Have Nepal's Banks formed a Cartel?

When a group of companies controlling an industry come together and determine prices or supply we usually call it a cartel. Cartels sometimes restrict competition and mostly mean higher profits for the companies at the cost of consumers. I'd like you to keep this in mind as we look at what has happened in the Nepalese Economy and what banks are doing and how it impacts you.

If you think banks have wrongly denied you better rates (say 12%) that would come from free market situation, you are wrong. You benefit short-term but lose out in many things. Increase in lending costs would increase production costs of corporates that would mean increasing expenses for you. Your investments value in the share market would drop. Real estate prices could fall. A more dangerous scenario would be credit risks caused by increased interest rates. Extra interest in deposits vs fall in value of your investments and property, what would you choose?

Liquidity Woes

It all began with liquidity woes. Please click here to understand more about how liquidity works in Nepal. Although this article is about last year's liquidity problems, the situation is the same and should help provide good insight. With credit growth largely surpassing deposit growth, fall in remittance, continuous trade deficit and very poor fiscal spending by government resulting in inadequate deposit creation, banks have once again entered into a deposit crisis. So fixed deposit interest rates started rising to 11% and beyond. Institutions were offered above 13% too. There was no new deposit creation and each bank was actively lending hoping the situation will better. It didn't and banks were only trying to solicit deposits maintained at other banks. So, one deposit holder would get offers and counter offers from all banks. If a large deposit matured in one bank, twenty seven other banks would line up to try and solicit that same deposit. You might guess what happens in this scenario.

Increase in Savings Rates too

This year, banks began increasing savings rates too primarily because of a central bank regulation which required banks to pay savings deposit holders higher rates than call deposit holders. Call deposit is basically an interest bearing current account offered to institutions. This was a very good move by the Central Bank as it protected the interest of individual deposit holders who have less bargaining power than institutions. Had the regulator not taken this step, savings deposit holders would continue to earn 3-5% on savings while call deposit holders would be earning 11%. Now, the competition for call deposits and need to protect existing savings, banks have begun raising rates in Savings accounts too. Say, if banks want to offer call deposit holders 6%, they would have to increase rates on savings to 6% and above.

Are Banks in a Liquidity Risk?

Now, you should understand that banks were not in a liquidity risk situation. Banks in Nepal have different liquidity controls for overall liquidity and 'deposit liquidity' which was in the article I shared in the above link. You could also read this article to know where banks invest their liquid funds and manage liquidity; and also about the bond market in Nepal. Banks have no liquidity risk and are only in a 'deposit crisis'. So you need not worry about a systemic risk or bank default risk at this point.

Risks of increasing Interest Rates in the Economy

Coming to the point, it became very difficult to control interest rates. One day a bank offered 11%, the other day, another bank would offer 11.5%. With no increase in deposits, if not controlled the rates wouldn't take time to reach 15% and even higher. It is the responsibility of the Central Bank to control interest rates in the economy. It is my view that central banks should have a monopoly over interest rates, you can read about them here. And this can be deadly. Banks have to earn a minimum spread for ensuring dividends. Increase in deposit rates would lead to increase in lending rates. Once fixed deposit rates start reaching 15%, lending rates in Nepal which are entirely floating-based would reach 20%. Now, if you are a borrower, would you be able to pay 20%? There would be a large credit default risk which could create system-wide problems. Investment climate would be damaged and the share market would crash. Higher interest rates has always known to be detrimental to the economy.

The Necessary Agreement among banks

If you think banks have wrongly denied you better rates (say 12%) that would come from free market situation, you are wrong. You benefit short-term but lose out in many things. Increase in lending costs would increase production costs of corporates that would mean increasing expenses for you. Your investments value in the share market would drop. Real estate prices would drop. A more dangerous scenario would be credit risks caused by increased interest rates. Extra interest in deposits vs fall in value of your investments and property, what would you choose? This agreement was not done for limiting supply or services, restricting competition or increasing profits to stakeholders. Please understand that floating rates mean banks don't lose out substantially on spread because of increasing rates. Therefore, banks won't worry much about increasing one percent in your savings as they can pass on the cost to borrowers. Base-rate based pricing model in Nepal means the cost is automatically transferred. However banks are worrying about whether these borrowers will be able to pay back the loans at such high rates. Therefore the necessity of the understanding. Banks agreed to limit interest rate hike to 11% on fixed deposits. This meant banks would not need to aggressively solicit other banks' deposits and should be able to manage liquidity by retaining existing funds. A healthy situation, something that we all desire.

This agreement was not done for limiting supply or services, restricting competition or increasing profits to stakeholders. Please understand that floating rates mean banks don't lose out substantially on spread because of increasing rates. Therefore, banks won't worry much about increasing one percent in your savings as they can pass on the cost to borrowers. Base-rate based pricing model in Nepal means the cost is automatically transferred. However banks are worrying about whether these borrowers will be able to pay back the loans at such high rates.

Further reading:

• A hitchhiker's guide to liquidity in Nepal
• Bond Market in Nepal: Why are Nepal's domestic borrowing costs cheaper than that of India or Sri Lanka
• Forget free market, central banks should have a monopoly over interest rates
• Hedge Funds in Nepal

The author is a Chartered Accountant and a Financial Sector Professional.