The paradox of interest rates

RMA will issue reforms in the interest of both public and financial institutions

Banking: With borrowers vying for a reduced lending rate and banks warning of a subsequent drop in deposit rates, the interest spread (difference in borrowing and lending rates), banks maintain, is in question.

In taking the private sectors’ concern of high lending rates, the government has asked the central bank to review interest rates on loans and study the possibility of lowering it down to make it more affordable to the borrowers. Banks had warned that reducing the lending rate might come at a cost of lowering deposit rates.

With the current deposit rate, a local economist said that there is no incentive but erosion of the money value. For instance, a fixed deposit yields 5 to 7 percent interest annually and it is taxed. Accounting for annual inflation, the money saved in fixed deposits is earning negative return. “This would discourage saving,” he said.

For the money to retain its value, people’s incomes should increase by at least the rate of inflation. If it doesn’t, then the purchasing power of the money decreases. So, after tax, the rate of interest on saving must be greater than inflation for the value of money to actually grow.

“Did the deposit rates change according to the inflation rate?” he said, adding the deposit rates remained the same when inflation hit double digits in 2012.

Base rate

While many borrowers complain about banks’ lending interest being higher than the base rate, bankers are of the view that the banks in the country are already exposed to more risks than they can bear.

The base rate, which is the lending rate below which it is not viable for the banks to engage in lending activities, is not the final lending rate. It is the minimum cost of funds that ensure that the banks don’t suffer losses and that it recovers all its costs.

The fact that no commercial entity will prefer to run at a break-even compels the banks to determine the final lending rate. The base rate is determined depending on the cost of fund, return on capital, and other operational costs.

Suppose a bank gets a deposit of a certain amount. It has to pay interest to the depositor. Banks also need to maintain a certain portion of its total deposits in cash with the central bank called the cash reserve ratio. Also, the banks set aside a certain portion of liquid assets as statutory liquidity ratio. This means that the banks will not be able to lend about 30 percent of their deposit funds.

Banks will also have to bear other operational expenses, including salary. They will also have to pull out some return on their capital invested in business. All these factors determine the base rate. The final lending rate will be the base rate added up with credit-risk premium, a compensation for tolerating risk. The Credit Information Bureau prepares the risk premium.

The chief executive officer of Druk PNB, Mukesh Dave, said lowering the interest rate on loans reduces the banks’ yield on advances. This, he said, would not only affect the profitability of banks but also hurt them on the operation front. These factors combined, he added, reduces the banks’ ability to take risk.

Risk exposure

Banks in the country are exposed to more risk than they can bear. Ability to bear risks would also affect the interest rate of both deposits and credit.

With capital market at an infant stage, banks have limited investment opportunities. A recently published study on the financial sector by the Asian Development Bank (ADB) stated that the financial sector in Bhutan is susceptible to vulnerabilities because of growing asset liability mismatches.

This is because a significant proportion of the deposit base consists of short-term, seasonal and volatile corporate deposits, while credit is concentrated in long term lending to the construction-related projects.

All the five banks in Bhutan need to borrow to fund their short-term liquidity mismatches, says the report. There is no bank with surplus liquidity for lending.

More than a quarter of the financial sector’s portfolio consists of building and construction loans, followed by personal loans, which constitutes around 16 percent of overall credit outstanding.

Because of the small number of government treasury bills and corporate bonds in the market, the money market in Bhutan is very narrow.

Besides developing the capital market, encouraging deposits via attractive schemes and exempting taxes on savings are a few initiatives that could strengthen the financial institutions in the country, says the report.

Royal Monetary Authority (RMA), however, is in the process of studying the interest rate structure.

“It is the responsibility of the RMA to constantly follow the interest rate structure and issue reforms considering the interest of both public (as depositors and lending entities) and financial institutions,” said Governor Dasho Penjore.

He added that the central bank is also in dialogue with the financial institutions to introduce priority-lending schemes to suit the needs of the economy, particularly in enhancing local production and employment generation.

Tshering Dorji

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