By Ali Abdi
“It’s sort of like a teeter-totter; when interest rates go down, prices go up” – Bill Gross
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When it comes to the world of banks and interest rates, three words come to mind: overwhelming, intimidating and frightening. For us “regular folks”, the questions seem never-ending. For example, if interest rates are low, they, in the long run, create a lot of activity in the market. At that point, how do we deal with inflation rates?
Last month, the President passed the Banking (Amendment) Bill, 2015, which now introduces new sections to the Banking Act. Section 31A will now require banks to disclose all charges and terms of loans before granting loans, while Section 33B introduces a limit to interests charged on credit facilities to 4% above the base rate set by the Central Bank of Kenya. It, as well, introduces and a minimum of interests earned in deposits earning interest to 70% of the base rate set by the CBK.
The passed amendment further refers to Section 36 of the Central Bank Act regarding the base rate. This is the rate at which the Central Bank offers loans to banks, which currently stands at 10.5 %. What this means is that interest rate will now be capped at 14.5 % from the previous 18 % average.
In turning the Banking Amendment Act into reality, the drafters have now created more dilemmas by not addressing crucial issues such as how inflation and currency risk will be accommodated in view of the reduced interest rates?
Will banks be prevented from gravitating prices for credit products previously below the capped amount, upwards towards the cap? How will a creditor be protected from a lender who manipulates the length of the loan in order to evade the intent of the cap? Further, will banks be prevented from making up for lost margin with fees and charges, which may make interest rates become less important as a component of the total price of credit.
It is widely known that interest rates are designed to incentivise banks to lend money to the broader society. Consequently, it is crucial that banks are allowed some leeway when setting interest rates for personal loans, so that they may generate some profit. Thus banks allow saved funds to “flow” through the economy, generating money. This vital function is, however, only fulfilled if the interest rate makes the act of borrowing – not just lending – a sensible and safe option.
They basically are recognition of the risk that the bank takes in (temporarily) parting with its wealth, particularly in light of inflation. The borrower gets some spare cash for immediate personal use, and the lender makes a medium- or long-term profit on their lending. All seems good, right?
Well, not necessarily. And most certainly not in the assented to Banking Amendment act (2015). Banks, in view of this, may be forced to brand all retail customers as being at the same risk profile, and thereby punishing customers who have a lower risk profile alongside unreliable borrowers.
The line of thinking employed by the creators of the Act does not make sense at all. It contends that by capping interest rates, economic crises caused by higher interest rates will be prevented; however, this has not given any mechanism as to how the cap would reduce the possibility of inflation or, in the long run, an economic crisis.
Not the solution
The cabinet secretary for National Treasury Henry Rotich said, “…capping interest rates is not the solution. If you fix interest rates, banks will check and look for people with high credit scores and lock out those with poor credit records. Banks will lend only to blue chip companies”. Also, the Central Bank Governor has submitted that capping interest rates will encourage an informal system where banks will abandon risky loans and loan sharks will emerge and prey on the weakest and that banks could start rationing credit. In the long run, this will deny the small and medium enterprises crucial funds to spur economic growth. The question is, in view of this expert advice, why would the President go ahead and sign the Bill into law? The answer is simple: politics.
A probable view as to why many people have lauded the move is that because of the fact that the banking sector has operated on an oligopolistic market mode, where credit pricing is not reflective of market fundamentals and that the move to cap lending rates will hinder such situations. This, they say, should cushion credit consumers against high rates and by making loans affordable to many.
In December 2003, the UK Government said that it was “not yet persuaded that the introduction of interest rate ceilings for the UK is the right approach to provide protection from credit costs”. It was of the view that interest rate capping mostly affects the availability of dedicated sub-prime models, and creates credit exclusion for those who cannot access mainstream credit. Further, lenders may respond to interest capping by raising access hurdles to high-risk borrowers.
The new Banking Amendment act, 2015 has indeed drawn a bright picture where, in its happy low-interest-kingdom, people will pay less interest on their loans and will therefore be better off. However, in reality, most people would be prevented from getting the loans in the first place. We ought to understand that loans are classified not equally across the board but based on the risk of the borrower.
Further, lowering interest rates per se does not promote more borrowing. Yes, the law is meant to benefit the society from investments – this is true by definition. However, how the plan will increase the investment levels in the country remains unknown.
In my view, whether a rate is excessive essentially depends on circumstances such as the size and duration of the loan, whether it is secured or unsecured and, if unsecured, the credit worthiness of the borrower. Capping interest rates may exclude some borrowers from accessing credit. Being denied credit not only has an instant effect on the borrower, but it also affects his ability to build a credit history, a critical support that allows him to borrow at lower rates in future.
It is not clear whether the cap, which is a form of price control, was introduced based on studied evidence and academic work or introduced on ideological grounds. Capping interest rates, it has been established, does much more harm than good. Therefore, if banks have interest rate caps imposed on them, they may respond by lending less and avoid granting credit to higher-risk small- and medium-sized businesses.
Everybody agrees that a complete lack of tight regulation in the banking sector is no longer desirable. Equally, however, excessive regulation in any part of the economy could yet backfire. So, how can the Banking Amendment Act ensure the best of both worlds – progressive banking principles and probable banking regulations, better regulations and hands off liberalism?
According to Financial Access Initiative, a consortium of researchers at the universities of New York, Harvard and Yale, and Innovations for Poverty Action (2010), suggested that overall, conventional models of financial systems show that interest rate caps distort risk and returns, and further reduce economic growth rates. More specifically, interest rate caps constrain private lending to borrowers who are perceived to be higher risk such as small businesses and the poor.
Therefore, using legislative caps as the remedy is not the solution. It looks good from far but it is actually far from good. History has shown time and time again that once the doors of liberalisation and open markets are opened, trying to close them will be like opening the Pandora’s box. Therefore for liberalisation to succeed, they have to be supported by respective laws that mitigate the extremes invariably caused by free market dynamics.
Issues of regulating interest rates are like a ticking bomb. Any careless tinkering with policies, let alone legislation, can trigger a financial crisis.