Most private banks in the country saw their profit rise, though slightly, in the first six months of the current year despite a cut in lending rate and reduced spread. The lending rate was reduced from 13.25 per cent in April last year to 11.88 per cent in the same month this year. The weighted average spread came down to 4.84 per cent in April this year from 5.14 per cent in the same month of previous year. It is being suggested by different quarters to reduce the lending interest rate to single digit level.
It is to be noted here that the proposition of low rate has both opponents and proponents. It is a universally known fact that a bank borrows funds in the short term and makes long-term loans and investments which is also known as maturity transformation. While doing so, banks benefits from a wide spread between long- and short-term interest rates. When the banks yield curve steepens, banks' net interest margins (NIMs) increase. Conversely, when the yield curve flattens, banks' NIMs decrease. The NIMs are affected if the assets and liabilities of banks are re-priced at different times. Subsequently, any changes in banks' net interest income affect the bottom-line profits of the banks when the interest is the dominant source of income compared to other sources of income. This idea is viewed as conventional wisdom and according to this view, change in interest rate will affect the banks' net interest income, hence, subsequently the profits. This view supports the idea that returns on bank liabilities are relatively closely tied to short-term rates, and to adjust to changes in short-term rates relatively quickly. By contrast, returns on bank assets are more closely tied to longer-term rates and slower to adjust to changes in market rates. Therefore, bank net interest margins (NIMs) are expected to be higher when the yield curve is steeper for a sustained period because, once assets and liabilities have been re-priced, a steeper yield curve implies higher rates on assets relative to those on liabilities.
The available literature also shows that low interest rates lead banks to take on more risk due to following reasons:
n Low interest rates increase the prices and collateral values of assets on banks' balance sheets, which in turn modify banks' estimates of probabilities of default, losses in the case of default, and overall volatility of bank returns. Bank may experience improvement of banks' profitability during low-short term rate and relax their budgetary constraints.
n In order to get high rate of return banks often enter into long-term contracts. During the period of low interest rates, these contractual rates may go beyond the yields available on safe assets. Banks, therefore, will go for higher yields from the more risky assets.
n Many banks assume that the central bank will ease monetary policy in bad economic times. This can create moral hazard problem. Subsequently, there will be an asymmetric impact on risk-taking and banks will take more risks.
n Low interest rates can reduce adverse selection in credit markets, which decrease banks' incentives for screening loan application.
Many argue that the high volume of non-performing loans (NPL's) in the country is due to the high interest rate and suggest to reduce the lending rate. But the reduction in the lending rate is not a foolproof solution. Rather, it may make the situation worse. For example, a study carried out by Jimenez et al. (2008) on the Spanish banks revealed that low interest rates affect the risk of bank loan portfolio in two opposing ways. In the short-term, it reduces the probability of default of the outstanding loans. In the medium term, banks act more aggressively and lend to borrowers with a bad credit history and grant more loans with a higher probability of default. Another study by Gaggl and Valderrama (2010) on Austrian banks found that the expected default rates of banks' business loans increased during the period of low refinancing rates from 2003 to 2005. Similar incidents may happen in our country. If the rate is lowered below the profitable rate, banks may act aggressively to get high yield and soften the lending policy to attract more customers without giving much consideration to the credit-worthiness and capability of the clients. As a result, banks may end up with more default clients .
While many supports the idea that low interest rate may affect banks' profitability negatively, influence them to take more risks and may not be conducive to reduce the level of default loans, some argue that low interest rate has no impact on the profitability of banks. It is, rather, the overall economic condition of the country which matters. A study carried out by Federal Reserve Bank of Chicago (2014) showed that 1.0 percentage point decline in the unemployment rate over a quarter increased bank's ROA (return on assets) up to 9 basis point which was nearly three times the largest estimated effect on ROA of a 1.0 percentage point increase in their yield curve measure and six times the largest effect of the same increase in their short-term interest rate measure.
The proponent of this view in our country may claim that this year started with political instability and decreased economic activities. So banks initially faced some difficulties. However, the situation began to improve later and banks saw a rise in their profits despite a reduction, though insignificant, in lending rate and spread.
Although, it is subject to more research, it appears that economic conditions and other factors are also important along with low interest rate. In the previous years, in more or less similar rate, political situation and economic condition, the size of NPLs in the banking sector was low compared to the current one. This supports the idea that it is not the high rate that increased their NPLs but some other factors. The low interest rate can squeeze banks' earnings. But if low rates result in better economic outcomes such as a lower unemployment rate, increasing investment activities and growth in GDP (gross domestic product), banks may find a positive trend in their profits.
