Lending and deposit rates spread

ON May 6, bdnews24.com quoted Bangladesh Bank's (BB) Deputy Governor Nazrul Huda as saying that BB would hold back issuing licenses to private commercial banks (PCB) for opening new branches if they didn't slash interest rate spread (IRS) between deposit and lending. He also warned about taking measures against PCBs with regard to opening of foreign exchange branches and other issues.
Nazrul said that the PCBs promised to bring the spread down to 5% by slicing the lending rate within three months and, at the same time, revising the service charges downward. He argued that the decision to press banks to cushion lending rates was in line with the recommendations of the Bangladesh Business Forum (BBF) headed by the chief adviser.
BB governor Salehuddin Ahmed said earlier that they could not just ask the banks to lower the lending rates. On the contrary, that is exactly what the BB did on February 19, asking PCBs to submit proposals within two weeks on how to reduce IRS and fees for various banking services, and on May 6 set conditions for issuing licenses for opening new branches.
The BB also proposed that the banks withdraw all charges relating to accounts operation and stop charging handling costs from the clients.
According to a BB report, the average IRS of commercial banks is 6.16%, whereas the average international spread ranges between 4% and 5%. A few examples of the IRS may be examined from the table (constructed from the February 19 Daily Star report).
As of April 20, the country's banking sector witnessed an upward trend on deposit rates while the lending rates exhibited a declining trend.
There is copious empirical evidence that suggests that bank-lending rates adjust differently to deposit rates, giving rise to an asymmetric adjustment in the spread.
Studies have shown that banks may adjust their lending rates asymmetrically, that is, raise their lending rates faster when market interest rates (on govt. bonds, savings certificates etc.) are rising, and lower lending rates when market rates are falling.
There are studies, which examined the relationship between prime lending rates (PLR: Interest rates charged to most trustworthy borrowers) and deposit rates. In fact, banks may set their PLRs as some "mark-up" relative to deposit rates (in the US this mark up is approximately 3% above 10 year T bonds). If this "mark-up" becomes too high or low, the market forces will put pressure on the banking industry to adjust back to some "normal" or equilibrium spread.
Bankers' Association Chairman Nazrul Islam Majumder, however, defended the current rates, saying that running PCBs incur higher costs as they employ skilled staff demanding higher pay and benefits. He argued that reduction of lending rates is unsustainable unless the interest on savings certificates and treasury bonds are slashed.
Make no mistake, the business of banking, anywhere in the world, isn't set to operate and maximise profit like perfectly competitive firms following the golden rule of "price equal to marginal cost" (MC=cost of producing an additional unit of service).
Banks operate more like monopolistic competition and maximise profit until MC equals MR, where marginal revenue (MR) is the additional revenue earned from a given service equal to the cost of that same given service (MC).
Don Patinkin, in Money, Interest, and Price (1965), argues that if banks were to operate under perfect competition and no government interference, then they would produce and sell their products like any other industry and would earn normal economic profit. But that is not so and, hence, banks make more than normal profits.
Because of monopoly power, banks can produce differentiated products and quality services, which reflect cost and price differences. If depositors and borrowers are willing to pay for those products and services, so be it. If PCBs operate inefficiently like the NCBs, then we won't have any PCBs existing on the horizon.
The wedge between the lending and deposit rates reflect information asymmetries between banks and their clients. Once banks and their customers establish some business contracts, it becomes costly for clients to switch to a different lender. As a result, banks may be slow to adjust their rates to declining market rates, causing the spread to widen relative to some equilibrium spread.
-Cost of intermediation -- one that facilitates mobilisation of savings, diversification and pooling of risks, and allocation of resources efficiently. Since savings deposits and loans aren't always synchronised, intermediaries like banks incur certain costs due to uncertainty. To recoup those costs, they adjust the interest rates for deposits and loans.
-Efficiency of the intermediation process. For example, under perfect competition the wedge is narrower, composed only of the transaction cost, while in an imperfect market, the wedge is wider, reflecting inefficiency in market operation.
-Inefficiency in the intermediation process of a repressed financial system (as in Bangladesh). This is because in a control policy regime (e.g. BB intervention) credit policies involve substantial administrative costs, and interest rates with set ceilings fail to reflect the true cost of capital. Such a policy regime encourages non-price competition (e.g. see the Table for divergences of rates).
-The government sector's reliance on the domestic market to finance its fiscal deficit; tightening of monetary policy to reverse inflationary expectations.
-Quality of collateral and, therefore, the cost of borrowed funds to the investors.
Political uncertainty, economic slowdown, and inflationary environment also significantly distort the coordination of deposits and lending, leading to a spectre of declining profitability, non-performing loans, and distress borrowing. As a result, the premium charged on credit is high, keeping lending rates high while widening the interest rate spread.
We are not saying whether banks should cushion the IRS or not. In the present inflationary environment in Bangladesh, lowering lending rates seem to be fuelling further inflation -- certainly a counter-intuitive inflation -- combating stance.
Besides, BB must assess the prevailing macroeconomic environment vis-à-vis the performance of the banking sector before pressuring banks to lower their lending rates.
Macroeconomic environment influences the ability to repay loans, and the demand for loans. Contractionary monetary policy by BB to reverse inflationary spiral, and pressuring banks to lower the lending rates at the same time, may be deemed as a flawed and unsustainable policy.

Dr. Abdullah Dewan is Professor of Economics at Eastern Michigan University and Sayeda Haq is a Ph.D (economics) candidate at Brandeis University at Boston, Massachusetts.