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Search date: 03-04-2018 Return to current date: Click here

Tapping an alternative source of term finance

Three-part article titled No hedging, but effective benchmark lending rate policy

Nironjan Roy from Toronto, Canada | April 03, 2018 12:00:00

Bond market is an area we have been talking about for the last two decades but it hasn't yet developed in Bangladesh. Efficient bond market is an essential part of modern financial market as it provides alternative source of term funding. Bond market provides suitable alternative source of fund to the business community as well as banks. Our banks exclusively rely on depositors for their entire loanable fund. At the same time, our business community has to substantially rely on bank loan even for their long-term investment.

Our bankers are always in a situation of fund mismatch. Their only source of fund, various forms of deposits, is short term in nature as depositors may want to withdraw their money any time. Even term deposit i.e., FDR (Fixed Deposit Receipt) although theoretically to be paid on maturity, still bank is bound to return on demand to the depositors.

On the other hand, banks lend fund to the business community for long term, but there is no guarantee that outstanding loans will be repaid on maturity. Further, working capital loan which is short-term finance is hardly paid off on time. In the developed and in many developing countries, long term lending viz., mortgage loan is sourced through securitising i.e., issuing bond on the outstanding debt in the country's bond market. Apart from this, bond market provides ample opportunity to the business enterprise with good financial and non-financial standing to maneuver interest rate fluctuation and thereby optimise the benefit. When interest rate on bank loan goes up, a business enterprise with good standing may issue bond at comparatively lower rate and can pay off the bank loan.

It is unfortunate that effective bond market has not developed in Bangladesh although initiative was taken in late 1990. During the period 1999-2000, international bid was invited for appointing consultant to develop country's bond market and I myself was one of the members of the committee responsible for bid evaluation. Almost two decades have elapsed; the bond market has not seen the light of the day. Time has come to actively consider bond market without further delay and Bangladesh Bank, BSEC (Bangladesh Securities & Exchange Commission), banks and Stock Exchanges should work together in that direction. Without the presence of bond market, vibrant and efficient financial market comprising both money market and capital market cannot be ensured.

EFFECTIVE BENCHMARK INTEREST RATE: Banking sector in Bangladesh has tremendously developed during the last four decades but standard lending rate policy has not been developed as yet. Primitive means of determining lending rate by adding bank's desired margin to its cost of capital within the brand set by the country's central bank is being followed in loan pricing. At the same time flat rate of interest is charged on any loan irrespective of the difference in the loan amount and structure. Fifty million taka borrowed for six months and one million taka borrowed for five years are probably charged at same rate of interest by banks which no way can be considered as a standardised loan pricing. Needless to say, the loan pricing measure has been standardised not only in the developed world but also in many developing countries long ago. Usually, two kinds of loan Libor loan and Prime Rate Loan have been put into the system under which the customer can borrow. More importantly, standard loan pricing system has been implemented utilising All in Rate (AIR) which is determined by adding the prevailing fixed interest rate or prime rate with the applicable spread as predetermined based on some specific parameters. This AIR includes the impact of current economic condition, financial situation and borrower's financial performance.

EFFICIENT LOAN PRICING STRATEGY: Standard loan pricing comprises two components: base interest rate and spread. Bank's money market department determines base interest rate analysing the demand for and supply of fund and other relevant factors. On rate fixing day, base rate remains the same and is applicable to all the borrowers irrespective of their rating, standing, volume of loans etc. However, the rates for different tenures of borrowing are different as the rate for one month borrowing will, of course, be different from the rate for three months borrowing. Even this base rate varies every day because it is determined on regular basis following change in fund availability and requirement.

The spread is determined through negotiation between the banker and the borrowers at the time of approval. However, this negotiation is governed by some set criteria which include the borrower's external and internal grading and business performance as well. The borrower is rated by the external credit rating agency based on which the banks internally rate them. Moreover customers' financial performance, especially EBITDA (Earnings before Interest, Tax, Depreciation and Amortisation), is reviewed to determine borrower's pricing level. Different pricing level assigns different spreads which are applied to the borrower's loan pricing. One hypothetical example will provide some clarity on the issue. Say borrowers may be graded A, B, C, D and so on, and the pricing level for these grades may be denoted as 1, 2, 3 and 4 respectively which may specify the spread e.g., 100 bps (basis points), 125 bps, 150 bps and 175 bps and so on. If the current rating and review of EBITDA find the customer grading to be B, then the borrower will be placed at the pricing level 2 where applicable spread will be 125 bps. The spread combined with base interest rate determines AIR (All in Rate). In fact, this AIR is the effective lending rate at which the borrower pays interest.

Borrower's grading and financial performance i.e., EBITDA is periodically reviewed to adjust pricing level. It may be mentioned here that when the borrower's grading and EBITDA improve, pricing level goes up and better spread is applied which ultimately keeps the lending rate low. The opposite situation arises when customer grading and EBITDA deteriorate, pricing level goes down and accordingly higher spread is applied which makes the lending rate high. In addition to AIR, bank charges various fees -- facility fee, commitment fee, utilisation fee, upfront fee, taking fee, closing fee etc. In order to introduce this type of efficient lending rate policy, a mechanism has to be developed to determine benchmark interest rate. There are two well-known examples of benchmark interest rates i.e., Libor (London Interbank Offered Rate) and Base or Prime Rate which is known as the benchmark rate set by the central bank of each country. Loans denominated in US dollar are priced at Libor rate while loans in other currencies are usually charged by the benchmark rates determined by the respective country.

So, many countries develop their own benchmark rate following the same technique and procedures as used in Libor loan operation. For example, Canada has CDOR (Canadian Dealers Offered Rate), Europe has ERIBOR (European Interbank Offer Rate). Following the same procedure and mechanism of Libor rate, banking sector in our country may actively consider developing the benchmark interest rate policy which may be dubbed DIBOR (Dhaka Interbank Offered Rate). At the same time, commercial banks in our country will have to develop some mechanism to add their operation cost to the bank rate set by Bangladesh Bank in order to determine their own prime rate which will be offered to the borrower for drawdown under prime rate loan.

Nironjan Roy is a banker based in Toronto, Canada.

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