Banking is a fairly straightforward business. Banks buy your savings and lend it to people and institutions to make more money out of it. It is therefore aptly said that banks are the only business entities where the end product is the raw material itself. In this blog today, I wish to explain to you how exactly banks charge what they charge to the customers when they take loans.

If you are not already aware, banking is a highly regulated industry not just in Bhutan but across the world. The governing body that frames and regulates banks in Bhutan is the Royal Monetary Authority (RMA), the central bank. RMA essentially tells banks what they can and can’t do and this includes how to set the interest rates on the credit products.

Credit interest rates have had their own share of history which we shall go over in some future post but in this one, let’s go over the methodology that the banks have to follow in order to arrive at their interest rates. This methodology is derived from the Minimum Lending Rate (MLR) policy that RMA instituted in 2016.

This methodology is used by the individual banks to arrive at their MLR, the rate below which they can’t lend. RMA takes these MLRs from the banks and averages them out to come up with a single MLR for all banks to follow.

Banks use the following formula to arrive at their MLR.

MLR = Marginal Cost of Funds + Negative Carry Charges on CRR + Operating Costs

Strap on your Math Helmet because we are going to do some arithmetic. :D

Marginal Cost of Fund

Funds are any deposits that banks have. There are two broad types, demand and term deposits. In order to arrive at the marginal cost of fund, banks basically multiply the actual interest rate of the product with its proportion within the deposit base. For instance, if a bank with Nu. 30 billion deposit has around Nu. 5 billion savings deposit, the marginal cost from the product would be 5/30*5% = 0.0083 which is 0.83%.

Similarly, the marginal cost of term deposits is also calculated using a similar technique, this time after taking individual tenure brackets. For instance, the marginal cost of Fixed Deposits with tenure 1-2 years is calculated separately from the same type of deposit with tenure 2-3 years. All the various marginal costs are added up together to arrive at the final marginal cost of the deposit.

Further, all other types of liabilities (which the bank owes) are factored in to arrive at their marginal costs.

Negative Carry Charges on Cash Reserve Ratio (CRR)

First of all, you need to learn the meaning of cash reserve ratio and negative carry. You see, as mandated in the regulations set by the RMA, all banks must set aside 10% of their deposits in the form of cash, with RMA. For instance, if a bank has a total deposit of Nu. 30 billion, they have to keep 10% * 30 = Nu. 3 billion in the form of cash at RMA’s coffer. The bank, however, keeps on paying the interest to the customers while getting nothing in return for the sum. This is exactly the reason behind the negative carry concept which is nothing but a way to show that banks are incurring additional costs due to their inability to use the funds.

The formula to calculate the negative carry on CRR is as follows;

Negative Carry on CRR = (CRR * Marginal Cost of Fund (arrived at by computing (1)) ) / (1- CRR)

That’s essentially = (10% * Marginal Cost) / 90%

If you are confused by this formula like I was, you may think like this: The CRR amount set aside is like a useless liability for the bank on which interest is given to the customers. Effectively the negative carry rate will be based on the CRR stripped deposit which is 90% of the total amount.

Operating Cost

Operating cost is the cost incurred by the bank while taking care of its day to day affairs. They include the following;

  • Employee Compensation
  • Directors’ and Auditors’ Fees
  • Legal and Premises Expenses
  • Depreciation
  • Cost of Printing and Stationery
  • Communication and Advertising Costs
  • IT Costs
  • Operating Expenses, etc.

The Operating Cost is taken as a fraction of the total deposits to arrive at the final which is as follows;

Operating Cost = Total Operating Cost (as of the July end) / Total Deposits

Finally, the MLR is calculated by summing these 3 components together. These MLRs of individual banks are then averaged out which then becomes the national MLR. The current MLR for banks in Bhutan is 6.86 % (January 2020). The individual banks add their expected spreads/profits and other risk components onto this MLR to arrive at the final interest rates.