Single-Digit Interest Rates: Impact on the Banking Sector and the Economy

Impact on the Banking Sector

1. Profitability Challenges:
   The mandated single-digit lending rates have compressed banks' net interest margins (NIM), the difference between interest earned on loans and interest paid on deposits. Studies show that while deposit rates have fallen below 6%, lending rates in many sectors such as consumer credit, construction, transportation, and SME financing remain above 9%, indicating banks struggle to enforce the policy uniformly1. The average lending rate of state-owned banks is closer to the 9% target with a spread below 3%, but private and foreign banks face wider spreads due to higher lending rates1. A 3% spread is generally considered the minimum for banks to remain profitable; narrower spreads threaten profitability and can lead to losses.

2. Operational Costs and Risk Premiums:
   Banks cite high operating costs, capital charges, and risk premiums as barriers to reducing lending rates to single digits. To address this, some banks are attempting to lower their cost of funds by restructuring deposit products to attract cheaper deposits. However, without significant improvements in operational efficiency and risk management, sustaining single-digit lending rates is challenging.

3. Credit Risk and Non-Performing Loans (NPLs):
   Interestingly, sectors with higher lending rates, such as consumer credit and SME financing, report comparatively lower NPL ratios, suggesting that higher rates may reflect higher risk but not necessarily poor credit performance1. The banking sector’s health could be compromised if banks lower rates without adequate risk assessment.

4. Market and Stock Impact:
   The policy has led to concerns about reduced bank profitability, reflected in declining banking stock prices. Analysts predict profit contractions of Tk 4,000-4,500 crore due to the interest rate caps, which could affect banks' capital and lending capacity.

Impact on the Economy

1. Stimulating Investment and Industrial Growth:
   The introduction of single-digit interest rates was intended to spur private investment, industrialization, and job creation by lowering the cost of finance. Industrialists, such as the managing director of BSRM, have acknowledged the benefit of reduced financing costs during the COVID-19 pandemic, which helped industries navigate economic challenges.

2. Potential Market Distortions:
   However, enforced interest rate caps can distort market mechanisms, reducing competition and potentially encouraging inefficiencies within banks. Forced capping may also discourage banks from lending to riskier but potentially productive sectors if returns are insufficient.

3. Historical Lessons:
   Past experience, such as the 2010 single-digit lending rate policy, is linked to a deterioration in Bangladesh’s banking sector, highlighting risks of prolonged enforced low rates without addressing underlying structural issues.

4. Broader Macroeconomic Effects:
   In general, low interest rates tend to encourage borrowing and spending, supporting economic growth but can also compress bank profits, possibly leading to tighter credit conditions if banks become risk-averse. Conversely, higher interest rates increase borrowing costs, potentially slowing economic activity but improving bank profitability and financial stability.

Conclusion

While single-digit interest rates in Bangladesh have provided short-term relief to industries and consumers by lowering borrowing costs, the banking sector faces significant profitability challenges due to compressed interest margins and high operating costs. The policy risks impairing banks' ability to lend sustainably, potentially affecting long-term economic growth. For the policy to succeed, it requires complementary measures such as improving banks’ operational efficiency, risk management, and regulatory support to balance affordability of credit with banking sector health. Historical evidence and international experience caution against prolonged enforced low rates without addressing structural banking sector issues.

Reference