Why Banks Should Not Invest Much in Treasury Bond

Commercial banks’ core function is to mobilise deposits and provide loans.  Although a bank provides other services, such as facilitating remittances, financing foreign trade, issuing letters of credit (LCs), and offering personal financial services, these are the bank’s auxiliary products. In the developed world, banks have undergone massive diversification and modernisation by introducing various investment products, which mostly include merger and acquisition deals, wealth management, cash management, portfolio management, obtaining funds from the bond market for customers, commodity trading and derivatives trading. Nevertheless, the core functionality of the developed world’s banking system is deposit mobilisation and loan disbursement. It is because when a bank deviates from its core functionality, it loses its banking features and turns into a non-bank financial institution. However, some banks have deviated from lending and focused more on investing in treasury bonds, as it more profitable and less risky.
Banks have shown immense interest in treasury bonds due to attractive interest rates, which once were above 12% but have recently been reduced to near 10%, which is still very high. Because a 10% interest rate on a treasury bill should be equivalent to a 15% or higher interest rate on commercial lending. A treasury bill issued by the government is considered a sovereign bond, which carries nominal or zero default risk. Interest rates on commercial lending include cost of funds, operational cost, profit margin and risk premium. Risk premium varies from country to country and even bank to bank depending upon the default culture. Where default risk is high, the risk premium will also be high or vice versa. Since this information is very sensitive and strictly confidential, it is very difficult to exactly know the risk premium applied in determining lending rates in our country’s banking industry. However, based on a high non-performing loan (NLP) ratio, the risk premium should not be less than 6%. On the other hand, the risk premium should be zero on a treasury bond, as there is hardly any default risk. This interest rate calculation formula should not apply to offering interest rates on treasury bonds because the government determines a lower rate, taking some advantageous factors, which include money market conditions, the demand for the bond, the tenor of the bond and potential yield, into consideration. It is not understandable how the government is managing massive interest expenses payable at a very high rate on treasury bills. If such a situation continues, the government may have to borrow money to pay interest on outstanding bonds, which may trap the government in a vicious credit cycle, breaking which would be the most difficult and even almost impossible task.
With massively investing in treasury bonds, banks are apparently reaping good benefits because they are maximising profit and minimising default risk but adversely impacting their core functionality, the country’s business and economy as a whole. Firstly, banks’ risk management processes will be getting weaker and, as such, will not be able to perform efficiently when their lending operations boost up. Secondly, the country’s businesses and entrepreneurs will not have an adequate source of funds, so the investment will be badly impacted. If investment does not rise, business will not grow, and the economy will be affected, which will eventually impact the country’s banking sector too. Now a question arises: why do banks keep heavily investing in Treasury bills despite the long-term cost? The answer is simply the high interest rate on bonds. 
Had there been a low interest rate on sovereign bonds, the banks would not have invested in treasury bonds; instead, they would have continued their lending activity. Usually, the interest rate on a sovereign bond is very low and should not be higher than 5%. People may think that investors will not show interest in buying treasury bills at such a low rate. This idea may apparently hold true, but the reality is that investors will show their keen interest in sovereign bonds despite offering lower rates if they can be offered properly. Selling sovereign bonds at a lower rate will only be attractive to the investors when the market has established a secondary bond market where sovereign bonds, along with other allowable debt instruments, will be traded. Because of the regular trading feature, a bond’s market price moves upward or downward. A sovereign bond, which carries nominal or zero default risk, usually rises, and there is no chance of going below par. The sovereign bond with a face value of one thousand taka may be traded for one thousand five hundred taka, and even more. In this situation, investors become more interested in investing in sovereign bonds because their risk-free minimum return is guaranteed by the quoted interest rate, but speculation gain is earned when the bond is traded at a high market price, which means that although the interest rate on the bond is lower, its yield may be higher.
In bond investment, yield is the most important factor, which also depends on interest rates and market price. In our country, this option is absent because there is no secondary bond market and the government is in need of mobilising enormous funds for supporting the deficit budget. So, the government will have to offer a higher interest rate for mobilising funds by selling treasury bills, which many banks take as an opportunity. Again, investing in sovereign bonds is also a bank’s regular activity, so they cannot be officially barred from massively investing in treasury bills unless they voluntarily keep this area of investment minimal and maximise commercial lending for the sake of their long-term goal. In the developed world, banks also significantly invest in bonds, but this is for earning yield without impacting their lending operation. The banking sector in the country should take a long-term perspective and core functionality into consideration and thus keep their involvement in bond investments as minimal as possible.
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The writer is a certified anti-money 
laundering specialist and banker based 
in Toronto, Canada. He can be reached 
at [email protected]