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Analysis: Interest rates and deposits

  • Published at 06:05 pm November 25th, 2021
banking
An efficient banking sector is key BIGSTOCK

This is the fourth part of a series that provides a retrospective look at Bangladesh's financial sector

The financial sector comprises a number of markets and the prices determined by the supply and demand in these markets are returns to asset values, usually interest rates. 

For deposit rates and lending rates in the banking sector competition among banks will determine these rates, subject to the rules that the central bank may establish. 

The operation of the two markets for deposits and loans and the interest rates generated are the central issues in achieving a successful banking sector. 

The banks match the borrowers and the savers charging a small amount (often called the spread) for so doing. 


Also Read - A retrospective look at Bangladesh's financial sector

Also Read - A retrospective look at Bangladesh's financial sector: Part 2

Also Read - A retrospective look at Bangladesh's financial sector: Part 3


A previous article argued that the banking system was the main source of financing private investment in Bangladesh, so one concludes that the markets for deposits and advances are the most important in the financial sector. 

The capital market provides little funding of private investment.

Major players

There are four players:  the banks, the central bank, the depositors and the borrowers. 

Two markets, for deposits and for loans; and one intermediating organization, and the banks. 

The central bank sets the major rules for the banks to follow.  

In Bangladesh there are seven types of banks or near banks: 

1.     The private banks operate on western rules and principles.  These make up most of the system.  The operation of these banks is the heart of the banking sector.

2.      Private banks that operate on principles of Islamic finance.  The basic idea is that interest charges are immoral; lending to an enterprise from an Islamic system bank establishes a claim on the profits earned by the borrower.  Depositors share in the profits of the bank.

3.      Non-bank financial companies including leasing companies, companies that focus on housing, all characterized by being allowed to take only large deposits.  Depositors are at greater risk.

4.     Private foreign banks.  These banks are branches of banks whose head office is not in Bangladesh. They take largely current account deposits.

5.      Government owned commercial banks.  There are five major banks in this category.  All are insolvent but depositors believe, correctly, that the Government will always protect their money so the financial condition of these banks does not discourage many small depositors who value access through the large chains of branches these banks have established.

6.      Government owned banks that have a specialized direction for lending for example agriculture or industry.  These banks are relics of the past; they are currently insolvent and subsidized by the Government.  They contribute little to the financial sector. 

7.      Micro-credit institutions that receive funds from NGOs, international aid organizations, or the Government. These organizations make small loans to households with a large percent of the portfolio lent to women. These institutions are characterized by high interest rates [compared to the lending rates of banks] and high loan recovery rates

 

The depositors are the general public and enterprises who have financial resources and prefer to safely and return to invest in bank deposits.

The deposit market is simple enough. 

One makes a deposit of whatever type, location, and bank that the saver chooses.

The bank has a schedule of interest rates for deposits.

However, there is perception by depositors of different risk levels associated with different banks.

Current regulations require that the interest rate on fixed deposits held by individuals, in contrast with companies, be adjusted each month to ensure that the deposit rate is greater than or equal to the rate of inflation. 

The rate is fixed when the deposit is made and of course remains unchanged through the contract period. 

The rate of inflation used is the 12 months average of the consumer price index.

Tables 1, 2 and 3 provide an overview of deposits in the banking system as of June 2021. 

Table 1 compares deposits of the total banking system with the private banks. 

Table 2 breaks down the ownership of the deposits in all banks also indicating the fixed deposit’s share of total deposits. 

Table 3 covers private banks including Islamic practice banks [Bangladesh Bank has classified the deposits in Islamic practice banks matching the categories.]

Total deposits are Tk14 trillion of which two-thirds are held in the private banks.

Table 2 reports 82% of deposits are owned by the private sector, of which 21% of the accounts are held by private non-financial corporations, 6% by financial corporations and 49% by households.  

Fixed deposits are 45% of total deposits. 50% of fixed deposits are held by households and 17% by the private corporations.

Regulating minimum interest rates

The past few months have seen the central bank regulating the minimum interest rates on fixed deposits owned by households.

This covers 22% of all deposits and 18% of private bank deposits.

Such restrictions on deposit rates, combined with the likely increase in the inflation rate, will drive up the cost of funds and hence the cost of lending. 

In addition, the rising borrowing by the government is driving up yield on Treasury bills and bonds. 

This will cause banks to raise the rates on other deposits not under central bank regulation. 

The result will be a broader increase in interest rates paid to depositors.

But the 9% cap on lending rates preventing higher lending rates despite higher deposit rates will result in tremendous pressure on the private banks to maintain capital requirements and earn a profit. 

State owned banks are allowed to avoid rules usually required to insure sound banking. 

Private banks are held to stricter rules.

The combination of rising deposit rates with lending rate cap will do great damage to all private banks. 

The consequences are taken up in the next article.

The impact of inflation on the deposit rates will come slowly. 

The increase of international prices combined with the high probability of a small depreciation of the Taka, will result in higher Taka prices of imports and inflation of domestic prices. 

It will take some time for the international price increases to influence the CPI. 

Further, the increase in the CPI from the external inflation will take at least a year to be fully incorporated in the prices as the banks use a 12-month average for the inflation rate. 

This leads to a small pace of increase but also as the inflationary pressures ease, inflation will decline only slowly. 

One should expect elevated interest rates on fixed deposits for the next two years assuming the rising world inflation can be controlled. 

The intent of the regulation on interest rates is to ensure that holders of fixed deposits earn a positive return. 

Actually the outcome is not quite as Bangladesh Bank planned.

There is a 10% tax on interest earnings. 

A 6% deposit rate actually earns only 5.4%. 

If the inflation is 6% then the depositor still faces a steady deterioration in his wealth.

Can Bangladesh Bank, through monetary policy, lower the inflation rate? 

The past few years have seen inflation in the range 5.5-6.5%. 

The inability to reduce inflation to a lower level resulted from the growing government deficit. 

Define the deficit as the sum of the bank credit to the public sector plus increases in the outstanding saving certificates issued by the government. 

The deficit so defined has increased 80% from FY 16/17 to FY 20/21. 

The CPI increased 21% over this period. 

The definition of money (adjusted for saving certificates) increased 58%. [This is related to M3 but is not the M3 as defined by Bangladesh Bank.]

To offset an increase of external inflation would require a substantial reduction in the government deficit. 

Given the strong development program underway such a reduction is unlikely.

Significant increase in revenue collection will not be achieved.  Non-payment borrowing from abroad in significant amounts is unlikely.

It is most likely that:

 

(1)            World inflation will drive up Bangladesh inflation.

(2)            The deposit rates will rise over the next 12-18 month by 3-5%. They will fall over the following 12 months.

(3)            Monetary policy will not be able to prevent externally driven inflation.

(4)            The private banks will require infusions of capital as their capital is eroded. Bank dividends will be limited. This effect is over and above the impact of recognizing bad debt costs incurred during the pandemic.

 

Forrest Cookson is an economist who has served as the first president of AmCham and has been a consultant for the Bangladesh Bureau of Statistics.

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