A dilemma for banking customersIn view of the high volatility, banks should be allowed to fix the interest rate on shorter term loans.
Nepal Rastra Bank recently issued directions to banks in Nepal to decide and publish their fixed interest rates on term loans. Against this backdrop, the scenarios and modalities for fixed interest rates in Nepal's financial market need to be analysed. In the international market, two types of interest rates are prevalent for term loans—floating and fixed interest rates.
A floating interest rate is the rate set by adding a risk premium to a variable reference rate such as LIBOR (London Inter-bank Offered Rate), Euribor (Euro Interbank Offered Rate), MCLR (marginal cost of funds based lending rate), SOFR (secured overnight financing rate) and base rate. In Nepal, this rate is called Base Rate. These reference rates change on a daily, weekly, monthly and quarterly basis. The floating rates on loans are subject to reset after a defined period which is generally one year or less.
Under a fixed interest rate mechanism, financial institutions offer a fixed interest rate for the full tenure of the loan which does not change. However, financial institutions put a rate reset period to manage their interest rate risk which is generally two years or more. The concept of fixed interest rate on loans is based on the fact that general borrowers may not have the capacity to predict future rates, but banks at least have some expertise. A fixed interest rate mechanism protects customers from the uncertainty of changes in interest rates. It protects customers by not increasing the interest rate liability despite an increase in the borrowing interest rate in the market. It also secures a steady income inflow for the lending bank.
A fixed interest is beneficial to borrowers if the market rate rises after obtaining the loan, but they will lose in case the market rate falls. Choosing between a fixed or a floating rate is a dilemma for most customers, but it has been observed that mature people opt for a fixed interest rate while young borrowers opt for a floating interest rate. More salaried people choose a fixed interest rate compared to self-employed people.
Scenario in Nepal
Interest rates in Nepal have been more volatile compared to any other country in the South Asian Association for Regional Cooperation grouping. Benchmark rates such as interbank lending rates and treasury rates are indicators of market rates. As per Nepal Rastra Bank data, during the one-year period from mid-April 2019 to mid-April 2020, the average interbank lending rate fluctuated from 5.28 to 2.13 percent. During the same period, the average 91-day Treasury bill rate swung between 4.44 and 2.13 percent. Similar volatility has been observed in the past years. Interest rates on fixed deposits have also shown almost similar variations.
Nepali banks have a big mismatch in maturities of assets (loans) and liabilities (deposits) which is called maturity mismatch. Banks hold less long-term deposits than issue long-term loans. As per central bank data for April 12, 2020, total fixed deposits held by commercial banks with a maturity period of two years or more amounted to Rs237 billion. Term loans, housing loans and hire purchase loans provided by commercial banks (they have a maturity of more than two years) totalled Rs943 billion. The housing loans provided by banks total Rs208 billion and have an average repayment period of about eight years, but the amount of fixed deposits with a maturity of eight years or more is almost negligible. This shows a huge maturity mismatch between long-term deposits and loans in Nepal's banking sector.
As per Nepal Rastra Bank guidelines, the Base Rate is a reference rate that is dependent primarily on the cost of deposits for banks along with other factors such as the CRR (cash reserve ratio), SLR (statutory liquidity ratio) and operation costs. Banks have the challenge to keep the base rate less volatile in view of the volatility in interest rates and liquidity. Banks have to fix interest rates on loans based on the Base Rate after adding credit risk premiums.
Due to the volatility of interest rates, banks were compelled to change interest rates on loan products which led to questions about efficiency besides denting their image. Amid the above challenges and central bank instructions to publish fixed interest rates on term loans for a fixed tenure, Nepali banks face a challenge setting fixed interest rates on term loans by finding an equilibrium between its returns and customer expectations.
In view of high volatility, banks should be allowed to fix the interest rate on term loans for a shorter term, that is up to one-two years initially or they should be allowed to insert an interest reset clause which permits banks to manage their interest rate risk.
It has been observed that in case of a decrease in loan interest rates in the market, customers with fixed interest rates prepay their term loans. Nepal Rastra Bank has barred banks from levying pre-payment charges for prepayment of loans up to Rs5 million. The central bank should allow banks to collect prepayment charges in case of prepayment of fixed interest rate loans. Banks should make their customers thoroughly understand the fixed-rate mechanism before offering such rates. Customers should have the option to convert from a fixed interest rate to floating interest rate or vice versa with some charges.
Banks should not be allowed to offer teaser loans where the fixed rate is for a very short-term initially and then forced to floating rates thereafter. Such teaser products attract borrowers at a lower fixed rate for a short term and then banks may charge higher rates and make unexplained gains. Banks should bring innovative deposit instruments to attract long-term deposits to reduce the prevalent maturity mismatch and offer clients long-term fixed interest rates on loans. The implementation of a fixed interest rate mechanism on loans protects customers from uncertainties and it is also expected to help banks to restore some positive image.
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