How banks fix interest rates

Recently, I took part in a dialogue organised by the Uganda Bankers Association (UBA) and the Civil Society Budget Advocacy Group (CSBAG), who have called for legislative action leading to the capping of rates. The UBA had previously called for structured dialogue on the issue of high interest rates and this meeting was for parties that have raised issues on interest rates to hear the lenders’ case.

During the meeting, the UBA asserted as follows: (i) There was no market failure in the credit markets in Uganda; (ii) Banks have to recoup their costs directly from interest charges; (iii) The Banks disagree with the Central Bank’s computation of cost of deposits presented in the BoU Financial Stability Report of 2015; (iv)The Central Bank Rate (CBR) is not consequential to interest rate formation in the banks in Uganda, rather banks use the Treasury Bill Rate (TBR); and (v) Treasury instruments are priced based on several factors and banks could not tell if they were mispriced or not.

The above positions are worrying as they fly in the face of the sea of evidence available, present an incorrect picture of what constitutes an interest rate and consequently invite questions about the intentions of the banks.

Market failure
Market failure is a situation in which the allocation of goods and services is not efficient. That is, there exists another conceivable outcome where an individual may be made better off without making someone else worse off.

At the dialogue, UBA attempted to equate market failure to a market crash, which is defined as a sudden dramatic decline of prices across a significant cross-section of a market, resulting in a significant loss of paper wealth. Crashes are driven by panic as much as by underlying economic factors. They often follow speculative market bubbles.

Market failure differs from a market crash and can be redeemed by regulatory, market and governmental action before events conspire to precipitate a market crash.

Cost-plus pricing model
It has emerged now that some of the issues at the centre of the current market failure are the banks use of the ‘cost-plus’ pricing model with which they build cost into the calculation of interest rates and the levying of charges on depositors for operating bank accounts.

While the charges on depositors offset the 3.3 per cent that Bank of Uganda (BoU) indicates banks pay on the deposits they manage, the lenders argue that they have to add their costs to the standard items, that is the real risk free rate, expected inflation, default risk, liquidity risk and horizon risk which are used in the determination of interest rates.

Anything extra added to the risk components in pursuit of the discredited ‘Cost-Plus’ pricing model is a distortion of the rate. This is true because in economics and finance, prices and costs are different creatures.

Interest rates
Interest rates, which are the prices in finance, if constructed properly, respond to the phenomenon of elasticity. Cost items, on the other hand, do not. Therefore, because the cost items do not respond to elasticity, they do distort the interest rate. It is probably one of the reasons why banks in Uganda find it very easy to raise rates when the CBR goes up, but are slow to reduce rates when CBR is lowered.

If lenders could respond to CBR announcements, CBR would be a useful tool in the determination of rates. Lack of response to CBR is a sign of market failure. During the recent debate on high interest rates in Kenya, the lenders failed to satisfy parliament on the use of the CBR and the Kenya Bank Reference Rate, resulting eventually in the decision to cap.

what is bank of uganda’s role in money supply?
In Stanbic Bank’s published pricing model, the CBR is an active component of their price, while in the model defended by UBA, the TBR is preferred and the CBR is mute. The TBR is subject to daily and intra-day variations, while the CBR is announced and set monthly by the Governor. In order to contain the variations banks that employ TBR will use higher rates than those that might opt for CBR.

Finally, according to Article 162 of the Constitution, BoU is supposed to operate independently of any authority in Uganda. Under the provisions of the Treasury Bill Act, 1969 and the Public Finance Management Act, 2015, Bank of Uganda can act as agent for the government in issuing treasury debt instruments. When the government issues debt instruments, it does so to fulfill its fiscal policy.

Bank of Uganda Act
On the other hand, according to the Bank of Uganda Act, the Bank is responsible for formulating and implementing monetary policy, a key feature of which is control of money supply.

Currently, there is no instrument by which BoU can exercise this control independent of the actions of the treasury, which is responsible for government expenditure. Such an instrument would probably be a bond issued by BoU itself, against its own credit rating and built within it options for redemption that give the Bank the flexibility to control money supply.

The instruments available are different in that they are issued by the government, on the government’s credit rating and with no options for redemption. Even if these options were included in the design of the fiscal policy instruments, they would only be exercisable by government, the fiscal authority, rather than BoU, the independent monetary authority.

Limited flexibility
The lack of flexibility on the part of BoU means that likely the bonds in the market are mispriced, which may affect the interest rate computations across the credit markets. We would all do well to acknowledge market failure given the tension between the CBR/TBR, the cost-plus pricing in the banks and the potential for mispricing offered by the modus in which we have executed the law covering the monetary and fiscal policy. If these features of failure are tackled, the borrowing public should begin to experience improvements on the interest rate market.

The writer is the chief executive officer of ALTX East Africa Ltd.

JOSEPH KITAMIRIKE
“Because the cost items do not respond to elasticity, they distort the interest rate. It is probably one of the reasons why banks in Uganda find it very easy to raise rates when the CBR goes up, but are slow to reduce rates when CBR is lowered.”