Another capricious regulation

The Bangladesh Bank (BB) has decreed that banks cannot set interest rates on fixed deposits below the inflation rate. In the circular, it explained that this is intended to protect the incomes of small depositors, encourage savings, prevent the diversion of savings to unsafe investments, and protect the asset-liability balance of the banks.

All these intentions are laudable. Will these be achieved by mandating that the term deposit rates cannot fall below the inflation rate, or could there be some unintended consequences that may make this intervention self-defeating?

Consider first the income protection argument. Yes, by making inflation rate the floor, you make sure individuals who hold term deposits in banks do not lose out in real terms. This takes a rather naive view of how it all works. Forcing banks to offer rates they do not want to offer will only make them not offer the product itself.

When you cap lending rate at 9% and set an inflation-based floor on fixed deposit rate when inflation has rarely been below 5.5% in recent memory, how do you expect banks to remain profitable other than by trying to minimise their cost of funds? This was happening anyway because of the cap on the lending rate. Decreased demand for credit and rapid accumulation of excess liquidity reinforced the effect of the lending rate cap.

Now the inflation-based lending rate floor will further exacerbate the preference for current and saving deposits from the banks' side. In that case the same individuals who the BB wants to protect may have no option but to hold their money in current and savings accounts that are not subject to the latest regulation. They will end up losing even the "low" interest rate on term deposits the banks were offering before this regulation was put in place.

What effect will this have on their savings and how savers store their savings? If availability of safe stores of value such as fixed deposits in banks decline, the savers will either stop or reduce saving and store it in unsafe or unproductive investments that the BB is worried about. The cure may be worse than the disease.

How will this regulation help protect the asset-liability balance of banks? BB officials cited the possibility of banks drawing down their capital because of weaknesses in deposit growth when rates on deposits are below inflation. They also told the media that the new regulation constitutes only 30% of the total deposit. If you think this is small, as the BB wants you to think, don't be surprised if it gets even smaller.

What has been the experience? Deposits have grown irrespective of whether the rates are in line with inflation. Deposit growth in the last twelve months makes it clear. This happened primarily because of a surge in formal remittances and a rise in digital commerce most which require payments through the banking system. According to BB data, the number of deposit accounts held by individuals in the scheduled banks have increased despite the growth recession caused by the pandemic.

There is a ceiling of 87% on the Advance-Deposit Ratio. This is intended to ensure that banks do not lend beyond their capacity to lend and thus avoid the need to draw down their capital. What is the need for yet another regulation to achieve the same objective? Just as too many cooks spoil the broth, multiple regulations aimed at the same objective can produce similar results, for instance, by increasing the maturity mismatch between the asset and the liability sides of bank balance sheets.

How much more will the BB micromanage the banking system? It imposed lending-rate ceilings, restricted servicing fees, and now there is a floor on deposit rate. What next? The consequences of added micro prudential regulation can be good, bad, or ugly depending on its logic and timing.

The logic of this new regulation is incomprehensible in the context of the pressing challenges facing the banking system. The combination of a lending cap and a deposit rate floor limits the space within which banks can compete based on interest rates. The timing could not be worse than when the banking system is flushed with excess liquidity.

The right thing to do is to mop up the excess liquidity, which the BB has started doing. The success of the new regulation in terms of increasing deposit may in fact undermine the objective of this open market operation unless there is a dramatic increase in demand for credit. If credit demand remains weak, more mopping up will be needed leading to unnecessary increase in the BB's interest expenses.

When caps on interest are set at levels that are out of equilibrium with market rates, they have unintended negative consequences which can make everyone worse off, reduce financial services and thus discourage both savings and investment. Interest rate controls on the surface appear like an easy fix, but they have lasting negative consequences for the health of the economy.