The Effects of Interest Rate Liberalization on the Risk of Commercial Banks in China - Literature review Example

? LITERATURE REVIEW The Effects of Interest Rate Liberalization to the Risk of Commercial Banks in China Interest rate liberalization Interest rate liberalization is a policy which is basically aimed to keep the costs of the funds low with a view that the cheap credit would promote the development through increased investment. Interest rates are basically used to manage monetary conditions and mobilize and deployed the resources in an efficient and effective manner. Interest rate usually remains the supervision and administration of government. Interest rate is calculated on reduction balancing method. Under such method levying of extra charges of loan is not allowed. Researchers say during 1974-1978 Development Plans, the government of different countries felt the need to review the interest rate in order to encourage the savings through the bank and to create disincentive to eradicate the speculation and uneconomic use of savings by the borrowers. During 1980 the interest rate policy was used to achieve the following objectives. Firstly interest rate policy was aimed to keep the general level of interest rate positive so that savings can be encouraged and contribute to the maintenance of financial stability in real terms. Secondly it was framed to allow greater flexibility and greater competition amongst the banks and non banking financing institution in order to enhance the effective and efficient allocation of financial resources. Thirdly the policy was objected to reduce the differential and to maximize the lending’s of banks. After 1974 a review on the interest rate liberalization was done during 1980 which allowed commercials banks to get a better room to complete and to have a better flexibility to meet the need of the customers (Ngugi and Kabubo, March 1998, pp. - 9-10). As per to Feyzioglu, Porter and Takas (2009); interest rate liberalization provide with many benefits. With virtue of better pricing of capital and risk, interest rate liberalization helps to improve the allocation and efficiency of investment. In this connection authors elaborated that a larger share of intermediation would be taken by more efficient bank and more specifically those who have got a better credit. They also suggested that the financial products should also expand allowing firm and household o manage the risk better by providing them with a wide portfolio diversification opportunities. On contrary interest rate liberalization also exert a negative impact on the financial sector (Feyzioglu, Porter and Takas, 2009). Again according to Shih (2011), interest rate liberalization reduces the cost of governance for central bankers. He added that interest rate liberalization gets affected with short term political incentives. But in long term liberalization of lending interest rates reduces the need for central bank official to ration the credit (Shih, September 2011, pp. – 437-438). The Current Researches on the Interest Rate Liberalization The researchers Bekaert, Harvey and Lundblad (April 2001) demonstrated that interest liberalization increase growth. They observed that the interest rate liberalization lead to a percent increase in the annual per capita GDP growth. They also added that they did find this growth to be statistically significant. Based on the researches the interest liberalization was also economically important. They examined the same by using a classic growth framework of regression for certain developing countries. They assumed that the human capital variables move from 25th percentile to the median of all countries in consideration. They also moved the size of the government sector and population growth from 75th percentile to the cross sectional median. Then a positive impact on growth was calculated given the changes in these four variables. Next a comparison with liberalization was made. The liberalization indicator added 1.1%. This liberalization contributed 40% of the total growth increment. Researchers also made a keen observation on channels where liberalization had an impact on increased growth. They came to a conclusion that GDP ratio increases where investment is partially get financed by foreign capital resulting into a negative effect on trade balance (Bekaert, Harvey and Lundblad, April 2001, pp. 34-36). According to Chinn and Ito (May 2007) world economy had enjoyed a period of numbness since the end of Argentina financial crisis. The in interest in effect of financial globalization had not been warned. It did lead to a debate in the academic circle. The issue was regarding the effect of financial liberalization policies on economic performances and benefits of capital control policies (Chinn and Ito, May 23 2007) Again author Agarwal (2004) has observed that higher interest rate caused a greater availability of bank credit which resulted into higher investment through usage of causality test. The cost of capital was found to have an insignificant effect over the investment rates. This indicated the importance of availability of bank finance over its cost of capital which in turn enhanced the investment rate (Agarwal, February 2004). The Development of the Interest Rate Liberalization in Different Countries The financial systems of most developing nations had come under anxiety as a result of the economic tremor as a result of the economic shocks during 1980’s. In addition financial repression, largely manifested through indiscriminate distortion of financial prices including interest rates, had tended to reduce the real rate growth and the real size of the financial system relative to non financial magnitudes. Financial repression had retarded the development process of mostly all countries. As a solution to that most of the countries, both developed and developing, had taken steps to liberalize their interest rates as part of the reform of the entire financial system. Different author held different views for the development of Interest Rate Liberalization in different countries (Omole and Falokun, 1999, p.1). Chinn, Ito (June 2002) made an exhaustive analysis of the evidences to come to a conclusion regarding the interest rate and its relationship with financial openness and financial development. Their findings said that interest rate liberalization is instrumented with the level of government surplus and current account balance. They econometrically verified the belief that financial system would benefit more from interest rate liberalization in different countries. It would have a positive effect on the financial institute development. The interest rate liberalization came up to have the largest effect on financial development when indicia are higher. Hence the researchers added to this prospective by bringing in the concept of legal protection that were mostly associated with rapid financial development followed by financial opening ( Chinn and Ito, June 2002, p. 20) . Prasad, Rogoff, Wei and Kose (2003) debated upon the fact weather interest rate liberalization promote growth in developing countries. The principle conclusion that emerged from the analysis was that many developing economies with a high degree of financial integration had experienced high growth rate. They added that interest rate liberalization enhanced the growth of the countries through a number of channels. The authors have given a solution of controlling risk by keeping a pace with the growth and development (Prasad, Rogoff, Wei and Kose, 2003, pp. 1-2) Again as per Belassa (1990) McKinnon and Shaw analysis hold good in the interest rate liberalization. He has defined interest rate liberalization as a link of higher interest rates that equates the demand, supply and savings. Higher interest rate would lead to an increased savings and financial intermediation as well as a mean of improvement in the efficiency of using savings. In this connection Wijnbergen and Taylor hold an opposite view and claimed that higher interest rates on time deposits did not lead to increased financial intermediation (McKinnon and Shaw, 1990, p. 68). Udoh and Ugbuagu made analysis for examining the impact of changes in interest rate policy and financial reforms on economic growth. This analysis had helped the authors to set the relationship between interest rate liberalization, financial deepening and economic growth in Nigeria. The authors observed that the policy directed for interest rate liberalization was relevant for financial depths. Financial depths had a cascading effect on the economic growth which through its effect on investment (Udoh and Ugbuagu, 2012, p. 297). Odhiambo (2009) analyzed the impact of interest rate on the economic growth of Zambia. He analyzed his findings in influence of the concept of financial deepening. He used two models namely financial deepening model and trivariate causality model in order to examine this linkage. The study showed that there was a strong support for the positive impact of interest rate of liberalization on financial deepening. But the study was subjected to a negative of short run feedback causality from economic growth to financial development (Odhiambo N, December 2009, pp. 554-555). As per as an article the author held the view that “developing country’s central banks keep interest rate artificially low to ensure sufficient low cost financing for the public sector, while avoiding large fiscal deficits and high inflation. But, in the long run, such low interest rates mat low interest rates may also discourage households from saving, lead to insufficient private-sector investment, and eventually in economy-wide under investment , as occurred in many Latin American countries in past.” (China’s Interest Rate Challenge, May 2013) The Development of the Interest Rate Liberalization in China: According to Feyzioglu, Porter and Takas (2009); interest rate liberalization played a central part in broadening the Chinese financial liberalization. China made several preconditions for interest rate liberalization by observing the experience and trend of several other countries. Their modeling results indicated that the reform had raised the cost of capital followed by a hike in the return of savings. The research also held suggestive and more efficient banks to enhance their role in intermediation. The marginal leading were discouraged and capital cost were more which paved the way for a likely increase in the efficiency of investments. All these benefits were achieved without banks becoming unprofitable. The market structure of baking system was rigid and strong. A few large banks remained at the core of the banking system reluctant for a change. On the contrary a range of smaller bank would compete for deposits and loans, giving a competition to the largest banks. Throughout the interest rate liberalization phase in China banking supervision and monetary policy remained vigilant over credit risks increase within the system. The researchers concluded that China was in favor of expanding its policy toolkit, make it flexible and conduct alternative monetary policy rather than quantity controls or directly setting key loans and deposits rates (Feyzioglu Porter and, Takas, 2009, pp. 23-24). As per as the recent development of interest rate in China concerned, a latest article named “Ex-U.S. Treasury Paulson: China needs Interest Rate Liberalization” of Wall street journal by Richard Silk, debated that China was in need of market set interest rate. Over there Richard elaborated the viewpoint of Chinese economists and government where they had argued that domestic banks need increased ability to set interest rates as a first step towards easing controls over cross border capital flows. The article stated that according to Mr. Paulson it was unbelievable fact to him that China was in a position to use fiscal stimulus to boost economic growth (Richard Silk, June 2013). In the words of Shih (2011) China has always been engaged in significant economic reforms of its own. By virtue of having control over the flow and the direction in investment, technocrats could ensure the optimum level of inflation and that the growth remained strong. Informal banks emerged to offer high deposits rates influenced by monetary policy and began to push for interest rate liberalization. As stated by author they made progress on liberalization when inflation was low and growth was robust (Shih V, September 2011, pp. 459-460). Jingu (September 2012) quoted, “China’s ongoing financial reforms were expected to proceed apace in 2012 irrespective of this autumn’s leadership transition, but they progressed faster than anticipated in the first half of the year” (Jingu, September 2012, p.1) Risk on Commercial Banks: The risks on the commercial banks were huge. The risk became a key issue concern in that scenario. There were possibilities that aggressive competition for deposits and market share among banks could drive the margin down. This could have lead to bankruptcies and created a condition of financial instability within the country. Government in most of the countries had controlled interest rates and credit allocation at one point in their history. These restrictions were formulated with an aim for maintaining financial stability and support development. But this restriction also reduced the borrowing capacities of government by imposing the low interest rate ceiling. This on the contrary had a negative effect on the commercial banks. The restriction led to inefficient intermediation and lower growth. As a result research showed that most country removed these restrictions after the macroeconomics crisis (Feyzioglu, Porter and Takas, 2009, pp.15-16). According to Mehran, Laurens and Quintyn (1996) interest rate elasticity of savings was a very relevant issue for China’s interest rate policymaking. As per theory when the country faces financial repression the liberalization of interest rates may enhance the mobilization of savings which in turn results into higher level of investment and economic growth. After going through several years of economic reforms, China’s deposits and lending interest rates were not being liberalized. The interest rate elasticity of investment raised two issues. The first query was whether the banks should decide to invest and secondly the liberalization of interest rates could be conducive for channeling financial resources to the most productive projects. It was told by the author that the time to liberalize interest rates had not yet come. The repayment on interest was rare in situation when the creditor is the commercial bank itself. So the commercial banks were going through the “soft budget constrain”. In those circumstances the administrative interest rate policy came out to be efficient and effective because it had considered different categories of borrowers of the commercial banks. The debate was still there that the liberalization of interest rate would facilitate the control over inflation which the commercial banks were suffering from. The issue of concern which came up in such situation was that irrespective of the liberalization of interest the there would be risk in the monetary policy which could be risky affair for the commercial banks. The problem lied when inflation rate would be high and the interest rates remaining low; it would be difficult for central banks to enforce interest rate controls. Since interest rates were administered the uses of market instruments were also not possible. So monitoring on commercial banks was started through open market operation through usage of government securities as a mean to control money supply (Mehran, Laurens and Quinty, 1996, pp. 145-151). Moody’s Investors Service (October 2012) stated on the present condition of the commercial banks and how they are thriving. As per the latest report they said that a progressive liberalized rate in China could be a challenge for the commercial bank’s current management capacities covering a wide range of areas including business strategy, risk control and governance. The commercial banks were in the condition where they could boast reasonably strong financial metrics but their ability to adapt to a fully market driven pricing environment would remain unsteady and might be subjected to additional uncertainties. On the other hand, these challenges also invited greater delineation within the sector as they would focus only over the importance of each bank’s individual ability to manage its risk and repositioning in the dynamic and evolving landscape. Commercial banks were characterized by its homogeneity but the latest development widened the range of standalone ratings. The development in the negative credit played a significant role in the risk assessments of the commercial banks which meant potential challenges for them on multiple levels. Moody predicted that the challenges would emerge in liquidity management as the broad liberalization of interest rates could give confidence to the depositors to seek yields and enduringly introduce market driven volatility into the entire funding system. They concluded saying that they viewed the proliferation of structured deposits and wealth management products in the commercial banks as a de facto form of rate liberalization as they represented the substitutes for deposits(Moody’s: Chinese banks face increasingly liberalized interest rate regime, October 2012). Model to Test the Risk of Commercial Bank: Azhad, Faiyaz and Sadi (Nov 2011) has found that the legal institution of the country could exert important influences on the financial system and economic outcomes. So a solution to the same a theoretical model to investigate the law finance growth was introduced. The model suggested economies with widespread presence of soft budget constrain. The model was an aim to problems of baking credit misallocation and investment inefficiency. The empirical results were derived from the model which showed the relationship between banking sector development and economic growth in China. The result concluded that development of commercial banks contributed partially towards the economic growth in absence of proper legal environment (Azhad, Faiyaz and Sadi, November 2011, pp. 94-95) In this connection, news daily of China has suggested a model to test the risk of commercial bank. As per them any further move towards interest rate liberalization accounted for all potential costs and benefits. They suggested that the degree of financial regression in a country could be estimated by calculating the gap between the average nominal GDP growth rate and the average long term interest rate. This gap, in the last 20 years record, accounted for 8% points for China compared to 4% points on average for developing economies and nearly 0% for most developed economies where the interest rate were fully liberalized (China’s Interest Rate Challenge, May 2013). Relationship between the Interest Rate Liberalization and the Risks of Commercial Banks of China: The interest rate liberalization and risks of commercial bank shared a relationship from the viewpoint of loan demand and deposits supply. As per deposits supply view if the elasticity of deposits were doubled then the deposits rate increased by less than under deregulation. As a result the deposits and lending market end up being less concentrated for which the banks expanded their presence by much more in the baseline. But the results used to remain unaltered if the loan demand got more elastic but did not change if the demand is less elastic. Bank used to become significantly more profitable if interest became more elastic and vice versa. If loan demand became more elastic then that had resulted into the loss of market power. This in turn translated into smaller increase in lending rates from the bank (Feyzioglu, Porter and Takas, 2009, p. 15). How does the Main Research Model For Interest Rate Liberalization Effect Commercials Banks on Risk Aspects? As per the Modigliani and Miller framework, unique optima; debt equity ratio did not exist in a firm’s investment decision. The theorem was based upon three assumptions which portrayed the effect of the interest rate on the risk faced by the commercial banks. The firm would be responsible to push the investment to the point where the marginal yield on physical assets was equal to the market rate of interest. The expected rate of return on yield, i on the stock of any company i, belonging to the Kth class is a linear function of leverage. This was plotted as mentioned below, S= Pk + (Pk-r)Di / S i Where: S = expected rate of return to yield Pk = capitalized rate r = interest charged Di = market value of debt for the company Si = market value of common share in the company Thirdly it was assumed that, if a firm (in class k), performing in the best interest of the stockholders at the time of decision making, then that would exploit an investment opportunity if and only if the rate of return on the investment (P) was as large as or larger than Pk and would be remain impervious completely by the type of security used to finance the investment (Omole and Falokun, 1999, p. 5). Another main aspect of the researched model, which influences the interest rate in assessing the risk of the commercial banks, was the debt equity ratio. The debt ratio was considered because the overall cost of capital to the investors (which influenced he fixed investment, its efficiency and profits) could be expressed as a weighted sum of opportunity cost of bank debt and that of equity, with the weight depending on the debt equity ratio. As a result of that, the multiplier effect changes in the cost of bank debt (interest rate) on the overall cost of capital and so on the share of debt in the investment financing and on the induced adjustments in this share as well as in the cost of equity. On execution it was found that there exists an optimum debt-equity mix for the firms. Accordingly, the cost of capital depended on the debt equity mix first falling and then rose as the debt ratio rose. As a result of this the financing and the real decisions were no longer independent. The model developed for this purpose derived a precise expression of the desired average debt ratio by postulating that firms strived to obtain the debt equity mix that minimized the cost of capital. The optimal debt equity ratio was expressed in the following mentioned way: DE*= d*(i u – i, II) Over here, DE* = desired debt-equity ratio d* = nonlinear function of the interest rate subsidy and the rate of inflation i u = nominal interest rate in the unregulated market i = weighted average of domestic and foreign interest rates (adjusted for exchange rate change) II = rate of inflation The MM model concluded that larger the interest rate subsidy, higher the desired debt equity ratio. Further the model also indicated that the desired ratio would rise and fall with inflation depending upon whether the marginal risk premium fall or rises with inflation. The model suggested by Feyzioglu, Porter and Takas (2009) showed that liberalization results into higher cost of capital with a lower volume of lending and more effective monetary policy transmission. These factors play a role without affecting the soundness of banking sector and the efficiency of the system as a whole increases. Smaller banks benefits more from the liberalization of interest rates as they get an opportunity of attract additional deposits and expand their operations. On the other hand larger banks scale back their deposit bases as funding cost rise. Free deposit rates enhance the impact of a given change in targeted interbank rates on deposit and lending rates, as well as on intermediation activity. As an effect of these; the banking sectors remained sound even in the face of greater competition after liberalization in China. In this connection the authors develop a model to capture the characteristics of the banking sector in China. The model allowed the banks to have different sizes on both their deposit and loans. The banks were allowed to operate in both increasing and decreasing return to scale with different levels of profitability. The model chosen was named as the “Baseline Oligopoly Model”. The model was based upon certain assumptions which were consistent for banks having market powers. The model assumed that there were n banks in the economy out of which bank i choose how many deposit (Di) it needed and how many loans (Li) to make. Against all these deposits the banks were required to maintain and hold a share ? as reserves. The banks had an aggregate supply curve for deposits and demand curve for loans which depended on deposit and lending interest rates respectively. The aggregate supply curve for deposits was denoted as rD(D) and that of for the loans was denoted as rL(L) where: D =Di L =Li Deposits as taken were either lent to enterprises or to the households at an interest rate of rL. Authors had suggested that the same could be lent to other financial institutions through an interbank market at a rate r. simplicity it had been assumed that required reserves and any government bonds were remunerated at the interbank rate, r. Each bank faced a cost function that depended on its volume of deposits, loans and some fixed cost. Deposit and loan management cost were denoted as d i(Di) and li (Li) respectively and fixed cost was denoted as Fi. Each bank, i, solved the profit maximizing problem. The equation which was framed up was max [rL(Li + L j) –r]Li + [r- rD(Di + Dj)]Di – di (Di) –li (L i) – Fi D i L i Subjected to, (1- ?)Di ? L I, with an associated multiplier ?i. In absence of the reserve requirement, the lending and deposit decisions were independent. But the two got linked when banks were required to hold the reserves. In case if the reserve requirement were binding, then the requirement acted as a tax on lending (size taken as ?i) and a subsidy on deposits taking [(1 – ?) ?i]. This in turn reduced the lending and increasing deposit volumes. It concluded that the market shares in both the deposit and lending markets were primarily dependent on the relative marginal costs across banks. On the other hand the banks with lower marginal costs had larger market share (Feyzioglu, Porter and Takas, 2009, pp. 3-7). Feyzioglu, Porter and Takas (2009) suggested that the Baseline Oligopoly Model is framed mainly to capture main characteristics of the commercial banks in China. This allowed the bank to operate both in increasing and decreasing scale which became risky to the commercial banks at times. Baseline Oligopoly Model was based upon certain assumptions which were consistent with banks that had market power despite competing against each other. The banks in the model were oligopolistic in nature. With a view of drawing implications from the model, researchers calibrated that which reflected the behavior of China’s banking system. Parameters chosen matched the implied behavior of the banking system in the model keeping a pace with the observed behavior of the entire Chinese banks. Key dimensions chosen in the model were the loans, deposits, profits and costs. The calibration considered while deposits rate is binding lending rate is not. The model captured the variable cost of majority if the banks assessing the risk (Feyzioglu, Porter and Takas, 2009, pp. 4-7). Another model which can also be taken in account is the “Multivariate Logit Model” as referred by Kunt and Detragiache (March 1998). To indentify the impact of the interest rate liberalization on the financial fragility of commercial banks, the probability of banking crisis was estimated and hypothesis was tested. The dependent variable was the baking crisis dummy which was equal to zero if there is no banking crisis and equal to one when there is a crisis. The probability that a crisis would occur at a particular time in a particular country was hypothesized to be a function of a vector X(i, t) including the interest rate liberalization dummy variable and n-1 control variables. P(i, t) was denoted as a dummy variable that took the value of one when a banking crisis would occur in country i and time t and a value of zero. ? was a vector of n unknown coefficients and F(?’X(i,t))was the cumulative probability distribution evaluated at ?’X(i,t). Then the model framed would be like: Ln L = St=1..T Si=1..n{P(i,t)ln[F(??X(i,t))] + (1-P(i,t)) ln[1- F(??X(i,t))]} Where the coefficient captured the effect of a change in a explanatory variable on ln(P(i,t)/(1-P(i,t)) (Kunt and Detragiache, March 1998, pp. 13-15). The Effect of the Interest Rate Liberalization and the Risk of Commercial Banks on China According to Feyzioglu, Porter and Takas (2009) the calibrated model can be applied to investigate the impact on deposits rates on interest rate liberalization. The impact of the liberalization is proportionate with the central bank operations. It was based upon certain assumptions. Firstly Central bank operates monetary policy by targeting the interbank rate holding that constant, secondly the bank considers a spread which determined the deposits rate and thirdly the interbank rate is allowed to clear the interbank market. The model based result showed that commercial banks taking full advantage of the additional channel while smaller commercial banks offered higher deposits to increase their rates. The larger banks shrink their deposits base to reduce cost. It resulted into a steep fall of concentration in the deposit market. This resulted into lower profit in large banks. As a result of the entire phenomenon the share of deposits in commercial banks suffered from losses and so as the entire banking system. In effect of the same the interest rate did not rise more after liberalization. The cost of interbank funds placed an efficient ceiling on the interest rates. The rates should had been a bit lower than the than the interbank rate. But as per the current scenario there was only a bit rise in the deposit rate and in the lending rate. The liberalization in interest rate failed to establish link between lending and deposit rates, as well as lending and deposit volumes of the commercial banks. Alternatively the rate liberalization enhanced the effectiveness of indirect monetary policy and interest rates as price signals. The change in the IB rate target resulted into a larger feed-through to the lending and deposits rates of the commercial banks after liberalization. This paved the way of additional demand for deposits and therefore a higher deposit rate. With all funds being more expensive, commercial banks restricted lending and o the lending rates were further forced up. The better alteration in the interest meant that center bank would need to intervene and undertake larger intervention in monetary market to achieve its target when the deposit rates would be free (Feyzioglu, Porter and Takas, 2009, pp. 8-15). Interest rate liberalization clubbed with other financial reforms helped to improve the efficiency of the capital allocation and optimization of the economic structure as a whole. The fixed differentials between interest rates on deposits and that of loans, under the current economic structure of China, translated into monopolistic profits for commercial banks. On the contrary, by creating more competition for interest income and reducing net interest rate differentials, liberalized interest rate could have reduced the profitability of the commercial banks. As per the latest updates the major risk that the commercial banks were facing arouse from the major risk associated with the interest rate liberalization in China which stemmed from rising public debt. This, in turn, leaded to the global financial crisis. The gap between interest rate and nominal GDP growth were a key parameter for determining the long term sustainability of public debt. But after the interest rate liberalized the GDP ratio was expected to augment significantly (China’s Interest Challenge, 2013). References 1. Agarwal P, February 2004, Interest Rates and Investment in East Asia: An Empirical Evaluation of Various Financial Liberalization Hypothesis, Taylor and Francis Ltd. 2. Azhad, I. Faiyaz, M. and Sadi, A.Z.M. 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