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Dhaka, Monday, 2016-02-06

Cutting interest rate on deposits

M S Siddiqui
When an economy is struggling, it is the standard practice of the central bank to cut interest
rates. That makes saving less attractive and borrowing more so, boosting the amount of money
being spent and kick-starting an economic recovery. Europe's central banks and the US Federal
Reserve have kept interest rates near zero for years now in the hope of making money cheap to
borrow. Bangladesh Bank (BB) talks about reduction of Bank interest rate for loan but not much
about deposits.
At present, interest rates in the USA and Europe are close to zero while our interest rate for
saving certificates is of double digit. It is presumed that because of the incentive on saving, the
country's economic activities are sluggish reflecting, among others, on poor investment. Some
central bankers are contemplating whether to drastically cut interest rates, as a kind of economic
punishment for unspent deposits. The theory is that if common people are deterred from keeping
cash in the banks, they will withdraw it and spend some of it, thus creating economic growth
through increased circulation of money in the market. Some economists consider this dangerous.
Since cash carries an implicit rate of interest of zero per cent, consumers might well respond to
negative rates by withdrawing money from banks and stuffing it in their mattresses. The resulting
shortage of loanable funds would push interest rates up.
Europe's central banks and the US Federal Reserve have kept interest rates near zero for years
now in the hope of making money cheap to borrow. The intent is that because it costs next to
nothing to borrow money, the depositors will take advantage of that and invest it in anything that
pays more than a zero per cent return. That usually creates inflation too, as the influx of cheap,
new cash devalues the existing stock.
The Wall Street Journal reported on February 10, 2015 that after the Danish central bank had
slashed its benchmark interest rate to well below zero, some of the country's lenders followed
highly unusual moves of their own. FIH Erhvervsbank announced plans to charge retail customers
to hold money in their deposit accounts, the first Danish bank to do so. The daily Mail of UK on
September 18, 2015 reported that the Bank of England was actively considering negative interest
on deposits. Such a move would mean that rather than earning on money deposited in banks
savers would be charged - at a rate that would act as a tax on savings. The chief economist of
the bank said Britain might require 'radical' action in order to keep the recovery on track,
including further cuts in interest rates. Sweden is shaping up to be the first country to plunge its
citizens into a new economic experiment: negative interest rates in a cashless society.
The Swedish central bank, the Sveriges Riksbank, imposed benchmark interest rate of -0.35 per
cent since July last year. Negative interest is normally approached from the depositor's
perspective and a saver who leaves money at the bank would pay money to do so rather than
earning money through interest. The idea behind negative interest rates is to get banks to lend
and businesses and people to borrow and spend - thus boosting economic growth. When interest
rates are cut below zero, they go into the negative territory.
Banks extend loan from the deposits and earn profits. There are many methods of calculation of
interest rates.

FIXED INTEREST RATE: In fixed interest rate, the interest to be paid is fixed in advance when
extending loan. The borrower knows the exact amount he needs to pay or the exact interest rate
on outstanding loan.
FLOATING INTEREST RATE: In case of floating interest rate, the interest rate is not determined
while lending. The London Inter-bank Offered Rate (LIBOR) is the average interest rate estimated
by leading banks in London that the average leading bank would be charged if borrowing from
other banks. LIBOR or ICE LIBOR is a benchmark rate that some of the world's leading banks
charge each other for short-term loans. This rate keeps on changing on a daily basis and thus
the interest rate at which a lender borrows will also keep changing. However, this change is not
made on a daily basis but is done once a year/six months and the interest rate is thus fixed till
the next update.
OTHER METHODS: The change in interest rate is usually tied to movement of an outside indicator,
such as the prime interest rate. Movement above or below certain levels is often prevented by a
predetermined floor and ceiling for a given rate. For example, you might see a rate set at "prime
plus 2.0 per cent". This means that the rate on the loan will always be 2.0 per cent higher than
the prime rate, which changes regularly to take into account changes in the inflation rate.
In many countries, floating rate loans and mortgages predominate. They may be referred to by
different names, such as adjustable rate mortgage in the USA. In some countries, there may be
no special name for this type of loan or mortgage, as floating rate lending may be the norm. For
example, in Canada, all mortgages are worked out on floating rates; borrowers may choose to
"fix" the interest rate for any period between six months and ten years, although the actual term
of the loan may be 25 years or more.
The commercial banks in Bangladesh are not 'listening' to BB on the excuse that since interest on
certain saving instruments applicable to retired government servants are high, they are unable to
lower interest on other deposits. However, interest rates on credit and deposit in Bangladesh
slowly declined by a small percentage in recent times.
Though the interest rate policy is market-based, the central bank often sets the maximum cap for
loans in different priority sectors considering national interest and overall macroeconomic
situation. For example, the current ceiling on interest rates for pre-shipment export credit is 7.0
per cent and for agricultural loans it is 11 per cent. The effective rate of interest for the Export
Development Fund (EDF) is less than 3.0 per cent. According to the central bank, no more than
10 per cent interest rate can be charged under the BB refinancing scheme for SMEs (small and
medium-sized enbterprises) and women entrepreneurs, while 4.0 per cent rebate is applicable to
agriculture sector for cultivation of pulses, oilseeds and spices.
Banks in Bangladesh has a more or less fixed rate policy and there is no other option like floating
or inflation-based loans. The BB has a special policy of reduced interest rate on loans from its
Export Development Fund (EDF) to help exporters get low-cost funds.
BB can intervene and change the policy of interest on loan and reduce the interest rate on
deposit to see how these affect consumption and investment in products and services.
The writer is a Legal Economist.