Conventionally, interest rate spread in our country hovers around 5.0 to 6.0 per cent. The extent of spread is very high from the standard point of view. The factors causing the spread have been identified as lack of competition, high inflation, domination of some large banks and financial institutions, inefficient market operations and high interest rates. The common point of view has stressed the importance of competition and its effect on spread. There is no doubt that lack of competition is one of the critical factors. But what should have drawn our attention more, in fact, has been quite neglected in discussion and analysis. It is the nature of lending market and how it differs from the conventional market mechanism. If a lender fails to learn the lesson that the so-called demand law - price rises when demand rises and decreases when demand decreases - doesn't work properly for lending market, then his or her business of lending, putting all strategies and efforts aside, will soon encounter many cases of defaults. In the end, his or her lending business will be accompanied by higher interest rate spread.
Interest rate itself can be used as a proper screening device to minimise risk of lending. This lesson is missing from the banking practice of many financial institutions. These institutions are fed with the conventional loanable fund theory that interest rate adjusts perfectly with supply and demand of loanable funds, and thus an equilibrium market rate is found. What is important is not the equalisation of supply and demand for funds but the minimisation of risks. If the rate yielded by the intersection of supply and demand curve doesn't minimise risk, then it can't be the equilibrium interest rate since this rate can't be the return maximising rate. So, we see a dichotomy over here. What is market equilibrium rate can't be the equilibrium rate from the point of view of a single lender, and what is not market equilibrium rate is the equilibrium rate from the point of view of a lender. Let us see how the dichotomy arises:
In the first figure, supply and demand for funds are measured on the horizontal axis and interest rate on the vertical axis. The market equilibrium interest rate is determined at the point where demand and supply line interests or re. When interest rate is below this rate, there is excess demand for funds and any rate below re is not the equilibrium rate. But the figure II shows that at an interest rate below re or at r* the expected return E(R) from lending is maximised. On the other hand, at re interest rate, return from lending is not maximised thought it is the market equilibrium rate. But in reality, most of the lenders try to lend at re rather than at r*, and this is the root cause of all problems in the financial institutions.
The point is that a lender shouldn't think of raising the interest rate when the demand for funds is high. The reason is when interest rate is raised in the face of higher demand, bad borrowers crowd the market to get the funds. In the process, they don't hesitate to bid higher interest rate. These types of borrowers are most likely to default since they are the ones who will take higher risk to earn higher return. The riskier projects they will undertake, the more likely they will default. Results are defaults and non-performing loans. This result will finally cause banks and financial institutions to raise interest rates to compensate for the loss. However, even this will not help them. Once they are trapped in this vicious circle and continue following the conventional market dictum, they will hardly be able to come out. This is an unending process. This is what mainly happens in our financial sector.
Bankers are far away from grasping the reality that lending market is characteristically different from the auction market where seller can freely adjust the price seeing the market condition. But in lending business, there is lack of such flexibility. This constrains the lending business and requires more critical judgment and less reliance on the conventional market mechanism. What we need is that we have to come out of conventional outlook that is structured in the so-called loanable fund theory - the higher the risk, the higher the interest rate.
The writer is Faculty member, School of Business, North South University. jheco.du@gmail.com
Reducing interest rate spread
Md Jamal Hossain | Published: May 13, 2015 00:00:00 | Updated: November 30, 2024 06:01:00
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