http://fe-bd.

com/2015/04/29/90672
VOL 22 NO 166 REGD NO DA 1589 | Dhaka, Wednesday, April 29 2015

Bringing down spread between lending and deposit

rates of banks
M S Siddiqui

Financial institutions (FI) play a critical role in emerging economies where most borrowers
have limited access to capital markets or any other potential sources of funds. These
countries, including Bangladesh, need well functioning FIs to accelerate economic growth.
The poorly functioning FIs are an impediment to economic progress. FIs in Bangladesh have
very narrow products and survive on interest on loan. One study pointed out that
traditionally 85 per cent of their income is contributed by interest on loans. Interest on
loans contributes significantly to interest income of FIs.
The government and Bangladesh Bank are trying to reduce bank interest rate to 9.0 per
cent or below from the existing effective interest rate of 18-22 per cent. The highest interest
rate paid by FIs on deposits is 10 per cent. Bank interest rate largely depends upon bank
interest spread rate (IRS). It is the difference between the lending rate and the deposit rate.
The magnitude of IRS, however, varies across the world. The spread is around 5-7 per cent.
In many countries banks charge interest on loan below 7 per cent. The existing IRS is very
high considering interest and spread in many other countries.
Since independence, IRS has remained high in Bangladesh relative to both the global and
regional standards. The policymakers and private businesses in particular have repeatedly
expressed their concern over the persistence of high IRS in the banking sector. In 1960 the
deposit interest rate was 2.4 and spread was 3.6 per cent, hence the interest rate was 6.0
per cent, and in 1995 the deposit interest rate was 3.4 per cent and spread was 5.9 per
cent and the interest rate was 9.3 per cent. Many countries liberalised their financial sectors
during the 1980s and the 1990s, with the objective of improving financial development and
economic growth.
The nature and efficiency of the financial sectors have been found to be the major reasons
behind differences in spread in countries across the world. In economies with weak financial
sectors, the intermediation costs involved in deposit mobilisation and channelling them into
productive uses are much larger.

Different independent studies have listed several reasons for high IRS. In developing
countries, these include high operating costs, financial repression, lack of competition and
market power of a few large dominant banks capable of manipulating industry variables
including lending and deposit rates, high inflation rates, high risk premiums in formal credit
markets due to widely prevailing perception relating to high risk for most borrowers etc.
Interest rate spread characterises a critical feature of the financial intermediation process in
the economy. Least developed countries (LDCs) with financial market imperfections have
been characterised by higher spreads due to factors such as absence of competition, burden
of non-performing loans (NPLs), high administrative costs, inefficiency etc.
Inefficiency originates from the government's 'interventionist policies' and inadequate
technical skills in the arena of risk and portfolio management. The central bank has options
to influence lending and deposit rates in the desired direction through the monetary policy
instruments such as open market operations (including repo and reverse-repo auctions),
setting the bank rate, statutory liquidity ratio (SLR), cash reserve requirement (CRR), and
the like.
Interest-rate spread influences the level of non-performing loans in many ways. For
instance, high interest rate charged to borrowers makes it difficult for the borrowers to
repay loans. Interest rates spread lead to the increase in non-performing loans as
ineffective interest rate policy can increase the level of interest rates and consequently the
NPAs. This can be done through reduction of interest rate spread. Loans that are given are
either unsecured or are secured on assets that are hard to recover. Therefore, interest rate
spread increases the likelihood of non-performing loans. High interest rates cause inflation
which increases the cost of production or costs of goods sold. Such cost escalation can
reduce earnings before interest and taxes.
Bangladesh's financial system is dominated by banks where the banking sector accounts for
around 96 per cent of total assets of the financial sector. At present, there are over 60
banks comprising four state-owned commercial banks (SoCBs), five specialised banks (SBs).
The rest are private commercial banks (PCBs) and foreign commercial banks (FCBs). The
question that arises is why competition among the PCBs do not lead to a lowering of the
spread. There is an invisible curtail among the FIs.
There is the need to explore policy options to increase competition in the financial sector,
and measures to break market dominance of banks will be one such option. Further, the
financial sector needs to explore internal as well as industry-driven strategies that counter
some of the bank-specific factors associated with higher spreads. These could range from
diversification of products to investment in cost-saving and efficient forms of technology.
The government's fiscal policy and high interest of borrowing instruments are also
responsible for the high spread. Non-interest income of banks is important and the higher
the non-interest income as a ratio of total assets of a bank, the lower will be its spread. FIs
in Bangladesh have some common services extended to clients. FIs may focus on other
services like credit default swap, futures market, hedging etc. FIs are not interested in those

value-added services since they can earn more profit without much effort with traditional
credit to borrowers.
The writer is a Legal Economist.
shah@banglachemical.com