Asked about the outcome of the lending rate cap, a well-known senior banker recently said: “In spirit, I support the regulator who caps our lending rate to reduce the cost of doing business and improve our ease of doing business. to do business. However, academics believe that lending rate caps are at odds with the spirit of the free market and that the financial cost is not the only cost to the business. “
The “academic” point of view is misinterpreted
It’s funny. If it had been just that, it would not have warranted any clarification. The problem is, it’s not quite correct either. I guess when he says “academics” he means economists who teach and do theoretical and empirical economic research. As far as I know, economists in Bangladesh have not expressed reservations about capping interest rates due to the “free market spirit” and other costs of doing business.
The reason is simple. Apart from a few ultra-libertarian economists, I don’t know any economist in the world, let alone Bangladesh, who believes in free markets as an empirically established fact. As the Nobel laureate Joseph Stiglitz often emphasizes, “the invisible hand is invisible because it does not exist”. Interventions in the market are judged on the extent to which they achieve the intended objective, and not on whether they are compatible with an indefinable notion such as “the spirit of the free market economy”.
The interest rate was never part of the “getting credit” measure of the Ease of Doing Business Report (late). Further, opposing attempts to reduce the cost of doing business in one area by referring to the costs in others is “what is issueism?” If the regulator believes it should start with the cost of credit, so be it.
Unintended consequences were the problem
No one has ever questioned the regulator’s good intention. Their intention is to expand access to credit for large and small businesses so that they can invest, innovate and employ more. The question was whether imposing a 9% cap on the borrowing rate will achieve these goals. Worse, is it possible that he could in fact defeat them?
Was the problem really the high cost of credit or structural barriers (guarantees, transaction costs, asymmetric information) to access to credit? Was the high cost of credit due to excessive profits resulting from the market power of some large banks or was it due to high credit risk, risk free rates and operating costs? Will the plug tackle the root causes or will it just cover up the symptoms?
Why do economists think unintended consequences are a likely outcome of the cap? We started from the assumption that the ceiling will be restrictive because the interest rate in force on the bank loan was in most cases well above the ceiling of 9%. It is reasonable to assume that the willingness to provide loanable funds, all things (such as cost of funds and credit risk) equal, is positively related to the lending rate. So when the regulator sets the cap below what the market is willing to support, the supply of loanable funds decreases. At the lower rate, the lender will not be willing to make as many additional loans and renew existing loans as the higher rate in effect.
A binding cap on the lending rate reduces the optimal size of the loan portfolio and changes its composition to lower risk loans. Since they can no longer play with the rate, bankers would prefer not to lend to market segments where transaction costs and lending risks cannot be covered in the cap. As all lenders do, the total loanable funds processed decreases with the reduction in high cost and risk borrowers. This can be partially mitigated if lenders can compensate for lost interest income by adjusting non-interest fees and charges related to loans.
There are other effects to be concerned about. It is the indirect effects elsewhere in the economy that in turn spill over into the market where the initial change occurred.
In this case, the most important indirect effect occurs through the deposit market. With less willingness to provide loans, it is natural that the banks themselves need less funds at a given rate. This means that their demand for all types of deposits will decline, more for high cost deposits, at existing deposit rates. As this happens the deposit rates will go down, more on the high end. The consequence is a reduction in the cost of funds which in turn may partially offset the initial drop in the supply of loanable funds if total deposits do not fall as savers do not have much to do elsewhere.
Thus, the unintended consequences of which economists were concerned were a decrease in the volume of credit, an increase in non-interest and loan-related charges, and a decrease in deposit costs both through lowering rates and changes in the composition of low-cost deposits. Reducing the volume of credit and reducing lending to risky opportunities defeats the policy objective of increasing access to credit and hence stimulating investment, innovation and employment.
What have we observed on these fronts?
Credit growth to the private sector fell from 9.1% in March 2020 to 8.4% in June 2021 after hitting an all-time low of 7.6% the previous month. After decreasing by 29.7% between July and September, disbursements of total industrial term loans from October to December 2020 decreased by 31.8% compared to the same periods of the previous year. During these same quarters, loan disbursements to Cottages, Micro, Small and Medium Enterprises (CMSME) decreased by 27.6% and increased by 0.68% respectively.
There is no systematically compiled data on non-interest charges and loan charges. Banking sector operating profit decreased 8% in 2020 compared to 2019, although total non-interest income increased by 24.5% (BB Financial Stability Report 2020). In June 2021, BB redefined the pricing of a cluster of banking services, including loans. It has set ceilings for loan processing fees and prepayment fees. BB has also waived loan application fees, service fees, loan management fees, monitoring or supervision fees, risk premium or any other fees other than interest. Such restrictions suggest at least the beginning of an increase in fees other than interest on loans.
The weighted average deposit rate fell from 5.5% in March 2020 to 5.1% in June and 4.1% in June 2021. These cuts recently prompted BB to set a floor for the deposit rate on the based on a three-month average headline inflation rate. The share of demand deposits at almost zero cost in total deposits increased from 11.2% in June 2019 to 11.5% in June 2020 and again to 12.3% in June 2021.
Most of what happened in the bank credit and deposit market after the 9% cap period is in line with expectations from the application of the standard framework for economic analysis of supply and demand. demand.
Does this mean that economists were right?
Not necessarily! The reason is the amalgamation of factors causing the changes.
The binding ceiling assumption was reasonable until Covid forced a sudden reduction in economic activity. The pandemic has depressed the demand for credit, increased the inflow of remittances through formal channels, and induces an expansion of liquidity through BB as well as fiscal stimulus through interest rate subsidies. It’s not easy to disentangle the impact of the cap from the effects of all these other changes caused by the pandemic. But a look at the subsequent behavior of lending rates is instructive.
Average lending rates for listed banks fell below 9% in April 2020 when the cap went into effect. However, it has since fallen to 7.3% through June 2021. The drop occurred for all categories of borrowers – SMEs, large industries, agriculture and services. The ceiling cannot explain these decreases. The decline in credit demand due to the disruption of economic activities induced by Covid seems to have pulled its teeth out of the cork. The persistent slowdown in credit growth may therefore have little to do with the persistence of the cap.
One factor that has escaped attention is the impact of the 9% cap on the operational efficiency of banks. According to the well-known banker mentioned above, “a major strategic move during the difficult period was to control our operating costs…”. There is anecdotal evidence that this has happened with many banks as they have accelerated the digitization of their systems. Was it because of the cap? While necessity is the mother of invention, profit is the midwife of innovation and adaptation. Why weren’t the banks exploiting the opportunities to cut costs before being pushed by the cap to do so, if that was indeed the case?
An economist will be inclined to regard such a phenomenon as a case of dynamic inefficiency. The extent to which a company introduces new products or processes depends on the contestability of the market. Firms with significant market power can be complacent because they are under no pressure to adapt new technologies. Competition can stimulate innovation, ex ante, but the investor cannot always fully appropriate the ex post benefits as competitors start to copy the innovator. Knowing this, each waits for the other to move first. The result is that no one invests in innovation. If this has indeed been the case in our banking industry, then the regulatory cap might have tipped the scales in favor of adopting better operations management systems or perhaps the “social distancing” at work necessitated by the Covid did the trick!
Economists are generally cautious in their assessment of interventions such as interest rate caps. Historically, economic theories have changed as the facts have changed, not the other way around. If the bankers are aligned with the regulator on the 9% cap in mind, they should be aligned in the letter as well, regardless of what academics say.
A more astute interpretation of the alignment of the spirit on the current ceiling can be linked to obtaining 9% on the credits disbursed within the framework of the stimulus plans (with interest rate subsidies of the government budget to 4%). , 5% and 5% for large and CSME respectively) while the rates of non-subsidized loans do not exceed 7.5%!