Helmi Arman,
Since late last month, commercial banks are each required to publicly disclose their so-called “prime-lending rate”. This is defined as the base rate that a bank refers to when charging for credit, excluding any customer-related risk premiums.
In Indonesia, the prime lending rate for each bank is obtained by adding up three main components; i.e. the cost of funds, overhead costs, and profit margins related to a bank’s three main lines of business (which are corporate banking, retail and consumer lending).
So the concept is quite different from the prime rate in the US, for example, which is more simply calculated as the central bank’s policy rate target (i.e. the Fed Funds rate) plus three percentage points.
Bank Indonesia’s (BI) apparent intention of requiring banks to publish these rates is to make loan pricing more efficient, with the final aim of reducing lending rates and improving the financial intermediation function of commercial banks.
This is indeed a noble goal; but how actually can publishing prime lending rates achieve all this?
We all know that the usefulness of a given set of data or numbers depends very much on how well the numbers are calculated; thus the term “garbage in, garbage out”. If the public is to make good use of the publication and to know which banks are charging high rates and which ones are not, the numbers have to be reliable.
But in reality, getting reliable numbers is easier said than done. BI’s manual for calculating prime rates is indeed meticulous; but like any manual it is not free from grey areas and room for judgmental
estimates.
How else, for example, could the prime rates of nearly all banks be so beautifully rounded to the decimals of .00, .25, .50, .75, etc?
If the calculation process were precise (not to say this is even possible) we would likely be seeing many odd decimals.
Anyway, the bottom-line is that the prime lending rates do not provide useful apple-to-apple comparisons. For example, at the time they were first published, it was seen that two commercial banks, both engaged in the high-margin micro-financing business, had a prime rate discrepancy of nearly 10 percentage points!
That huge gap was clearly not consistent with the similarity in actual interest rates charged by the banks, which is reflected by their relatively thick net interest margins. If the man on the street had selected this bank on the basis of such information, then he would have been seriously misled.
And it’s not like lending rates are the most important impediment against financial intermediation to begin with.
For businesses such as micro-financing institutions, for example, a 2010 World Bank survey titled Improving Access to Financial Services in Indonesia notes that what matters more to borrowers is not interest rates, but the size of monthly payments and whether borrowers’ cash flows are suffice to service these payments.
The same survey also found that some borrowers who do not have access to banking services (due to problems such as lack of documentation, etc.) don’t mind tapping money from informal sector lenders with annualized rates of up to 300 percent per annum, which is sky-high compared to rates banks, between 20 and 30 percent.
Meanwhile for large corporate and commercial borrowers, they are regularly approached by many competing banks thus should already have easy access to interest rate comparisons. And the information at their hand is of much more use because the offer rates quoted by the banks can actually be taken.
So it looks like the policymakers’ time and effort in devising the prime lending rate policy probably would have been better spent elsewhere.
For example, banks hold nearly Rp 500 trillion (US$58.13 billion), or 26 percent of their third party funds, of excess liquidity in the form BI short term papers/deposit facilities.
However the domestic interbank borrowing market is underutilized and many medium-small sized banks are struggling to gather third party funds for accommodating loan growth demand.
This is one serious impediment to financial intermediation that could never be tackled by the mere publication of prime rates.
In early 2008, the average transaction volume in the interbank market was around Rp 12 trillion per day. Now it hasn’t increased but actually decreased to less than Rp 10 trillion per day, in spite of a 50 percent rise in banking sector assets.
This problem with the interbank market is not just the result of a chronic lack of trust/counterparty credit lines between banks (which is the legacy of past crises), but also of an apparent misallocation of incentives. Some large banks are able to collect low cost funds and earn risk-free profits by “investing” them in higher yielding central bank papers/facilities — providing a disincentive to lend interbank.
The writer is an economist at Bank Danamon Indonesia. The views expressed are his own.
Publishing prime rates may not achieve much in improving efficiency and financial intermediation if the long-standing problems of the banking system are left unaddressed.
Since late last month, commercial banks are each required to publicly disclose their so-called “prime-lending rate”. This is defined as the base rate that a bank refers to when charging for credit, excluding any customer-related risk premiums.
In Indonesia, the prime lending rate for each bank is obtained by adding up three main components; i.e. the cost of funds, overhead costs, and profit margins related to a bank’s three main lines of business (which are corporate banking, retail and consumer lending).
So the concept is quite different from the prime rate in the US, for example, which is more simply calculated as the central bank’s policy rate target (i.e. the Fed Funds rate) plus three percentage points.
Bank Indonesia’s (BI) apparent intention of requiring banks to publish these rates is to make loan pricing more efficient, with the final aim of reducing lending rates and improving the financial intermediation function of commercial banks.
This is indeed a noble goal; but how actually can publishing prime lending rates achieve all this?
We all know that the usefulness of a given set of data or numbers depends very much on how well the numbers are calculated; thus the term “garbage in, garbage out”. If the public is to make good use of the publication and to know which banks are charging high rates and which ones are not, the numbers have to be reliable.
But in reality, getting reliable numbers is easier said than done. BI’s manual for calculating prime rates is indeed meticulous; but like any manual it is not free from grey areas and room for judgmental
estimates.
How else, for example, could the prime rates of nearly all banks be so beautifully rounded to the decimals of .00, .25, .50, .75, etc?
If the calculation process were precise (not to say this is even possible) we would likely be seeing many odd decimals.
Anyway, the bottom-line is that the prime lending rates do not provide useful apple-to-apple comparisons. For example, at the time they were first published, it was seen that two commercial banks, both engaged in the high-margin micro-financing business, had a prime rate discrepancy of nearly 10 percentage points!
That huge gap was clearly not consistent with the similarity in actual interest rates charged by the banks, which is reflected by their relatively thick net interest margins. If the man on the street had selected this bank on the basis of such information, then he would have been seriously misled.
And it’s not like lending rates are the most important impediment against financial intermediation to begin with.
For businesses such as micro-financing institutions, for example, a 2010 World Bank survey titled Improving Access to Financial Services in Indonesia notes that what matters more to borrowers is not interest rates, but the size of monthly payments and whether borrowers’ cash flows are suffice to service these payments.
The same survey also found that some borrowers who do not have access to banking services (due to problems such as lack of documentation, etc.) don’t mind tapping money from informal sector lenders with annualized rates of up to 300 percent per annum, which is sky-high compared to rates banks, between 20 and 30 percent.
Meanwhile for large corporate and commercial borrowers, they are regularly approached by many competing banks thus should already have easy access to interest rate comparisons. And the information at their hand is of much more use because the offer rates quoted by the banks can actually be taken.
So it looks like the policymakers’ time and effort in devising the prime lending rate policy probably would have been better spent elsewhere.
For example, banks hold nearly Rp 500 trillion (US$58.13 billion), or 26 percent of their third party funds, of excess liquidity in the form BI short term papers/deposit facilities.
However the domestic interbank borrowing market is underutilized and many medium-small sized banks are struggling to gather third party funds for accommodating loan growth demand.
This is one serious impediment to financial intermediation that could never be tackled by the mere publication of prime rates.
In early 2008, the average transaction volume in the interbank market was around Rp 12 trillion per day. Now it hasn’t increased but actually decreased to less than Rp 10 trillion per day, in spite of a 50 percent rise in banking sector assets.
This problem with the interbank market is not just the result of a chronic lack of trust/counterparty credit lines between banks (which is the legacy of past crises), but also of an apparent misallocation of incentives. Some large banks are able to collect low cost funds and earn risk-free profits by “investing” them in higher yielding central bank papers/facilities — providing a disincentive to lend interbank.
The writer is an economist at Bank Danamon Indonesia. The views expressed are his own.
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