The interest rate at which commercial banks borrow money from each other to manage liquidity has been going up over the weeks, raising hopes of a hike in interest rates on deposits in the coming days.

The interbank rate of commercial banks, which stood at less than 1 percent for a long time, currently hovers around 2 percent, marking a correction that bankers say was long overdue.

“It is not known what is exactly pushing up interbank rates, but the interest rate corridor launched by Nepal Rastra Bank (NRB) a month ago has played a positive role in correcting these rates,” Sanima Bank CEO Bhuvan Kumar Dahal told the Post.

NRB, the central monetary authority, launched the corridor on August 10 to bring short-term market rates within a band and reduce interest rate volatility.

At the time when the corridor was launched, the weighted average interbank rate hovered around 0.4 percent.

The rate, however, stood at less than 1 percent for a week after the launch of the corridor before shooting up to 2.3 percent. Since then, rates have not fallen below 1.6 percent.

“If this trend continues, deposit rates may gradually go up because higher interbank rates indicate banks are in need of fresh deposits,” Dahal said. “So, when demand for deposits goes up, deposit rates also go up.”

Depositors who park their hard-earned money in banks have always complained about low deposit rates. Currently, a one-year fixed deposit generates a return of around 6 percent while the average savings deposit rate stands at less than 3 percent.

At this rate, depositors are not getting any return in real terms by depositing money in banks as inflation currently stands at around 10 percent, which means the value of money is eroding by 10 percent annually.

Bankers have long been saying that inflation must be contained and excess liquidity mopped up from the banking system in order to give real benefits to depositors.

NRB has absorbed Rs50.6 billion from the banking system using different tools since the introduction of the interest rate corridor.

“If NRB continues to mop up excess liquidity in large volumes, interbank rates will keep on going up, which will raise deposit rates as well,” said Dahal.

How does interest rate corridor function?

The interest rate corridor uses three different rates. The first is the standing liquidity facility (SLF) rate.

Using this rate, NRB injects liquidity into the banking sector whenever there is a shortage of funds. This rate has been fixed at 7 percent, and it forms the upper bound, or ceiling, of the corridor.

The second rate used in the corridor is the repo, or policy, rate. NRB uses this rate to inject liquidity into the market for a period of two weeks. This rate floats in the middle of the corridor. It is fixed by adding 200 basis points, or 2 percentage points, to the weighted average interbank rate of commercial banks of two working days ago.

The third rate used in the corridor is the two-week term deposit rate. This rate is used to absorb excess liquidity from the banking sector. This rate forms the lower bound, or floor, of the corridor. It is fixed by deducting 10 basis points, or 0.10 percentage point, from the weighted average interbank rate of commercial banks of two working days ago.

When the corridor was first introduced, the ceiling rate stood at 7 percent, the repo rate, which floats in the middle of the corridor, stood at 2.4 percent, while the floor rate stood at 0.3 percent. This meant the interest spread in the corridor stood at 6.7 percent, which was pretty wide.

This allowed interest rates to fluctuate between 7 percent and 0.3 percent, signaling high volatility in interest rates.

But as interbank rates are going up, the interest spread in the corridor is gradually narrowing, signaling a reduction in volatility in interest rates.