Basic principle in finance/economics of risk return trade off dictates that Government Issued Debt Instruments should yield the lowest interest rate for the (lender/investor) and the Government should be able to borrow at the lowest cost since the government paper is suppose to have no default risk (Giltedged). However, in Sri Lanka this principle does not seem to hold. As long as I can remember (even in the 1990s) this had been the case and this needs to get corrected. As far as I am concerned discussions of the current hot topic in the country on Domestic Debt Restructuring (DDR) highlighted this fact in a glaring way in the fact that most Commercial Banks in Sri Lanka hold massive amounts (upto 39% according to one research report!!!) of Government Paper in their Asset or Loan Portfolio going well beyond the inclusion of T Bills/Bonds under Tier 2 Capital requirement etc.
Term Structure of Interest Rates
How are the interest rates constructed or formed? The largest portion (perhaps upto 80%) of a given Interest Rate is expected inflation (not past reported inflation) for the period/tenure (3 Months to 30 Years) of the debt instrument or the deposit. Then the next most important factor (perhaps 15%) is a default risk premium attached to the institution which issues the debt instrument (institution that borrows). Then comes all the other risk premia which are supposed to cover such risks as reinvestment rate risk, liquidity risk, risk associated with tenure etc. As a result, the Government Issued Debt Instruments in any country carries the lowest (close to zero or zero) premia for Default Risk and Liquidity Risk as Government Paper is the most liquid. Default Risk is zero since the government has extraordinary/unique authority/powers to 1) Impose Taxes 2) Print Money.
Function of Commercial Banks
The main function of Commercial Banks in an economy (Capitalist economy) is to function as an intermediary between the ultimate saver and borrower (usually a business, government or individuals). It’s called intermediation. The Commercial Banks (which are specifically authorized/licensed by the Central Bank to collect/accept deposits from the Savers) will gather scattered/dispersed savings from individuals (small or retail savings) by offering an attractive or appropriate (market driven) interest rate and lend or loan them to businesses/corporates (usually large amounts) to do their productive activities (capital investments, operational activities etc.) in all sectors of the economy keeping a reasonable margin (spread) for their expertise in risk assessment/intermediation. This is the critical function/process of Capital formation in a Capitalist economic system. By and Large traditional Commercial Banks do not directly get involved in the Equity sphere of financing/raising capital or in the disintermediation process though these traditional boundaries have now largely disappeared.
In this context, is it correct for Commercial Banks to hold such large amounts of T Bills/Bonds without channeling them to productive economic activities of Corporates/Businesses through their traditional lending activities? And this is only possible/viable because there is an anomaly in the interest rates in Sri Lanka.
Function of Primary Dealers
Primary Dealers are appointed by the Central Bank and require to be well capitalized and of good repute. They perform a critical function in financial markets and the economy. Their job is to bid at the weekly Primary auctions for Government Securities and create a secondary marketplace (liquidity providers) for T-Bills/Bonds. The term Dealer means an entity that quote both ways (buy and sell) which requires them to maintain some inventory of T-Bills/Bonds (to sell) as well as Cash (to buy). And they are expected/obliged to create an active secondary market for T-Bills and Bonds. This process should create a market driven interest rate/yield for Government Securities which reflect expected inflation and other risks. And these rates (1 year, 5 year and 10 year) should act as the Benchmark (lowest) Rates for a particular tenure on which all other rates are built upon.
Disintermediation using Capital Markets
Capital Markets (Primary) are used by seekers of Capital (Borrowers and Recipients of Equity Capital) to bypass the Commercial Banks (Deposit taking Institutions) and directly go to the Saver and raise funds/capital. This bypassing the Banks (via Capital Markets) is called disintermediation. Stock Market is the best example of this process and mainly used for raising of equity capital. Treasury Bill/Bond Markets can be considered the largest and most liquid other market where the government goes directly to the market/savers to borrow debt capital. Then there are other markets (centrally organized or exchange traded or over the counter-OTC) for Corporate Bonds/Commercial Paper etc. Commercial Banks are not prohibited from participating in any of these markets but it is not their primary economic function.
Primary Market is where the borrower/seeker of equity or debt capital initially sell/market their Security (share, promissory note, commercial paper, T-Bill/Bond etc.). Initial Price Offering (IPO) of shares (Equity), and T-Bill/Bond (Debt) auctions are the best examples of Primary Markets. At weekly T-Bill/Bond auctions though, only authorized Primary Dealers can participate. Most Commercial Banks are also Primary Dealers. And the Primary Dealers have a responsibility and obligation to create a secondary market in T-Bills/Bonds so that retail investors have an opportunity to participate/invest/lend directly to the Government and create liquidity for the T-Bills/Bonds thereby creating an efficient, market driven price/yield discovery mechanism. Since this market is less transparent and inactive in Sri Lanka than it ought to be, it would be correct to say the interest rate/Yield is not 100% market driven and reflect the correct risk premia for expected inflation and other risks.
At this stage I like to remind the reader another fundamental principle of Finance/Economics which states; higher the risk, higher the return should be. The lender/investor of equity will expect a higher return (usually annualized returns for ease of comparison with other investment options) for their funds as the riskiness of the borrower/recipient of equity capital is higher and vice a versa.
Interest Rate Anomaly
As explained earlier once the risk premia are added up, in any developed and efficient capital market, the Government issued debt instruments should yield or return the lowest for a lender/investor as the government has the lowest default risk and liquidity (trading in the secondary market) of government issued debt instruments ought to be the highest. Therefore (correspondingly), the Yield/Return of T-Bills/Bonds should be the lowest for a given tenure (3 Months to 30 years). However, in SL, this fundamental principle does not hold true. Here T-Bill/Bond rates often exceed (higher) than the Commercial Bank deposit Rates for similar tenures. This is the anomaly.
This anomaly allows Commercial Banks to mobilize deposits from mainly unsophisticated (un informed or uninitiated) retail and corporate savers and turn around and park those funds in higher yielding T-Bills/Bonds and make an easy/effortless profit (including tax free capital gains). This is wrong/inappropriate at two levels;
1) This (lending to the government) is not the core Commercial Banking function and responsibility/obligation
2) As Primary Dealers of T-Bills/Bonds, Commercial Banks appear not meeting their obligation to actively create a secondary market for T-Bills/Bonds as this directly goes against their deposit mobilization objectives.
What is the reason for this persistent and abnormal disparity in interest rates?
I believe this anomaly exist in SL because of two main reasons;
- The lack of financial literacy or understanding of retail lenders/depositors/savers of the above explained principles and obvious/myriad of advantages of investing in a tradable debt (in the Secondary Market) instrument like T-Bills/Bonds. It even allows the investor/lender/saver an opportunity to make a Capital Gain which is tax free (Ex. Those who invested in T-Bills/Bonds at high rates seen in the past six months to an year can now exit with upto 100% capital gains!!!).
- Most primary dealers (ones with deep pockets) being Commercial Banks and their lack of interest in creating the secondary market which requires them to actively market the T-Bills/Bonds to the retail investors/lenders/savers. And I believe this is the reason why Commercial Banks carry large T-Bill/Bond investments in their Asset/Loan Portfolios as pointed out in the research report mentioned at the begining.
Why would the Commercial Banks lend/loan their funds to riskier customers when they can lend to the government? And if the Saver/Depositor is ignorant/ill-informed enough to deposit their funds/savings in Commercial Banks at lower rates (sometimes this gap can go upto 4-5%!!!) than what T-Bills/Bonds (safest investment/debt instrument) pay/yield them?
Some ideas/suggestions to correct the persistent interest rate anomaly
It is in the interest of the Government/CBSL to do so. The Government should be able to borrow at the lowest cost in any market. My suggestions to correct the anomaly;
- Mandate all Primary Dealers (including Commercial Banks) to actively create a secondary market and market/trade a minimum amount obtained at the Primary Auction to retailers and corporate or institutional investors/savers/lenders. Ideally they should be required to advertise the T-Bill/Bond rates along with their deposit rates at all their Branches. Being a Dealer should obligate them to carry inventory, quote both ways (buy and sell) have a good track record of active trading/market making.
- Periodically educate (on going wide publicity/marketing campaign by the government/CBSL) everyone, specially the general public/retail savers (ideally this should be in the school curriculum along with other elements of financial literacy) about all the advantages of investing in T-Bills/Bonds – risk return principle, and how easy to access (on line etc.) T-Bills/Bonds, the high liquidity in the secondary market (just like cash), and very importantly the potential for capital gains (which is tax free).
These two measures in my humble opinion should correct the interest rate anomaly and bring the T-Bill rates down (and conversely deposit rates up) allowing the government to borrow at the lowest cost like in any other country in addition to giving the general public access to a low risk, liquid Security (Debt Instrument) that can be easily accessed, traded, mortgaged and liquidated (turned into cash).