Nironjan K Roy

Our business community commonly alleges that interest rate on bank loans is very high in Bangladesh and in support of their argument they always refer to the low interest rate in the developed countries. On the other hand, if one customer borrows Tk 1.0 billion for six months or Tk 100 thousand for five years from any commercial bank in Bangladesh, probably he will have to pay almost same rate of interest with nominal variation. What our business community alleges is not correct and how the commercial banks charge interest on their lending is not correct too, because both the situations are far from the standard procedure of loan pricing. In fact, there is no standardised way of loan pricing in our country.

Our banking system has undergone a series of reforms starting from the introduction of LRA (Lending Risk Analysis) to implementation of CRM (Credit Risk Management) but unfortunately, neither of them could produce any fruitful result in bringing about the qualitative change in the operation of bank loans except CIB (Credit Information Bureau). CIB is considered as the most successful initiative in developing centralised database on country's borrowers from where the lender can ascertain borrower's total credit exposure. However, CIB does not provide any credit rating on the borrower which is also the part of Credit Bureau Report in many countries.

Importance of bank loan: The role of credit (Loans and Advances) is very important in the banking business of our country. Truthfully speaking, the country's banking business is extensively dominated by the operation of credit. Bank earns its lion's share of profit by extending credit facility to the borrowers. This is because sanctioning credit is very simple for which high quality analysis is not required and therefore any banker can easily take decision on lending. The popularity of bank credit is very high not only in our country but also in developed countries including the USA, Canada and Europe. In spite of developing various financial derivatives and hybrid financial products in developed countries, the bank extensively operates its credit and earns a huge amount of profit from this area. From the borrower's point of view, the business community depends extensively on bank loans for managing their financing activity and this phenomenon is predominantly prevalent in our country and the developed countries as well. Although capital market and bond market are very strong and matured in the developed countries, yet the business community depends substantially on bank borrowing because the bank loan is the main source of their working capital and short-term financing requirement.

Nowadays, business activities have become very challenging and competitive all over the world. Minimising cost and maximising profit have become the most important strategy of all business efforts and therefore, the management of business organisation always places emphasis on company's financial operation to efficiently manage fund with utmost care and prudence. In the developed world, most of the business organisations have access to capital market and bond market as well, yet they always use considerable amount of credit facility from the bank for efficiently managing their fund. Our country is not exception to this practice and even our business community mostly prefer bank loan to any other source of fund. So the importance of bank credit is historically proven and will remain very high in future as a quick source of business finance.

Streamlining the operation of bank loan: Considering the importance of bank loan, norms of credit and its operation has undergone a series of streamlining process in the developed countries over the last two decades and has now reached a mature level. During the last two decades, the loan disbursement mechanism matching with the borrower's need, true debt servicing, grading of customers, both internal and external, loan pricing, documentation, procedure of loan operation have been developed so structurally that has virtually established standard system and procedure in operation of bank credit. Two kinds of loan, Libor Loan and Prime Rate Loan, have been put into the system under which the customer can borrow.

The introduction of these two kinds of specific loans as a means of disbursement has not only ensured the end use of credit facility but also restricted the scope of fund diversion. More importantly, standard loan pricing system has been implemented utilising All-in Rate (AIR) which is determined by adding the prevailing Libor Rate or Prime Rate with the applicable spread as predetermined based on some specific parameters. This AIR includes the impact of the current economic condition, financial situation and borrower's financial performance what reflects the true interest rate being applied on the borrowing, so there is no scope of any confusion from any quarter.

Unfortunately the standard procedure has not been developed in operation of bank credit in our country and still now, primitive way of lending is predominant in our banking industry. Although the practice of loan syndication has considerably developed during the last one decade, yet our country's banking industry is lagging behind in setting standard procedure in operation of bank loan. So-called overdraft facility and term loans are two common means of disbursement. One- or two-page credit agreement is executed between bank and borrower where the contents are mainly prepared just to catch the borrower in case of default but the operation and pricing issues, which are considered the most important aspect of bank loan, have never been addressed. As a result, the borrower does not know what he can do and what he cannot do in managing his bank finance and mostly rely on what bank does. This kind of practice results in confusion and confrontation between banker and borrower which is very common when the borrowers' debt servicing ability deteriorates. But the standard practice includes all the operational issues and pricing options in the executed credit agreement what all the concerned parties comply with. Neither bank nor borrower is allowed to do anything what is not covered in the executed credit agreement.

Similarly, loan pricing or interest rate is another important factor of the credit facility extended by the bank but this pricing system has not been standardised leaving the scope for the business community to bring an allegation of high lending rate being charged by the bankers.

It is true that our banking industry has tried to introduce, from time to time, some standard procedure mostly adopted from offshore banking (not from international banks; there is a difference between international bank and their offshore operation) and suggested by the consultants hired for restructuring the country's banking sector. The introduction of syndication loan and most recent CRM (Credit Risk Management) has resulted from these efforts. But these procedures have unfortunately never been introduced in a comprehensive and integrated way, rather have been implemented on a piecemeal basis which has failed to produce the desired results.

Developing efficient loan pricing mechanism

Standard loan pricing comprises two components i.e. base interest rate and spread. Bank's money market department determines base interest rate analysing the demand for and supply of fund and other relevant factors. On rate fixing day, base rate remains same and is applicable to all the borrowers irrespective of their rating, standing, volume of loans etc. However, the rate for different tenure of borrowing is different as the rate of borrowing for one month will, of course, be different from the rate for three months' borrowing. Rate for shorter period borrowing may even be higher than that of longer period borrowing or vice versa. Even this base rate varies everyday because it is determined on a regular basis following change in fund availability and requirement.

The spread is determined through negotiation between the banker and the borrowers at the time of approval. However, this negotiation is governed by some set criteria which include the borrower's external and internal grading and business performance as well. Borrower are rated by the external credit rating agency based on which the banks internally rate them. Moreover customers' financial performance, especially EBITDA (Earnings before Interest, Tax, Depreciation and Amortisation), is reviewed. While processing the credit proposal, banker and customer discuss the pricing issue and reach an agreement with the pricing level at different grading and EBITDA. Different pricing levels assign different spreads which are applied to the borrowers' loan pricing. As for example, a borrower may be graded A, B, C or D and the pricing level for these grades may be denoted as 1, 2, 3 and 4 respectively which may specify the spread 100 bp (basis points), 200 bp, 400 bp or 700 bp. If the current rating and review of EBITDA find a customer's grading to be B, then the borrower will be placed at the pricing level 2 where applicable spread will be 200 bp for that borrower. The spread, combined with base interest rate, determines All-in Rate (AIR) which is, in fact, the lending rate at which the borrower pays interest.

A borrower's grading and financial performance i.e. EBITDA are reviewed after every six months when her/his pricing level is reassessed and accordingly spread is adjusted. Mentionable that there is linier relationship between customer grading, EBITDA and pricing level. However, there exists inverse relationship between pricing level and spread. When the borrower's grading and EBITDA improve, pricing level goes up and better spread is applied what ultimately keeps the lending rate low. Opposite situation arises when customer grading and EBITDA deteriorate, pricing level goes down and accordingly higher spread is applied what makes the lending rate high. In addition to AIR, bank charges various applicable fees comprising facility fee, commitment fee, utilisation fee, upfront fee, taking fee, closing fee etc. which are also parts of loan pricing.

Libor (Eurodollar) loan and prime rate loan: Bank's credit facility is disbursed through two types of loans i.e. Libor loan and prime rate loan. Libor loan has specific maturity which can be one-week Libor, two-week Libor, one-month Libor, two-month Libor and so on up to one-year Libor. Libor loan is also known as Eurodollar loan or Fixed rate Loan. Prime rate loan does not have any specific maturity and remains valid till the maturity of the credit facility. Based on the analysis, research, funding requirement and subsequent negotiations with the borrower, credit facility or limit is approved which may be revolver and non-revolver (Term Loan) having validity of the limit for multiple years like three years, five years etc.

Under the approved credit limit, the borrower will avail either Libor loan or prime rate loan. Since Libor rate is fixed two business days prior to the disbursement day, the borrower will have to submit disbursement notice to the lending bank two business days before for availing Libor loan. Considering the nature, scope and requirement, the borrower will decide the tenure of Libor loan i.e. one-week Libor, one-month Libor etc. and will serve the drawdown notice to the bank two business days before and accordingly bank will apply the appropriate Libor rate to the Libor loan being disbursed. If any urgent requirement arises, the borrower has the option of drawing prime rate loan. Although prime rate is higher than Libor rate, the borrower avails this loan in order to meet their urgent requirement what arises instantly and does not allow serving notice two business days before. The borrower is allowed to draw and repay prime rate loan on the same day with short notice as many times as they require. This loan has been specially designed to meet the borrower's immediate requirement what cannot be satisfied with Libor loan.

Rollover of fixed rate loan and repayment option: Fixed rate loan has specific maturity when the borrower will either pay off the loan with accrued interest or extend the maturity for another term matching with their requirement. While extending the loan for further tenure, interest accrued on maturing loan will be paid off. Usually two business days prior to the maturity, the borrower will determine his/her requirement and cash-flow based on which they will decide to either extend the maturity or pay off the loan.

In general, fixed rate loan does not provide the scope of paying off the loan before maturity because this loan is an implicit contact on interest rate between borrower and lender. Nevertheless, a situation may warrant for prepayment, especially when the business generates adequate cash-flow enabling the borrower to pay off the loans. Therefore, prepayment is allowed before maturity what is known as Libor breakage. However, Libor breakage may cost some charge for the borrower. This is known as breakage fee which is basically the difference between the Libor rate at the prepayment date and the Libor rate of that particular loan. When the current Libor rate is lower than that of the particular loan being prepaid, the breakage fee calculated, as reinvestment cost, is realised from the borrower.

Libor rate setting and interest rate determination in Bangladesh: Libor stands for London Interbank Offer Rate what is determined by the British Bankers Association and published by the Reuters. From the Reuters screen, all the banks and financial institutions collect Libor rate and determine their own Libor rate. Money market department analyse and forecast the availability and requirement of fund based on which bank's own Libor rate is determined as well as published for applying to all loans. Prime rate is basically linked with the bank rate and each bank/financial institution adds their operation cost with the prevailing bank rate in order to determine the bank's own prime rate and therefore, prime rate varies with the change of country's bank rate.

The banking industry in Bangladesh is far from using this standard procedure of loan pricing and the traditional way of fixing interest rate on loans is still being followed. The Bangladesh Bank issues a lending rate circular giving the range with upper and lower cap and commercial banks set their own lending rate somewhere in between this range.

Implementing effective lending rate

Since Bangladeshi taka is not internationally recognised currency, the introduction of Libor loan or using Libor rate in the country's loan pricing is not justifiable at all. However having close similarity and with similar modus operandi of Libor, our banking industry may consider introducing their own interest rate mechanism what may be called BIBOR (Bangladesh Inter-bank Offer Rate). Mentionable that in addition to Libor, many countries have their own interest rate mechanism e.g. Canada has CIDOR (Canadian Inter-bank Deposit Offer Rate), Europe has ERIBOR (European Inter-bank Offer Rate) and many others. Likewise, our commercial banks may develop some mechanism to add operation cost with country's bank rate in order to determine their own prime rate what will be offered to the borrower for drawdown under prime rate loan.

When I went to Bangladesh in 2009, I came to know that the Bangladesh Bank was contemplating to introduce DIBOR (Dhaka Inter-bank Offer Rate) and more than two years have elapsed but that proposed DIBOR has not yet seen the light of the day. Traditional way of fixing interest rate is continuing what resulted in too much criticism, debate and blame game among the stakeholders. Furthermore, introduction of mere DIBOR or BIBOR will not bring any fruitful result as integrated measures are required to make this system effective and successful. Three specific measures are necessary to introduce efficient loan pricing mechanism which will have Libor or Prime-type interest rate policy and these include grading of borrowers, efficient money market department of each bank and the role of the Association of Bankers, Bangladesh (BAB) in determining DIBOR or BIBOR.

Grading of the borrowers: The grading of borrowers is the first step towards introducing an efficient loan pricing system and this grading is rated externally and internally. As far as I know, most banks have introduced grading system as a part of implementation of CRM (Customer Relationship Management). However, this grading system is very simple and uses only a few parameters giving maximum weight to the borrower's financial reporting. As a result, this grading does not reflect the actual position, specially the risk status of the borrower and the bank can hardly rely on this grading system. At the same time, some credit rating agencies are operating in our country but their activities are very limited. So, the system is there but neither comprehensive nor is being properly used. In order to effectively use the grading system, the business organisation will have to be broadly classified into two groups i.e. corporate borrowers and small business. Irrespective of the incorporation status or definition of small & medium enterprise, the Bangladesh Bank or the BAB will set a benchmark which will categorise the borrower either as corporate or small business. Say, the benchmark is set as BDT 100 million loan, then any customer willing to borrow BDT 100 million and above will fall under the category of corporate borrower and the customers willing to borrow less than BDT 100 million will belong to the small business group.

First of all, any corporate borrower will have to be rated by the country's external rating company who are reputed, recognised and licensed by the regulatory authority and based on the external rating, bank itself will internally rate the borrower. In this connection, bank's grading system will have to be updated encompassing some more essential parameters which will scan external and internal situation of the company and will thus reflect the risk status of the borrower what the bank is going to undertake through sanctioning the credit facility. Needless to say that there must have stringent rules and regulations which will govern the activity of the rating agency with the provision of making the credit rating agency accountable and punishable for any kind of negligence or misconduct in preparing the company's grading. For small business, the rating criteria will be quite different and the perimeters are mostly related to the borrowers' liquidity position, cash-flow and debt servicing ability which may include timely interest payment, making minimum payment all the time, paying more than minimum payment, never defaulting before, complete repayment once in a year etc.

The role of bankers' association: In introducing DIBOR or BIBOR, the role of the BAB is very important because they will initially determine and publish the DIBOR or BIBOR. In this connection, they will form a committee which will prepare a report analysing the industry data related to lending activities, industry's liquidity position, demand for and supply of investable fund on that particular date, economic condition, monetary policy, central bank bulletin and other relevant factors. According to the report, the designated committee will determine the DIBOR or BIBOR which the association will approve and publish for the use of all lending organisations. At the same time, bank's efficient and independent money market department will have the responsibility of determining the bank's own DIBOR or BIBOR. They will analyse the bank's fund position, demand for and supply of investable fund, liquidity requirement etc based on which the DIBOR or BIBOR published by the BAB will be adjusted upward or downward to determine bank's own DIBOR or BIBOR.

This standard loan pricing mechanism has innumerable advantages. It makes interest rate policy very competitive and will remove the common criticism of high lending rate. Under this system the borrower will have to truly pay the interest on every maturity of DIBOR or BIBOR and will stop the practice of taking unrealised interest earning into bank's income (At every quarter-end bank debits client loan account and takes into income regardless the borrower actually pays). This will not only ensure the end use of the loan but will also restrict the scope of fund diversion which is very common in our country and is considered to be one of the important reasons behind high default rate. Finally, this will ensure lower rate to the good borrower while higher rate to the bad borrower, so the customer will always try to remain as a good borrower in order to avail lower interest rate.

Interest rate is the most crucial aspect of the entire lending system and therefore calls for elaborate discussion. It has direct impact on a bank's income, the country's business and finally, the economy. The introduction of DIBOR or BIBOR may apparently seem to be complicated bur not really so, rather this system is very simple and straight-forward which the bankers and the business community will understand easily. Once the system is introduced and the people get acquainted with this new system, the procedure will become very easy and convenient. Needless to say that our banking industry has implemented many complicated policy like LRA, Basel I & II, Anti-Money Laundering Act, ALM (Asset Liability Management) and CRM. Compared to those reforms, the implementation of an efficient lending rate mechanism with the introduction of DIBOR or BIBOR is very simple and easily adoptable. Moreover, this does not require considerable investment but only a kind of policy support from the Bangladesh Bank. The determination of the bankers and cooperation from the business community will be enough to implement the proposed effective lending rate policy.