Borrowers deserve a choiceBanks must not resist the central bank’s call to set fixed rates for term loans.
Nepal Rastra Bank and the commercial banks have had a testy relationship at times. The monetary policy of 2015-16 required these banks to raise their minimum paid-up capital from Rs2 billion to Rs8 billion. Nepal Rastra Bank sought to tempt the banks into mergers, resulting in fewer bigger banks. The banks instead bulked up by issuing rights and bonus shares. As of the last fiscal year ended mid-July, 27 commercial banks had a combined paid-up capital of Rs285 billion. The central bank routinely failed to intervene when these banks, in a cartel-like behaviour, capped deposit rates. As things stand, the regulator and the regulated are headed for another tug of war.
The history of competitive banking in Nepal is relatively short. Banking began as far back as 1937 when Nepal Bank Limited was established. But it was not until the 1980s and 90s that private entities entered the sector. Of the 27 commercial banks currently operating, 13 were founded this century. The sector is young and continues to evolve. Each new small improvement goes toward gaining maturity. In the long run, Nepal Bankers’ Association, an umbrella body representing commercial banks, will do the sector a big favour if it stops tinkering and let the forces of supply and demand set interest rates. Banks also do not offer fixed rates on term loans—a practice Nepal Rastra Bank wants to end. Banks are resisting it.
Term loans come in various types. A short-term loan generally runs less than a year. An intermediate-term loan runs between one and three, and a long-term loan from three to 25 years. These loans can be either fixed or variable. Fixed-rate loans are exactly that—fixed; rates remain the same for the entire duration of the loan. Variable-rate loans—also known as floating or adjustable—can change over the duration of the loan. Typically, variable-rate loans are based on benchmarks such as the LIBOR (London Inter-Bank Offered Rate), or the base rate in Nepal’s case. Commercial banks in Nepal only offer variable-rate term loans, which arguably in and of itself is a sign of immaturity.
Fixed rates long overdue
Nepal Rastra Bank is determined to change the status quo. It has directed the banks to set and publish fixed rates for term loans with maturities exceeding one year. This is a major development in Nepali banking. The management at these banks are not happy, and understandably so, as the business model of a loan portfolio with variable rates will look a lot different from the one with fixed-only or with fixed and variable combined. Probably realising that the time has come for the practice to end, they are trying to salvage it with a new twist. Banks want Nepal Rastra Bank to require fixed rates for maturities of only up to three years, arguing that it is impossible to approve a 25-year fixed-rate loan not knowing what the future holds that far out.
Bankers should try to put themselves in their customers’ shoes. If professionals who do this for a living are unable to model the uncertainty surrounding interest rates, then we can imagine the plight customers find themselves in when faced with variable rates. Picture the tension a customer with a tight budget will be in when he finds out his monthly mortgage just went up as rates got adjusted higher. The availability of fixed rates will fix this. In the end, it should be up to the customers to choose between fixed and variable. If a homebuyer believes rates are headed lower in the future, he may opt for a variable rate option. Those that locked in higher rates will be at a disadvantage if rates trend lower. The dynamics change in a rising rate environment.
The issue of fixed versus variable permeates the economy. Companies incur two types of costs. Variable costs rise and fall with production volume. Examples include labour, commissions, raw materials, etc. Fixed costs such as lease payments, utilities and insurance payments remain the same. Both are essential. This holds true for a bank as well. If the goal is to minimise risk from adverse movements in interest rates, a combination of fixed and variable is better than having only one option. In a cycle when rates are falling, banks with a loan portfolio that only consists of variable will be making loans at progressively lower rates. The existence of fixed loans at higher rates would provide a cushion in a time like this.
Maturity mismatch not an issue
Banks cite the existing maturity mismatch between liabilities (deposits) and assets (loans) for not wanting to offer fixed-rate loans for all maturities. As of the last fiscal year, commercial banks held Rs2,907 billion in loans and Rs3,490 billion in deposits. Of this, term loans, home loans and hire purchase loans together amounted to Rs977 billion. Against this, there was Rs252 billion in fixed deposits of two years and above. At first glance, the mismatch is evident. However, they also held Rs592 billion in fixed deposits of one to two years. Further, home loans (totalling Rs208 billion) are the only ones that mature in up to 20-30 years. Others, not so much. Auto loans, for instance, are of much shorter variety, around five to six years.
In mature economies, banks routinely make loans maturing in 20-30 years, such as home mortgages, but they hardly ever have matching 30-year deposits. What they do have is other sources of revenue, such as trading, investment banking, wealth management, etc. In Nepal, banks strictly take deposits and make loans. A positive spread between the two is their bread and butter. For that, as is true with banking in general, they borrow short and lend long. In the last fiscal year, commercial banks’ interest expenses were Rs200 billion and interest income Rs329 billion. The onset of fixed-rate term loans can ignite volatility in the hitherto stable income stream, but, for maturity’s sake, managements should learn to deal with this.
In the 2018-19 fiscal year, 28 commercial banks paid out Rs47 billion in dividends, Rs26 billion of which was in cash. If they retain more of their profit, banks do not only have to rely on deposits to make loans. The capital market is still evolving in Nepal. The bond market hardly exists. Pension funds such as Employees’ Provident Fund or insurance companies need products matching their long-term liabilities. Properly constructed long-term deposits can attract these institutions. Over time, banks will be in a position to securitise their loan portfolios themselves. In the meantime, Nepal Rastra Bank now requires commercial banks to issue 25 percent of their paid-up capital in debentures, which should help lessen the reliance on deposits. It is time borrowers are given a choice.