Can interest rates be reduced via a legislative amendment?

It’s important to pay attention to relevant constraints when developing new economic policy suggestions. Let’s discuss recent suggestions of “reducing interest rates by reducing banks’ funding costs.” Leaving the capital aside, a bank has three main methods to maintain resources: It may take deposits, issue bonds and can borrow from abroad through instruments other than bonds. The lower the cost of these resources, assuming a “normal” profit margin, the lower that bank’s interest rates will be for the credits it gives. Therefore, it is appropriate for an economic policy, aiming to reduce interest rates for credits allocated to non-financial enterprises and households, to focus on reducing banks’ funding costs. But only with the following condition: The new policy should not lead to a situation contradicting the initial goal.

Let’s evaluate this recent suggestion in the frame for this simple premise. What’s the fundamental goal of “deducing interest rates through reducing banks’ funding costs?” Stimulating consumption and investment expenditure and increasing the growth rate by reducing credit interest rates for companies and households. But wait: You should not lead to a decrease in credit volume while reducing interest rates. If credit volume falls, credits can’t increase consumption and investment expenditure and you can’t increase the growth rate.

To prevent credit volume from falling, the amount of resources banks collect should not decrease. The banks’ main funding source in Turkey comes from deposits. An individual putting his/her deposit into a bank can’t accept a lower than inflation interest rate. Instead of putting their money in a bank with an interest rate lower than inflation, one may prefer buying foreign exchange or just spending it. In that case, we have our fundamental constraint: The deposit interest rate cannot be lower than or equal to the inflation rate (a fact also valid for bonds and such).

So, the new economic policy may only work if deposit rates and credit rates are far above inflation. But what could such a policy be? We should look at bank costs other than inflation. (Attention: I took inflation as a cost element; the reason for that is the result of the simple analysis mentioned above.) Banks have some costs under their own control, such as personal costs and costs arising from current legislation. Economic policy makers can’t intervene with costs under the banks’ control. And any legislative amendment made without focusing on the main problem won’t work.