PRESENTATION TO THE ASSOCIATION OF CHARTERED AND CERTIFIED

PRESENTATION TO THE ASSOCIATION OF CHARTERED AND CERTIFIED ECONOMISTS “TO WHAT EXTENT DO CHANGES IN THE CENTRAL BANK’S POLICY RATE AFFECT COMMERCIAL BANK’S LENDING RATES” BY FESTUS A. KWOFIE (AGM, FINANCE, OPERATIONS & ADMINISTRATION-AMALGAMATED BANK LTD) VENUE: UNIVERSITY OF CAPE COAST DATE: 27 TH MARCH , 2010

PRESENTATION OUTLINE q. Introduction q. Policy Initiative q. Objective of the Prime Rate in Ghana q. Relationship between Prime Rate & Base Rate/Lending Rates q. How Banks Fix Base Rates q. Graphical Representation: Relationship Between Prime & Base Rates & Treasury Bill q. A 3 -Year Treasury Bills Rates Analysis q. Objective Of FINSAP & FINSSP II q. Why Has It Failed To Achieve Its Objective q. What Ought To Be Done To Bring Rates Down q. Public Outcry About High Lending Rates By Banks q. Conclusion

INTRODUCTION q. The rate used by Central Banks to lend to Commercial Banks has varying names from one country to the other. In Ghana, the rate that the Central Bank lends to commercial Banks is called the Prime Rate, also known as the Policy rate. On the other hand, the minimum interest rate by which commercial Banks use in lending to their favoured customers, i. e. those with high credibility, is called the Base Rate. q. By economic theory, since there exist a positive correlation between the Prime Rate and Base Rate, an upward movement in the Prime Rate should immediately lead to the same , but not necessarily equal , movement in the Base Rate and vice versa. The theory holds all other economic variables constant and is therefore challenged by the complexities of other macro economic variables. q. Over the years, the financial sector of the Ghanaian economy has struggled in developing a platform that links at least the entire working population to the banking system. The economy is still cash based instead of a planned credit based economy. Sources of deposits to the banking sector have been very limited and expensive –a good excuse used by banks when they refuse to reduce their lending rates when the policy rates drop- and hence in 2007 one of the objectives of the policy initiatives in the financial sector was to help banks diversify the sources of funding. At the time, it was realized that 10% of the bankable population has bank accounts. To deepen the financial system therefore, the government introduced a National Payment system to ensure delivery of financial service to the unbanked, under banked and the banked segment. q. Further, in responding to the high cost of finance , the Bank of Ghana since 2007 directed all banks and non bank financial institutions to disclose transparently to all prospective borrowers their Annual Percentage

INTRODUCTION - Contd. q. Rate(APR) to their loans including loan processing and administration fees. In addition, the Central Bank was to on regular basis publish the various main bank charges of all the banks to provide customers with comparable information. q. At the heart of all these was basically to help reduce the base rates of banks and improve access to cheap credit for economic growth and development. q. Rates are perceived to be high by the public and the recent reduction by BOG of its Prime Rate from 18% to 16% has mounted some pressure in the banking institution to correspondingly reduce their Base Rates or Lending Rates. q Though the banks have responded, the interest groups still see it as not enough. This paper will seek to address why inspite of the prime rate reduction high Base Rates are being maintained.

THE OBJECT OF PRIME RATE IN GHANA q. The Prime Rate is essentially an economic tool used to achieve the final target of monetary policy, i. e. reduce inflation, sustaining and improving output growth, creating employment and ensuring price level and currency stability. In Ghana, however, it has become evident that the Prime Rate is used as a tool to guide mainly money supply which means that all other final targets of monetary policy are secondary to inflation.

RELATIONSHIP BETWEEN PRIME, TREASURY BILL AND BASE RATES

RELATIONSHIP BETWEEN PRIME, TREASURY BILL AND BASE RATES - Inevitably, decision on the Prime Rate will reflect in transaction interest rates as the Monetary Policy Committee (MPC) intends to influence the amount of money that is available to the public. This has led to the assertion by many businesses that under instances of an upward review of the Prime Rate, commercial Banks also increase their transaction interest rates (price puzzle) which then affects the borrowing and saving decisions of consumers and businesses. According to Sampson Akligoh of the Data Bank Research, “this argument is inconsistent with the inherent monetary policy stance. The truth is that monetary policy operates in an industry and market environment that should be relatively efficient. Evidence has shown that Commercial Banks do sometimes hold to their existing base rates independent of Prime Rate changes”. To concur what Akligoh said, the Prime Rate in Ghana although has a relationship with the Base Rates of Banks , the relationship between the overnight interbank lending Rate and that of the Base Rate is stronger. As a result, one major challenge that the Prime Rate faces is the stickiness of transaction rates to prime rates reductions. Therefore, over the past seven years commercial Banks responses to the Prime Rate decision are reactive which partly explains the parity between transaction interest rates and policy rates in the economy.

HOW DO BANKS FIX BASE RATES? . The sluggish response by Banks when the BOG reduces its Policy rate has become a source of concern to many a Ghanaian entrepreneurs and the Central Bank itself. However, it is important to state that the cost of funds is a major ingredient that determines the base rates of banks. Banks compute their Base rate firstly by determining their weighted average cost of funds. The weighted average cost of funds is arrived at firstly by either annualizing the current interest expense and expressing it as a percentage of average deposits or using moving averages for the past 12 months of the cost of funds. Secondly, the cost of intermediation, i. e. . expenses to be incurred such as staff cost etc needed to play the intermediary role of getting income on the funds sourced to repay the interest charged, is added. Finally, the cost of losing depositors funds or loss on loan impairment in the process of intermediation is also added. The cost of funds is then arrived at. Riskless margin which is arbitrary but depends on the level of competition, current lending rates and the least budgeted return on investment for shareholders is added to the cost of funds to arrive at the Base Rate.

BASE RATE COMPUTATION

BASE RATE COMPUTATION From the above it is realized that as long as banks carry expensive funds which have not matured, it will be difficult to reduce their base rates and for that matter, lending rates even when there are reductions in the Policy rate. Further, it should be noted that even after maturities of expensive funds with banks, the expected decline in the base rate by the BOG will depend largely on the banks knowledge of the demand supply of money, government fiscal discipline etc. q. BOG should ensure that the expected relationship between the Prime Rate and Base Rate is achieved otherwise since Commercial Banks play in the same market as the BOG their pricing will always be based on their expectations regarding the demand for money and hence the impact of changes in internal rates on their financial statements. To add to this argument, corporate financial strategy expects financial institutions to analyse their balance sheets to assess the percentage of rate sensitive assets and liabilities to fixed rates assets and liabilities. The discipline has proven that where an institution has more rate sensitive liabilities than assets, upward movements in rates simply means that the institution stands at a loss. The reverse is true. q. Bigger banks with low cost of funds appear insensitive to upward movements of rates on deposit. q. Duration analysis also augments this Gap analysis by sounding a caveat to financial analyst to also determine the maturity periods of their risk sensitive assets and liabilities before making decisions on changes in their rates. q. Quick response to downwards adjustment of lending rates to risk sensitive assets will affect the income stream i. e. low interest income. q. Quick reduction in risk sensitive liabilities can put the bank in serious liquidity problems if not in response to the market mechanism. q. In rate decline regime, deposits mobilization appears to be difficult as depositors adopt keep funds in forex and watch the trend. It is only when significant deposits are mobilized to dilute the high cost of funds, that banks would be comfortable enough to reduce lending rates.

TREASURY BILL RATE OVER THE PAST THRE YEARS AND ITS ANALYSIS q. Notable amongst transaction rates is the Government of Ghana 91 -day Treasury Bill Rate. It is the benchmark rate because it is short term and usually the highest risk free rate in the country. From January 2007 to March 2009, it grew steadily except for October 2008 when it recorded a decline from 24. 80% to 17%. q. The reduction was partly a political strategy to increase the supply of money in the country to excite the populace against the Presidential elections in December, 2008. As the impact of the financial crises heightened during the first half of 2009 coupled with the fiscal deficit of the country , the BOG increased its Policy Rate in February 2009 to 18. 5% whiles the benchmark rate continued its steady growth to a year high of 27. 80% in March 2009. The increases in these rates were to mop funds primarily to shore up government funds for infrastructural growth and economic stability. Between July 2009 and September 2009, the benchmark rate remained unchanged at 25. 9% and thereafter declining steadily to 24. 90% as at December, 2009 to reflect partly the recovery of the economy from the shocks of the financial crises as well as the beginning of economic stability for the country which was seen in the rise of the cedi against the major trading currencies during the last quarter of 2009. q. In November 2009, the MPC reduced the BOG’s Policy Rate to 18% in line with the declines in inflation rate from a year high of 20. 74% in June to 15. 97% in December, 2009. The benchmark rate same time was reduced from 25. 80% in October, 2009 to 24. 90%. q. Unfortunately, given all these developments, the base rates of banks did not see any significant changes with banks average base rates still high from 26% to 32%.

GRAPH OF 3 KEY INTERESTS

LENDING RATES DETERMINANTS These are: q The Bank of Ghana policy rate - that we all know q The cost of borrowing- Banks are having to pay very high interest rates on certain types of deposits q Last year when lending rates reached around 34%, Banks paid as much as 30 -32% on some deposits q Thus, the spreads are much thinner than you think q The risk profile of the prospective borrower – The credit history of the borrower helps here q The risk profile of the particular transaction – So that the same customer with different projects may get different rates of interest if one project is riskier than the other q The risk profile of the borrower’s industry or sector – Some sectors are inherently riskier than others q The inflation expectations over the credit period – because we are expecting the repayment over some future period of time q Costs associated with customer default q Reserve requirement costs q Direct and indirect taxes banks pay to various levels of government q Overheads of banks

OBJECT OF FINSAP AND FINSSP II q. It is important to state that the government of Ghana has not relented on using other alternative strategies in achieving economic growth despite the downward inflexibility of transaction interest rates to cuts in the Prime Rate. FINSAP in 1988 became FINSSP in 2003. q. In 2003 the Financial Sector Strategic Plan (FINSPP II) was developed to serve as the blue print for the financial sector which aims at broadening and deepening the financial sector. Through the implementation of the FINSSP the Government of Ghana intended to q. Promote the evolution of a financial sector which is appropriate for the needs of a country moving towards middle income status. The vision was one of a financial sector which is responsive to the needs of the 21 st century, particularly given the prospect of greater international and regional competition and opportunity for Ghanaian financial market participants. q. Consistent with the Government’s vision at the time, the project had an underlying theme of establishing an enabling environment supported by effective regulation, with an objective that all savers and investors will have the benefit of regulatory oversight. q. As a “second generation” financial sector reform program, it was accepted that the basic institutions required for effective provision of financial services were largely in place; the objective was rather to allow them to operate more efficiently. q. Following significant improvements in the financial system, there was no doubt that the sector was then in a better shape to play the effective role of harnessing financial resources for sustainable economic growth of the country. q. The operating institutions included both foreign and local major banks, Rural and Community Banks (RCBs), Savings and Loans Companies (SLCs) and other finance and leasing companies.

OBJECT OF FINSAP AND FINSSP II - Contd q The stated objectives of government under the FINSSP were to: promote efficient savings mobilization; q make Ghana the preferred source of finance for domestic companies; q establish Ghana as the financial gateway to the Economic Community of West African States (ECOWAS) region; q enhance the competitiveness of Ghana’s financial institutions within a regional and global setting; q ensure stronger and more facilitative regulatory regime; and q achieve a diversified domestic financial sector within a competitive environment.

KEY PILLARS OF FINSSP II Government realizing the private sector as the engine of growth mapped out strategies to ensure that: q Funds available q Funds Accessible q Funds Affordable Availability q. Abolishing of the secondary reserve for banks. q. Increase in capital requirement. q. Promoting financial literacy to pursue the agenda of reducing the large section of the population lacking basic financial knowledge and increasing the savings culture. q. Total market capitalization of all commercial banks in Ghana in 2015 was estimated at US$600 million with total assets of US$4. 5 billion. The banks provided loans of only US$1. 90 billion as a deposit base of US$2. 7 billion representing laon to deposit percentage of 70. 4%. q. Comparatively in Nigeria, as at August 2006, the top 7 banks’ market capitalization ranged from US$800 million to US$3. 2 billion. By implication, the smallest of the top 7 banks in Nigeria has a market capitalization bigger than all the banks in Ghana.

KEY PILLARS OF FINSSP II – Contd. STATED CAPITAL & SHAREHOLDERS FUNDS- GHANA INDUSTRY 2007 2008 2009 GH¢'000 Shareholders Funds 815, 852. 00 1, 112, 752. 67 1, 809, 881. 88 Stated Capital 275, 763. 00 364, 000. 00 7, 800, 000. 00

KEY PILLARS OF FINSSP II – Contd. Accessibility q Inability of Ghanaians to offer their houses as collateral because of lack of proper legal title i. e. “Deed Capital”. Consequently, the government tasked the AG and Ministry of Lands, Forestry and Mines to explore alternative approaches to land title that would free up this “dead capital” to support a credit-based economy. q Micro-finance scheme, house numbering and street names and implementation of National Identification System. Affordability q Government expectation was to make funds cheaper or affordable after recognizing high cost of finance. q Government resorted to long dated instrument. The issue of 5 year bond etc. both local and international. US$ 750 million Eurobond/10 -year domestic bond in 2008. q Fiscal discipline to reduce Public Sector borrowing regime in the effort to reduce interest rate. q Financial literacy programme objective q Government urged financial institutions to reduce agricultural loans to between 5% to 10%. Lengthen maturity between 5 -10 years. q To promote fair and competitive interest rates, the Bank of Ghana has directed all banks and non-bank financial institutions from 1 st January, 2007 to disclose transparently to all prospective borrowers, the Annual Percentage Rate - APR to their loans. q In addition, the Central Bank is on regular basis to publish the various main bank charges of all the banks to provide customers with compiled information.

WHY HAS IT FAILED TO ACHIEVE THE OBJECTIVE? q Credit referencing is still non-operative q House and street numbers with the NIS is suffering some set backs. q Proliferation of foreigners and nationals with false identity rendering identification system unreliable. q Large section of the population is unbanked. q Cost of borrowing as a result of government high PSBR. q Land litigation and the processing and obtaining legal title to land is very frustrating and cumbersome. q Government institutions that have undertaken to issue cheques in joints name feel reluctant to abide by their promise and promote diversion of cheques making awarding bodies contract document as collateral, inevitable or unsecured i. e. “TRUST” as questionable. q Government delay in paying contract proceeds. q Competition for customers makes the adherence to the KYC Policy almost impossible. q Significant amount bank’s assets are in risk free investment because of the high risk of lending loans.

WHAT OUGHT TO BE DONE? q Critical among them include the following: q Ensuring the efficient / effective operation of the Credit Referencing Bureau. q Enactment and enforcement of the Borrowers and Lenders Act q National Identification System be resumed and computerized. House numbering and street renaming. q Recognizing the competition as synergy to promote the economic development of the country so as to weed out the few troublesome customers. q Government offering some sort of guarantee to the agricultural sector/farmers to encourage credit to the sector. q Instituting the platform or the infrastructure to promote the savings culture. q An efficient Commercial Courts system is needed q Government needs to ensure that, the Treasury Bills investments are unattractive i. e. discipline in its PSBR so as to make funds available for credit. Industry Investment Portofolio 2007 2008 2009 GH¢ ‘M 1, 370 1, 514 2, 968

CONCLUSION The downward inflexibility of transaction interest rates to cuts in the Prime Rate by the MPC indicates the prevalence of market failure. Money market interest rates depend on real interest rates and inflation and Bank Base Rates must respond to Prime rate reduction unless there is evidence of real interest rate increases caused by increases in demand for money. The latter is the case in Ghana and the MPC needs reforms especially concerning data used in its pricing decisions, until then Banks have research and finance departments whose information on the economies demand for money will almost always be at variance with that of the BOG and their expectations from Banks concerning their changes in the Prime Rate will not be met.

Thank You