The chief of the tax administration is trying to set prices for banks. This is not a clever way of running a banking system.
Both the collection of taxes, and a functioning and profitable banking system are necessary for the economy to thrive, but we shouldn’t be mixing and matching the two sets of expertise. For what does the taxman know about the correct pricing structure or banking?
Mosharraf Hossain Bhuiyan made the insistence at a news conference with the MCCI. His point being that corporate taxation breaks have recently been introduced. Those banks which charge excessive interest on loans to business won’t get them. So he says at least, or perhaps urges.
This simply isn’t the way to do it. For a start, there’s no reason to believe that a revenue officer knows the correct price for money. In fact, there’s no particular reason to think that any one person does, which is why we don’t try to have prices set by politics, politicians, or the government. It’s rather the point of a market economy that prices are set by that intersection of supply and demand.
It’s also possible - and we should - to delve into rather more specific points. For example, the interest rate charged upon any one loan isn’t really the point. For we know that some loans will go bad, the borrower will never repay. This is the default rate. Whatever rates are charged on the whole portfolio of loans has to cover the loss of the capital in those loans not repaid. Plus, of course, the operating expenses of the bank and hopefully some profit.
Thus we need to look at the interest rate with reference to the risk of default, it’s simply not possible to say that any one rate is “too high” without considering that risk.
We can, using this insight, ponder whether interest rates in general are too high. Given the level of non-performing loans (those somewhere between might default, about to default, and have defaulted) in many Bangladeshi banks, their need for government subsidy to keep operating at all, we’d probably say that interest rates are too low. They’re not covering that risk of the loan not being repaid after all.
Another more specific point is to ask, well, who should be regulating the price of bank loans? The correct answer being that it should be competition in that market place. For again, we’ve no evidence that any individual knows the correct price of anything.
It is the ebb and flow of supply and demand which enables us to discover that correct price, where the market clears. All those who wish to lend at that price can do so, all those who wish to borrow -- given their risk -- at that price can do so. This correct price is emergent from the system, not something we define before we start, nor anything we impose upon it.
We’re really not in favour of imposing interest rate ceilings upon banks therefore. But we can and should go further too, in two manners. The first is the effect of a price cap. Any such set below that market clearing price will lead to more people desiring to borrow and fewer being willing to. This, inevitably, leads to shortages. Only the favoured will be able to gain loans in such a system.
Those who will be favoured, given the state-owned nature of many banks, will be those with the right political connections. Do we really want to increase the benefits of being politically connected in Bangladesh today?
The last major point here being that we’d actually like banks to take risks on people who might default. That means they’ve got to be able to price loans to cover the risks of their doing so. Another way to put this is that point above, that there is no right price for a loan, there’s only a correct risk-adjusted price.
OK, so a large manufacturer with reliable income streams might and should be able to borrow at a relatively low rate. They’re pretty secure as a risk, that is. How about a small company just emerging from the informal economy into the registered, tax-paying, and legal part of the nation’s work? They’re obviously riskier as a loan prospect. But we’d also very much prefer that such organizations did make that transition.
So, as a matter of public policy, we’d like them to be able to access bank finance. It will be a great deal cheaper than that on offer in that informal economy, after all. This availability of more affordable finance should act as a magnet to encourage the change.
However, they’re still going to be much riskier than that more established organization, and the bank will need to charge a much higher price to cover that default risk. This higher legal price still being less than the informal economy’s lending rates.
If the bank can’t charge enough because lending rates are capped then the loan doesn’t exist, the company isn’t financed, and potentially doesn’t leave the informal sector. Not the outcome we desire.
Finally, we do in fact have a method of limiting interest rates. It’s called market competition. Any bank that starts making excessive profits will find other banks trying to copy it. To steal its customers by offering a better deal. Which is, rather again, the point of having a market economy, that prices are not centrally set.
We shouldn’t be using the tax system to set interest rates, we shouldn’t be imposing limits upon interest rates either. To do either is to miss the very point of having a market economy in the first place, that prices are set by supply and demand. More specifically, banks should price their loans not according to just the interest rate, but also the risk of default.
And we’ll have a much more vibrant economy if they’re allowed to charge rates high enough to allow riskier loans.
Tim Worstall is a Senior Fellow at the Adam Smith Institute in London.
