Choosing the option of fixed versus floating rate has been a dilemma for most customers.

--BY ASHUTOSH SHARMA

Nepal Rastra Bank recently issued directions to banks to decide and publish fixed interest rates on term loans. In this backdrop, the scenarios and modalities for fixed interest rates in the Nepali financial market need to be analysed.

Background
In the international market, two types of interest rates are prevalent for term loans i.e. floating interest rate and fixed interest rate and borrowers have the option of choosing either one, while getting term loans from Financial Institutions.

Under the floating interest rate option the rate on the loan taken by the customer is set by adding a risk premium to a variable reference rate, such reference rates are LIBOR, Euribor, MCLR, SOFR, Base Rate, etc. This rate in Nepal is called "Base Rate". These reference rates change on a daily, weekly, monthly, quarterly etc basis. The floating rates on loans are subject to reset on a defined period which is, generally, one year or lesser period.

Whereas under the fixed interest rate mechanism, financial institutions offer fixed interest rates on the term loans to the borrowers for the full tenor of the loan, which does not change. However, Financial Institutions put rate reset period to manage their interest rate risk which is generally two years or longer.

The concept of fixed interest rate on loans is based on the fact that the general borrowers may not have the capacity to predict future rates however banks at least have some expertise. The fixed interest rate mechanism protects customers from the uncertainty of change in interest rates. It protects the customers by not increasing interest rate liability despite an increase in borrowing interest rates in the market and also secures the bank's steady income inflow.

Fixed interest on loans is beneficial to borrowers if the market rates on loans rise above the fixed rates availed by the borrower. However, borrowers will be at a loss in case market rates on loans fall after availing a loan at a fixed rate.

Choosing the option of fixed versus floating rate has been a dilemma for most customers however it has been observed that mature people opt for fixed interest rates whereas the young generation opts for a floating interest rate. Borrowers opt for fixed interest rates when they perceive that the market interest rate will not go down in view of the country's economy or the region's economy. Salaried-class people opt for fixed interest rates more compared to the self-employed.

Nepal’s Scenario
Interest rates in Nepal have been more volatile compared to any other country in the SAARC region. Benchmark rates such as interbank lending rates and treasury rates are indicators of market rates. According to NRB data, during the last one year (Chaitra 075 to Chaitra 076) average interbank lending rates have moved from 5.28% to 2.13% and on average 91-days treasury bills rates moved from 4.44 percent to 2.13 percent. Similar volatility has been observed in the past years too.  Similarly, interest rates on fixed deposits have also shown almost similar variations.

Nepali banks have a big mismatch in maturities of assets (loans) and liabilities (deposit) which is called maturity mismatch. In other words, there are less long term deposits held by banks compared to long term loans provided so, in terms of the amount with long term maturity on assets side and liability side, there exists a huge mismatch. For example, as per NRB data for Chaitra-end 2020, the total fixed deposit which has a maturity of two years or above held by commercial banks is Rs. 237 billion whereas sum of Term loans, housing loans and hire purchase loans provide by commercial banks (these loans have a maturity of more than 2 years) is Rs 943 billion. Similarly, the housing loans provided by banks is Rs 208 Billion and have an average repayment period of about 8 years but fixed deposits with a maturity of 8 years or more is almost negligible. This shows a huge maturity mismatch between the long term deposit and the long term loans in the banking sector of Nepal.

As per NRB guidelines, the "Base rate" is a reference rate that is dependent primarily on the cost of deposit of the bank along with other factors such as CRR, SLR, and operations costs. Banks face a challenge to keep the base rate less volatile in view of volatility in interest rates and liquidity. Banks have to fix interest rates on loans based on the Base Rate after adding credit risk premiums.

Due to the volatility of interest rates, banks were compelled to change interest rates on loan products which have led to questions on efficiency as well as denting the image of banks.

Amid the above challenges and NRBs instructions to publish fixed interest rates on term loans for the fixed tenor, Nepali banks have challenges to set fixed interest rates on term loans making equilibrium between its return and customer expectations.

Recommendations
In view of high volatility, banks should be allowed to fix the interest rates on term loans for shorter-terms i.e. up to 1 to 2 years initially or banks should be allowed for interest reset clause which may allow banks to manage its interest rate risk.

It has been observed that in case of a decrease in loan interest rates in the market, customers with fixed interest rates prepay the term loans. NRB has restricted banks to levy pre-payment charges for prepayment in loans up to Rs 5 million. NRB should allow prepayment charges in case of prepayment in fixed interest rate loans.

Banks should make customers thoroughly understand the fixed-rate mechanism before offering such rates. Customers should have the option to convert from fixed interest rate to floating interest rate or vice versa with some charges.

Banks should not be allowed to offer teaser loans where the fixed rate is for the very short term initially and then forced to floating rates thereafter. Such teaser products attract the borrowers at a lower fixed rate for shorter-term then banks may charge higher rates to the customer making unexplained gains.

Banks should bring innovative deposit instruments to attract long term deposits to reduce prevalent maturity mismatch and offer clients long term fixed interest rates on loans.

Finally, implementation of fixed interest rate mechanism on loans would protect customers from uncertainties and also help banks restore some positive image.

The views and opinions expressed in this article are those of the author and do not necessarily reflect the policy of the agency he is associated with.