Reflections on bank liquidity and rising interest rates in Malawi

Quote:“Anyway, no drug, not even alcohol, causes the fundamental ills of society. If we’re looking for the source of our troubles, we shouldn’t test people for drugs, we should test them for stupidity, ignorance, greed and love of power.” – P. J. O’Rourke

Over the past two months, from early June, 2012, the financial market in Malawi has witnessed an unprecedented level of low liquidity. This induced a systemic risk as practically all banks were resorting to the Reserve Bank discount window to seek relief and meet Liquidity Reserve Requirements and, for some, even settlement balances. The lack of liquidity in the market, in our opinion, reached crisis proportions with discount window accommodation for the week ending 6 July, 2012 at an average of MK33.65 billion per day before coming down to MK26.33 billion per day as at end of 13 July, 2012. Despite the improvement, the unprecedented figures underscore the gravity of the liquidity problem. The improvement follows discount of some securities by the banks, most likely at the specific behest of the Reserve Bank of Malawi.

A country’s economy!

The tight market liquidity forced banks to proactively adjust their interest rates as a coping mechanism. Average base rates moved from 17.5% to 23.5%, with corresponding increases in deposit rates, in the face of an unchanged bank rate of 16%. This was the first time in recent memory to see such movements emanating from the banks and, perhaps, reinforces the principle of a liberalized economy.

RBM’s handling of the situation was somewhat creative – perhaps rightly so to prevent a collapse of the system – refusing to raise the bank rate whilst introducing a new, uncollateralized discount window facility that attracts a much higher rate than the “normal” rate; at that time, banks were accessing funds on this window at 18.50%. As far back as two weeks ago, it was evident that the central bank would have to succumb to market pressures and adjust the bank rate accordingly.

In line with market anticipations, last week the central bank had no option but to adjust the bank rate from 16% to 21%. The move had to come in view of rising inflation and perhaps as a measure to prevent undue arbitrage by the commercial banks abusing the discount window facility after they had, for the first time in my living memory, unilaterally adjusted their base and deposit rates upwards in light of the prevailing liquidity crisis.

Average prime rates were, then, pegged at 20.5%. The actions of the Reserve Bank inevitably triggered an immediate response from the market, with average base rates jumping to 31.75% practically overnight! The uncollateralized discount window accommodation is now at a maximum of 23.5% up to 31 July, 2012. We gather that this will be adjusted to 4% above the concerned bank’s published base rate with effect from 1 August, 2012.

It will be interesting to see the effect of this policy and how banks will react with regard to their pricing. We hope that it will not lead to a vicious circle of increases and would urge the Reserve Bank to, at best, use “moral persuasion,” or at worst, even arm-twisting (or blackmail!) to ensure that financial stability is maintained. How about denying access to the discount window for banks that do not adhere to certain written and unwritten codes of conduct?!! Or strictly implementing remedial measures, penalties and administrative sanctions as required by regulations and directives? After all, the central bank is supposed to be a “lender-of-last-resort“ and not “lender-of-daily-resort!”

In a press release supporting the bank rate adjustment, the Reserve Bank of Malawi stated that the move was necessitated by the excessive growth in money supply and frequent recourse by the banks to the discount window. Apart from reducing lending, thereby effectively stemming the creation of money, the adjustment is designed to ultimately temper or even reduce inflationary pressures as there is a limit to which consumers can continue to accommodate increased prices in the face of crumbling disposable incomes. The obvious option is that consumers will have to adjust their consumption habits and opt for alternatives in order to live within their means. Headline inflation was last recorded at 20.1% in June, up from 17.3% in May, 2012; even higher rates are envisaged for the remainder of the year.

Given this scenario, the acknowledged economic problem of “Unlimited wants, limited means” will forcefully come into play and we could well see major lifestyle changes with urban and semi-urban Malawians opting for porridge vis  a vis cereals, running one car instead of two, greater use of public transport instead of private cars, car pools, “chinangwa” or “mbatata” versus bread etc.!!!!

So, how did we get to a situation of extreme forex shortage to one where the Malawi Kwacha is now in short supply leading to increases in interest rates? Well, following the change of regime in April, 2012 and the rapid wide-ranging changes thereafter, banks were caught unawares especially by the practically overnight, substantial 49% devaluation and subsequent increase in supply of forex from tobacco proceeds, Reserve Bank intervention and some donor inflows which virtually wiped out a significant proportion of Malawi Kwacha balances that had been accumulated during the three year forex drought.

Banks had most likely increased their lending portfolios on the back of this money and invested substantial sums in medium to long-term assets and securities, thereby creating a mismatch between assets and liabilities. Suddenly, after paying off forex liabilities, they were left with significant “illiquid” loan assets and securities (perhaps enforcing the need for an active secondary market for treasury bills and bonds) vis a vis comparatively fewer liquid assets on their balance sheets to meet immediate requirements.

Re-balancing this position has become a major challenge hence the excessive use of RBMs discount window facilities even at the highly punitive uncollateralized rates. This has, predominantly, been in order to meet their Liquidity Reserve Requirements (LRR), currently at 15.5%. It is critical, at this point, to note that there are three basic types of liquidity shortages viz:-

1.       Central Bank liquidity, which refers to a bank’s deposits with the Reserve Bank and usually comprise the reserves required for LRR and/ or settlement balances for transactions in the payments system;

2.       Market liquidity, which simplistically means the ability to buy or sell large quantities of assets within a short or of time without major changes in price in order to raise money for payments (or ease of with which assets can be converted into money or cash; and

3.       Funding Liquidity, the ability of an institution to raise substantial raise or cash equivalents via asset sales or borrowing. Assets can comprise loans, bonds, securities and even property.

All three are inter-related but my take is that the current liquidity crisis has moved from an overall systemic problem observed in the earlier stages – exemplified by central bank liquidity problems – to a combination of market and funding liquidity issues, with some banks specifically under pressure to be compliant. Given the recent devaluation, it will be interesting to see how the Reserve Bank will enforce issues of recapitalisation for Authorised Dealer Banks (ADBs) whose minimum capitalisation is set at US$5.0 million (now MK1.375 billion from pre-10% devaluation amount of MK750 million). This is bound to put added stress on some already distraught banks.

As a matter of interest (no pun intended), Malawi’s LRR is one of the highest in the SADC region where the average is below 10% and we might see the RBM lowering this in line with the region as one way of mitigating the bank’s liquidity positions, perhaps with the hope that the banks will, in turn, reduce their interest rates and spreads. Bank interest spreads (difference between lending and deposit rates) have been a long-running issue in the country and a reduction would be seen as a sign of goodwill by both the central bank and consumers.

High interest rates will make borrowing prohibitive thereby affecting the survival of some businesses. This could lead to closures and attendant unemployment and ultimately slow-down in economic activity. This is clearly not in-line with the recently passed recovery budget which aims at resuscitating the economy through private sector initiatives. The prevailing problems in the financial market, therefore, have wider serious implications for the new government and its agenda. Political vultures must be savouring and salivating at the prospect of an economic corpse to feed on as a means of scoring points with the electorate as we approach 2013, a crucial pre-election year.

One unfortunate result of the current liquidity crisis and the adjustments in interest rates is the effect that it is likely to have on the property market, especially the residential sector. Increased interest rates mean increased interest costs and higher risk of default. During the times of acute forex shortage, there was a huge build-up of Malawi Kwacha in the banking system and the banks, perhaps understandably taking a view that the problem was here to stay, are bound to have locked in these funds in long-term assets by way of loans and advances (including mortgage loans) and purchase of relatively medium to long—term securities.

We envisage a high rate of default on most loan facilities and a high incidence of foreclosures within the next three months at current interest rates. This could lead to a general crash in the property market where, we believe, properties have been over-valued for some time due to what may be termed “irrational exuberance” driven by low interest rates and a relaxation of mortgage lending policies powered by the desire of banking institutions to get a bigger share of the residential mortgage market. Now the chickens may be coming home to roost! Repossessions and foreclosures may become the order of the day, unleashing untold financial misery to affected families. Not to speak of the potential for court proceedings upon default on other credit facilities as pressure on incomes continues to build with the ever-rising cost of living!

All-in-all, it is incumbent that the Reserve Bank seriously ensures that the financial market remains stable and they have done a sterling job so far. However, other financial market players need to take collective responsibility to ensure that the situation does not get out of hand, failing which the central bank authorities must crack the whip to bring matters under control in the face of the need for prudential control and monetary policy implementation.

The global financial crisis that begun in 2007 has taken time to stabilize but, through collective efforts, some progress has been made towards taming the beast. Malawi needs firm and responsible individuals and financial institutions to help the country to weather our economic storm. Proper handling of the current liquidity crisis and rising interest rates is part and parcel of that responsibility before consumer rights groups, civil society and people mobilise themselves in protests as recently happened in the US and some European countries.

The recent interest-rate scandal that has severely dented the credibility that underpins bank lending, damaged the reputation of Barclays Bank and led to the resignation of some of its key senior executives is also a good lesson for bankers around the world to avoid two of the seven deadly sins: greed and gluttony. Given the substantive profits posted by financial institutions over the years and to contradict the 1987 classic “Wall Street” movie’s protagonist Gordon Gekko’s iconic statement, my advice to banks in Malawi is: “Greed is NOT Good!”

 

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