||Central Bank Of Barbados
Global and national events have resulted in
interest rates trending downward over the past decade, says Dr. Patrick Honohan, the Central Bank of Barbados’ 4th Distinguished Visiting
Fellow. Honohan, a former Governor of the Central Bank of Ireland, was speaking
during a presentation to the staff of the Financial Services Commission (FSC).
First addressing the global trend, Honohan
said that several factors had contributed to low interest rates, including overall
saving and investment trends, low inflation, and deliberate efforts by central
banks to jumpstart economic activity and to raise inflation to the desired
level. He explained that when interest rates are low, it creates an incentive
for investors and developers to borrow to finance projects and can induce the
public to spend rather than save.
Honohan used the example of the United
States of America and Germany as examples of countries where interest rates
were deliberately driven down in the post global crisis era, noting that in
Germany and other Euro-area countries there have even been negative interest
rates, which means that customers were essentially paying banks to store their
money. Honohan went on to reveal that when short term interest rates cannot be
set any lower, central banks sometimes engage in quantitative easing, the
practice of buying government securities so as to bring down the overall
interest rate as well as to bring inflation back up to target.
The former central banker went on to explain
why interest rates in some countries are much higher than what is typical now. In
those countries, he said, perceived exchange rate risk or credit risk drive up
interest rates. Returning to the euro area, Honohan detailed how, in the
pre-common currency era, the potential for fluctuations in the exchange rates
of national currencies resulted in countries having to pay higher interest to
attract investment, and then how the perceived possibility of default during
and after the European financial crisis had the same effect.
Moving on to the topical issue of wide interest
rate spreads – the disparity between the interest paid on deposits and the
interest charged on loans at banks and other financial institutions – Honohan identified
four reasons that these occur. The first is credit risk. When banks have
concerns about the potential for higher than expected levels of default, they often
charge higher interest on the money they lend as a cushion against losses from
The second cause relates to banks’
operating costs and their ability to generate the kind of profit that makes
doing business worthwhile. Honohan noted that this is especially true in small
economies, where banks, particularly those with headquarters in larger
countries, have significant operating expenses but not the benefit of economies
of scale. For these banks, while the difference in percentage might be
substantial, the actual value is small relative to what is collected in other
jurisdictions where the bank operates.
Honohan acknowledged that sometimes wide
interest rate spreads are simply due to a lack of competition. Admitting that
this assertion is difficult to prove, he said that when banks know that customers
have few options for where to put their money, they recognise that they can pay
less interest and charge more for loans without the threat of losing business.
Finally, he believes that cross-subsidization
can play a role. When banks are involved in other lines of business that are
less profitable, charging a premium for borrowing while paying low interest on
deposits can become a means of recouping any losses.
Honohan told the audience that concern
about wide interest rates spreads is universal and that suggestions have been
put forward that governments or central banks should put a cap on the interest
banks can charge for loans. He noted, however, that such a policy could
discourage banks from setting up business as it automatically limits their potential
Asked about whether central banks should
set a minimum savings rate to prevent banks from paying only negligible
interest, Honohan reiterated that interest rates are very low the world over,
then pointed out that such a policy could have a similar effect to the earlier
proposal that there be limits on how much customers should be made to pay for
loans. He concluded his presentation by saying that any prescribed minimum
savings rate would need to be “in keeping with reality” or the jurisdiction
would not be seen as profitable.