Banking Article, Banking Finance 2020, Banking Finance July 2020

Interest Rates in Banks and Its Role in Economy

Abstract of the Article:

This artefact discuss briefly about how the different interest rates offered by banks to different customers such as a housing loan borrower or a pensioner or a small businessman. What are the factors that are driving force to define these rates? The phenomenon of coupon rate and yield to maturity in bond market is also inscribed briefly. I have also illustrated How these interest rates are being used as an instrument to control inflation, recession and deflation in the economy. At the end I have scripted about recent rate cuts by Reserve Bank of India to upturn the down sliding economy due to Covid-19 pandemic and its effectiveness


What is Interest Rate…

The interest rate is the amount a lender charges for the use of assets expressed as a percentage of the principal and typically noted on an annual basis. Here a common man who does not understand banking much, may ask that what they are getting on their deposits is not an interest, and the answer is yes as in a way in that case the depositor is lending the money to bank and getting paid for it. The only difference is that in this case the depositor cannot decide on this rate rather the banks can. The depositor has the option of choosing the best rate available in the market.

This is the basic definition of interest rate that a layman can understand but interest rate goes much beyond that. There are many questions that one may raise like how this rates are defined, which are the factors affecting the rates, how interest rates can affects our lives and the economy, how the policy makers use it to control the economy etc. So to understand those, first let us see the tools which are used by the policy makers to control the rates which are being offered to the consumers.

Tools used by RBI to decide the interest rate for consumers…

Reserve Bank of India, the central bank of our nation as a part of its monetary policy measures sets the following rate to control the liquidity in the economy.

  • Repo: in repo or the repurchase agreement, Banks sells fixed-income securities to RBI at one price and commits to repurchase the same assets from the central bank at a different price at a future date. The rate at which interest is paid on these securities is called Repo rate. In a simplest way we can say that the rate of interest at which the RBI lends short term money to banks is called repo rate.
  • Reverse Repo: In a reverse repo transaction the opposite of above transaction takes place. So reverse repo rate is the rate at which the RBI borrows money from commercial banks within the country.
  • MSF-Marginal Standing facility: It is a special window for banks to borrow from RBI against approved government securities in an emergency situation like an acute liquidity shortage. MSF rate is higher than repo rate.
  • Bank Rate: This is the long term rate(repo rate is for short term) at which central bank lends money to other banks or financial institutions.

Which rates ultimately offered to Consumers…

Consumers are defined as the ultimate user who invest or borrow the funds at grassroots levels i.e. business houses, salaried individuals or pensioners. Banks accept deposits and pays interest and then lends that money and charge interest (price) on that. Other than that, banks also have to maintain a certain level of capital for their lending portfolio. Let us first see how deposit rates are defined in banks.

Asset-Liability Committee (ALCO) in banks decides these rates. Bank can raise funds by accepting deposits, borrowing from market or borrowing from RBI as we have discussed earlier in repo. Cost of raising fund is different from different sources. So depending upon the rates of other sources bank decides on rates to offer to its depositors. Another factor is time i.e. the period for which the fund is available with banks. If the fund is available for a longer period, banks tend to offer a higher rate than those with shorter period as with a fund available for longer period bank’s treasury can take a better investment decision and get a good return. That is the reason why banks offer lower rates in savings bank account than a term deposit account and also charge penalty for premature closure in term deposits. Another factor is the amount of fund available with banks. If banks are unable to invest or lend to the tune of funds availability and have excess liquidity then also banks offer lesser rate as the demand for money is less and they face difficulties to pay higher rates on idle funds.

Now let us see how the lending rates are decided. The common equation for interest rate is

Interest Rate = Risk free rate + Other cost + Credit (default)Risk Premium + Tenor Risk Premium +/-Strategic Premium/Discount

Here risk free rate is decided depending upon the cost of the funds and guidelines issued by central bank time to time. Then other costs like operational cost, capital charge etc. are added to it to get the benchmark rate. Credit (default) risk premium depends on the risk profile of the exposure which is derived from past experience, market information etc. Tenor premium is also one kind of risk premium which arises out of the extra risks that banks have to bear due to longer expiry of the exposure as the external factors change over a longer period of time and with that the repayment capacity of the borrower. Strategic premium or discount is decided depending upon the strategy adopted by higher management. These all are added to the benchmark rate to get the card rate.

Over the years banks have used different rates as benchmark rates such as Benchmark Prime Lending Rate (BPLR), Base Rate and Marginal Cost of Fund-Based Lending Rate (MCLR) etc. At present banks are using a new benchmark rate called External Benchmark Lending Rate (EBLR) for MSME and retail loans. This rate is directly linked to repo rate to pass on the benefits of rate cut by RBI to the consumers promptly.

Let us understand this with an example. We assume that repo is 4.5%, spread is 3.5% and premium is 1.5% for an MSME loan of Rs. 10.00 lakh then

EBLR = Repo (4.5) + Spread (3.5) =8%

Where spread depends upon the operating cost and capital charge

Offered Card Rate = EBLR (8) + Premium (1.5) = 9.50%

Banks reset these benchmark rates time to time and the card rate for a borrower, who has availed floating rate of interest will also changes.

If lending rates changes then to make balance between asset and liability, banks reset the deposit’s rates accordingly and vice versa.

What rates actually customers are getting – Nominal Vs Real Interest rate…

Nominal interest is the card rate which customers are offered by bank and the real interest rate is nominal interest rate minus inflation i.e. the rate after taking into consideration the time value of money or the purchasing power of the consumer.

Let us understand this with an example. 9% offered on deposit in 2011 or 7% in 2019, which rate is better? The quick answer is of course 9% in 2011. But wait for a second, is this so simple. No, this is not so simple and the reason is inflation. Let us assume that the inflation were 9% and 5% in the year 2011 and 2019 respectively. So the real interest rates come to 0% and 2% after making the inflationary adjustments to the nominal rates.

Suppose a depositor is having Rs. 10000/-savings and he deposited it in a bank for one year. He just loves to eat Samos as and will buy Samos as with the matured amount. Now we assume that the rate of Samos as is Rs. 10/- per plate now. So with 9% interest he will receive Rs. 10900/- after maturity and the price of one plate of Samos as will be Rs 10.90/-. So he will be able to buy 1000 plates of Samos as with money. Now in the second case with 7% interest rate he will receive Rs 10700/- and the price of one plate of Samos as will be Rs 10.50/-. So he can buy 1019 plate of Samos as i.e. the purchasing power has increased in 2nd case where he can buy 19 more quantities than the previous one.

How interest rates work in fixed income security/bond market…

A bond is a debt instrument in which an investor loans money to an entity (typically corporate or government) which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money to finance a variety of projects and activities. Owners of bonds are debt holders, or creditors. As we already learned during our discussion of repo, government or RBI issues such bonds and sells them in the marked like Govt. Securities (G-Sec), State Development Loans (SDL), Treasury Bills etc. to raise money and buy them back as well. These securities are issued with a coupon rate and a fixed maturity. Coupon rate is a rate, which is paid on the face value of the bond on half yearly or yearly basis till the maturity. When buying a bond, the investor should also look into another aspect i.e. yield to maturity (YTM) which is also called interest rate in case of bonds. This interest rate determined as the equation given below.

Interest Rate = Risk free rate + Inflation Premium + Default Risk Premium + Liquidity Premium + Maturity Premium

So this yield keeps on changing depending upon various macro-economic factors. Then the price of the bond is determined by discounting all the future inflows till maturity from the bond by the interest rate or the YTM. So an upsurge in the yield results into drop in bond price. We can also see that ceteris paribus, a high inflation results into higher interest rate and lower bond prices.

Let us understand this with a small example. Suppose a government bond with 1 year maturity, face value of Rs 100/- and coupon of 8% issued on 01.01.2020 which pays the coupon yearly. Now on 01.07.2020 the yield is 10%. We will get Rs 108/- on maturity of the bond with 8% coupon rate. If we discount Rs 108/- by 10% i.e. a discounting factor 0.1, we get Rs 98.18/- so the price of the bond goes down to Rs. 98.18/- from Rs 100/- when yield goes up from 8 to 10.

How interest rates are used to control inflationary economy…

Inflation refers to the rate at which the prices of goods and services rise.  Interest rates and inflation are closely related to each other and often referred together.Inflation occurs when an economy grows due to increased spending. When this happens, prices rise and the currency within the economy loose its value. The currency essentially won’t buy as much as it would before.

One popular method of controlling inflation is through a contractionary monetary policy and as we have discussed earlier controlling interest rates is one aspect of monetary policy. The goal of a contractionary policy is to reduce the money supply within an economy by decreasing bond prices and increasing interest rates. By raising interest rates such as Repo, the RBI causes banks to raise rates (as we discussed the lending rates are directly linked to repo now) and thus lowers demand. Firms do not borrow as much to invest when rates are higher and individuals stop buying durable goods against credit and, instead, turn to save. Also a higher reverse repo provides the banker with an risk free investment option with higher return so they tend to lend less.  Lower demand growth leads to a better match between demand and supply, and thus lower inflation.

How interest rates stimulate economy during recession…

During a recession, unemployment rises, and prices sometimes fall in a process known as deflation. At the onset of a recession, some businesses begin to fail typically for economic bottlenecks that result from the incompatibility of production. These businesses lay off workers, sell assets, and sometimes default on their debts or even go bankrupt. All of these things put downward pressure on prices and the supply of credit to businesses in general, which can spark a process of deflation.

Then the central bank in its monetary policy announce rate cut which lower the interest rates.  Lower interest rates enable the businesses to borrow low cost funds and sustain their activities. This also enable consumers to make more purchases on credit, keeping consumer prices high and likewise extend themselves further into debt rather than live within their means. So money supply increases, businesses retain their employees and recession tends to go away.

Is rate cut by RBI during Covid-19 really helping to upturn the economy…

As we all are aware that due to spread of Covid-19 pandemic and the lockdown the large economies worldwide have taken a hit and India is no exception. To boost the economy Government announced many stimulus packages, and the central bank has not remained behind. Along with extension of repayment moratorium to the borrowers the RBI has stepped up to the plate at the right time with measures of rate cuts that will reduce the cost of capital and ease the financial burden on businesses due to the extended lockdown. With latest repo rate cut of 40 basis points on 22nd May, the RBI has shaved off 1.15 percentage points from the rate chart in less than two months since the lockdown began on 24th March, bringing the repo rate down to 4% and the reverse repo rate to 3.35%. With this, it does appear that the central bank may have played out its rate cut card for now.

But the question arises that is it really helping? In fact, it is believed that the latest cut may be no more than a sentiment booster as economic activity is at its nadir and there are not many loan proposals lying with banks that may benefit from the lower interest rate. Fresh lending by banks are at its lowest levels. On the other hand to maintain asset liability balance banks will cut deposit rates which will result into lower returns on their investments to depositors.  Existing borrowers may be the only beneficiaries of the rate cut at this point in time. Once the lockdown ends, economic activities start to get going then this rate cuts may play the pivotal role to upturn the economy.

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