Interest Rate Caps: Smartest Way To Stimulate the Economy?

Bangladesh is a growing economy and it is the job of the financial regulators to aid in the growth in any way they can. The economy of Bangladesh is largely dependent on the service sector. But to move into the next stage of the world economy, Bangladesh needs investments in new businesses and industries. To encourage entrepreneurs into building new businesses, easier access to financing must be ensured. Interest rate caps are a widely used tool to make financing easier. An interest rate cap is when a fixed upper limit for the borrowing or lending interest rates is given to protect borrowers from excess interest rates.^[1]

The Bangladesh Bank is trying to implement a 6% deposit interest and a 9% lending interest rate with similar intentions. Ideally, the interest rates in banks are determined by a number of factors like the risk associated with the bank/debt, the demand of loans, the supply of funds etc.

Possible Outcomes: The Good and The Bad

It is not uncommon for Central Banks to take such steps to help grow the economy. However, the outcomes are not always desirable. Since the single digit interest rates have not been applied completely yet, its impacts on the economy can only be predicted. This article tries to look at both positive and negative outcomes.

The Good

Higher Investments: Theoretically, a lower lending rate should lead to an increase in investments. This is because, with lower cost to lend money, more people will get access to investment. Historically, this trend has also been seen.

This trend is encouraging for the government since it supports their rationalization for decreasing lending rates. These investments could assist old and new businesses alike. While entrepreneurs can get access to funding at a cheaper cost, current businesses can get credit easily for buying raw materials and machineries.

This will especially benefit small businesses and industries. It can be seen that without the interest rate cap, Small Businesses usually have to pay a higher rate of interest for their debts than larger industries and corporations.

The Bad

Worsen Liquidity Crisis: The Banks of Bangladesh have been facing a liquidity crisis since the early 2018s. This has been due to deposits in Banks not increasing at the same rate as they are disbursing credit.

One of the main purposes of lowering the lending rate was to increase loan disbursements to businesses. However, it is evident that credit disbursements have already been increasing steadily in the last few years while deposits have not been growing at a similar rate. Thus, there is a possibility that lowering the lending rate will further exacerbate the liquidity crisis in the banking industry.

Decrease Profitability in the Banking Industry: Bangladesh currently has 60 scheduled banks of which include 42 Private Commercial Banks.^[3] For an economy of Bangladesh’s size, the industry is extremely concentrated. Since the number of unbanked population is not increasing, these banks are having to compete for the current consumers. The banks’ profits are determined by the spread between the interest they give to their depositors and the interest they earn from their lenders. In 2018, before the introduction of the single digit interest rates, the spread had high variations among different banks.

Thus, the banks determined their spreads to maintain enough profitability to be able to survive in the industry. But now, since their spread shall be predetermined at 3%, it might result in a devastation in the banking industry.

Discourage General Populace From Depositing Money In Banks: Previously, the banks could provide various deposit schemes where interest rate could extend upto 8%.^[4] However, now that they shall only be able to give a maximum of 6% deposit rate, it will make depositors choose alternative sources like the National Savings Certificate where the interest rate is significantly higher and could range upto 13%.^[4]

Moreover, an important factor for determining deposit interest rates is the risk associated with the banks. Since the national savings certificate has the least risk, consumers have no incentive to deposit at banks where the risk is higher but interest rate is lower.

Possible Increase in Non-Performing Loans: A major issue that has been plaguing the Bangladeshi Financial Sector is the rise in non-performing loans. One theory in favor of single digit interest rates has been that a lower lending rate will decrease the amount of non-performing loans since they shall have to pay lower interest. However, that has not always been the case. When Kenya put on interest caps with intentions similar to Bangladesh, they saw a rise in their non-performing loans. The reason was, the lower interest rates encouraged people to take unnecessary loans on which they later defaulted.^[1] Bangladesh has also seen a rise in non-performing loans despite lowering lending rates in recent years.

Single Digit Interest Rates And The Future of Bangladeshi Banking Industry

The single digit interest rates have not yet been applied properly and thus it cannot be said with certainty that it will fail. However, as this article shows, single digit interest rates might bring up more problems than it solves. Moreover, currently, the most worrying phenomenon in the Banking Industry is the rising non-performing loans. This issue should be solved before policies to ensure single digit interest rates are applied. Since, the main target behind reducing interest rates is to increase economic activity, it is to be ensured first that cash is not being siphoned off the economy by loan defaulters. In the Swiss Banks alone there were BDT 5,347 crore in 2018.^[7]

Another important issue in the banking sector is the rise in the number of banks compared to the size of the industry. Since the clientele is not increasing, the current banks are having to compete with each other to survive. The single digit interest rates can be devastating to the banks who already have low profitability. However, in the long run, this could be a blessing in disguise for the industry since it will help to weed out the under-performing banks.

Despite the good intentions behind it, the single digit interest rates might not have the positive effect in the economy that it is expected too. Thus, it would be pertinent to implement it carefully and only after the current underlying issues are solved.

Kidwa Arif, Trainee Consultant at LightCastle Partners, has prepared the write-up. For further clarifications, contact here: [email protected]