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Capping interest rates: the situation around the world

In a historic move, President Uhuru Kenyatta    signed    the    banking Amendment bill 2015 into law in August 2016. this effectively means that moving forward, banks will be compelled to cap lending rates at not more than 4 per cent of the central bank of Kenya (cbK) benchmark rate.

Similarly, deposit rates will be at least 70 per cent of the benchmark rate. the President’s move has attracted widespread support (mostly from public), but also sharp criticism (mostly from banks and regulators). the long-term implications of this law remain to be seen, but at least there are some indicators of how things may play out from the 76 other countries around the world that cap interest rates.

“At least 76 countries around the world currently use some form of interest rate caps on loans—all with varying degrees of effects,” says an october 2014 policy research work- ing paper by the World bank. the paper, authored by Samuel Munzele Maimbo and claudia Alejandra Henriquez  Gallegos,  offers  some seminal  insights  on  an otherwise age-old practice—capping interest rates.

 

Since ancient times

“Usury laws for implementing interest rate caps have a long history going back to ancient times,” affirms the aforementioned World bank research paper. Just to get some background, debate on capping interest rates is as old in some countries as the very practice of banking. Different mech- anisms have been used down the cen- turies to control interest rates. From putting controls on maximum rates, to abolishing rates altogether, the range of tools is broad. Nevertheless, the objective of these practices has always been the same—to protect consumers from usury and exploita

tion by banks.

throughout history, the  move  to protect consumers from usurious practices has been inspired by ethi- cal, and at the same time, religious considerations.

the ethical debates on capping interest rates are robust, and date back to ancient philosophers such as Plato and Aristotle. A lot of the ongoing media punditry on capping interest rates also exhibits a certain bent towards philosophy—many agree that there is something intrin- sically wrong with usury, few agree at what point interest rates should be considered just or unjust. this conflict in views makes the debate all the more insightful.

the religious views on interest rates also cut  across  the  board. In some majority Muslim countries today interest rates are completely forbidden, explaining the rise of sha- ria compliant banking in areas with high Muslim populations. Similarly, the roman catholic church has always condemned usury through- out the past two millennia, but in modern times, with the rise of cap- italism and the disestablishment of the catholic church in majority catholic countries in europe, this ban on usury has not been enforced. clearly, the conversation on interest rates is one that has occu- pied a prioritized spot in different civilizations throughout the centuries down to this very day.

the  common  practice  today the codification of usury laws. these regulations govern the amount of interest that can be charged on a loan. Usury laws specifically target the practice of charging excessively high rates on loans by setting caps on the maximum amount of interest that can be levied. these laws are designed to protect consumers. this is basically the path that Kenya has taken.

“Interest rate caps can also be justified to protect consumers from usury and exploitation by guaran- teeing access to credit at reasonable interest rates and to facilitate pros- ecution of exploitative and decep- tive lenders,” observes the aforemen- tioned World bank research paper.

Kenya following global practice there  are  some  indicators that

suggest what Kenya is doing does not rail against the spirit of free market capitalism, as opponents of the caps have strongly suggested. Some of the world’s exemplars of capitalism, such as the United Kingdom and Spain, control interest rates with the

sole objective of protecting consum- ers. even Switzerland, the seventh heaven of global banking and high finance, exerts a considerable level of legal control on interest rates.

“Most countries regulate interest rates with the broad aim of pro- tecting consumers, as in the case of Spain,” says the World bank research paper, which in great detail, outlines the countries that have capped inter- est rates and the implications that the practice has left in its wake.

According  to  the  World  bank paper, some countries provided more specific objectives for capping rates, such as protecting the weakest par- ties (Portugal); shielding consumers from predatory lending and excessive interest rates (belgium, France, the Kyrgyz republic, Poland, the Slovak republic, and the United Kingdom); stopping the abuses arising from too much freedom (Greece); controlling over-indebtedness (estonia); and decreasing the risk-taking behavior of credit providers (the Netherlands). the paper also offered insights from Africa. In South Africa, the authorities signed an exemption in the usury law to remove small loans from the interest rate ceilings in 1993. then, after more than a decade with no cap on small loans, a National credit Act went into effect in 2007 and reintroduced a cap on small loans and introduced a cap of 5 percent per month on short-term loans as part of an integrated credit framework.

equatorial Guinea, cameroon, Gabon, the central African republic, chad and the republic of congo capped interest rates in 2012. A year later in 2013, Zambia’s authorities introduced the caps at nine percent- age points above the benchmark rate. the motivation was to mitigate the perceived risk of over indebt- edness and the high cost of credit, as well as to enhance access to the underserved.

In as much as the National

bank of ethiopia scrapped off all interest rate ceilings in the finan- cial sector in 1998, ethiopia is still considered to have de facto interest rate ceilings since most microfinance institutions have chosen to maintain a lower interest rate. the motivation is primarily political.

According to the World bank paper, the main reasons for using interest caps on loans were not only to protect consumers from excessive interest rates, but also to improve access to finance, and to make loans more affordable.

this has certainly been the three pronged argument that proponents of capping rates in Kenya—both opposition and government—have been pushing. the argument is that the new law will protect Kenyans

 

from banks’ avarice, improve access to finance and make loans more affordable.

With these kind of arguments, it is easy to understand why the public are impressed by the new law, and even more specifically, why no politician could afford to position themselves as an opponent to the law. besides, politicians’ worst kept secret is the gigantic amount of debt that most of them have. So why not kill two birds with one stone?

 

Apples and oranges

but saying that Kenya’s law aligns to global best practice just because other economies—including iconic ones like Switzerland—have used it is lazy at best and specious at worst. Anyone who has done some broad reading on the   issues

around globalization, comprehends that terms such as “global best prac- tice” have frequently been misused to impose generic views on narrower situations where these views do not fit.

comparing the Kenyan situation to the global one, important as it is in formulating a broad view, runs the risk of comparing Apples and oranges, as the idiom goes. there are apparent differences between the Kenyan economy and others—espe- cially developed economies—that are incomparable.

one of the key areas of discon- nect is the problem of information asymmetry. In Kenya, borrowers have limited information on credi- tors. Likewise, creditors have limit- ed information on  borrowers.  this is in contrast to the situation in, for example U.K., where digitization, standardized and advanced data collection techniques, and robust information sharing laws, ensure that lenders have sufficient informa- tion on borrowers.

In Kenya, banks don’t have this kind of information. It therefore doesn’t make sense to lend at a cheap rate as the bank is never sure whether the collateral offered, or even the name of the borrower, is genuine. the numerous cases of falsified log books and title deeds being used to fraudulently obtain loans by con artists are compelling cases in point.

the big task for Kenya is to encourage  information  sharing.

 

the credit reference bureaus have helped, but only to some extent. they principally share negative information, and not positive infor- mation, meaning that borrowers cannot get good rates based on their transparent behavior.

How can SMes and small bor- rowers be encouraged to be more lib- eral with information without add- ing to the already high costs of doing business, or adding another layer of bureaucracy that will undoubted- ly reverse financial inclusion? Until Kenya can square this circle, then it will be hard to realistically drive financial inclusion. even if the law does indeed provide for low rates and hence more inclusion, banks could lower rates in principle but in practice avoid the risky, who are the vast majority.

In fact, now that interest have been capped, the most probable route for banks is to sidestep risky borrowers such as SMes and indi- viduals, and instead lend to big business and government. Liquidity will concentrate in the hands  of big players while smaller ones are starved. this means that the very SMes that are meant to benefit from the new laws could be the ones that are most adversely affected.

the new law could also introduce a bad kind of innovation—secretly inserting fees and commissions to increase what otherwise looks like a good price (rate).

“In countries where the caps do not cover fees and commissions and when the definition of interest rate is not clear, for example, financial institutions may give the impression of compliance with the ceiling  but

 

charge fees and commissions that are not considered part of the cost of the loan,” says the World bank.

 

Necessary wakeup call

Much as there are some valid points and counterpoints for and against the new law, one thing is clear: the new law is a necessary wakeup call for banks. this perhaps is the big- gest benefit of the law, one that far outstrips its loopholes.

For a long time, banks have wielded immense political capital. rather than use this power to appeal to the goodwill of the public, they have done the opposite—boast about the billions they amass in profits while others perennially lament about the harsh business environ- ment.

banks have eroded public goodwill and it is no surprise that President Kenyatta said in a state-

 

ment that Kenyans are frustrated with the lack of sensitivity by the financial sector. “these frustrations are centered around the cost of cred- it and applicable interest rates on their hard-earned deposits. I share these concerns,” said the President, adding that banks have previously failed to live up to their promises to lower rates.

the time for empty promises has ended, and the government has cracked the whip on banks, remind- ing them of the harsh reality that the government’s primary objective is to protect the interests of the people.

banks may avoid low income earners and SMes for now, but they cannot do it for long. this is because a lot of SMeS with short-term bor- rowing needs—such as working cap- ital—can move to Saccos, depriving banks of the customer base they built through efforts such as agency banking and mobile banking.

Granted, Sacco loans are short term and pegged on savings, but the rates are much lower (around 12-15 per cent per annum) than banks. the practice of only borrowing three times savings in Saccos also means that SMes will inadvertently learn the art of fiscal responsibility. they will not stretch the size of their loan portfolio beyond the ability of their asset base.

Meanwhile, things will get worse for banks before they get better. cbK sector data for 2015 shows the interest earned from loans amounted to Sh272.11 billion for the banking sector, accounting for 60 per cent of the total Sh448.03 billion income made by the lenders during the year. banks are therefore heavily exposed to interest income and they will certainly take a hit with the lower rates expect a lot of decline in banks’ profitability in upcoming quarterly reports. Similarly, expect the cur- rent bearish run on listed banks to persist.