Over the past year, the banking industry in Ghana has been in the news for wrong reasons. The central bank has intervened in the operations of three local banks and in the process announced a new minimum paid-up capital of Ghs 400m. A group of indigenous banks have had to petition the President Nana Akufo-Addo to intervene for an extension of the deadline set by the central bank to raise the new minimum paid-up capital. Amidst all these, the central bank has a new model for the computation of bank base rates.

The President recently at the opening of the new head office building of Ecobank Ghana called on banks to reduce the interest rates at which they lend to the public especially businesses. Similar calls have been made in the past by various stakeholders of the banking industry including the Association of Ghana Industries (AGI). The high cost of credit has been one of the key factors that inhibit the growth of businesses in Ghana. It has featured in the AGI’s quarterly Business Barometer Report for many years.

Calls to reduce bank lending rates are usually strong and visible when indicative market rates like the central bank’s policy rate and Treasury bill (TBill) rates drop significantly over a period. Bank lending rates are expected to follow the trends of these market rates but in Ghana, it doesn't happen much or even if it does, it is remarkably slow. Between April 2016 and March 2018 TBill rates have dropped from about 23% to about 13%. In the same period, the Bank of Ghana (BoG) has dropped its monetary policy rate (MPR) from 26% to 18%. Average lending rates of banks have however stayed within the range of 30 to 34% over the same period, essentially oscillating within this range. Any central bank who runs an inflation targeting regime should be worried about this interest rate transmission mechanism which is practically non-existent or at best dysfunctional.

In an inflation targeting regime, the central bank through its Monetary Policy Committee(MPC) sets and announces its prime rate (currently referred to in Ghana as the “Monetary Policy Rate) which in turn should affect money market rates and general lending rates of banks in the country. Meanwhile, these policy actions and announcements affect expectations about the future course of the economy and the confidence with which these expectations are held also affects asset prices and exchange rate. These changes, in turn, affect the spending, savings and investment behaviours of individuals and firms in the economy which translates into aggregate demand and domestic inflationary pressures. Ideally, this is how the central bank controls inflation in the market under an inflation targeting regime.

Bank lending rates, therefore, play an important role in the monetary policy transmission mechanism relative to the speed and the extent to which banks adjust their lending rates to general interest rates movement in the money market. The BoG, therefore, decided to take initiatives to improve this mechanism by regulating how banks determine their internal lending base rates. The BoG in consultation with the Ghana Banking Association (GBA) constituted a Working group that developed a Base Rate Model to be used by banks to determine their internal base rates. The model first came into effect on April 2^nd, 2012 and a revised version replaced the first model on July 2^nd, 2013. Hitherto every bank had their own mechanism for determining what their base rates were and how often they made changes to it. Under the then new regime, banks were required to use a standardized model that incorporated market rates like the Policy rate and TBill rates in addition to bank-specific factors like operating expenses, total assets, weighted average cost of funds and return on equity.

The consequence of this new model then was that while the “big banks” had their base rates reducing from an average of 28% to the range of 18% to 20%, that of the relatively smaller banks had theirs around the prevailing average of 28%. This was largely because of differences in bank-specific factors for the different tiers of banks that were required in the model. Banks continued to lend at the existing lending rates of 30-34% despite the significant decrease in their base rates this time at margins of 10 – 14 %. Some banks moved away from the base plus margin regime that prevailed to a simple straightforward lending rate with no breakdown of its composition. Justifying the astronomical margins for big banks was simply untenable but they did anyway. The new regime required that banks report the computation of their base rate monthly to the central bank and publish new base rates every time there was a 50 basis point difference between current advertised rates and new rates.

Question is what happens to existing loan facilities with floating rates when a bank announces a new base rate lower than the base rate on which the loan facility was granted? Rates on these facilities should drop by the base rate decreases announced by the bank but, this does not happen. A floating rate facility hardly ever sees such adjustments when base rates of banks drop. The initial motivation to have changes in market rates transmitted to lending rates and ultimately to aggregate demand and inflation through a standardized unified base rate model failed.

In response to this the BoG again in consultation with the GBA reconstituted the Base Rate Working Group to come up with a more suitable model based purely on market rates. This came into effect April 4^th, 2018 after it was postponed from its originally scheduled date in September 2017. The key objective of the new framework is to move towards a more market-based model of setting base rates for lending. The new model has only three factors which are all market-based rates; Monetary Policy Rate (MPR), Interbank rates(IBR) and 90-day TBill rate(TBR). These rates are weighted 40% for MPR, 20% for IBR and 40% for the TBR to arrive at what the BoG calls the Ghana Reference Rate (GRR). Just a little note, the TBR is adjusted with the BoG cash reserve requirement and the Cash-in-vault ratio.

What makes this model and its directive different from the first model and what will make it successful is the question of interest of this article. I highlight a few key things that have changed in the latest framework:

- The GRR will be computed and published by the BoG every month in consultation with the GBA and it will be one single rate for all banks.

- Unlike the previous model where the base rate was the minimum lending rates for banks, the GRR is only a reference rate and banks are required to either add or subtract a risk premium which is their assessment of customer specific risk. What this means is banks can lend below the GRR if they find it commercially prudent to do so.

- Banks are required to reset the rates on their flexible or floating rate loans after each month’s publication of the GRR. This, of course, applies to only facilities advanced with the GRR as its reference rate and will not apply to legacy loans. What this means is that in any month where there is a significant change in any of the market rates used in arriving at the GRR, the GRR will be affected and existing facilities that have the GRR as the reference rate will be impacted immediately the following month.

- Banks are also required to disclose to its customers in a facility letter the fees and charges, the size of the spread around the GRR and the factors responsible for the spread. This means right at the beginning of a facility, a customer should know what margin has been put on his/her facility and what drives that spread. The spread from my understating should not change during the duration of the facility and only changes in the GRR should drive changes in the interest rates on the facility. And of course, this applies to only flexible or floating rate facilities. Most facilities in the Ghanaian Banking sector fall into this category I must add.

Finally, each bank is required to report monthly the components/parameters of the risk premium (in this case the spread or margin) charged to its categories of customers to the BoG. This requirement should make it difficult for banks to vary their margins on facilities arbitrarily and at will. What banks have done in the past is to increase their margins when base rates decline to keep their overall lending rates at the same level. The transmission effects of changes in the indicative rates on lending rates are lost when this happens.

- This new framework is interesting and promises to shake up the industry with respect to lending rates. But like any other thing in Ghana, it can fail and not have the desired effects if not vigorously and effectively implemented by the regulator. I highlight a few points that could be challenging which require the BoG to have strict implementation guidelines around lest this becomes another policy with no significant results.

- How will the BoG ensure that banks do not reset their margins on existing facilities when the GRR drops to keep lending rates on their existing portfolio at the same levels? This is what happened in the past but then there was no requirement to keep margins the same for the entire duration of any facility. Without this, changes in the GRR will have no impact on market rates and this new framework will fail.

- How does the BoG expect banks to report monthly the composition of the margins on their facilities for the different categories of customers? Remember even within the same category of customers, different customers may have different rates based on customer specific factors. With this challenge will the banks be allowed to report the components of the spread in ranges? Example for private banking customers a bank can report the following as the components of their spread; Liquidity risk (2-4%), Default risk (2- 5%) and counterparty risk (1-2%).If this is allowed how will the BoG ensure that this is not abused by the banks as they can set wide ranges that allow them to adjust the lending rates when the GRR drops.

- Finally, customers need to be vigilant and insist on facility letters that have details of the margins/spread clearly explained. Unfortunately, the BoG has been cagey on this new framework with the first announcement. How will customers insist on these rights if they are unaware of this directive? Public education on the new framework should be enhanced and I dare say the whole framework should be made public to enhance transparency.

I really hope this new model achieves its intentions and I will be monitoring its effects 6 months after its implementation. For once, let’s see something through.

The author is a PhD researcher, Financial Analyst, Project Management Specialist and a former banker.