This weeks focus note is about the ongoing debate on interest rate caps. The Kenyan public is lately very angry with Kenyan banks for a whole list of reasons - we have had recent bank failures but there isnt a single ongoing prosecution, livelihoods and investment deposits lost or locked up in failed banks, investments lost in bank bonds such as Chase and Imperial Bank bonds, value of investments in bank shares have almost been halved, and yet banks continue to charge high interest rates on loans coupled with low interest rates paid on deposits. Trust for the Kenyan banking sector is at its most recent low. The anger has culminated in the Kenyan people delivering an interest rate cap bill that has broad base support and is now only awaiting presidential signing to become law. We compare the interest rate cap bill to Brexit a very populist move, fueled by anger, but an equally unwise move that we may quickly regret.
Our view is that interest rate caps would have a clear negative effect on the Kenyan economy and ultimately to the Kenyan people. Consequently, the President should certainly demonstrate leadership by declining to sign the bill into law because it would not be good for the Kenyan public. However, the President should also understand the bill as a strong protest by an angry public, and in return deliver to the Kenyan people (i) a strong consumer protection agency and framework, and (ii) promote initiatives for competing and alternative products and channels that will make the banking sector more competitive.
The bill before the President of Kenya which seeks to (i) cap interest rates charged to borrowers to 4% above the Central Bank Rate (CBR), and to (ii) set a floor for deposit rates paid to depositors at 70% of the CBR, is a bad bill and we are confident the president will not sign the bill, simply because it would have a negative impact in the financial sector and ultimately the economy.
With CBR currently at 10.5%, the bill seeks to limit lending rates to 14.5% (CBR benchmark of 10.5% plus 4% margin cap) and enforce interest on deposits to 7.35% (70% of CBR benchmark of 10.5%). While the prospects of getting loans at 14.5% and receiving 7.35% on deposits seems attractive, a closer analysis reveals that in reality, rate caps would have significant negative effects such as reduce access to funding, slow the economic growth and ultimately reduce the standards of living.
We demonstrate these potential negative implications in various ways. First, through general observations of global trends and second, through a review of existing research on evidence on interest rate caps.
First, general observations of global trends: A general survey around the world illustrates that free movement and pricing of labor, capital, goods and services, otherwise referred to as free markets, tends to be strongly correlated with stronger economic growth and prosperity. This does not mean that there should be absolutely no government involvement, but that government involvement should be very constrained, limited and targeted for example, requiring specific disclosures. Legislating the price and terms at which private citizens access capital is wading to far into the private sector. Kenyas own recent track record with government involvement in the private sector is not inspiring; think of Uchumi, National Bank, Mumias Sugar, and Kenya Airways - all these companies are suffering in industries where other pure private sector competitors are thriving. Governments are not good in private sector matters such as pricing of capital.
Secondly, there is just no compelling evidence that interest caps have worked. According to a World Bank report, there are 76 nations in the world that have experimented with interest rate caps. Based on a reviews of their experience, The World Bank report concludes that rate caps are blunt instruments, and supports other alternative interventions, and in many cases, there is clear evidence of negative effects. Here is a sample of experience with rate caps according to the report:
- In South Africa, some financial institutions evaded the interest rate caps by charging credit life insurance and other services, which reduced the transparency of the total cost of credit.
- In West African and Monetary Union (WAEMU) countries, the imposition of interest rate caps on micro-finance loans caused micro-finance institutions to withdraw loaning to the poor and more remote areas and to increase the average loan size to improve efficiency and returns as the interest rate ceiling was considered low
- In Japan, the supply of credit appeared to contract, acceptance of loan applications fell and illegal lending rose
- In France and Germany, Ellison and Forster (2006) found that interest rate ceilings decreased the diversity of products for low-income households
- In Nicaragua, the application of an interest ceiling caused micro-finance institutions to reduce lending and prompted a number of such institutions to leave urban areas due to high operational costs and risks. They also responded by adding fees so as to circumvent the interest rate cap hence passing on a constraint to depositors
- In India, the enacting of interest rate margin cap in 2011 led to slower borrowing and lower formal financial access
- Zambia introduced interest rate caps in December 2012 and January 2013 and removed them effectively on November 2015.
Based on the above, the proposed interest rate caps bill is most likely bad for the Kenyan economy. It is most likely going to lead to the following consequences;
- Banks will simply introduce new and lawful types of fees required to access loans, and the total cost will go back to what is commercially viable
- Loan pricing will become even less transparent given the new types of lawful fees
- Given the free flow of capital in the global markets, capital that is looking for banking exposure is likely to flow to more attractive geographies where they are no caps
- Credit would not be accessible to the most risky, who have the least access and the most need for credit; on the other hand, prime borrowers will have easier access as they would be pursued by most banks
- Shadow banking and informal credit will quickly mushroom, which will lead to even more exploitation of borrowers.
While rate caps are bad, it does not mean that the government should do nothing. Our view is that the President should send back the bill to parliament with specific recommendations around consumer protection and improved competition:
- Establish strong consumer protection agency to specifically develop and enforce a consumer protection framework for the financial services sector. Just like the bankers have the Kenya Bankers Association taking care of the interest of banks, there should be an equivalent and strong association / agency taking care of the interest of consumers. It should be a strong association anchored in law and funded by statutory levies from the banking sector players and other financial services companies
- The aforementioned consumer protection agency would work on a consumer protection framework to include robust disclosures on cost of credit, free and accessible consumer education, enforce disclosures on borrowings and interest rates, expeditiously handle and hear clients complaints. The rumors of an office of an Ombudsman with the powers of a judge seems to be headed the right direction
- Establish strong protection and support for alternative products that compete with banking products. For example, the proposed legislation is not just concerned with rates of borrowing, but also the meager rates banks pay to depositors. Alternative forms of savings that bypass the banking sector to enable members earn higher levels of returns, such as organized Chamaas, Saccos, Investments Cooperative and Partnerships should enjoy the same incentives such as banks. For example, providing alternative savings organizations with the same withholding tax incentives that banking deposits enjoy, of a 15% final withholding tax
- In addition to supporting alternative products, the government should develop incentives and protections for product innovation, which tend to experience hostility from the banking sector.
In summary, the president should not sign the rate caps bill into law, but in return, should (i) provide fundamental and strong consumer protections for Kenyan public, (ii) support innovative and competing alternatives that will make the banking sector more competitive.
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Disclaimer: The views expressed in this publication, are those of the writers where particulars are not warranted- as the facts may change from time to time. This publication is meant for general information only, and is not a warranty, representation or solicitation for any product that may be on offer. Readers are thereby advised in all circumstances, to seek the advice of an independent financial advisor to advise them of the suitability of any financial product for their investment purposes.
