‘Base rate’ concept and reducing lending rate

Interest rate reduction is now a popular topic of discussion. This was facilitated by the announcement that the government was cutting down savings certificate rates. It is a general conception that if government cuts the rates of savings certificates, then the central bank will definitely follow it by cutting down deposit rates and the final result would be a reduced lending rate. But, is the linkage between deposit rate and lending rate that straight forward? This answer should be sought first.
To understand the link between deposit and lending rates, we need to familiarise ourselves first with the term ‘Base Rate’. This term is nothing uncommon to bankers and even some borrowers are also familiar with this. So what is this base rate? By definition, the base rate is the minimum rate below which it is not viable for a financial institution to lend in the market. This rate is the break-even point for financial institutions and sometimes it is called the ‘prime rate’ because only prime borrowers are eligible for availing this rate. Some cost components are considered in the calculation of base rate;
1. Cost of fund.
2. Cost of CRR and SLR
3. Cost of administration and
4. Cost of equity capital
COST OF FUND: This is the weighted average interest rate of all the interest-bearing liabilities of banks/financial institutions (FIs). In this calculation, all non-equity funded liabilities are considered. Commonly cost of fund covers the cost of deposits and both short and long-term borrowing (e.g. bonds, inter-bank borrowing etc). Interest paid on deposits and borrowings in a certain period can be used to determine the final annualised cost of funds (CoF).
COST OF CRR AND SLR: This includes the negative carry-on Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) which includes CRR. Negative carry-on CRR and SLR balances arise because the return on CRR balances is nil and the SLR balances provide little return.
COST OF ADMINISTRATION: This is the unallocated overhead expense which includes aggregate employee compensation relating to administrative functions in corporate office, directors’ and auditors’ fees, legal and premises expenses, depreciation, cost of printing and stationery, expenses incurred on communication and advertising, spending on information and technology, operating expenses, etc.
Total operating expense attributed to the investible funds for the purpose of base rate calculation is allocated as per interest-earning and other earnings ratio.
Cost of Administration = Total Operating Expense / (average interest-bearing investible funds + average equity capital).
An adjustment factor can be used here for attribution to interest income. The factor is a ratio between interest income and total revenue.
COST OF EQUITY CAPITAL: This cost reflects the expected return of the shareholders. For the purpose of base rate calculation, moderate risk should be considered and a before-tax expected rate of return needs to be assumed.
Cost of Equity = (Paid-up capital/ Expected rate of return) / (Average interest-bearing investible funds + Average equity capital).
Only the paid-up capital is considered in the denominator because the expected return is calculated on this capital component only.
So considering the above components, Base Rate = Cost of Funds + Cost of CRR and SLR + Cost of Administration + Cost of Equity Capital.
The actual lending rates charged on borrowers shall be the base rate plus the risk premium and the tenor premium. In other way, actual lending rates charged on borrowers shall be the cost of funds plus margin.
Actual lending rate = Base rate + risk premium + tenor premium + other premium   
Or
Actual lending rate= Cost of funds + Margin
Margin = Cost of CRR and SLR + Cost of administration + Cost of equity capital + Risk premium + Tenor premium + other premium.
Now if we have a look at the components of base rate, cost of funds is the only part which is sensitive to interest rate changes. Interest paid on deposits and borrowings is only considered here. So a cut in the rate of deposit products will have an impact in this part. But how much would be that impact? The deposit base of most commercial banks in Bangladesh are generally three types--savings, current and term deposits. Among these three types, current deposits are generally non- rate sensitive and the impact of rate cut is insignificant on savings deposits. So it is obvious that term deposits will be most sensitive to rate changes. The composition of deposits varies from bank to bank but a common practice is to keep the portion of high-yield term deposits around 50 per cent of the total deposit base. So the rest are low-yield savings and current deposits. From here we can conclude that the rate change of deposit products will not affect cost of funds completely.
Cost of administration is not sensitive to rate changes but it is sensitive to banking models. Banks focused on corporate lending tend to have lower operating expenses than those targeting retail and SMEs. As the central bank is focused on agriculture and SME finance, so in line with this view, banks need to open more rural branches which is increasing the administrative cost. Introducing new technologies for mobile banking, alternate distribution channels and real time settlement will take this cost further.
The cost of equity capital is completely dependent on the expected rate of return of the owners of the bank/FI. Dividend rates declared by banks are hovering around 15-20 per cent which shows that the cost of capital is very high. Though dividend is applicable on the paid-up capital only, paid-up capital consists of major portion of equity capital of banking companies and financial institutions. We want to add one more thing here: as per the BASEL-III guideline, the Bangladesh Bank (BB) has introduced a standard for capital conservation. This means capital base of a bank has to be very sound to declare a good dividend. But what would be the source of this capital? According to the definition of Common Equity Tier-1 (CET-1) capital, banks have to increase their earnings to reach the strength for dividend distribution. So there would be a definite pressure on banks to maximise interest income to comply with BASEL accords and satisfy the demand of shareholders.
Considering the above-mentioned components of base rate, it is understandable why lending rates cannot decline in the same pace as deposit rates and why banks are free to fix the level and structure of interest rates under the market- based interest rate policy. These cost components vary from bank to bank and an interest rate cap would not be healthy for the financial market at this point.
This writer was looking at some articles on the issue of reducing interest rates. Some of these articles had a message that the Bangladesh Bank should take steps to reduce the lending rate to a rational level. But before doing that the BB should monitor the base rate of the banks to figure out the minimum price of funds and what should be the rational lending rate. Analysing the base rates will give a clear indication where the intervention of the BB is required to bring down the lending rate to a rational level. The BB has already given a method of base rate calculation for non-banking financial institutions which can work as a reference for banks also.
Banks and financial institutions in Bangladesh have been playing a significant role in the country’s financial system. This sector has achieved impressive growth in recent years reflecting the process of financial innovation and holding the promise of deepening financial intermediation. In the process of ensuring corporate governance and sustainable development of this sector, the BB extended its policy support in risk management culture through adoption of the best practices on prudential regulations, Basel accord implementation etc. Base rate system could be a new inclusion in this endeavour with adding some benefits. The system promotes transparency in product pricing and encourages healthy competition in the economy. Besides meeting the primary objective of bringing about required transparency in the pricing of the lending products, the base rate will also facilitate transmission of monetary policy that is translated through the policy rate and other policy instruments. Thus, in order to make the lending rate more responsive to the BB’s policy, banks can periodically review and announce their base rates to the public.
Other advantages of the base rate are as follows:
* Offers interest rate differential treatment for different borrowers for the same products;
* Provides better rates for good borrowers on the same product; and
* Enables floating interest rates;
The base rate could also serve as the reference benchmark rate for floating rate loan products, apart from external market benchmark rates. The floating interest rate based on external benchmarks should be equal to or above the base rate at the time of sanction or renewal.
The writer works for a foreign commercial bank operating in Bangladesh.
tanjib.eee@gmail.com