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Interest Rate Corridor: Will it fly?

NRB’s new tool to shape up the money market can work. But only with some important caveats.

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Nepal Rastra Bank (NRB) has recently introduced the concept of “Interest Rate Corridor” (IRC) in Nepali Money Market through its midterm review of Monetary Policy. As it is a new concept, it has attracted attentions of banks and their customers. The business dictionary simply mentions that the IRC is a derivative product which one bank issues to other banks to protect its interest rate risk and to utilize the unused portion of its funds. At a time when Nepal has excess liquidity and the banks are under pressure to reduce lending rates, IRC’s introduction has raised some questions. How it functions is of great interest to many of us.

Although NRB has introduced the term “interest rate corridor” in its policy, it is yet to publish the modalities on how it works. NRB has already announced 80 percent Credit Deposit ratio, 20 percent Liquidity ratio and 15 percent Statutory Liquidity Ratio (SLR), which has contributed to the downswing in interbank market. While complying with SLR requirements as per NRB guidelines, around 10 percent of the bank resources will remain idle all the time.

It’s not that the policy of credit deposit and other limits are inherently bad, but where NRB seems to have erred is in calculation of the impact of maintaining such standards. When the market was in acute shortage of liquidity, the directive worked as a guideline for the banks and financial institutions (BFIs) to come out of the crisis. Now that all the ratios are maintained by most BFIs, the excess liquidity which the banks have been keeping idle has to be transferred to the end customers so that the banks can return to profitability.

BFIs have been trying to invest the idle fund in completely secure areas, one of which is Government Securities. Meanwhile, the interest rate on Treasury Bills has gone down, to as low as below 1 percent p.a. The pressure of maintaining profitability among the banks while the Treasury Bills yield is at one of its historic lows has forced the banks to transfer the cost of maintaining similar profitability, as in previous years, to the end borrowers, i.e. Credit Customers. As a result, despite decreased interest rates on deposits due to high liquidity, the interest rate on loans remains intact.

This implies that the borrowing clients are simply paying the cost of idle funds required to maintain banks’ statutory ratios as per NRB directive. In order to avoid this undesirable situation, instead of introducing high end derivative product like IRC, NRB could have sold the securities in their possession for the time being, which could have brought parity to the liquidity and interest rates at the same time.

Similarly, due to the volatile environment and high interest rate, the demand for loan from the productive sector has gone down drastically. In order to cope up with the lower loan demand as well as low interest rate of Treasury Bills, the banks have started refusing institutional deposits. This could be one of the reasons why NRB introduced IRC in Nepali market, which has in fact contributed to shrinking bank Balance Sheets.

As a measure, NRB can implement IRC in several ways. One of the commonly used methods is quoting two-way interest rates of funds, the base of which could either be 91 days Treasury Bills or the bank rate. When the base is the bank rate, the securities can be sold to banks for a fixed period of time at a fixed rate. For example, if the current bank rate is 10 percent p.a., NRB will buy/sell securities from/to banks at +/_ 2 or 3 percent p.a. when this door is opened.

Alternatively, the transaction can also be based on 91 days Treasury Bills rate, but as this rate is very low, this track is irrelevant in our context. Another model may be fixing the rate for repo and reverse repo for certain period, wherein the base of coupon rate of the securities should never be used. If NRB opts to use any of these models, the ultimate beneficiary will be the commercial banks and the borrowing customers, which might eventually result in decreased interest rate in loans and increase the probability of attracting genuine and good loan clients.

Is the IRC good for our country at this point in time? Yes, if NRB is not interested in selling the scripts in its possession to absorb the liquidity, which could be an easier and faster way out, but only if it’s implemented immediately. However, this is not the only method to improve the current situation in banking system. This method can only address interest rate issues and others related to creating credit in the system.

For the overall change in the market, NRB needs to address its policies on Non-Performing Assets (NPA), profitability, real estate as well as the share market. As per the latest BFI reports, NPA has increased while profitability has gone down, compared to previous year. Similarly, as the inflation rate is much higher than the average savings interest rate, the country is already running a negative interest balance. Thus, NRB will have to come up with some relief tools for the market. When the government is borrowing at a rate as low as under a percentage p.a. from the public’s fund, NRB should not close the policy issue just by introducing a derivative product like “Interest rate corridor”.

source:Nepal,Raju(2012),"Interest Rate Corridor: Will it fly? ", republica, 18 feb 2012

The author is Chief Operating Officer at Citizens Bank International Limited. The opinions expressed in this article are personal




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