Stabilising Lending Rate

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Stabilising Lending Rate

There are several reasons behind the failure of measures introduced by the central bank and bankers to achieve interest rate stability.
The interest rate in the Nepali banking sector has risen significantly over the last few years. In July 2018, the weighted average lending rate (WALR), the aggregate rate of interest paid on all debt, reached to 12.47 percent which was at 8.8 percent in July 2016. The interest rates on hire purchase, bank overdraft rate and real estate sky rocketed to 15-16 percent. This rise in interest rate has noticeably affected all stakeholders of banking including the corporate sector, small and mid-size enterprises, investors and consumers. The Nepal Rastra Bank (NRB) has made a series of efforts to stabilise the interest rate. However, the market forces are so strong that the policies introduced by NRB have so far failed to tame the increasing lending rate. 
The government has set the economic growth target at 8 percent. NRB has also tried to facilitate the growth target by introducing an expansionary monetary policy. Nevertheless, such a move of the central bank has not been that fruitful in maintaining a good financial environment in the country. 
In order to achieve the growth target of this size, it is obvious that huge domestic and foreign investment is required. The availability of sufficient investment-grade funds in the financial system at lower interest rates is essential in this respect. Given the current situation, the chances are very low for this target growth. Besides, the higher bank interest rate has also affected the domestic stock market, eroded the value of property and affected the purchasing power of the people. 
The central bank and commercial banks have already made a series of efforts in a bid to stabalise the rising lending rate, a time series of which has been presented below:
June 21, 2018: Nepal Bankers’ Association (NBA) capped interest rate on savings at 7% and set maximum interest rates of 11% for ordinary depositors and 10.5% on fixed deposit. 
July 11, 2018: Spread rate was reduced to 4.5% from 5% and interest rate corridor maintained at 3.5% to 6.5% from 3% to 7%.
Dec 20, 2018: A NBA meeting decided to cap interest rate on savings at 6.5 %, 9.25 % on individual fixed deposits and 8.5 % on institutional fixed deposits.
Dec 24, 2018: The central bank in its mid-term Monetary Policy review removed the return on asset (ROA) (0.75%) portion from the base rate calculation.
The graph below shows that the lending rate did not improve significantly after the efforts by the central bank and bankers:
Root Causes of the Problem
The roots of the current problems related to the short supply of investible funds and the rising interest rate can be traced back to July 23, 2015 when NRB announced a new paid-up capital plan for BFIs, a fourfold increase in the paid-up capital of the institutions, in the Monetary Policy of FY2015/16. The biggest threat the new capital requirements brought was the dilution of Earnings per share (EPS) because a fourfold increase in paid-up capital of banks means a fourfold increase in the number of shares resulting in a significant drop in EPS if the profitability of the institutions remains constant.
This situation pressurised the management of banks to find ways to boost profits and maintain EPS at good levels. Bankers resorted to significantly increase their business volumes. In order to do so, banks started lending aggressively in all ways possible to generate higher profits and to maintain their EPS. 
However, the extension of loans of banks outpaced their collection of deposits ultimately causing a shortage of investment-grade liquidity in the country’s financial system. The noticeable increase in economic activities across the country and post-quake reconstruction works after the end of the prolonged political transition fueled the demand for credit acting as a catalyst for bank lending. 
In the wake of the problems created by the short supply of investible funds in the banking system, NRB and NBA came up with several initiatives aiming towards achieving interest rate stability. Let’s take into account some of the major steps of the banking sector regulator and bankers.   
June 21, 2018 - Agreement in NBA to Cap Interest Rate: Interest rates on deposits and lending are largely correlated. It is because banks lend money at rates above their deposit rates in order to sustain themselves. When the short supply of investment-grade liquidity in the banking system left the banks high and dry, the financial institutions resorted to pulling each other’s deposits. As a result, interest rate on deposits went up to 14 percent which in fact was a lose-lose situation for bankers. It was a time when banks were collecting deposits at exorbitantly high interest rates, whereas NRB was pressurising banks to lower the lending rate.
In this situation, a ‘gentlemen’s agreement’ between the members of NBA on June 21, 2018 capped interest rate on savings account at 7 percent and a maximum of 11 percent for ordinary depositors and 10.5 percent for institutional depositors on fixed deposits. Nevertheless, some banks breached the agreement and started collecting deposits at above 12 percent and as a result the agreement became void. 
July 11 2018 - Reduction of Spread Rate and Adjustment of IRC: Spread rate is the difference between weighted average lending rate (WALR) and weighted average deposit rate (WADR). The higher the spread rate, the higher the lending rate. In a bid to curb the sky rocketing lending rate, NRB adjusted the spread rate by reducing it from 5 percent to 4.5 percent in July 11, 2018. Bankers expressed their dissatisfaction over this move of the central bank as they claimed such a measure will reduce their profitability levels. But they did not have options other than to follow the directives of NRB.
Similarly, the interest rate corridor (IRC) was also adjusted. IRC is a tool of the central bank to stabilise the interbank lending rate. The amount borrowed from interbank lending can be used as deposit; therefore it also affects the lending rate.
IRC has lower and upper bounds. Higher the gap between the lower and upper bounds, higher will be the chances of fluctuation of interbank lending rates which in turn helps to fluctuate the bank lending rate. At the time of IRC adjustment, the lower and upper bounds were 3 percent and 7 percent respectively.
NRB tries to maintain interbank lending rates within this limit by using tools like repo and reverse repo. After observing a sharp rise in bank interest rates, NRB narrowed the gap by increasing the IRC’s lower bound to 3.5 percent and decreasing the upper bound to 6.5 percent in July 11, 2018 through the Monetary Policy for FY 2018/19. However, no significant improvement was seen on lending rates. 
 Dec 20, 2018 - Second ‘Gentlemen’s Agreement’ in NBA: Bankers capped the interest rate on deposits for the second time in 2018. Interest rate on savings was set at 6.5 per cent, whereas it was 9.25 percent on individual and 8.5 percent on institutional fixed deposits.
If this agreement continues, positive effects might be seen after a couple of months. It is because the interest rate on deposits is the most influential factor that affects the lending rate. Dec 24, 2018 - Removal of ROA from Base Rate Calculation:   Base rate is an interest rate, below which banks cannot lend to their clients. Lending rate is determined by adding spread rate on base rate. For instance, if the base rate is 10 percent and spread rate is 4.5 percent, then the average lending rate will be 14.5 percent. Base rate is calculated by adding five different components (cost of fund + CRR cost + SLR cost + operating cost + ROA). Higher the base rate, higher will be the lending rate.
Before NRB issued a circular on December 24, 2018, banks were allowed to put 0.75 percent ROA on the base rate. But NRB removed the ROA portion as a component of the base rate. Other things remaining constant, WALR should go down by 0.75 percent. Though the rise in interest rate has badly affected borrowers, it has made depositors happy as they are benefitting from the higher interest rates on deposits.
The finance minister may be happy because this situation might have served his intentions to curb lending in the stock market, hire purchase, real estate and other ‘unproductive sectors’. Nonetheless, borrowers in these sectors have become the greatest victims. On the one hand, the monetary authority’s inability to lower the interest rate indicates the strength of market forces. On the other hand, it has raised questions about the competency of the central bank.
The author is Assistant Manager, Strategy and Business Development at Sipradi Trading. He is also an MPhil scholar at Katmandu University.

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