Response of Deposits to Fixation of Minimum Rate of Return: Evidence from Pakistan’s Banking System

Transcription

1. SBP Working Paper Series No . 105 December, 2020 Response of Deposits to Fixation of Minimum Rate of Return: Evidence from Pakistan’s Banking System Muhammad Ejaz STATE BANK OF PAKISTAN
2. SBP Working Paper Series Editor : Farooq Pasha The objective of the SBP Working Paper Series is to stimulate and generate discussions on different aspects of macroeconomic issues among the staff members of the State Bank of Pakistan. Papers published in this series are subject to intense internal review process. The views expressed in these papers are those of the author(s) not State Bank of Pakistan. © State Bank of Pakistan. Price per Working Paper (print form) Pakistan: Rs 50 (inclusive of postage) Foreign: US$ 20 (inclusive of postage) Purchase orders, accompanied with cheques/drafts drawn in favor of State Bank of Pakistan, should be sent to: Chief Spokesperson, External Relations Department, State Bank of Pakistan, I.I. Chundrigar Road, P.O. Box No. 4456, Karachi 74000. Pakistan. Soft copy is downloadable for free from SBP website: http://www.sbp.org.pk For all other correspondence: Postal: Editor, SBP Working Paper Series, Research Department, State Bank of Pakistan, I.I. Chundrigar Road, P.O. Box No. 4456, Karachi 74000. Pakistan. Email: wps@sbp.org.pk ISSN 1997-3802 (Print) ISSN 1997-3810 (Online) Published by State Bank of Pakistan, Karachi, Pakistan. Printed at the SBP BSC (Bank) – Printing Press, Karachi, Pakistan
3. Response of Deposits to Fixation of Minimum Rate of Return : Evidence from Pakistan’s Banking System Muhammad Ejaz 1 Abstract This paper evaluates the impact of the policy of fixing a minimum return on deposits on growth in deposits. The analysis, based on balance sheet data of 36 banks for the period from 1Q2008 to 2Q2019, shows that 4-quarter moving average growth in total, fixed, and saving deposits declines because of fixing minimum rate of return. This result varies considerably across maturity buckets and types of banks. The event analysis conducted over different sizes of the banks shows that deposit growth was lower for smaller banks and higher for big banks. This indicates redistribution of deposits from small to big banks. The evidence points towards the possibility of policy induced changes in the pricing behavior of the smaller banks, who may have been overpricing their deposits before the fixation of minimum rate. JEL Classification: G14, G21, E43, E58 Key Words: Deposit, monetary policy, interest rate, event analysis Acknowledgments Authors would like to thank Sajawal Khan, Farooq Arby and anonymous reviewer for the thoughtful comments on an earlier version of this paper. Contact for correspondence: Muhammad Ejaz Joint Director, Monetary Policy Department State Bank of Pakistan I.I. Chundrigar Road Karachi 74000. Email: Mohammad.Ejaz@sbp.org.pk 1 Joint Director, Monetary Policy Department, State Bank of Pakistan, Karachi
4. Non-Technical Summary Central banks can influence the earnings generated and realized on investment (otherwise known as yield) through many channels. One such channel is the interest rate channel. Changes in central banks' policy rates work though this channel first by affecting the rate at which commercial banks borrow and lend among themselves in interbank market, and then sebsequent interest rates for bsinesses and individuals. While, these changes in policy rate quickly transmit to interbank rate; their impact on retail lending or deposit rates comes with some lag. In fact, such changes in central banks’ policy rate do not always fully transmit to ultimate interest rates on loans and deposits due to a number of frictions. However, central banks can devise mechanisms to bypass the usual transmission mechanism and directly affect final rate on loans or deposits. One such strategy is to link the minimum rate of return on deposits paid by banks to their depositors. This may be done by tagging the interest rate on deposits with policy rate. The intention behind such mechanism can be twofold: First to quicken the transmission; and second to be prudent especially where market structure has asymmetries. In 2008, SBP decided to introduce such a mechanism through its circular BP&RD No. 07/2008. The mechanism was revised a few times until 2013 when SBP set the minimum rate of return on deposits to 50 basis points below the prevailing SBP repo rate of the interest rate corridor (ICR). This paper explores empirically the effects of such a mechanism on deposit growth. Apparently, deposits should grow faster after such policy of fixing minimum deposit rate as compared to in the absence of such policy because the opportunity cost of holding money in presence of policy is higher. However, we have found, on the basis of a rigorous Event analysis, that the deposit growth was lower during the period after fixing of minimum rate as compared to that before the introduction of this policy. Moreover, the results vary considerably across various maturity buckets and deposit-sizes. The event analysis conducted over different sizes of banks shows that deposit growth was lower for smaller banks while for big banks, the deposit growth rates actually increased. This indicates redistribution of deposits. One explanation of this result is that, in the absence of the policy of fixing the return, smaller banks may have been overpricing their deposits. Subsequent to the policy, these banks may have lowered their margin on top of minimum return, which resulted in redistribution of deposits from smaller banks to bigger banks. Page 4 of 39
5. 1 . Introduction Traditionally, the central banks, including State Bank of Pakistan (SBP), influence the yield on government securities in an attempt to affect monitor money market rates, which in turn transmit to both lending and deposits rates. The changes in these rates affect the cost of capital of banks and eventually determines the level of investment and consumption in the economy. This is the traditional view of monetary policy transmission as established in literature. However, in May 2008, SBP directly influenced the deposit rate and fixed a minimum interest rate of 5 percent on saving deposits, apparently for the benefit of depositors.1 This rate was later increased to 6 percent in 2012.2 Then in 2013, SBP linked the return on deposits to prevailing floor of the interest rate corridor (ICR).3 This policy is in vogue since then. Although not explicitly stated in the regulatory instructions, the purpose of fixing the minimum rate on deposits appears to be regulatory in nature, aimed at forcing banks to pass on benefit of rising interest rates to depositors; and consequently, to ensure a steady growth in deposits. Theoretically, this would increase the opportunity cost of holding cash thereby encouraging growth in deposits of the banking system. Yet an unintended consequence of this policy is that it directly affects the cost of a major source of banks’ financing (deposits) thus affecting their pricing decision. Accordingly, it is important to test whether subjecting deposits to a minimum return has had a meaningful impact on the primary purpose – that is deposit growth. Therefore, this study examines the impact of the policy on deposit growth in Pakistan’s banking system. We have used bank level data and aggregated it across various types of banks such as Private Banks (PBs), Public Sector Banks (PSBs), Foreign banks (FBs) and Islamic Banks (IBs); and by size (Big, Medium and Small) on the basis of their average deposit size (Table-1). We have explored if the effect of minimum rate of return policy varied with the type and size of bank across various different dimensions of deposits, i.e., category, maturity and size. The remainder of the paper is divided in eight sections. Section 2 reviews the literature. Section 3 outlines the methodology used for evaluation of the policy. Section 4 discusses data and sample properties. In section 5, we present findings of the event analysis to see the trajectory of growth in deposits over time before and after the policy. Sixth section summarizes the findings of event analysis in tabular form to establish factually whether the growth before and after intervention was any different. Seventh section of the paper provides results of the regression analysis while eighth section concludes findings. 1 http://www.sbp.org.pk/bprd/2008/C7.htm http://www.sbp.org.pk/bprd/2012/C1.htm 3 http://www.sbp.org.pk/bprd/2013/C7.htm 2 Page 5 of 39
6. 2. Literature Review This section examines the existing literature on implications of forcing banks to link pricing of their deposits with the policy rate. Goodfriend and Macullum (2007) provides evidence to suggest that a central bank that fails to recognize the distinction between interbank and other short rates could miss its appropriate settings by as much as four percent per annum. Also, shocks to banking productivity or collateral effectiveness call for large responses in the policy rate. Kwapil and Schlarer (2006) studied the pass through of policy rate to retail interest rate for US and Euro Area (EA) economies. The general finding is that pass through is incomplete and limited which may have implications for stabilizing role of monetary policy. By the same corollary, linking of deposit rate with policy rate must complete the pass through and in turn increase the stabilizing role of monetary policy. According to Sellon (2002), in a simple and stylized view of the interest rate channel, monetary policy first influences bank lending rates and short-term market interest rates. Changes in short-term rates are then transmitted to long-term rates. Since the regulatory decision to link policy rates applies to deposits across all tenors, it is likely that the transmission of policy to long-term rates may be direct for investments in financial products. Agénor and Aynaoui (2010) used a model with credit market imperfections to study the implications of excess bank liquidity on monetary policy effectiveness. In their model, opportunity cost of holding cash is one of the determinants of excess reserves. Authors argue that excess liquidity may impart greater stickiness of the deposit rate in case of a monetary contraction. This will ease collateral requirement on borrowers and reduce risk premium. As a result, asymmetric bank pricing behavior under excess liquidity can affect monetary policy’s effectiveness for arresting inflation. In a regime where cost of funding is fixed for every bank in the financial system, there is no basis for asymmetry in pricing of loans. Accordingly, the presumed effectiveness of monetary policy may not be severely compromised. Arteta et. al (2016) study the effectiveness of negative interest rate policies (NIRP). NIRP could pose financial stability risk particularly when policy rates are kept substantially below zero for a protracted duration. Madaschi and Nuevo (2017) investigated profitability of banks in Sweden and Denmark in the context of negative interest rate. They provide evidence to confirm that transmission mechanism was not impaired in negative interest regime. The banks’ interest expense decrease significantly, which bolstered the resilience of their net income, which points to downward stickiness in the bank deposit rate. In the literature, researchers have mainly looked at the fixation of return on deposits from the perspective of transmission mechanism. 3. Methodology The study uses Event Analysis technique as well as regression analysis for the purpose of exploring the impact of fixing minimum rate of return on deposits. In case of event analysis, let Et denotes the point in time when minimum rate of return is fixed on saving deposits.4 For each bank