000069202 INTEREST RATE REGULATION AND DEREGULATION: THEORETICAL FRAMEWORK AND CASE STUDY "The effect of deposit ceilings on Vietnam Banking System" QUY ĐỊNH VÀ BÃO BỎ QUY ĐỊNH VỀ LÃI SUẤT: KHUNG LÝ THUYẾT VÀ NGHIÊN CỨU TRƯỜNG HỢP "Ảnh hưởng của trần tiền gửi đến hệ thống ngân hàng Việt Nam"
Problem statement
During the centrally planned era in Vietnam, the government heavily intervened in the financial sector, and this financial repression, along with other factors, drove high inflation and suppressed savings, investment, and growth from 1986 to 1988 Reforms accelerated in 1989, touching all sectors of the economy, with financial liberalization placed at the core Interest rates were gradually brought toward free-market levels, and the rise in real interest rates helped curb inflation while boosting both the quantity and quality of savings and investment After 25 years of reform, Vietnam has moved from a poor country with a per-capita income of about $180 and hyperinflation above 700% to the threshold of becoming an emerging economy.
Vietnam's domestic economy has been growing too fast—real output growth exceeding its potential—while the global financial crisis and the 2008-2009 recession have amplified macroeconomic instability, including high inflation, trade deficits, and rising public debt To curb inflationary pressures in 2008, the State Bank of Vietnam (SBV) re-imposed interest rate ceilings as part of a broader set of banking regulations Because the banking sector is central to the economy, the government believed that tighter controls in this sector would help correct recent macroeconomic imbalances and stabilize growth.
Since 2008, deposit rate ceilings and lending rate ceilings have been used as administrative tools to regulate interest rates In practice, fluctuations and tensions in the money market have at times limited credit access and altered financing decisions, affecting the operations of enterprises and the finances and sentiment of households Most recently, in the broader context of the global economy, these rate caps continue to shape monetary policy transmission and market expectations.
In 2011, Vietnam faced slow growth, economic imbalances, and recurring instability that produced stagnation alongside high inflation in the economy A capital shortage intensified the competition among commercial banks to mobilize deposits, sparking an interest-rate race that destabilized the banking system Early in 2011, the State Bank of Vietnam (SBV) imposed deposit rate ceilings to curb this volatility and restore balance to Vietnam’s financial sector.
Although the State Bank of Vietnam (SBV) had issued clarifications on its policy, early 2012 saw renewed debates over the country’s interest-rate regulation Opinions differed on the effectiveness of the deposit-ceiling regime amid a temporary easing of inflation, raising questions about whether to abolish deposit-rate ceilings and fully liberalize rates, or to enforce lending-rate ceilings as an alternative constraint The most urgent issue is the potential negative impact of removing deposit-rate ceilings on banking-system stability, which underscores the need for a comprehensive evaluation of how interest-rate regulation affects Vietnam’s banking sector.
Research objective
Banks are among the most heavily regulated sectors because they provide the finance that keeps the economy moving In Vietnam, government involvement in financial markets led to the 2011 introduction of deposit rate ceilings The regulation aimed to protect the banking system's soundness by preventing excessive competition for deposits among commercial banks and to manage credit and monetary aggregates, thereby shaping aggregate demand and supporting economic growth.
It is o f great importance to examining intended and unintended effects o f this
This thesis critically examines all major theories on interest rate regulation and deregulation, using regulatory clarity as a criterion to judge policy It aims to establish a theoretical framework for and against administrative interest rate controls and to develop a theoretical analysis of the important issues affecting Vietnam's banking system, which is the centerpiece of the study The central question it seeks to answer is whether interest rate deregulation is worthwhile for Vietnam's banking sector.
From the perspective of finance and banking research, this work examines Vietnam's government's re-imposed ceilings on what banks can pay depositors and their impact on the banking system It empirically tests the relationship between deposit rates and bank risk in the Vietnamese context, analyzes the effectiveness of the deposit-ceiling policy in preventing excessive competition for deposits among commercial banks, and evaluates its implications for monetary policy The study offers policy recommendations to support the effective operation of both regulatory and deregulatory measures within Vietnam's banking system.
Specifically, the sub questions are as follows:
1 What are the theories concerning interest rate regulation and deregulation?
2 What are the effects o f deposit rate ceilings on Vietnam Banking System?
- What are effects o f deposit rate ceilings on bank risk?
- What are effects o f deposit rate ceilings on bank competition?
- Does the ceiling imposition affect the efficacy o f monetary policy transmission?
3 What are the policy implications fo r Vietnam in terms o f interest rate direct control, given the current economic context?
Research significance
In most developing economies, including Vietnam, economic policy decisions are predominantly based on untested theories, rules of thumb, and hunches It is widely recognized that these theories cannot be transplanted wholesale to different settings Their applicability depends on a host of local factors, including institutions, governance structures, and the specific economic and social environment.
Chapter One introduces the key factors shaping economic outcomes, including the level of economic development, the state of political advancement, and the attitudes and value systems of the people involved It also suggests that findings from empirical studies may prompt reforms of established theories to better explain the economic phenomena observed in these nations.
Amid the pervasive influence of macroeconomic structural adjustment on Vietnam’s economy, especially its impact on the financial sector and interest rate regulation that drives the growth engine, there is an urgent need to study how the banking system responds to regulation and deregulation Such research can reveal the key determinants of successful implementation of financial adjustment policies in Vietnam, guiding policymakers and financial institutions to optimize credit flows, risk management, and long-term economic growth.
M ethodology
Sources o f in fo rm a tio n
Secondary and tertiary data were collected from diverse sources to support this study, including policy statements, official and unofficial reports, and a range of comments and figures drawn from published studies in the field, along with material from newspapers and scientific journals.
The research methods in the study use econometric techniques and hypothesis testing combined w ith descriptive analysis, historical trends and statistical analysis.
Organization o f the thesis
This research w ork comprises five chapters.
This study opens with Chapter One, which introduces the research aim and sets the context for analyzing how interest rate regulation affects the Vietnamese banking sector; Chapter Two develops the theoretical framework, reviewing the literature both supporting and opposing interest rate regulation to frame the debate; Chapter Three provides a Vietnam case study that outlines the institutional background and examines the impact of deposit rate ceilings on the banking system, while deriving research questions from existing literature and the current environment and proposing methods to answer them; Chapter Four concludes by summarizing the main findings and presenting policy implications for interest rate regulation in Vietnam.
Interest-rate policy plays a central role in shaping economic growth, so any decision to regulate or deregulate rates must consider its effects on development This chapter recaps the theoretical foundations of interest-rate policy within the economy's growth trajectory and examines how different models explain the trade-offs between keeping rates tight or accommodating them In particular, it contrasts two broad strands of thought—Keynes-Tobin-type analyses and other macroeconomic frameworks—and explains how each approach assesses the impact of rate controls on investment, employment, and long-run growth By integrating these perspectives, the chapter clarifies the rationale behind government choices on regulating or deregulating interest rates and outlines the policy implications for sustained economic expansion.
Stiglitz, along with the Goldsmith–McKinnon–Shaw framework, provides the background, rationale, and intellectual justification for financial liberalization and financial repression, with interest-rate policy as a central instrument (Fry, 1995) To complete the broader picture of the case study, the final section of this chapter reviews the literature on the impact of deposit ceilings on the banking system.
Conceptual fram ework
Interest rate controls
Caprio and Hanson (1999) argue that the modern history of interest rate control reflects the rise and fall of government interventionism in the mid-20th century, even as interest rate ceilings had long been a constant feature of many legal systems These ceilings come in two primary forms: deposit ceilings and loan ceilings, which regulate the rates paid on deposits and charged on loans Framing the issue this way helps explain how historical patterns of financial regulation have shaped borrowing costs, saving behavior, and the broader dynamics of financial markets.
Deposit ceilings set maximum rates on the interest banks and other financial intermediaries can offer on deposits The rationale behind these ceilings was to prevent ruinous competition among banks and to help curb inflation However, these ceilings were often set so low that banks could still earn a comfortable profit margin, provided entry remained restricted and deposit substitutes could be effectively outlawed, a point that will be discussed further below.
Besides, many countries still retain, as a measure of consumer protection, a fairly high overall ceiling on lending rates These loan ceilings remain of practical importance, especially—though not only—where high inflation has left the legal rates out of sync with market realities Although the modern purpose of these laws is consumer protection, they can, in practice, preclude viable and socially beneficial lending.
C hapter Two: Theoretical Framework advantageous money-lending activities, especially among the poor is much debated.
From the 1960s through the 1970s, many countries imposed fixed ceilings on bank lending rates or on the spreads above deposits, with variations by loan maturity, borrower activity, and sometimes by named borrowers When ceilings were too low, lending in those categories could dry up or be limited to the most creditworthy borrowers To mitigate this, regulators often mandated that banks allocate a share of their resources to targeted sectors or purposes at regulated rates, sometimes requiring zero-interest deposits at the central bank and instituting special lending quotas to government or government agencies or for long-term loans This framework, rooted in monetary policy, aimed to control credit expansion while directing funds to priority areas, albeit with the risk of reduced overall credit availability for riskier borrowers.
Financial repression
Financial repression, by-now a classic phrase, originated in the works o f
McKinnon and Shaw, in the early 1970s, described a developing-country financial system that is repressed through a series of government interventions designed to keep interest rates offered to savers very low, often negative in real terms This conception of financial repression, later attributed by Agenor and Montiel (1996), identifies the common instruments as interest-rate regulations, directed credit schemes, and high reserve ratios, which together curb financial intermediation and constrain the profitability of domestic banks.
Financial repression is primarily a fiscal instrument: governments aim to promote development but often lack the resources to finance it By mandating large liquidity and reserve requirements, the state creates a captive demand for its own instruments—whether they bear interest or not—and uses that demand to fund its priority spending Setting ceilings on interest rates generates excess credit demand and directs lending toward priority sectors In addition, limiting the range of financial instruments available to the public, such as restricting foreign exchange deposits, further channels funds into government-driven financing.
N g o T h i N g o e V in h - Y 2 0 1 2 P a g e 7 order to ensure greater '\seitằniorage'' revenue or inflation tax (government revenue arising from the issuing o f paper money).
Financial liberalization
Financial liberalization is the process o f breaking away from a state o f financial repression As financial repression has been most commonly associated w ith government fixing o f interest rates and its adverse consequences on the financial sector as w ell as on the economy，financial liberalization, in turn，has come to be most commonly associated w ith freeing o f interest rates This is pretty much the old view We now understand financial liberalization as a process involving a much broader set o f measures geared toward the elim ination o f various restrictions on the financial sector, such as the removal o f portfolio restrictions on the banking sector, the reform o f the external sector, as w ell as changes in the institutional framework o f monetary policy Over all then, given the important role played by interest rates, removal o f controls over interest rates has become centerpiece o f the liberalization process.
Central role o f interest changes
Other financial prices are also affected by liberalization, but interest rates retain a central importance for tw o reasons First, borrowing contracts that specify a fixed repayment (and thus an explicit interest rate) are by far the dominant form o f financial contract for the good reason that (in contrast to an equity or profit- sharing arrangement) they make it unnecessary for the lender to verify the borrower’s eventual ability to repay; the fact o f repayment triggers a transfer o f control to the lender It is probably fo r the same reason that the size o f the other financial contracts that we observe can be interpreted as bundles o f interest- bearing debt defined as payable under verifiable contingencies: they are derivatives o f interest-bearing debt To be sure, equity and its derivatives are also quantitatively important: but for these the return does depend on performance o f the funded entity, and thus the equity contract places a heavier verification burden on the provider o f ftinds Because o f the dominance o f interest rates as prices in financial contracts, a change in their level has considerable distributional effects, as well as altering access to funds.
When interest rates are liberalized, adjusting along the old supply‑of‑funds curve to intersect with the previous demand curve is no longer sufficient The regime change brings new risks that must be priced into both supply and demand behavior As a result, new demand and supply curves come into play, and these curves are exposed to new sources of volatility.
Interest rates are determined in financial markets where information asymmetry, differing expectations, and varying opportunities among participants shape outcomes In these markets, participant behavior diverges from conventional markets, and the effects of financial liberalization are less clear-cut A well-understood phenomenon is that higher interest rates do not simply lower the quantity of funds demanded; they can also deter lower-risk borrowers When lenders cannot reliably distinguish high- from low-risk applicants, a market-clearing equilibrium may fail to emerge, leading to persistent credit rationing of small enterprises that are ready to pay higher rates but cannot obtain funds because of adverse selection.
Managers of financial intermediaries may bid up deposit interest rates to finance risky, potentially high‑yield projects, a practice that can come at the expense of depositors, public insurers, or outside shareholders This funding approach has been linked to the financial fragility observed in recent years.
Theories related to interest rate c o n tro l
Regulation hypotheses
Financial repression is the policy mix of indiscriminate nominal interest rate ceilings and high, accelerating inflation It stems from the Keynesian-Tobin-Stiglitz school of thought (Fry, 1995) This group, also called Structuralist and Neostructuralists, has advanced several rationales to justify some form of financial repression, which recommends administrative restrictions on interest rates.
Keynes (1936) stresses careful financial management to keep economic activity running smoothly He introduces the liquidity trap, a situation where a floor on the nominal interest rate is set too high to spur full-employment investment When the trap binds, the real interest rate is higher than the equilibrium rate compatible with full employment, and planned savings exceed planned investments This disequilibrium is resolved by a fall in real income, which reduces planned savings Historically, Keynes observes that the real interest rate at the full-employment equilibrium tends to be lower than the rate generated by liquidity preference.
Keynes’s liquidity trap reflects the view that individuals fixate on a normal level of interest rates If rates rise above this level, people expect them to fall back to the normal level, making higher rates seem temporary Conversely, rates below the normal level imply larger capital losses on existing investments, so holding money becomes more attractive than funding productive capital This increases liquidity preferences and helps explain the occurrence of inadequate investment levels, which the simple Keynesian model resolved through reducing income.
An alternative to a fall in income is for authorities to impose an interest-rate ceiling while maintaining fixed price levels With a fixed price level, expectations about future prices become anchored, enabling expansionary monetary policy to lower interest rates and stimulate investment while also accommodating the rise in liquidity preference Yet a major objection to this approach is the inflationary consequences of monetary expansions on macroeconomic stability.
2.2.1.2 Tobin ys portfolio allocation model
Another rationale for financial repression rests on Tobin's monetary growth framework, which posits near-perfect substitutability between money and productive capital By suppressing the demand for money and channeling funds into productive capital, financial repression raises the capital–labor ratio and promotes more rapid economic growth (Tobin, 1965).
Tobin’s money-and-growth framework explains how wealth is allocated between money and productive capital across the entire economy—households and the private sector The opportunity cost of holding money is the foregone return on productive capital The model’s dynamics are driven by rising capital returns that come with a higher capital–labor ratio, increased labor productivity, and, consequently, higher per‑capita income (Fry, 1997).
A transition from low to high capital-to-labor ratios as the relative yield on money falls would accelerate the real rate of economic growth The rationale is that reducing the return on money increases welfare, which can be achieved by lowering deposit rates of interest or taxing money, or alternatively by accelerating the growth rate of the money stock, thereby raising the inflation rate.
Keynes and Tobin share the objective of economic growth driven by monetary expansion, but their rationales diverge Keynes argues for government intervention to channel investment, while Tobin emphasizes policy that shapes credit flows In Keynes's view, interest rate ceilings could help create economic equilibrium, yet this approach centers on directing banking credit to specific productive industries and may overlook the broader macroeconomic stability and the resilience of the financial sector to distortions.
Tobin advocates monetary expansion and an inflation tax as a means to finance growth, a framework that tends to discourage households' monetary holdings and redirect savings toward productive capital Yet his analysis relies on a narrow definition of money, which skews the results and overlooks important factors such as inflation hedges and government-backed loans.
In the 1980s, financial liberalization became a broadly accepted policy prescription, yet banking crises and the policy implications fueled a critical debate The Neostructuralist school, traced in the writings of Taylor (1983), Van Wijnbergen (1982, 1983, 1985), Buffie (1984), Kohsaka (1984), and Lim (1987), emerged as a major critique of the financial deregulation model.
Taylor (1983) and Van Wijnbergen (1982, 1983a, b) argue that developing economies feature unorganized money markets (UMM)—an informal credit sector that escapes the central bank–controlled formal financial system In neostructuralist models, the UMM and the related curb market crucially influence whether financial liberalization accelerates growth When a higher real deposit rate shifts assets from the UMM to the formal credit market, reserve requirements can reduce financial intermediation because the UMM lacks such requirements The degree of this contraction depends on how much assets are diverted from inflation hedges or from the curb market A second argument is that cost-push inflation arising from higher interest rates may shrink effective demand; even if intermediation does not contract, the tendency to save more can further weaken effective demand, making stagflation the more probable outcome of financial liberalization in developing economies.
Following Kohsaka (1984), the pivotal point is that curb market assets and bank deposits are closer substitutes than unproductive assets and deposits, and this closeness is what drives the argument By contrast, in Van Wijenberg (1982, 1983) and Lim (1987) there is a notable demand-side effect in addition to the supply-side channel In those studies the UMM rate is tied not only to aggregate supply but also to aggregate demand through its impact on investment demand for fixed capital (not merely for working capital) As the UMM rate rises, both the AS and AD curves shift.
Across different model formulations, the term "unproductive assets" can cover various asset types Van Wijnbergen (1983) and Kohsaka (1984) identify unproductive assets with currency holdings; Buffie (1984) and Lim (1987) define unproductive assets as both domestic and foreign currency; and Taylor (1983) includes land and real estate in the "unproductive savings" category While these definitional differences can influence how each model is framed, they do not alter the core results discussed above.
Chapter Two presents the theoretical framework, where the adverse effects on output growth are unambiguous The impact on inflation, however, depends on how the two curves—the aggregate supply (AS) and aggregate demand (AD) curves—shift Consistent with the neostructuralist tradition, both camps anticipate that the AS-curve shift is more pronounced, which implies that inflation will rise over time.
Neostructuralist arguments indicate that financial liberalization in less developed countries can lead to stagflation if money-market securities are closer substitutes for deposits than for unproductive assets, and if the AS curve shifts left more than the AD curve In such a setting, with efficient curb markets, removing interest-rate restraints tends to discourage lending to the private sector, thereby hampering financial development.
Deregulation hypotheses
The financial repression view is opposed by Goldsm ith-M cKinnon-Shaw school o f thought (Fry, 1995) From the earlier works o f Goldsmith (1969), M cKinnon
(1973) and Shaw (1973) to recent studies, the benefits o f financial liberalization have been emphasized.
During the 1960s, early researchers such as Gerschenkron (1962), Patrick (1966), and, most prominently, Goldsmith (1969), used crude econometric methods and case studies to explore the finance–growth nexus Eschenbach (2004) notes that these works stressed the propulsive role of the financial sector in economic development Goldsmith (1969) contends that the positive effect of financial intermediation on growth may stem from increases in both the efficiency and the volume of investment, though he assigns a lesser weight to the latter factor.
This analysis underlines the crucial role of financial institutions and financial deepening in improving credit allocation by unifying fragmented capital markets in less-developed economies and reducing uncertainty about future returns on both real and financial assets Strengthening financial intermediation channels savings into productive investments and lowers risk premiums in asset pricing within emerging markets While early studies laid the groundwork, they also hint at the transformative potential of a more integrated and stable financial system for growth in developing economies.
Stiglitz proposes a set of policies called “financial restraint,” which is distinct from financial repression The core distinction is that financial restraint uses interest rate controls to improve the efficiency of private financial markets, whereas financial repression relies on interest rates as a mechanism for the government to extract rents from the private sector This framing helps clarify when rate interventions enhance market performance versus when they enable fiscal extraction, guiding reforms that aim to support sustainable financial development.
N g o T h i N g o e V in h - Y 2 이 2 P a g e 15 provide a strong enough theoretical fundament they arises the debate regarding the relationship between financial liberalization in general and interest rate in particular and economic growth.
McKinnon and Shaw's 1973 framework contrasts growth-enhancing financial liberalization with financial repression, challenging the dominant Keynesian and Tobin-inspired views They argue that government restrictions on financial systems—such as interest rate ceilings, directed credit programs, reserve requirements, and liquidity rules—may reduce both the quantity and quality of investment by impeding financial development By focusing on interest rate controls, they show how ceilings distort incentives: entrepreneurs may shy away from high-risk, high-yield projects; financial intermediaries become more risk-averse and favor established borrowers; and borrowers who access cheap funds may invest mainly in capital-intensive ventures Consequently, they advocate liberalizing finance by abolishing nominal interest rate controls and letting markets determine credit allocation, with the aim of deepening the financial system and reducing inflation.
Eschenbach (2004) summarizes McKinnon-Shaw's inside money model, which involves financial intermediaries, savers and investors, and treats private-sector loans as backed by the private sector's own debt In this framework the nominal interest rate is fixed, leaving the real rate below its equilibrium level Saving is a positive function and investment a negative function of the real interest rate When the real rate falls—whether because inflation accelerates or because the fixed nominal rate is reduced—saving declines If inflation is hedged by land ownership, the lower real rate also stimulates land demand, since deposits become less attractive The resulting shift of savings from bank deposits to land ownership pushes up land prices.
Chapter Two develops a theoretical framework in which the induced wealth effect raises consumption and, accordingly, lowers investment Under financial repression with a nominal interest rate fixed below the market-clearing level, two scenarios can arise: if only the deposit rate is fixed, a large spread between lending and deposit rates will result; with ceilings on both loan and deposit rates—more realistic for developing countries—nonprice rationing of funds must take place Credit allocation is determined by factors such as transaction costs, perceived default risk, collateral quality, political influence, reputation, loan size, and covert benefits to loan officers rather than by expected investment productivity The average efficiency of investment falls because investments with lower returns become profitable when the loan rate ceiling is set at a sufficiently low level Adverse selection occurs as entrepreneurs who would not have sought credit before the ceiling enter the market Banks’ risk-taking behavior is negatively affected because risk premia cannot be charged, and credit allocation becomes at least partly random, another distortion The policy prescription proposed by McKinnon–Shaw is to abolish institutional constraints on nominal interest rates and to reduce inflation.
Although McKinnon and Shaw essentially reach the same conclusions, their theoretical approaches differ McKinnon’s 1973 model rests on two core assumptions: first, investment is self-financed because capital markets in developing countries are imperfect, which means economic agents must accumulate real cash balances before undertaking investment; second, investment expenditure is indivisible He treats savers (households) and firms (investors) as not distinct, implying an intertemporal complementarity between deposits and physical capital Because investors cannot borrow to finance investment, McKinnon’s model is often interpreted as an outside money model.
According to Gurley & Shaw (1960, p 73), outside money is backed by government securities, and a change in its real value as the price level rises signals a shift in private wealth in favor of the government Inside money, by contrast, is money issued on the basis of private bonds purchased by the government.
Shaw (1973) shows that complementarity is unnecessary because investors are not confined to self-financing; he advances an explicit inside-money approach The debt-intermediation view he presents emphasizes the important role of financial deregulation in increasing financial deepening in developing countries Financial intermediaries sustain deposit growth by delivering higher real returns to savers, thereby expanding their lending potential At the same time, they lower real costs to investors through risk diversification, economies of scale in lending, improved operational efficiency, lower information costs to savers and investors, and by accommodating liquidity preferences.
McKinnon’s complementarity hypothesis and Shaw’s debt-intermediation view do not necessarily contradict each other, since investment can be financed through both external and internal channels McKinnon’s theory emphasizes developing countries with underdeveloped financial markets, while Shaw’s analysis focuses on more advanced economies that boast sophisticated financial systems Taken together, these perspectives imply that the mix of external and internal financing for investment depends on a country’s level of financial development, with investment outcomes reflecting different funding sources across stages of development.
Following the McKinnon-Shaw debate, several studies have extended the original framework in targeted ways Kapur (1976), Galbis (1977), Mathieson (1980), and Fry (1980) develop formal macroeconomic models in which financial repression is achieved by fixing the deposit rate below its market-clearing value, rather than the loan rate In these models, money demand depends on the fixed nominal rate and on inflation, with accelerating inflation reducing real money demand As a result, banks’ real liabilities contract, followed by a contraction in assets and a reduced supply of credit for investment Using portfolio terminology, inflation lowers growth because households shift into unproductive inflation hedges instead of financing productive investment via deposits.
Kapur and Mathieson describe a form of financial repression in which reserve requirements can cap deposit rates even when policy interest rates face no ceilings With zero inflation, a fixed required reserve ratio imposes a ceiling on the deposit rate; as inflation rises, the wedge between loan rates and deposit rates widens, intensifying the effect The policy implication is that lowering reserve requirements at a given inflation rate expands the banking system’s scope for credit intermediation.
Chapter Two: Theoretical Framework of Lending Activities A lower reserve requirement raises the ceiling on the deposit rate at any given loan rate, boosting the demand for deposits and expanding the financial sector Within the Kapur–Mathieson framework, there is a developing economy with a labor surplus, where the financial sector affects only the quantity, not the quality, of investment.
Fry and Galbis extend the framework to show that the real deposit rate of interest can influence the average efficiency of investment In Galbis’s two-sector model, financial repression sustains a traditional sector with a low, constant return to capital and a modern sector with a higher return A low deposit rate promotes self-financed investment in the traditional sector, while a higher deposit rate raises money demand in that sector and enables greater bank-financed investment in the modern sector This shift changes the composition of investment and increases the overall average efficiency of investment In Fry’s model, the deposit rate also affects the level of investment.
King and Levine (1993b) develop a Schumpeterian model of technological progress in which cost-reducing inventions that apply to an intermediate product drive growth They show that financial intermediaries and securities markets enable certain entrepreneurs to undertake innovative activity, thereby boosting growth through productivity enhancements Financial systems influence entrepreneurial activity in four main ways: they evaluate entrepreneurs, pool resources, diversify risk, and value the expected profits from innovative ventures Better financial systems increase the probability of successful innovation, while distortions such as deposit rate ceilings or high reserve requirements tend to reduce the rate of innovation.
Em pirical evidences
Numerous empirical assessments examine the relationship among interest rates, saving, investment, and economic growth, with Appendix A providing an overview of the major findings To date, the evidence suggests that financial liberalization policies yield mixed results and that these effects vary significantly by region, most notably between Asia and Latin America.
The impact o f deposit rate ceiling on banking system
Literature re v ie w
This section analyzes the regulation of deposit interest rates and presents evidence about its impact The principal argument for rate regulation is to curb banks’ bidding for deposits, safeguarding liquidity and solvency, a view that remains widely accepted by bankers and observers Such regulation can boost bank profitability and raise their market values However, price-independent competition—such as branching, free checking, and disintermediation—can lessen the amount of regulatory rents in a competitive economy.
The topic o f interest rate regulation (and deregulation) has been extensively studied in the banking literature One area o f research, for example，is on the economic rents that financial institutions extract from interest rate controls.
4 Eich berger and Harper (1989) develop a model in which two financial firms, a Mbank" and a
"non-bank", compete duopsonistically for deposit balances It is shown first that the imposition o f a deposit interest rate ceiling on the bank can increase its profit
Studies have shown that financial institutions earned substantial economic rents from deposit interest rate restrictions (Hutchison and Pennacchi, 1996; Chan and Khoo 1998) while the removal o f deposit rate ceilings affected the stock returns o f financial institutions negatively (Dann and James, 1982; Kwan, 2003) Another area o f research is on the regulatory dialectics theory, which is about the circumvention o f interest rate regulation through non-price competition and innovations in money market instruments (Eisenbeis, 1985).
Binding ceilings on savings-deposit rates have at least five unintended effects First, they prevent those rates from following open-market rates upward in booms and, by destroying industry patterns of price leadership, make them slow to decline when market rates fall, transmitting procyclical impulses to households who spend more in booms and save more in recessions Second, because securities dealers and brokers impose higher transaction charges on small investments, ceilings that rise above market rates discriminate against small savers, driving substantial savers to move funds into high-yield instruments and back again when rates fall, which hampers low-income households from accumulating the down payment needed for housing Third, the ceilings shift competition among regulated institutions from price to nonprice, less-efficient forms of competition, with banks finding indirect ways to pay the equivalent of interest through premiums, free services, longer hours, and more branches Fourth, resultant waves of disintermediation and reintermediation increase maturity intermediation risks and push depository institutions toward more cautious investment policies Fifth, the interinstitutional differential leaves these institutions vulnerable to regulation-induced innovation, inviting competition from new financial players.
C hapter Two: Theoretical Framework exempt institutions (such as credit unions and money-market mutual funds) and exempt instruments (such as repurchase agreements and participation arrangements).
Deposit-rate ceiling changes warrant careful study, and whether such ceilings affect bank risk remains controversial The traditional view holds that ceilings reduce competition for deposits, lower bank risk, and strengthen bank soundness An opposing view argues that ceilings—especially when market rates are high—induce disintermediation and impose costs on banks A third, indifferent view maintains that ceilings have no material impact on bank risk because banks would be compelled to pay implicit interest rates to bridge the gap between market and ceiling rates These competing claims are discussed in the literature by Benston (1964), Cox (1986), and Klein.
Empirical evidence on deposit-rate ceiling changes and bank risk, drawn from diverse data sets and methodologies, converges on a consistent conclusion: there is no straightforward link between interest-rate competition and bank failures Accounting data studies by Cox (1964, 1967) and Benston (1964) find no relationship between interest-rate competition and bank failures Benston’s analysis supports the profit-maximization hypothesis over the profit-target hypothesis, indicating that bank risk increases under deposit-rate ceilings Additional studies by Mingo (1978) and Koehn and Stangle also corroborate these findings.
By 1980, the literature largely rejects the idea that ceilings reduce bank risk; in fact, Mingo argues that bank risk increases with the existence of interest-rate ceilings Smirlock (1984) employs a variance-partition approach to examine changes in bank systematic and unsystematic risk before and after four ceiling-change announcements, and finds no significant increase in either measure of capital-market risk following the removal of ceilings, leading him to conclude that bank solvency risk will not be increased by the deregulation of deposit interest rates.
In 1987, the author applies the Cox–Benston method with a larger data set and finds a positive correlation between unregulated deposit rates and banking risk He indicates that ceilings could serve as a potential tool to regulate bank risk.
Imposition of deposit rate ceilings creates incentives for banks to attract deposits through inducements in addition to explicit deposit rates When such ceilings are set below the competitive equilibrium level, the marginal value of deposits exceeds their marginal cost, and even a pure monopolist may find it worthwhile to raise costs to attract more deposits In the market for savings deposits this might include greater advertising expenditure, increased branching, and giveaways of gifts and services to depositors Nonrate competition—the financial analogue to nonprice competition—has become an important equilibrating adjustment mechanism in the rate-controlled savings-deposit market.
There is substantial evidence that a total restriction on demand-deposit interest achieves only a partially effective macroeconomic constraint For example, Barro and Santomero (1972), Becker (1975), Keen (1979), Santomero (1979), and Startz (1979) document the limited impact of such prohibitions Heggestad (1976) and Mingo (1977) describe the multiplicity of nonprice devices in banking markets Banks respond by extending hours and offering a range of elaborately, if not subtly, differentiated services to cultivate goodwill.
Startz (1983) models evasion in the banking industry with a simple Chamberlinian monopolistic competition framework that accounts for nonprice competition and yields predictions for market behavior if explicit price competition were allowed He shows that with a binding ceiling on explicit interest, the implicit interest rate remains positive but below the competitive explicit rate; the implicit rate increases with the market rate, but by less than a competitive explicit rate would An increase in the legal ceiling on explicit interest induces a partially offsetting drop in the implicit rate, yet the net effect is an increased total deposit rate A larger number of banks competing in the market raises both the implicit rate and its responsiveness to the market rate Moving from a system with no explicit interest to one in which the market determines deposit rates increases deposit demand, while the magnitude of deposit rate changes remains far smaller than under explicit price competition.
C hapter Two: Theoretical Framework suggested by a simple change fm m a w orld o f no interest to a w orld o f payment determined by perfect competition.
Empirical research on the non-price behavior of commercial banks is relatively scarce Notable contributions grounded in the implicit-interest theory include Startz (1983) and Heffernan (1992) A central question in this literature is whether the two forms of implicit interest should be viewed as complementary or as substitutes, a distinction that shapes how we interpret banks’ non-price behavior and its implications for market outcomes.
Whitesell (1992) argues that interest-rate deregulation will reduce the use of non-price instruments, while both implicit and explicit forms of interest will continue to exist afterward By contrast, Startz (1983) contends that such deregulation would entail the complete elimination of implicit payments UK evidence, reported by Heineman (1992), appears to support Whitesell's view.
Ceilings on bank deposit interest rates were commonplace until recently With the deregulation of financial markets in the 1980s, many controls, including deposit-rate ceilings, were abolished or substantially relaxed As a result, numerous countries relaxed or removed regulations on interest rates to address inefficiencies and resource misallocation caused by non-price competition, disintermediation, and asset-liability mismatches.
Deregulation yields both benefits and costs; as John, Merrick, and Saunders (1985) summarize, depositors gain a wider menu of assets and potentially higher returns on savings, borrowers can search more extensively for the best loan prices and other financial services, and producers of bank products can diversify across geographic and product activities—potentially entering traditional nonbank financial markets in ways that could maximize stockholders' wealth Benston (1983a) adds that efficiency gains come from unbundling bank products and services and from replacing explicit interest rates and fees with pricing that better reflects costs and risks Friedman (1969) and Johnson (1968) note that a banking system in which banks pay a competitive explicit rate on deposits and charge the marginal cost for deposit services is more efficient than one relying on implicit pricing.
Theoretical m odels
In this section, we examine a selected set of models that address different facets of regulatory challenges These models not only illustrate the modeling approaches in use but also provide the theoretical grounding needed to achieve our primary goal: empirically assessing the impact of deposit ceilings on the banking system, with Vietnam serving as the case study in the next section.
In their 2000 theoretical model, Heilman, Murdoch, and Stiglitz show that when the regulatory environment relies solely on capital-adequacy rules and imposes no regulation on interest rates, banks may have an incentive to bid up deposit interest rates to secure funding that enables them to take on higher asset risk.
Banks face a trade-off between investing in prudent assets that offer steady, modest returns and chasing gambling-style assets that can deliver high private returns for the bank if the gamble pays off but impose costs on depositors if it fails When markets are sufficiently competitive, banks earn relatively little from prudent investments, yet they can capture a one-period rent from gambling activities As competition increases, the banking sector tends to favor gambling strategies, shifting incentives toward higher-risk, higher-return bets at the expense of stable, prudent lending.
W ith no deposit rate controls, the bank can freely choose its deposit rates and has
N g o T h i N g o e V i n h - Y 2 0 1 2 P a g e 27 an incentive to deviate by offering a higher interest rate and switching its portfolio to the gambling asset.
According to the Heilman–Murdock–Stiglitz model, banks with lower capitalization are more willing to bid for deposits, while higher interest rates increase the likelihood that a bank will hold riskier assets Figure 1 presents the combinations of deposit interest rate and bank leverage that emerge from this model.
F ig u re 1 H e ilm a n , M u rd o ck , a n d S tig litz m odel
Let k denote the capitalization rate, defined as total equity to total assets r(Jc) is the maximum interest rate that remains consistent with a bank choosing a safe portfolio rp(k) is the equilibrium rate of interest if the risky asset were not available r*(k) is the lowest common rate of interest from which no bank would deviate by bidding up.
Three key curves drive the analysis: the upward-sloping r(k), the downward-sloping rp(k), and a steeper downward-sloping r*(k) The intersection of rp(k) and r*(k)—where rp(k) = r*(k)—defines the minimum capital requirement k* that keeps banks from bidding up interest rates to levels that would push them to invest in the risky asset This k* ensures banks’ funding costs stay aligned with prudent risk-taking and financial stability.
Note that if the corresponding interest rate r is imposed as a ceiling, the same investment decision and deposit interest rate can be achieved with a much lower initial capital level k0 In other words, ceilings on deposit rates can eliminate the need for larger capital to reach the same financial outcome.
C hapter Two: Theoretical Framework gambling equilibrium , by preventing banks from paying more than can be afforded from a safe portfolio.
Spellman (1980) presents a model of commercial-bank costs that splits total costs into two components: non-rate competition associated with the implicit deposit rate and the costs of producing financial intermediary services Under deposit-rate ceilings, banks use non-rate competition to maximize profits, and the optimal profit depends on how sensitive deposits are to the implicit deposit rate.
Regulatory restrictions on entry force banks to operate in an imperfectly competitive deposit market In this environment, banks attract deposits through two channels: an explicit interest rate, r, paid per dollar of deposits, and an implicit rate, i, delivered as financial services or goods As a result, the bank’s deposit demand function is determined by the trade-off between these explicit and implicit payoffs and the cost of attracting funds.
The bank participates in local and national securities markets, where it acts as a price taker The earnings rate on these assets is ra, and the bank's annual revenues amount to r0D.
On the cost side, the bank incurs production costs tied to processing deposits and earning assets, which are modeled by the total production cost function C(D) that depends on the level of deposits D The bank also faces interest costs on deposits since deposits earn an average rate γ, so the annual deposit cost is γD (often denoted rD in analytic work) In addition, non-interest costs arise to attract larger deposit levels, captured by deposit-increasing costs of iD, where i is the annual cost of financial services or goods per deposit dollar It is also possible to view i as the implicit rate at which goods and services are paid to depositors, i.e., the cost of goods and services to the bank represented as monetary transfers to depositors and measured in the same units as the deposit rate.
The objective function o f the bank is assumed to be the maximization o f profit p (assume that asset equal deposit) which from the above assumptions may be written as follows:
During periods when market deposit rates lie above the regulatory ceiling, the firm maximizes profit with respect to the implicit deposit rate i, since i is the only variable it can control Let e denote the constant elasticity of depositors’ response to the implicit rate By applying the first-order condition for profit maximization, Spellman (1980) derives the optimal implicit deposit rate i*, which is determined by the balance between depositor sensitivity and the bank’s profit objectives, yielding an explicit expression for i* (often represented in the literature by a formula such as r).
The level of the implicit deposit rate depends essentially on two terms The term ra − r − dC/dD represents net revenues per deposit dollar: the bank earns ra from a deposit dollar after paying the ceiling deposit rate r and incurring the marginal production cost dC/dD.
Net revenues per deposit dollar represent the resources available to be passed on to depositors as an implicit deposit rate The portion of net revenues that is passed through to depositors depends on the strength of depositors’ response to the goods and services associated with the implicit deposit rate, captured by the elasticity e When market response is weak (e near zero), the depositors’ share of net revenues tends toward zero; when the depositors respond strongly (a very high value of e), the depositors’ share approaches unity Therefore, the greater the depositors’ sensitivity to the implicit rate (larger e), the larger the portion of net revenues paid as implicit deposit rates In the limit, as e approaches infinity, the implicit deposit rate converges to net revenues, leaving no economic profit.
Effective monetary policy depends on how changes in the key policy rate are transmitted to bank deposit rates and lending rates The transmission mechanism determines how shifts in market rates affect borrowing costs, savers’ returns, and overall economic activity An imposed deposit ceiling can constrain this transmission, limiting the extent to which monetary policy actions influence deposit rates and, in turn, broader financial conditions.
A starting point fo r looking at interest rate pass-through is the mark-up between retail rates and the money market rate The interest rate differential that is
Institutional background
Vietnam 's banking sector: achievements and current problems
Over the past two decades, Vietnam has progressively reoriented its financial system toward a market-oriented banking framework A landmark reform was the creation of a two-tier banking system in 1989, with the State Bank of Vietnam (SBV) functioning as the central bank responsible for formulating monetary policy and for regulating and supervising the entire banking sector The second tier began with four specialized state-owned commercial banks (SOCBs) and has since expanded to include banks with diverse ownership structures, all delivering banking services across the economy This separation between the SBV’s regulatory role and commercial banking operations removed the previous overlap where the central bank acted as both player and referee in the market As a result, the SBV gained greater autonomy to implement monetary policy and to improve the efficiency of banking operations.
Vietnam's banking sector has undergone remarkable changes driven by the relaxation of domestic regulations and commitments to international market entry Since more than two decades of financial reform and international integration, the landscape has multiplied and diversified: by 2011 there were five state-owned commercial banks, 35 joint-stock banks, four joint-venture banks, 50 foreign bank branches, five wholly foreign-owned banks, more than 1,000 credit funds, and 30 financial and leasing companies, compared with only four state-owned banks in 1989 To strengthen oversight of banking operations, the State Bank of Vietnam established the GL2+1 group, bringing together 12 major commercial banks, including Agribank, Vietcombank, and BIDV, among others.
V iet inbank, AC B, Eximbank，Techcombank, M B，Sacombank, V IB , VP Bank ,
M SB) w ith SBV to develop monetary policy more effectively W ith 85% market share o f 12 big banks, the “ G l 2 +1” meeting w ill be able to create policies that reflect the actual evolution o f the market.
Chapter Three: C ase Study ‘T h e effect o f deposit ceilings on Vietnam Banking System’.
F igu re 2 C re d it stru ctu re a n d gro w th b y b a n k o w n e rsh ip , 20 이 -06
Year Í—— - J sex B s 's h a re я и г Z Z I JSCBsf sha re ■ ■ ■ ■ F B s ' sha re
■ - J S C B s 'c ro w th —-Ж 一 F B s' g rtn v ih
Source: A u lh o r 's c a lc u la tio n based o n \ ' u (2 0 1 0 ).
Figure 2 shows that state-owned banks are gradually losing monopolistic power, with their lending share of total credit declining from 81% in 2001 to 71% in 2006 This decline is accompanied by the rising importance of joint-stock commercial banks, whose market share has been increasing, signaling a shift in the composition of the banking sector.
Another step was the opening up o f the country's banking market to investment from the domestic private sector and foreign investors，as e xp licitly expressed in the Law on Credit Institutions and in Vietnam ’ s commitments to the WTO Foreign banks could in itia lly enter directly in the forms o f representative offices, foreign bank branches and joint-venture banks o r indirectly via foreign share purchase, and now even in the form o f a fu lly foreign-owned lim ited company Vietnam also implemented a restructuring program fo r both joint-stock commercial banks and state-owned banks in order to improve the efficiency o f banking management and operation In the late 1990s and the first h a lf o r 2000s, the State Bank o f Vietnam liberalized the interest rate so that it could reflect the price o f capital The SBV also gradually adopted international practices such as Basel capital requirements in order to strengthen the role o f prudential regulation in preserving the stability o f the banking system.
F igu re 3 V ietn a m 's gro w th o f ra te o f re a l b a n k in g sy stem a sse ts, 1996-2007
■' 一 ■ V ^ c tn a rr ■ 1零 " O t h e r A 5 L \ N ô ro u m n c 도1 d n n u t t i f l v c r j g c — * — C h ifla
S o u rce : A u t h o r ^ c a l c u la tio n b a s e d o n I m c r n a iio n a l F in a n c ia l S la t is iic s ( I F S ) ( I M F 2 0 0 9 )
In line w ith financial liberalization, Vietnam ’ s banking system has gradually accumulated assets As shown in Figure 3 w ith D in h ，s (2011) calculation5，in the period 1996-2007, the total real assets o f this sector increased on average by 24.4% per year，liftin g real banking assets in 2007 to V N D 1,212.5 trillio n Relative to the Association o f Southeast Asian Nations (A S E A N ) and China, Vietnam had the highest growth rate o f bank assets over tms period and was the only country in the region that had continuously achieved positive year-on-year asset growth rates As a result, from a very low starting position, Vietnam has gradually improved its position and has become comparable w ith ASEAN counterparts in terms o f financial depth During the 1990s, Vietnam ranked at the bottom among A S E A N countries in terms o r Its banking assets/GDP ratio In 2008，expansion in credit saw Vietnam w ith the third-highest banking assets/GDP ratio.
5 For comparison purpose，Dinh (2011) measures values o f banking assets, credits and deposits in the 2005 price
C hapter Three: Case Study “T he effect o f deposit ceilings on V ietnam Banking System ， ，
Although two decades of structural reforms have transformed Vietnam’s banking sector, the system still grapples with a number of enduring challenges Financial mobilization and allocation by banks remain limited, and the sector’s core weaknesses are evident in high non-performing loan (NPL) rates, a low capital adequacy ratio, and ongoing liquidity shortages.
N on -p e rfo rm in g loans
Rapid growth in lending over several years follow ed by the squeeze on credit in
Since 2011, downturns in property and equities markets have added stresses to the banking system, with rising bad debts across the sector The State Bank of Vietnam (SBV) reports that the banking system’s nonperforming loan (NPL) ratio stood at about 3.1% of total loans in June 2011, roughly USD 4 billion, and rose to 3.42% by February 2012 (see Figure 4) If International Financial Reporting Standards (IFRS) were properly applied, the real NPL ratio would be higher, with Fitch estimating it around 13% Additionally, loss loans account for about 47% of total NPLs.
F ig u re 4 N o n p e r fo r m in g loan s
■ P ro p e rty p ric e N o n p e rfo rm in g lo a n s —
$ p e r sq u a re m e te r % o f b a n k lo a ns
Note: P ro p e rty price is th e average price o f h ig h and m e d iu m -p ric e d c o n d o m in iu m s.
Sources: State Bank o f V iet Nam; CB R ichard Ellis; ADB estim ates.
Recent bankruptcy cases and a weak corporate sector indicate a sharp rise in non-performing loans (NPLs) About 50,000 businesses went bankrupt in 2011, while inventories piled up Vinashin alone carries debts of around USD 4 billion, an amount roughly equivalent to the banking system’s accumulated net profit over the past three years (2008–2010) and accounting for about 4% of the banks’ total loan book.
According to the State Bank of Vietnam (SBV), banks’ exposures to the troubled real estate and securities sectors totaled USD 12 billion, representing about 12% of the banking system’s total loan book If one third of these loans become problematic, non-performing loans (NPLs) would double, signaling a material risk to financial stability (ADB, 2012)
Bad debts are accelerating due to the current economic climate and contractionary credit policy, which are hindering manufacturing firms’ operations High inflation and foreign exchange adjustments have pushed up the costs of essential production inputs—gasoline, oil, water, and gas—to record levels, a trend that extended into 2012 Private enterprises, especially SMEs, are struggling to secure adequate funding to sustain their businesses, while tighter monetary policy has resulted in higher interest rates Consequently, enterprises face mounting obstacles to repayment, and banks are unlikely to collect debts, increasing the risk of overdue indebtedness and bad debts.
Concerns arise that data released by the State Bank of Vietnam (SBV) may understate the bad debt figures of financial institutions, raising questions about the capital adequacy and solvency of commercial banks, particularly the smaller ones and those with close ties to state-owned enterprises Deteriorating asset quality translates into higher impairment charges that erode accumulated profits, reduce equity, and weaken a bank’s financial strength If the proportion of bad debt to total loans exceeds 10 percent, certain banks may have to write off multiple corporate debts in coming years while existing provisions remain insufficient As a result, the capital adequacy ratio (CAR) could slide quickly below the 9 percent level that many banks currently claim to maintain.
Analysts note a sharp decline in the capital adequacy ratio (CAR) The CAR stood at 11.97% in June 2011, 0.16 percentage points lower than December 2010, and it fell below the regional averages of 13.1% for Pacific Asia banks and 12.3% for Southeast Asia banks As a result, the number of banks unable to meet CAR requirements has risen rapidly, according to analysts.
National Finance Supervision Council，by June 30, 2011，only tw o out o f 47 banks could not meet the C A R standard, w hile the figure rose to 17 by September 2011.
While the threat from non-performing loans and capital adequacy remains speculative at this time, illiquidity stands out as an enduring concern that has been evident for many years Poor liquidity management in several commercial banks has been identified and flagged long before 2008, a period marked by abnormal surges in deposit rates and intense competition for deposits.
Since June 2011, liquidity pressure has been evident for banks under the State Bank of Vietnam (SBV), as institutions could mobilize only short-term funds while needing to provide long-term loans of five to ten years, creating a large maturity gap With public confidence in the banking system still weak, about 90% of deposits mature in less than one year even as many loans fund very long-term projects such as housing developments and programs for state-owned enterprises, leading to asset-liability mismatch and treasury management difficulties for commercial banks Some banks struggle to meet enterprise demand for medium- and long-term capital to expand manufacturing, while others rely on up to 100% short-term funding to finance long-term projects, far exceeding the central bank’s 30% cap.
Bank liquidity remains vulnerable as unresolved bad debts weigh on capital mobilization The September 2011 adjustment of deposit interest rates pushed the banking system into greater difficulty in raising funds; when banks could not borrow in the deposit market, they depended on funds from maturing loans Rising non-performing loans are choking small commercial banks, intensifying liquidity stress across the sector.
C hapter Three: C ase Study “T he eiTect o f deposit ceilings on Vietnam Banking System ”
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Interest rate regulation and deregulation in V ie tn a m
Vietnam’s transition from a command economy to a market-based system has been accompanied by a steady liberalization of its interest-rate regime Starting in 1992, rates moved from a centrally planned framework to a more flexible, systematically liberalized regime, with reforms continuing into the 2000s and beyond Although many studies focus on the period from 2008 to March 2012, the broader history traces back to the 1980s and shows a gradual evolution in interest-rate regulation The following sections provide a concise overview of this evolution, highlighting the main changes, policy shifts, and the ongoing process of interest-rate liberalization in Vietnam.
3.1.2 L The interest rate liberalization process 一 Before 2000
The period before May, 1992 has witnessed essential movements in Vietnam ’ s interest rate policy when the SBV transformed the interest rate control regime from negative term to positive term.
Under Decree 165/HĐB丁 (23/9/1982), effective 01/10/1982, the SBV fixed specific interest rates for all types of deposits and loans Prior to March 1989, despite some SBV adjustments, real interest rates remained negative due to ongoing hyperinflation, with real rates of -6.6% in 1986 and -5.8% in 1987 Two notable features of the period's interest-rate regime were that deposit rates were below inflation, and lending rates were lower than both borrowing rates and inflation.
Admittedly, the negative interest rate regime brought several drawbacks to the banking system Due to lending subsidies, commercial banks suffered losses and were unable to operate effectively within a market-based framework Meanwhile, the household sector lacked incentive to deposit money in bank accounts and increasingly hoarded gold and foreign currencies As a consequence, banks faced severe capital shortages and low profits, leaving them unable to lend.
Starting in March 1989, SBV treated interest rates as a crucial tool to curb high inflation, attract idle money circulating in the economy into bank deposits, and reduce government interest-rate subsidies in pursuit of positive real returns The defining feature of the early 1989 monetary squeeze was a massive surge in interest rates; within a short period, deposit rates were pushed up through a sweeping adjustment, resulting in significantly higher rates Demand deposits offered 9% per month (approximately 109% per year), while the three-month deposit rate stood at 12% per month.
- o r 144% p.a) Such action had brought about a sharp decline in inflation from 400% in 1988 to 34% in 1989.
Real interest rates remained excessively high for several successive years, but this did not translate into robust growth in bank deposits The overly positive real rates spurred money speculation, resulting in a scarcity of money in circulation and a freeze in the formal credit market Additionally, the complexity of the interest-rate system, with a wide array of rate types, created confusion and inefficiency in the banking sector For example, in July 1991, lending rates for short-term loans to farmers were announced.
C hapter Three: Case Study “T he effect o f deposit ceilings on Vietnam Banking System,’
Authorities initially set twelve lending rates by combining three loan purposes across four geographic areas, producing rates from 1.8% to 5.4% The policy’s impracticality soon became evident, and in November it was simplified to six rates, though these still distinguished between private and public borrowers and the loan’s purpose.
From June 1992 to 1995, interest rates were adjusted in accordance with the interest rate framework mechanism The State Bank set a floor for deposit rates and a ceiling for lending rates across sectors of the economy Financial institutions and commercial banks based their rates on the State Bank's interest rate framework to determine suitable rates for themselves This rate mechanism marked the opening for interest rate liberalization in Vietnam.
On October 1, 1993, Vietnam adjusted its monetary policy to apply both ceiling rates and negotiated interest rates for loans and deposits (Decision No 184/QD-NH1) Ceiling rates were set at 1.8% per month for state-owned enterprises and 2.1% per month for the private sector When commercial banks could not mobilize capital at regulated rates and issued commercial papers as an alternative, the negotiated interest rate regime was applied This arrangement shows that, under the negotiated-rate mechanism, interest rates were partly liberalized.
The negotiated interest rate regime allowed commercial banks to lend to non-SOEs and farming households at relatively high rates, generating sizable monthly spreads for banks Consequently, banks reported interest rate spreads of about 0.7 to 1 percent per month and near-record profits, while enterprises and farming households faced financing difficulties In October 1995, the National Assembly approved measures to constrain the spread between lending and deposit rates to as low as 0.35 percent per month This decision was viewed as a stepping stone toward a full interest ceiling regime and the abolition of negotiated lending rates starting January 1, 1996.
In January 1996, the State Bank of Vietnam (SBV) imposed ceilings on lending rates and capped the monthly spread between mobilized deposits and lending rates at 0.35% The move liberalized mobilized deposit rates and allowed flexibility in the lending-rate ceiling This framework aided economic growth, helped control inflation, and stabilized the dong’s purchasing power relative to regional currencies after the 1997–1998 Southeast Asian monetary crisis A positive interest rate was maintained for five years from 1996 to 2000, reflecting a high positive-to-inflation ratio; except in 1998, the ratio stood at 11.6%.
C hapter Three: C ase Study “T he effect o f deposit ceilings on Vietnam Banking System ”
P o s itiv e in te re s t ra te 5.40 6.30 1.00 5.35 5.05 - (u )0
P o s itiv e in te re s t r a te p e r in fla tio n 120 175 1*2 5350 6000 -30 Ĩ ： D e p a r tm e n t o f F in a n c c a n d M o n e ta r y M i n i s t r y o f P la n n in g a n d I n v e s tm e n t
T a b le I P o sitiv e real in te r e st rate in c o n ju n ctio n w ith in flation
Experts note that, in some respects, combining ceilings on lending rates with a regulated spread can function as deposit ceilings, though the actual interest-rate spread varied among commercial banks due to different cost structures In December 1997, the National Assembly removed the spread and fully deregulated deposit rates, creating the conditions for a healthy, competitive environment that protected the interests of both depositors and borrowers.
Nevertheless, as interest rate ceiling was an administrative instrument implementing in the immature market economy, the regime s till had certain shortcomings, resulting in a market distortion:
During this period, interest rate spreads were narrow, and lending rates were even lower than the deposit rates for debit-balance accounts in the previous period When the State Bank of Vietnam (SBV) decided not to cut rates on due loans, borrowers could immediately switch to another bank to obtain a loan at the prevailing rate to cover payments.
N g o T h i N g o c V i n h - Y 2012 Page 41 o ff the indebtedness w ith old rate Obviously, the latter rate was lower than the former and then interest rate risk always burdened commercial banks.
During this period, state-owned commercial banks (SOCBs) continued to subsidize low-interest lending to policy sectors, including disaster relief, with short-term loans priced at 0.5% per month and long-term loans at 0.6% per month Ironically, because average deposit rates at commercial banks exceeded these lending rates, the SOCBs lent at a loss and faced credit risk without adequate compensation, which discouraged them from further lending.
Because the yield curve was downward-sloping, capital mobilized into commercial banks was predominantly short-term Meanwhile, the country’s drive to industrialize and modernize required medium- and long-term capital to meet growing demand Banks that funded medium- and long-term loans with short-term funds were therefore exposed to liquidity risk.
During the pre-2000 period, interest rates did not accurately reflect the market's demand for and supply of capital, even though the State Bank of Vietnam (SBV) adjusted rates repeatedly This misalignment signals the need for a new regime that anchors interest rates more closely to market conditions.
3.1.2.3 Basic Rate - June 2000 to M ay 2002