulator to protect the interest of the depositor. 

The recent reduction of the deposit rate due to the implementation of a 9% lending rate is a concerning issue for the depositor. The rate is now lower than the inflation, which produces a negative real return (Real Return = Nominal Return – Inflation) for the depositor. 

As a result, savers are being affected and losing their purchasing capacity. The situation forced them to look for alternative sources like sanchaypatra, real estate and other unproductive sectors so that they can achieve, at least, a positive return at the end of the year. Such a trend will affect banks in the future, creating an imbalance between deposits and assets. 

Bangladesh Bank's circular focused on this area. 

As per the circular, the bank's interest rate of term deposits must not be less than that of inflation, which is quite reasonable as it will protect the interest of the depositors. 

How will the banking system handle this double-edged sword? Banks are required to increase efficiency in various activities to conform to the regulatory norms regarding deposit rate and lending rate. The efficiency may be improved by increasing productivity, reducing cost and minimising Non-Performing Loans (NPL). 

With regards to cost reduction, the possible options may be the reduction of unnecessary use of stationery, conveyance, and refreshment; as much as possible limiting the number of time annual reports are published; arranging virtual board meetings and annual general meetings; hiring office space at a reasonable rate; avoiding luxuries decoration of branches/head office, etc. 

But on the contrary, some banks have started to curtail the salary, increment, and other benefits of their employees. Undoubtedly, cost reduction is necessary but it should not be at the cost of employee motivation and productivity. A demotivated employee is a burden for banks, which will have long-run effects. 

With regards to NPL management, the banks display structural weaknesses or inefficiencies in selecting good quality borrowers. Publicised banking scams highlight the frequent intervention of the board members in the day-to-day credit decisions. Thus, bank managements have failed to apply professional judgment in all lending decisions, and lending criteria were compromised in many instances. And so, distorted corporate practices affected bank credit quality, which adds extra cost because of higher provisioning requirements associated with classified/bad loans. 

Banks should improve their corporate governance practices to a level that will promote sound credit practices, improve quality of credit and reduce NPL. For achieving this, all stakeholders must be aware of their role and act accordingly. 

Finally, from a risk management perspective, a 9% lending rate should not be equally applicable for all borrowers. This rate is appropriate for most inferior quality borrowers, considering the risk-based pricing concept. 

As per risk-based pricing, lending rate is the summation of Cost of Fund, Cost of Operation, Cost of Capital, and Risk Premium. Risk Premium is the price a borrower must pay to the bank for assessing and accepting the risk. Risk premium can be calculated by using the internal credit risk rating (ICRR) of the borrower. 

For attracting good borrowers, the lending rate offered should be lower than that offered to an inferior quality borrower. The bank is at present charging the same interest rate to all borrowers. As a result, good borrowers are being penalised. The application of risk-based pricing can be beneficial for all types of borrowers, as well as for banks. 

All these initiatives might help the bank to adjust to the new regulatory norms regarding the deposit rate and lending rate, especially, in a situation where the economy is in a recovery phase from the Covid-19 pandemic. 

Md. Nehal Ahmed is a professor and the Director of Bangladesh Institute of Bank Management (BIBM).