Base rate decline halts, where will loan interest head now?
The base rate of banks and financial institutions has increased slightly in the last two months. Due to regulatory provisions allowing a higher share of operating expenses to be included in the base rate and limited room to reduce deposit interest rates, the possibility of further decline in the base rate has weakened.
Kathmandu. The base rate (base rate) of banks and financial institutions, which had been continuously declining for the past few years, has now stopped falling.
Although deposit accumulation in the banking system has continued due to weak loan demand, the room for further improvement in banks' cost structure has narrowed, halting the decline in the base rate. Data from the last two months even show that the base rate has started to increase slightly.
In Shrawan, the average base rate of banks and financial institutions was 4.72 percent, which rose to 4.75 percent in Ashwin. Although this increase of 0.03 percentage points over two months is not large, it signals a significant turning point in the declining phase of interest rates in the banking sector. Since the base rate is the main basis for determining loan interest, its direction has now become a matter of interest for borrowers as well.
When there is sufficient liquidity in the banking system, there is generally pressure for interest rates to fall. When deposits are high and loan expansion is slow, banks must compete by lowering interest rates to increase new lending. This is why, in recent years, as the cost of deposits decreased, banks' base rates also continued to fall.
However, the current situation appears somewhat different. Although banks have sufficient investable funds, loan expansion is relatively weak. In such a situation, even if banks try to reduce costs by significantly lowering deposit interest rates, they appear to have reached their limit. On the other hand, the provision to include operating expenses and other costs in the base rate has also brought a slight increase in the base rate recently.
Nepal Rastra Bank has made a provision allowing banks and financial institutions to calculate a certain portion of operating expenses in the base rate. Previously, up to 85 percent of operating expenses could be included in the base rate, but from Bhadra, this has been increased to 90 percent. This provision has given banks, especially those with relatively high operating expenses, an opportunity to cover a larger share of costs in the interest rate determination basis.
Its direct impact has been seen in the base rate of the last two months. After allowing an additional five percentage points of operating expenses to be included in the base rate, the average base rate of banks has increased by 0.03 percentage points. Although this increase is not large in itself, it shows that the possibility of lowering the base rate solely by reducing banks' costs is becoming limited.
An increase in the base rate does not mean that interest rates on all types of loans will immediately rise in the same proportion. Banks determine interest rates based on the nature of the loan, premium, and other conditions. However, since the base rate itself is the basis for determining loan interest rates, its increase weakens the downward pressure on loan interest rates.
Another important aspect now is the cost of deposits. The average interest rate on deposits in banks and financial institutions is 3.15 percent.
- Savings account average interest rate: 2.73 percent
- Fixed deposit: 4.73 percent
- Current account average interest rate: 0.49 percent
This shows that banks' deposit costs have already become much lower compared to the past.
However, it is not easy for banks to continuously reduce deposit interest rates. One reason is linked to the lower bound of Nepal Rastra Bank's interest rate corridor. When there is excess liquidity, banks can deposit their extra funds with Nepal Rastra Bank and earn a fixed interest income. For that, banks are limited in reducing deposit interest rates below a certain level.
Currently, the lower bound of the interest rate corridor is 2.75 percent. Banks are maintaining interest rates around this level for ordinary savings and short-term fixed deposits. If deposit interest rates are lowered below this, banks may have to offer depositors a rate lower than the return they would get by keeping excess liquidity with Nepal Rastra Bank. This could also affect the bank's liquidity management.
Therefore, even though a large amount of investable funds is piled up in the banking system, there is no situation where deposit interest rates can be reduced indefinitely. Currently, banks are keeping nearly 9 trillion rupees with Nepal Rastra Bank at an interest rate of 2.75 percent. This shows how much liquidity is in the banking system compared to loan demand.
However, having excess liquidity and continuously reducing bank costs are not the same thing. When loan demand is weak, money can pile up with banks, but due to operating expenses, the minimum cost of deposits, and regulatory provisions, the capacity to reduce the base rate may be limited. In this situation, banks' base rates have recently begun to find a lower bound.
This means that although there is no clear indication of whether interest rates in the banking sector will immediately rise or fall, the possibility of further decline in the base rate has weakened. Unless loan demand increases, interest rates are unlikely to become high, but due to the cost structure and regulatory provisions, the door for the base rate to fall further is now narrowing.