Why misconception could lead to crisis when it comes to interest rates

There is a growing narrative amongst the general public that commercial banks have become the enemy of the people, charging high interest rates and conducting usury practices for the benefit of the few. As many people see it, high interest rates are nothing but the product of usury lending or the practice of giving out unethical loans to unfairly enrich the lender. This polarized view of the issue, which has only been aggravated with the involvement of politics, has created a disconnect which could eventually lead to a crisis later down the line.

Discontentment with high interest rates and cost of loans is neither an exclusively Mongolian nor a recent phenomenon. The idea of usury lending and the resentment of the common man against this practice are almost as old as banking itself. In fact, any form of interest was seen as usury lending in many societies. One example of this fact is that interest of any kind is forbidden in Islam to this day. Specialized codes of banking were developed and honed over centuries to obey Islamic law. The bottom line is that displeasure with high interest rates is such a large source of frustration that you can almost say that it has become a universal human struggle.

In many cases, especially in Mongolia, this struggle and its criticism is both justified and understandable. People are not wrong for speaking out against high interest rates. In the last 10 years, in terms of average interest rate, Mongolia ranks in the top 15 globally. Despite this, Mongolia has come a long way in this regard. From 300 percent interest rate in the 1990s, to 40 percent in 2000, and currently hovering around 18 to 19 percent. Relative to other countries however, the current rate is still high. Nobody, including banks, denies the fact that interest rates are too high and need to be brought down. But the frustration of the public has solely been directed at banks.

The idea that banks are colluding to keep interest rates high just for the sole purpose of fattening their wallets is irresponsible at best and dangerous at worst. Persisting suspicion of banks has resulted in politicians proposing drastic measures such as introducing a hard cap on interest rates. S. Erdene, chairman of the opposing Democratic Party, formally submitted a bill to introduce a hard cap on interest rates in order to “combat usury lending”. This bill gained a significant amount of traction amongst the public and was even discussed in Parliament until cooler heads prevailed.

Persisting belief that a bank can just freely modify their interest rates as they please has been a dangerous misconception. Everything from cost of raising capital, policy interest rate of the central bank, macroeconomy, and market conditions are major determining factors in interest rate. Based on this, one can conclude that interest rates are in fact a major indicator of the economy rather than the sole will of the banks.

Interest rates are essentially payment for using a product, in this case, loans. As with any product, there are costs. Costs of lending from the bank’s side include raising capital, operational costs, loan loss provisions, and profit margins. Despite conventional belief, the cost of raising capital, not profit margins, are the biggest source of high interest rates. Capital is in short supply in Mongolia and savings are the biggest source of capital for banks. That is why savings interest is relatively high. In the last 10 years, the average savings interest rate was 12 percent, according to Mongol Bank, which ranks in the top nine globally.

In this sense, it is ironic that many of the people who enjoy the high savings interest rates go on to complain about high interest rates, not realizing the close interconnected nature of the two. In addition, the increasing amount of non-performing loans in the banking system has only aggravated the issue. Due to higher rates of bad loans, banks must expend more money for loan loss provisions, all of which is included in the interest rate. This creates a vicious cycle in which when non-performing loans increase due to high interest rates, this only further increases the rates.

Moving forward, the strategy of Mongol Bank to lower interest rates is not predicated on intrusive measures such as hard caps but objectives that help create the foundation in which interest rates can be lowered organically. The 11 key objectives in the central bank’s strategy are telling of the reality of the situation. Its objectives are less oriented towards the management of commercial banks and more geared towards general economic stability. This includes stable inflation, fiscal discipline, good foreign reserves, and economic diversification.

Obviously, governance of banks is an important factor that cannot be forgotten. Recent legal reform of the banking sector including more operational independence for Mongol Bank has been a positive in this manner. The asset quality review conducted on the banking system and regular shock tests help reveal shortcomings and allow them to be rectified. In addition, banks are also being held more accountable for better risk and asset management.

In terms of non-banking financial organizations, there needs to be more oversight in regards to usury lending. Simply due to the sheer number, it is harder to maintain oversight of non-banking financial organizations. The fact that there are 14 commercial banks allows Mongol Bank to maintain prudent oversight over commercial banks while the Financial Regulatory Commission understandably has a harder time regulating over 500 nonbanking financial institutions.

The financial sector and especially the banking sector are rather sensitive to drastic changes. Too much regulation can put a stranglehold on economic prospects while too little oversight can be disastrous. Right now, the authorities are attempting to tow this thin line. At a time like this, it is vital for the public to not get caught up in the politics surrounding interest rates and make more of an attempt to differentiate between what is reality and what is rhetoric.

...The idea that banks are colluding to keep interest rates high just for the sole purpose of fattening their wallets is irresponsible at best and

dangerous at worst...