Interest Rate Anomaly and Large Treasury Bills/Bonds Holdings of Commercial Banks – Is there a fundamental Conflict of Interest in Commercial Banks being Primary Dealers?

By Chandu Epitawala

A fundamental principle in finance and 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 supposed to have no default risk (Giltedged).

However, in Sri Lanka, this principle does not seem to hold. This has been the case for as long as I can remember (even in the 1990s) and needs to be corrected. Discussions of the current hot topic in the country on Domestic Debt Restructuring (DDR) glaringly highlighted this. Most commercial banks in Sri Lanka hold massive amounts (up to 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 requirements.

Term Structure of Interest Rates

How are the interest rates constructed or formed? The largest portion (perhaps up to 80%) of a given Interest Rate is the 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 the default risk premium attached to the institution which issues the debt instrument (the 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, any country’s Government Issued Debt Instruments carry 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 Impose Taxes and to Print Money.

The function of Commercial banks

The primary 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 individual). It’s called intermediation. The commercial banks (which are specifically authorised/licensed by the Central Bank to collect/accept deposits from the savers) will gather 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. However, these conventional boundaries have now largely disappeared.

Therefore 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? This is only possible because there is an anomaly in the interest rates in Sri Lanka.

The Function of Primary Dealers

The Central Bank appoints Primary Dealers who must be well-capitalized and of good repute. They perform a critical function in financial markets and the economy. They are expected 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 quotes both ways (buy and sell) which requires them to maintain some inventory of T-Bills/Bonds (to sell) as well as cash (to buy). They are expected to create an active secondary market for T-Bills and Bonds. This process should produce a market-driven interest rate/yield for Government Securities, which reflects expected inflation and other risks. These rates (one year, five years and 10 years) should be the benchmark (lowest) rates for a particular tenure upon which all other rates are formulated.

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. The Stock Market is the best example of this process and is mainly used for raising equity capital. Treasury Bill/Bond Markets can be considered the largest and most liquid market where the government goes directly to the market/savers to borrow debt capital. Then there are other markets (centrally organized, 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.

The primary market is where the borrower/seeker of equity or debt capital initially sells/markets 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. Only authorized Primary Dealers can participate in weekly T-Bill/Bond auctions. 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.

Another fundamental principle of Finance/Economics states; the higher the risk, the higher the return. 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 borrower/recipient of equity capital riskiness is higher and vice 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 (three Months to 30 years). However, this fundamental principle in Sri Lanka does not hold as 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 (uninformed 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 doesn’t seem right or inappropriate on two levels;

This (lending to the government) is not commercial banks’ core function or responsibility.

As Primary Dealers of T-Bills/Bonds, commercial banks appear not to be 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 exists in Sri Lanka due to 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 a year can now exit with up to 100% capital gains!!!).

Most primary dealers (ones with deep pockets) are commercial banks and lack interest in creating a secondary market, which requires them to actively market the T-Bills/Bonds to the retail investors/lenders/savers. I believe this is why commercial banks carry significant T-Bill/Bond investments in their Asset/Loan Portfolios, as pointed out in the research report mentioned at the beginning.

Why should commercial banks lend their funds to riskier customers when they can lend to the government if the depositor is ignorant or ill-informed enough to deposit their savings in commercial banks at lower rates (sometimes this gap can go up to 4-5%), than what T-Bills/Bonds (safest investment/debt instrument) pay/yield them?

Some suggestions to correct the persistent interest rate anomaly It is in the interest of the Government/CBSL to ensure that the government can borrow at the lowest cost in any market. My suggestions to correct the anomaly are;

Mandate all Primary Dealers (including commercial banks) to actively create a secondary market and market and trade a minimum amount obtained at the Primary Auction to retailers and corporate or institutional investors. Ideally, they should be required to advertise the T-Bill/Bond rates and deposit rates at all their Branches. A dealer should be obligated to carry inventory, quote both ways (buy and sell) and have a good track record of active trading and market making.

The government/CBSL should educate the public/ retail savers through ongoing marketing campaigns. 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 – the risk-return principle, and how easy to access (online 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).