The Baseless Rate

In the second week of November, the Nepal Rastra Bank (NRB) issued a base rate circular targeting the commercial banks. The circular, however, has taken only a recommendatory rather than a mandatory stance as regards its compliance. In other words, it is a mere paper, not a policy. It is because if the banks were to treat this as a mere reference rate on lending, as the NRB claims, the rationale of the whole exercise, as it is, would be futile. If the NRB intended to make the circular mandatory but remained short of doing so in apprehension of reprisals, it is on the wrong plank of policy formulation.

The formulae suggested by our central bank through this circular to calculate the cost of fund for lending make us believe that the rate is similar to the ‘base rate’ of the Reserve Bank of India that came into effect in July 2010 or the Discount Rate of the US Federal Reserve that has been there for years. Central banks enforce such base rates to prevent the systemic failure of financial institutions, if the latter indulge in deficit-driven transactions for a long period of time. But in our case, there are only a few instances where Class ‘A’ banks have actually incurred losses by resorting to competitive lending rates, which are below the actual cost of fund.

If the idea behind the NRB’s base rate circular is to keep the interest rate regime transparent, then it may be taken positively. However, the transparency component has already been incorporated in the concept of quarterly publication of the financial statements of the banks and financial institutions. Therefore, this circular without teeth was an unnecessary exercise.

In fact, central banks which have to handle a financial system with abundant liquidity often enforce base rates to prevent banks from resorting to cheaper lending rates to attract or retain clients. Also, such rates are applicable where the interest on lending, like in the US, is very low - at times below 3-4 percent per annum. Or, in the case of the 2010 Indian economy which was feared to be over-heated. But Nepal’s banking system at present has no such issues. The system, more often than not, remains cash-strapped. As a result, the banks’ interest rates are usually high - at times as high as 20 to 22 percent.

Besides, the practice of central banks fixing base rates has become an outdated and anti-free-market concept over the past couple of years. If a particular bank opts to lend at a cheaper rate with low profit margin, it may earn even more out of the sheer volume of the transactions. Therefore, it is up to the business manager of a bank to decide what market strategy to adopt and at what price to sell its products.

 The NRB’s circular to the banks to publish their base rates on a monthly basis is an additional cost burden on them. Not only that, barring the banks in all circumstances from lending at rates lower than the base rate is barring them from the freedom of portfolio and treasury management. The interest rates on lending to a variety of projects (like SME loan, consumer financing and mega-project financing) are bound to be starkly different. Therefore, an efficient bank may like to finance at lower interest rates the projects that give it a better mileage in the market, though not a direct profit, and compensate for the ‘loss’ by lending to projects where it may be able to charge higher interest rates.

 In this exercise of base rate policy, the intentions of quite a few stakeholders got badly exposed. The NRB’s actual intention was to make it mandatory, not because it would do any good to the system, but because the regulator perhaps wanted to show that it still has some controlling powers over the financial sector.

 It was clear that some established bank were in favour of the circular whereas the new ones, whose costs of fund are likely to run high if calculated according to NRB guidelines, were averse to it. But, the new banks could not muster the courage to say that the circular was an unnecessary exercise. The NRB, on the other hand, could not justify its half-hearted approach in introducing it.