Bringing down spread between lending and deposit rates of banks
Financial institutions (FI) play a critical role in emerging economies where most borrowers have limited access to capital markets or any other potential sources of funds. These countries, including Bangladesh, need well functioning FIs to accelerate economic growth. The poorly functioning FIs are an impediment to economic progress. FIs in Bangladesh have very narrow products and survive on interest on loan. One study pointed out that traditionally 85 per cent of their income is contributed by interest on loans. Interest on loans contributes significantly to interest income of FIs.
The government and Bangladesh Bank are trying to reduce bank interest rate to 9.0 per cent or below from the existing effective interest rate of 18-22 per cent. The highest interest rate paid by FIs on deposits is 10 per cent. Bank interest rate largely depends upon bank interest spread rate (IRS). It is the difference between the lending rate and the deposit rate. The magnitude of IRS, however, varies across the world. The spread is around 5-7 per cent. In many countries banks charge interest on loan below 7 per cent. The existing IRS is very high considering interest and spread in many other countries.
Since independence, IRS has remained high in Bangladesh relative to both the global and regional standards. The policymakers and private businesses in particular have repeatedly expressed their concern over the persistence of high IRS in the banking sector. In 1960 the deposit interest rate was 2.4 and spread was 3.6 per cent, hence the interest rate was 6.0 per cent, and in 1995 the deposit interest rate was 3.4 per cent and spread was 5.9 per cent and the interest rate was 9.3 per cent. Many countries liberalised their financial sectors during the 1980s and the 1990s, with the objective of improving financial development and economic growth.
The nature and efficiency of the financial sectors have been found to be the major reasons behind differences in spread in countries across the world. In economies with weak financial sectors, the intermediation costs involved in deposit mobilisation and channelling them into productive uses are much larger.
Different independent studies have listed several reasons for high IRS. In developing countries, these include high operating costs, financial repression, lack of competition and market power of a few large dominant banks capable of manipulating industry variables including lending and deposit rates, high inflation rates, high risk premiums in formal credit markets due to widely prevailing perception relating to high risk for most borrowers etc.
Interest rate spread characterises a critical feature of the financial intermediation process in the economy. Least developed countries (LDCs) with financial market imperfections have been characterised by higher spreads due to factors such as absence of competition, burden of non-performing loans (NPLs), high administrative costs, inefficiency etc.
Inefficiency originates from the government's 'interventionist policies' and inadequate technical skills in the arena of risk and portfolio management. The central bank has options to influence lending and deposit rates in the desired direction through the monetary policy instruments such as open market operations (including repo and reverse-repo auctions), setting the bank rate, statutory liquidity ratio (SLR), cash reserve requirement (CRR), and the like.
Interest-rate spread influences the level of non-performing loans in many ways. For instance, high interest rate charged to borrowers makes it difficult for the borrowers to repay loans. Interest rates spread lead to the increase in non-performing loans as ineffective interest rate policy can increase the level of interest rates and consequently the NPAs. This can be done through reduction of interest rate spread. Loans that are given are either unsecured or are secured on assets that are hard to recover. Therefore, interest rate spread increases the likelihood of non-performing loans. High interest rates cause inflation which increases the cost of production or costs of goods sold. Such cost escalation can reduce earnings before interest and taxes.
Bangladesh's financial system is dominated by banks where the banking sector accounts for around 96 per cent of total assets of the financial sector. At present, there are over 60 banks comprising four state-owned commercial banks (SoCBs), five specialised banks (SBs). The rest are private commercial banks (PCBs) and foreign commercial banks (FCBs). The question that arises is why competition among the PCBs do not lead to a lowering of the spread. There is an invisible curtail among the FIs.
There is the need to explore policy options to increase competition in the financial sector, and measures to break market dominance of banks will be one such option. Further, the financial sector needs to explore internal as well as industry-driven strategies that counter some of the bank-specific factors associated with higher spreads. These could range from diversification of products to investment in cost-saving and efficient forms of technology.
The government's fiscal policy and high interest of borrowing instruments are also responsible for the high spread. Non-interest income of banks is important and the higher the non-interest income as a ratio of total assets of a bank, the lower will be its spread. FIs in Bangladesh have some common services extended to clients. FIs may focus on other services like credit default swap, futures market, hedging etc. FIs are not interested in those value-added services since they can earn more profit without much effort with traditional credit to borrowers.