Controlling interest rate: Is it a good idea?

In recent years, the interest rate charged by the commercial banks, especially in lending, has been a subject of raspy debate. Voices have been raised against the high interest rate charged by the banks and many attributed high interest rate to the growing level of non-performing loans (NPL's) and low level of private investment activities in the country. Various claims have been made to reduce the interest  rate to a level conducive  to promote investment activities and  reduced NPL's.  Claims have been made for forceful reduction or government intervention.   
Indeed, interest rate is emotive subject for generations, particularly when set in the context of lending money. To what extent is the pursuit of profit   through lending acceptable?  Should there be any ethical dimension of lending  rate at interest  ? What can be the price of using someone else money? What is the economic benefit of lending and borrowing? How can the price be fixed? These question have been  asked over the generations and attempts have been made to answer this questions by academics, bankers, economists and by politicians either  by scholarly debate or by  practical usage of theories and models  in the economy. Amid ongoing debate on interest rate in the country, this write-up is an attempt to  revisit some of these  issues of interest rate which are relevant to this ongoing debate.
GREEK AND ROMAN PRACTICE: Lending at interest rate has been a recognised activity in human society for ages. Therefore, the interest rate has been a matter of great concern throughout the history of mankind.  The regulation of interest rate started since the beginning of recorded human history.  Ancient Greek and Roman Civilisations made a significant contribution in terms of regulating lending money at interest.  In the Roman history, the Twelve Tables of 443BCE allowed for the payment of interest at a rate of 8.33 per cent, while the lex Genucia of 342 BCE banned the payment of any interest, only for the lex Unicaria of 88 BCE to re-introduce interest at a ceiling rate of 12 per cent.
 The medieval regulators   viewed that the economic benefit of money lending were substantial, but given the dangers of exploitation, this activity needed to be regulated. Therefore,  state invention in interest rate  was reaffirmed and adopted by many in the history.
The British reformer Frances Bacon in his essay  Of Usury which was published in 1625, opined money-lending is necessary and should not be abolished, but should be regulated. His  recommendation involved a two-tier interest rate cap: a five per cent ceiling on retail lending, with no tax or restraint on trade, and a rate of nine per cent for commercial lending, to be conducted only by licensed lenders, who would pay a small tax to the state.
It is undoubtedly admissible that  the intention of such regulations over generations after generations was to protect the interest of borrowers from the unscrupulous lenders , to  flow of credit to more borrowers rather than large borrowers only and to increase the productive economic activities through credit creation.  But how effectively this view of regulators worked ?
For example,   Solon, the Greek statesmen who is known as  one of the seven wise men in the Greek history,  reformed  the lending at interest rate system in Athens . During his time, the non-payment of loan often led to debt-bondage and enslavement.  However, he soon  discovered that reforming the laws concerning debt did not improve the situation of poor Athenian borrowers and  economic injustices prevailed.   
LATIN AMERICAN EXPERIENCE: A more recent  example of  state-regulation of interest rate can be drawn from the experience of imposition of credit ceilings in poorer countries in Latin America in the 1960s and 1970s.  Due to low interest rate imposed by governments banks were not able to lend to smaller firms or poorer borrowers because the costs of serving these marginal clients were higher than the levels of interest that could legally be charged for the loans. This led to a concentration of credit supply to larger borrowers. In addition, low interest rate reduced   the volume of savings mobilized by the financial system, restricting the supply of new credit and lowering levels of economic activity.
Mark Hannam, the chair of  the Board of Fair Finance ( a London-based Micro Lender)  in his easy  The morality of Money-lending  revisited the above  facts  which he in fact termed  as a 'political answer ' to the question of  what can be the price of money lending. He mentioned  that  in recent times, in many countries the political regulation of money lending had simply reduced the amount of credit available to those without a credit history or who lack access to collateral to pledge against the loan.
ADAM SMITH: While political intervention of the interest rate continued,  a new pattern of thinking as to what should be or can be the price of lending money started to emerge. Adam Smith in his book  The Wealth of Nations   which was published in 1779, explored the problem of interest rate from two perspectives: the borrowers' and the lenders'.  His view included that an interest rate ceiling should be imposed, at a rate not much higher than the current market rate of interest. Smith viewed that given the limited amount of capital available to be loaned, those who were most likely to invest wisely and productively would be those of good credit standing, who could secure loans at the lowest interest rates.  Setting the legal ceiling just above this rate would exclude the bad borrowers. For Smith, the aim of the interest rate ceiling was to direct scarce capital towards the most productive investments and away from speculative investments.
Critics find problems with Smith's proposition. Firstly, under such a situation, some  borrowers will have to pay a very high rate of interest because their payment includes an 'insurance fee' to cover the lender for the risks associated with breaking the law. Secondly, it is really difficult  to make distinction practically as to  who will make productive use of their loans, and who will take excessive risks or invest money  in to  unproductive consumption. Besides, many high risk  ventures may turn out to be highly profitable.
STIGLITZ'S CREDIT RATIONING HYPOTHESIS: In modern times, Nobel laureate  American economist Stiglitz   developed credit rationing hypothesis to address the issue of  interest rate.  According to this theory, banks should set interest rate a level and should not lend below or above that level.  If banks offer rate above that level , bad borrowers will tend to borrow at higher interest rate.   This may reduce banks expected rate of return due to the probable increase in defaulters.  Bank should not lend below that level as lending below that that level will  not increase bank's return.  
During the period of the nineteenth century, economists developed the idea that costs of supplying incremental additions to the exiting stock of any  goods and services will determine the prices of  such  goods and services . Any extra utility derived from incremental additions of any  good and  service tend to decrease  as the volume of exiting stock increases. These ideas are known as 'Marginalist  Ideas' in economics.  These' Marginalist  Ideas' are the foundation of modern economic theory of interest rate.
In modern  economic theory, the credit market is viewed like any other market. This market consists of buyers (borrowers) and sellers (lenders) of credit; the price of credit is the interest rate. Like any other price, the price in the credit market is what is agreed between the borrower and the lender when they execute to the transaction. Here money is like commodity  and the price of which  will vary in accordance with time and place . The supply and demand will determine the interest rate .  Therefore, any artificial intervention in the price mechanism will upset the system.
BANGLADESH POLICY:   After independence, Bangladesh adopted an administered interest rate policy under which the interest rate was controlled in order to limit the cost of financial intermediation and ensure a reasonable structure of lending and deposit rates.  Bangladesh began to liberalise its policy in the    1980s and in 1989  the Bangladesh Bank (BB) introduced flexibility in determining deposit and lending rates.  BB started to set the ceilings and the floors and individual banks were allowed to set their interest rates within the stipulated band. In 1992, BB removed the  interest rate bands for lending for all sectors except agriculture, small industries, and exports while, for deposits, the ceilings were removed but the floors were retained and banks were allowed to set lending and deposit interest rates within bands set by BB. Finally, other restrictions were removed in 1999 enabling the banks to enjoy greater flexibility in setting interest rates.
 At present banks are free  to fix the level and structure of interest rates  under the market-based interest rate policy. The boards of the directors of scheduled banks  determine interest rate  on their own.  However, Bangladesh Bank often sets the maximum cap for loans in different priority sectors considering national interest and macroeconomic situation.
Under the prevailing conditions, any kind of intervention, price control or ceiling   may alter the way in which price and quantity are determined. If the legal ceiling is  determined at a rate which  is below the market rate of interest, the regulation can affect the market . It obviously alters the price of credit  as the ceiling rate becomes the rate of interest  that any bank can charge.  It will also reduce the quantity of credit supplied.  If the lending costs is not covered  and the lenders do not get an adequate return on its resources, it will put those resources to work elsewhere. At one point,  the market will not satisfy  the prospective borrowers who are willing to borrow at ceiling price  and excess demand will be  created which will eventually lead  rationing of the reduced amount of credit among borrowers  by some other means other than price.
The above situation is called  "credit crunch" which will affect many borrowers.    Lenders will set rigid loan terms, screen borrowers more rigorously,  increase  non-interest fees and charges which will effect certain borrowers and lending based on  individual characteristics  without the flexibility of adding risk premiums, can ration credit away from new or high-risk consumers who might be willing to pay higher-than ceiling rates. In order to cover  extra costs, lender may add non-interest charges (such as higher fees) which will eliminate borrowers for whom these extra costs matter. Therefore,  this will effect first-time borrowers, small borrowers, low-income and high-risk borrowers  as they are likely to find it more difficult to obtain credit while the most creditworthy borrowers may obtain more credit than they would have at normal market interest rates. Therefore,  ceilings may fail to produce results  that they are intended to provide in economy as a whole.  
The decision of BB about following a market-based interest rate policy is a good   decision.  This policy works better in a competitive market. Economic theory suggests  that  a competitive market is sufficient to prevent lenders from exercising power over pricing or earning more than a normal return. The price established in a competitive market reflects suppliers' costs of providing the given amount of that good. However, if credit markets are competitive, the resulting market rate of interest will not exceed lenders costs (including a fair return) of supplying credit. It is when competition is absent that consumers may face unreasonable interest rates.  The recent decrease in lending rate and spread   in the country  has been possible partly  due to market-based interest policy of the government  in the somehow competitive market in the country. Besides,  the publicly available information on the rates being charged by lenders have helped  to foster competition in credit markets. In the absence of such knowledge in the market, lender has more freedom to charge any rate.
To conclude, it is better to leave the interest rate to be determined by the market. If rates are too high, demand will tend to be too low; if rates are too low, income from lending will be unprofitable; in both cases the business will  become unsustainable. The pragmatic solution to this problem,  as suggested by Mark  Hannam, is to set interest rate at a level  which  is  high enough and low enough for  both the lenders and borrowers to sustain.  Banks  should be free to make this decision . However, this liberty  should not compromise with the fact that lending institutions require  regulatory scrutiny. Transparency and accountability  should be in place regarding charges and costs, and protection for borrowers  from unfair dealing or coercive practices .  Only then, a well functioning market  can be established with a reasonable interest rate.
The author works in a private bank in Bangladesh and has a post-graduate degree in Islamic Banking, Finance and Management from United Kingdom.
Email: akbar.chowdhury@yahoo.com