Are commercial banks parasitic?

Are commercial banks parasitic?
New Business Age, September 2007
By Bipin Hada

Lower interest rate on Trust Receipt Loan is subsidizing big corporates by exploiting the poor workers who send in remittance.

As the name suggests, commercial bank’s major component of business comprises of commercial activities. Significant portion of the business comes in the form of trade finance. Some of the credit products extended for financing working capital need are overdraft, demand loan, cash credit, hypothecation loan etc. These credit products are the sources of financing stock and receivables of most business enterprises, especially bigger ones.

In an import based country like Nepal, the most popular credit product being offered by banks to finance working capital needs of business enterprises is the Trust Receipt Loan. Trust Receipt Loan is provided against endorsement of title documents (Bill of Lading) of consignment of imported goods by the import letter-of-credit issuing bank. Against this endorsement, the applicant of import letter of credit will be eligible to take possession of imported goods in transit on behalf of the bank from the shipping liner/ transporter.

Technically, Trust Receipt Loan should be extended for a transit period of imported goods during which it is off-loaded by shipping liner at the port of entry and moved to the final destination to the importer’s country. Going by the same line, in case of Nepali import business, this should not be more than 15 days duration considering the port of entry as Kolkata and Kathmandu as the final destination. Once the possession of goods is taken over by the importer (import LC applicant) and the goods reach the godown of the applicant, the technical validity of ‘Trust Receipt Loan’ ceases to exist and the imported goods simply become stock in hand of the borrower. All such stocks in possession of borrowers with proper title are to be generally financed by other credit products like overdraft, demand loan, cash credit, hypothecation loan etc. Is this the case in Nepal? Going by the evidences, the answer is quite obvious.

In Nepal, almost all commercial banks are extending Trust Receipt Loan for a period up to 180 days to importers, both manufacturing as well as trading enterprises. This tenure is very much comparable with the loan tenure of demand loan/ working capital loan provided to industrialist and trader to hold stock considering the average trade cycle of most of the industrial raw materials and trading goods. The time period of 180 days is very much more than enough compared to the general trade cycle comprising of ‘import, stock, sales, receivables and recovery of receivables’ of any industrial or trading enterprises. Industrial as well as trading enterprises are utilizing Trust Receipt Loan for longer period as far as possible due to lower cost tag attached to this loan product.

Almost all commercial banks are extending Trust Receipt Loan at an interest rate as low as 6.00 percent per annum for tenure up to 180 days. However, the appropriate credit products to finance stock and receivables are overdraft, demand loan, cash credit, hypothecation loan which are tagged with an interest rate of around 8.00 to 10.00 percent per annum. Due to this low cost of Trust Receipt Loan, borrowers are diverting this source of short term financing to finance long term capital expenditures. This technical mismatch leads to situation where borrowers more often request bank for time extension of Trust Receipt Loan deal even after the lapse of 180 days. In a way, this has led to erosion in financial discipline of the borrowers. Banks have been lenient on this issue mainly because of fear of losing business in the ever-increasing competitive market and borrowers have been enjoying a free-ride capitalizing on commercial banks’ fear factor.

It is a universal assumption that the interest rates quoted against loans and advances should equal to the sum total of cost of fund, risk premium and profit margin. Cost of fund depends on the sources of fund, while the tenure and risk premium primarily depends on security arrangements whereas profit margin depends on profit goal of the service provider and of course, the market scenario. In the present context, the main source of funds of a commercial bank is saving deposit where cost of fund is somewhat lower than real rate of inflation. The tenure of saving deposit and working capital financing are convincingly comparable as saving deposit is considered to be stable source of fund and the above referred working capital financing are extended for period less than one year. Regarding risk premium, security arrangement available for Trust Receipt Loan as well as other working capital loan products are the same, i.e. hypothecation of stocks with insurance coverage in almost all cases except for some small borrowers. Regarding profit margin, this will not be a differentiating factor among commercial banks in the context of present competitive market scenario. Therefore, there is no obvious difference between Trust Receipt Loan and other credit products to properly justify the disparity in interest rate.

The main reason for this disparity in interest rate between Trust Receipt Loan and other working capital loans is the other incomes that can be earned by trade finance activities. The foreign exchange income from import letter of credit business is a good attraction. Import letter of credit business mainly generates revenue in the form of letter of credit issuance commission and foreign exchange gain. A straightforward estimation implies that around 80 percent of revenue from import letter of credit business is from foreign exchange gain. In the prevailing Nepali banking market, letter of credit issuance commission is around 0.10 percent of letter of credit value whereas foreign exchange gain is around Rs. 0.30 per USD, which is about half of the difference between the buying rate and selling rate of Foreign Exchange. At this rate, letter of credit issuance commission and foreign exchange gain per USD 100 value of import letter of credit will be Rs. 6.55 and Rs. 30.00 respectively at the exchange rate of Rs. 65.50 per USD. In order to take maximum benefit out of the foreign exchange gain, commercial banks are trying to get more and more import business by offering lower interest rate on trade financing. This effort has been reflected as leverage shown by banks in Trust Receipt Loan by allowing lowest interest rate compared to other credit products available to finance stocks and receivables. The question that immediately comes to mind is how do we explain this leeway provided by commercial banks?

One of the main sources of the country’s foreign exchange is inflow remittance coming from the Nepali workers working in foreign countries. The import business is primarily being supported by these remittances. Commercial banks are capitalizing on the almost a fixed margin, i.e. difference between foreign exchange buying and selling rates. Banks are doing this in order to achieve their goal of profit maximization. Looking at this from the consumers’ perspective, commercial banks are reaping substantial returns by subsidizing a loan product that primarily goes to big corporate houses at the cost of individuals selling/ surrendering their hard earned foreign exchange. This is not at all a fair treatment.

To mitigate this, the difference between the foreign exchange buying and selling rate has to be rationalized and interest rate applicable to each loan type has to be rationalized on the basis of facility’s nature, risk, tenure and security arrangement.