From one frying pan to another?

The Bangladesh Bank (BB) has apparently decided to change its 9-6 percent policy stance on interest rates, according to at least one newspaper report. 

There will no longer be a 6 percent cap on the deposit rate. The bankers are free to charge any lending rate on lending to all sectors except industry. The lending rate to the latter cannot exceed 9 percent. The change comes following unsuccessful attempts to impose a blanket 9 percent ceiling on the lending rate and 6 percent ceiling on the deposit rate for last year and a half.

Two questions:

• Will this cure the key ailment—non-performing loans--in the banking sector?
• Will this help expand access of industrial enterprises to cheaper loans?

The answer to the first question depends on the impact on the incentives for defaulting and the quality of new loans extended after the interest rate policy change.  As reportedly widely today, NPLs rose to 12 percent by end-September. It increased despite rescheduling Tk 130 billion NPLs under the new rescheduling policy.  NPLs of all types of banks increased—state-owned banks, domestic private banks and foreign banks.

This clearly indicates a behavioral change on the part of borrowers. Like all profit maximizing agents, they are responding to incentives for defaulting to get access to concessional rescheduling terms.  The lifting of the ceiling on lending rates to non-industrial borrowers has no impact on the loan classification and rescheduling policy.  On this count therefore there can be no impact on the NPLs.

Let us suppose, for the sake of argument, that banks comply with the new interest rate policy.  What form will such compliance take?  In an environment where there is still pressure on bank liquidity due to excessive government borrowing, weak deposit growth and continued sale of foreign exchange by the BB, the cost of funds to the banks are unlikely to fall.  In fact, with the lifting of the ceiling on the deposit rate, banks will be free to use rates to attract deposit.  They will look to invest the money thus raised where they can get returns high enough to cover the cost of funds, operating expense and the default risk premium. 

Given the ceiling on rates charged on loans to industrial enterprises, they will naturally look for borrowers in the rest of the economy where they can charge any rate based on the bank-customer relationship.  This increases the chances that they may miss out some good industrial borrowers who would have repaid the loan in time and lend to risky borrowers outside industry hoping that the higher interest earnings from such borrowers will cover the probable loss due to loan defaults. 

Consequently, we cannot rule out the possibility that NPLs may increase further because of this new policy. But we can more or less rule out the possibility that NPLs will not fall as a result of this policy because it has no impact on the incentives for default at the individual borrower level.

The answer to the second question depends on the impact of this policy change on total banking liquidity and the demand for credit from non-industrial sectors. The impact on bank liquidity is unlikely to be significant because the ceiling on the deposit rate was not binding to begin with.  The incentive on the part of the banks to lend to industries is weaker now since there is no ceiling on lending to others and since the industry sector cannot compensate it with a better record on loan repayment—NPL ratio in the industry sector was in fact the highest in 2016, according to a BB study.  There can be no better prescription for drying out lending to a sector than the combination of a bad credit history and a ceiling on the lending rate to the sector.

If banks are somehow pressured to do industrial lending at the ceiling rate, there could be loan arbitrage with industrial borrowers borrowing more than they need, so they can use the excess for non-industrial purposes or set fake industrial units to access the concessional industrial lending from banks.

While a relaxation of controls may appear like a move in the right direction in the sense of lessening controls, but that may not necessarily be the case.  As we know from the economic theory of the second best, if a requirement for achieving an optimum economic situation is not satisfied, attempting to satisfy those requirements that can be met might not be the next best option. It may even be harmful.

Alternatively, consider a light-hearted analogy to cookie-baking borrowed from The Economist (August 21, 2007): "If the optimal cookie contains chocolate chips and coconut flakes, but you have no chocolate chips, chances are you don't need the coconut either. The second-best cookie may be the gingersnap. If ingredients (or logical conditions) do their work through a certain combination or complementarity, you may have to aim for something completely different even if you're missing just one of them."

What Bangladesh Bank should do is to get rid of all interest rate caps and focus on implementing the macro-prudential regulatory framework symmetrically for all banks.

The author is an economist.