Interest rate: Is it too high?

There seems to be some confusion about bank interest rates and interest spreads, both of which are believed to be too high. In fact, the confusion is an old one; it also dogged the policymakers during the last caretaker government. A reason for it seems to be that far too many people think banks can unilaterally set any interest rates on deposits and loans. Bangladesh Bank as the regulator of the financial sector can also willy-nilly impose its will on the banks. BB itself has a history of pandering to such notions.

If this were true then one would have to question the competitive nature of our banking industry. It is well known that in a competitive market a seller can set prices above that of its competitors for similar products only at the risk of losing customers. A seller would not also set prices below the market price as it would lose money. Any hope of increasing the number of clients through price cuts would be soon dashed when the competitors retaliate by cutting their prices. Thus, if our financial market is competitive, no single bank should be able to unilaterally set the prices of its loan products (i.e. interest rates); it will be forced to follow the market trend. Economic theory suggests that it is not possible to reduce prices below the competitive prices as these are the lowest prices at which the sellers can carry on business sustainably.

However, this should not be interpreted to mean that the rates of all banks will be the same. The rate set by each bank comprises not only the ordinary cost of funds, but also the cost of services including goodwill. Depending on how the clients value such services the rates can differ and should not be forced to be equal. If a bank sets the deposit rate above the market norm in the hope of attracting funds because it is facing difficulties in maintaining the required liquidity ratio, it should be allowed to do so.

Only when a market is monopolised or cartelised, a seller can set prices on its own. A monopoly does not face any competition since it is the only seller in the market. In a cartelised market, a small number of sellers act in collusion in order to prevent competition. Obviously such prices will be higher than the competitive prices. If the commercial banks are charging excessively high prices (interest rates) for its loan products, it must be concluded that the banking industry is not competitive.

If BB itself alleges that the banks are charging too high interest rates or the interest spreads are too high, it is in effect alleging that the banking industry is not competitive. Since it is the mandated responsibility of BB to ensure that the sector functions competitively, it should investigate how and where competition has broken down, and take measures to restore competition.

Since there are 47 scheduled banks in Bangladesh, the banking industry cannot be, by definition, a monopoly. Hence, it has to be a cartel (oligopoly) if it is behaving noncompetitively. Although many an eyebrow will be raised to the hairline how such a large number of  banks could form and maintain a cartel, only an organisation, formal or informal, in which all banks are members (or accepts its decisions) could possibly act as an arbiter or coordinator of interests of all individual banks.

Curiously, BB asked the Association of Bankers of Bangladesh (ABB), an organization of the senior-most executives of mostly private banks to ensure that the interest rates did not exceed a limit that BB considered appropriate. ABB apparently has agreed to comply. The important question is whether the rates that existed before this intervention were competitively determined or not. If they were not and were reduced by ABB under the pressure of BB's moral suasion, it would imply that ABB has the power of a cartel manager to reduce (and therefore, increase) interest rates. The fact that the interest rates have been temporarily brought down to, say, competitive levels does in no way reduce that power. If this is the case, BB has avoided the principal issue of breaking up the cartel and ensuring more competition in the industry. Since the cartel remains in force, it can use its power whenever the time is propitious.

Now suppose that the banking industry is competitive and the interest rates that existed earlier were actually the competitive rates. There may be good reason to believe that they were since they were established after BB discontinued capping. If moral suasion by BB had forced ABB to ask its members to reduce the rates, what would be the implications of such a reduction?

An increase in the interest rate will normally increase the supply of bank deposits and hence the supply of bank loans. On the other hand, an increase in the interest rate will reduce the demand for loans. Hence, the reduction of the interest rates below the competitive levels will reduce the inflow of deposits, but increase the demand for loans creating an excess demand situation in the loan market. Since the supply of loans falls short of the demand, either some mechanism has to be worked out to ration the limited supply of loans, or there will be side payments by keen borrowers to secure loans. Such payments are feasible since the borrowers in such a market are willing to pay higher than the market interest rates. Thus, by forcing the banks to reduce the interest rates, BB opens up opportunities for either selective loans (to preferred clients) at best, or outright corruption at worst.

Since the competitive price is the lowest price for long term sustainability, by forcing banks to reduce their rates BB would have put the long term survival of the banks into jeopardy if the banking industry were competitive. It was the responsibility of ABB to persuade BB away from this course if it believed the industry to be competitive. By complying with BB's request to instruct banks to reduce their rates, ABB would appear to have accepted the non-competitive nature of the industry.

It is instructive to note that any reduction of the interest rates increases the demand for loans. Thus, the moral suasion to reduce interest rates actually runs counter to the current monetary policy that requires a reduction in credit demand, which in turn requires an increase in the interest rates. BB seems to be reluctant to accept the unpleasant fact that a reduction in inflation rate is not possible without a significant reduction in the money supply and that a monetary contraction will inevitably raise the interest rates. The sooner it comes to terms with this, the better it can address the current monetary problems.

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M. A. Taslim is a Professor of Economics of the Department of Economics, University of Dhaka. He is currently holding the charge of the Chairman of the Department. He was formerly the Chairman of Bangladesh Tariff Commission.