How Banks Zero in On Interest Rates
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As the impact of high commercial lending rates continues to hit borrowers in Uganda, commercial banks have moved to explain how they arrive at interest rates charge on various loan products as they seek to clear lingering misconceptions.
The explanation by the commercial banks aims at helping the public understand that the banks are not in the business of cheating borrowers as it has been alleged. In an interview with Prosper, Director Global Markets at Stanbic Bank Uganda, Mr Philip Andrew Wabulya explains that the first factor in arriving on the interest rates charged is Inflation rate - Core and headline (Return on any investment should at least be higher than the rate of inflation in order to make a real return).
Mr Wabulya says the higher the inflation, the higher the interest rate an investor would expect to earn in order to make a profit on the investment. The second factor is the Cost of funds- Deposit, CBR (Because banks act as financial intermediaries, the pool of funds available to banks to loan out are sourced from various sources at different prices. "The cost of funds will be typically passed onto the borrower. The higher the cost of the funds, the higher the borrowing cost," Mr Wabulya said.
Treasury Bills and Treasury Bond rates:
T-Bills and T-Bonds are risk free assets and are considered as an alternative investment avenue by banks and as such the interest rates on these assets may be used as a benchmark when considering loans to ordinary borrowers. The higher the risk free rate, the higher the borrowing cost because the bank will include a margin to cater to the risk attached to the borrower.
Tenor - liquidity premium
Typically, the cost of funds varies based on the tenor. Mr Wabulya explains that long tenors tend to attract a higher cost because of the uncertainty over long periods. Thus loans made for a longer period will tend to attract a higher interest rate most of the time.
Credit risk of borrowers
Different borrowers have varying degrees of risk depending on their source of income, stability of their income, collateral provided, among others. Mr Wabulya says the higher the risk profiles of the borrower, the higher the interest rate.
This applies to foreign currency borrowing. Country risk emanates from factors like political instability; break down in legal and regulatory frameworks which may affect property rights, etc. "The higher the country risk, the higher the interest rates," he explained.
Uganda's economy has experienced and is still experiencing high inflationary pressure. For instance, the Uganda's headline annual inflation rate as of December 2011 closed at 27 from 29 per cent in November while the core inflation rate stood at 29 from the 31 per cent recorded in November.
In response to the high inflation and in line with its mandate of maintaining macroeconomic stability, Bank of Uganda has been tightening monetary policy since January 2011 by mopping excess liquidity (through issuing higher volumes of Treasury Bills and Bonds) and increasing the CBR (Central Bank Rate). The CBR affects the rate at which commercial banks can access funds from Bank of Uganda.
High CBR means high costs for borrowers
Bankers say the higher the CBR, the higher the cost of accessing funds from Bank of Uganda. In addition, the increase in CBR was also aimed to reducing the depreciation pressure on the shilling, which had depreciated to as high Shs2900 per dollar- the depreciated exchange rates were also partly responsible of high inflation.
In Uganda the interest rates on government securities have tripled over the last four months. As of November 30 2011, the average yields on the 91- day rose to 22.8 per cent from 22.2 per cent while that of the 182-day and 365-day T-bills declined to 23.5 per cent and 22.4 per cent from 23.7 per cent and 23.9 per cent in November 2011.
Banks push up borrowing to stay in business
In response to the tighter monetary policy (which has affected the cost of funds available for credit) and the higher inflation (which has adversely affected the banks' costs of doing business), Banks have had to increase the interest rates charged on loans in order to maintain a sustainable business.
Interest rate defined
According to Mr Charles Katongole, Head of ALM Liquidity Management at Standard Chartered Bank interest rate is the cost of providing funds to a borrower over a period of time. This generally entails the cost of the actual liquidity. The credit risk premium varies depending on the type of borrower, the operational cost of analyzing, disbursing, booking and tracking and the return on capital/investment or profit margin.
Thus rates within the same market will vary dependent on the risk profile of the market segment, funding costs and/ or operations.
Calculating the rate
The criteria banks use to calculate interest rate: Mr Katongole says interest on ordinary loans is usually calculated basing on the simple interest methodology on a reducing balance basis using the 365 day convention.
Credit facilities - fixed and floating loan rates
In Uganda's credit market there are different interest rates and products. Mr Katongle says there are simple interest rate products like Loans and Overdrafts; Term deposits; High yield deposits; Fixed Income securities (corporate bonds; government securities).
On the various facilities available in Uganda's credit market, Mr Katongole reveals that there are two main types of credit facilities offered in our market. a- Fixed Rate Loans: Interest Rate is fixed throughout the tenor of the facility. b- Floating Rate Loans: Interest rate is based off a benchmark rate (i.e. a spread off the benchmark).
The benchmark rate might be internally determined (base lending rate) or externally (Treasury Bill or Libor). Thus, depending on the interest rate type; the interest rate on the loans would fluctuate save for those on a fixed rate irrespective of the period serviced.
Mr Katongole said as explained, the benchmark rates have been raised in response to the tight liquidity situation in the market. Libor in full means: London Inter-Bank Offered Rate. The Libor is used by the British banks and banks from other countries as well.
What borrowers should look out for
Mr Katongole says: "One of the critical issues with borrowing is ensuring that your cash flows from the investment can meet the loan repayments. Most challenges with loan servicing arise from mismatching cash flows, leading to a strain on a borrower." "Other issues to consider include rate, tenor, basis (that is floating vis-à-vis fixed) repayment schedule," he added.
Loans tenors the in credit market vary from person to person. Mr Katongole says loans can be as short as overnight (overdrafts) or as far out as 25years for mortgages. Overall, the high interest rates charged on various loans continue to be one of the most disturbing issues in Uganda's credit market despite reforms that have taken place over the years in the country's financial sector.
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