Bank interest rates: The A-Z

Originally appeared on The Morning

By Dhananath Fernando

As the Annual Budget approaches in November, there lies the risk of introducing price controls again. Budgets are usually like auctions of resources that don’t actually exist, often used by governments for publicity. In the 2015 Budget, there was a salary increase for Government workers and price controls were placed on items like hoppers and plain tea.

Budgets that come around election periods more often include giveaways and price controls, which cannot be maintained sustainably.

Meanwhile, the Central Bank, in a recent Monetary Policy meeting, hinted at controlling interest rates for certain banking services like pawning, credit cards, and pre-arranged temporary overdrafts.

The Central Bank appears to be in a tough spot, facing pressure from political authorities, the people, and other stakeholders. People and businesses are still struggling with the economic crisis, the aftermath of the Easter attacks, and the after-effects of Covid-19. People need loans (credit facilities and services) during this tough time. Unfortunately, the banking sector is slow to respond by lowering interest rates, even with the Central Bank’s new policies.

Recently, the Central Bank has been lowering interest rates – the Standard Lending Facility Rate and the Standard Deposit Facility Rate. The Statutory Reserve Ratio (SRR) has also been brought down by 2% and changes have been made, but this hasn’t led to a proportional decrease in lending rates by banks.

Unique situations for different banks

Some banks have responded more than others. For example, some banks charge higher interest rates for pawning (27% compared to 20% in other banks) and credit cards (33% compared to 28% in other banks). The same goes for personal loans (4% vs. 2%).

Let’s try to understand why some banks offer higher rates while others don’t.

Each bank’s lending and deposit portfolio is unique. Some banks generally have a higher percentage of Non-Performing Loans (NPLs). For them, bringing interest rates drastically down may be difficult. Since interest income is the key income for banks, if a particular bank has a higher NPL ratio, it would be difficult to adjust the interest rates.

On the other hand, with domestic debt restructuring, certain banks had higher exposure to Treasury bonds. Prior to debt restructuring, these banks faced higher risk, yet as they have been excluded from restructuring, this same exposure became a blessing later. For them there is greater room to adjust the interest rates while others may not have the same leeway.

Different banks have different types of loans. Some focus on small businesses, while others offer pawning. Pawning is safer because there is something valuable as collateral. Each bank’s situation is unique, and ideally in a market system people should switch to banks with lower rates, assuming everyone has the same information.

Options with consequences

However, these changes take time, especially when the country’s monetary system isn’t stable due to debt restructuring and weak economic policy. Also, due to instability, in most cases banks aren’t offering fixed interest rate loans anymore; most loans have flexible rates.

Mounting pressure on the Central Bank has left a few options, each with its own consequences. One option is offering special low-interest credit lines (e.g.: special credit lines with the support of the Asian Development Bank, etc.), like the Enterprise Sri Lanka loan scheme introduced before by former Finance Minister Mangala Samaraweera. This could lead to unintended consequences, like people using the loans for non-productive purposes.

For instance, many bank managers disbursed the loans to their existing customers, who basically settled their previous high-interest loans with the new loan at a concessional rate. Some loans were taken for consumption purposes, such as weddings and buying vehicles. There were reports that existing companies, including large companies, set up new entities just to obtain a loan to cover their previous debts. However, this is a solution that can be tested with the least impact within a strict monetary system, but unintended consequences should be expected.

Another option is the Central Bank artificially lowering rates by printing more money. This could worsen the economic situation, causing problems for the exchange rate and later on for inflation and the entire financial system.

Alternatively, the Central Bank could use its influence for the funds it manages (e.g.: Employees’ Provident Fund) and buy Government bonds at lower rates, attempting to push rates down. This also has downsides and is not advisable.

No simple solutions

When a country’s monetary system isn’t stable, these complex situations arise. This column has warned, time and time again, against the monetary instability caused by money printing that led to these situations.

Setting a cap on interest rates is like controlling prices, which isn’t a good idea. It could set a bad precedent and cause further problems. On the previous occasion the Central Bank controlled the exchange rate and forex repatriation, the Balance of Payments (BoP) crisis got worse. Though interest rate caps may have good intentions, the fallout could be tricky. In response, banks with portfolios that don’t support lower rates may reduce their lending, affecting people who need loans.

People who have credit needs may have to settle for further high interest options, making their situation worse on one side. More fake microfinance solutions with very high interest rates may emerge and people will have to depend on informal financial borrowing if the banks impose more restrictions on pawning and selected operations.

Social costs can be seen as there were multiple incidents of conflict in recovering debt and in extreme cases, even the loss of life. The experience over years has been for the Government to provide debt cancellation and relief for people by taking responsibility for the debt when people suffer from bad loans.

Unfortunately, there is no simple solution. The best approach is understanding the issue and its consequences before taking action.