Interest rate caps & their impact on financial inclusion in Kenya

The recent introduction of a lending rate ceiling for banks and other financial institutions in Kenya reopened an old debate over the appropriateness of regulatory intervention to limit the charging of rates that are deemed, by policymakers, to be excessively high.

This article attempts to analyze at a high level the theory behind interest rate caps and aims to figure out: composition of the interest rate and attempts to answer the following questions:

i)                    Where are interest rate caps currently used, and where have they been used historically?

ii)                    What have been the impacts of interest rate caps, particularly on expanding access to financial services?

iii)                  What are the alternatives to interest rate caps in reducing spreads in financial markets?

Understanding the composition of the interest rate

In order to assess the appropriateness of an interest rate cap as a policy instrument, or whether other approaches would be more likely to achieve the desired outcomes of government, it is vital to consider what exactly makes up the interest rate and how banks and MFIs are able to justify rates that might be considered to be excessive. Generally there are four components to the interest rate

The cost of funds is the amount that the financial institution must pay to borrow the funds that it then lends out. For a commercial bank or deposit taking microfinance institutions this is usually the interest that it gives on deposits. For other institutions it could be the cost of wholesale funds, or a subsidised rate for credit provided by government or donors. Other MFIs and Banks might have very cheap funds from charitable contributions such as Equity Bank.

The overheads reflect three broad categories of cost. The first is the general administration and overheads associated with running a network of offices and branches. The second is the cost of credit processing and loan assessment, which is an increasing function of the degree of information asymmetry. Finally, there are outreach costs; the expansion of a network or development of new products and services must also be funded by the interest rate margin.

It is the overheads, and in particular the processing costs, that can drive the price differential between larger loans from banks and smaller loans from MFIs. Overheads can vary significantly between lenders and measuring overheads as a ratio of loans made is an indicator of institutional efficiency.

Lenders must also absorb the cost of bad debts that must be written off in the rate that they charge. This allowance for non-performing loans (NPLs) means that lenders with effective credit screening processes should be able to bring down rates in future periods, while reckless lenders will be penalized

The final charge that lenders will include is a profit margin that again varies considerably between institutions. Banks and commercial MFIs with shareholders to satisfy are under greater pressure to make profits than NGO or not-for-profit MFIs.

The rationale behind interest rate caps Interest rate caps are used by governments for a range of political and economic reasons, most common of which is to provide support to a specific industry or area of the economy. It may be the case that government has identified what it considers to be a market failure in a certain industry, or that an interest rate cap is an attempt to force a greater focus of financial resources on that sector than the market would determine.

It is also often argued that interest rate ceilings can be justified on the basis that financial institutions are making excessive profits by charging exorbitant interest rates to clients. This is the usury argument, and is essentially one of market failure: government intervention is required to protect vulnerable clients from predatory lending practices.

The argument, which is predicated on an assumption that demand for credit at higher rates is price inelastic, postulates that financial institutions are able to exploit information asymmetry (and in some cases short run monopoly market power) to the detriment of client welfare. Aggressive collection practices for non-payment of loans have exacerbated the image of certain lenders.

Economic theory suggests that market imperfections will results from information asymmetry and the inability of lenders to differentiate between safe and risky borrowers.

When making a credit decision, a bank or a microfinance institution cannot fully identify a client’s potential for repayment.

Two fundamental issues arise:

 Adverse selection: clients that are demonstrably lower risk are likely to have already received some form of credit. Those that remain will either be higher risk, or lower risk but unable to prove it. Unable to differentiate, the bank will charge an aggregated rate which is will be more attractive to the higher risk client. This leads to a raised probability of default ex ante.

 Moral hazard: clients borrowing at a higher rate might be required to make riskier investments in order to cover their borrowing costs. This leads to a higher probability of default ex post .The traditional microfinance group lending methodology helps to manage adverse selection risk by using social capital and risk understanding within a community to price risk.

The impact of interest caps

 Supply side financial outreach

The major argument used against the capping of interest rates is that they distort the market and prevent financial institutions from offering loan products to those at the lower end of the market that have no alternative access to credit. This runs counter to the financial outreach agenda that is prevalent in many poor countries today. The debate can be boiled down to the prioritisation of cost of credit over access to credit.

Financial Institutions have historically been able to expand outreach rapidly by funding network expansion by profits from existing borrowers, meaning that existing clients are in effect subsidising outreach to new areas. Capping interest rates can hinder this process as financial institutions may remain profitable in existing markets but cut investment in new markets. At the extreme, government action on interest rates can cause existing networks to retract.

Price rises

There is some evidence from developed markets that the imposition of price caps could in fact increase the level of interest rates. In a study of payday loans in Colorado, the imposition of a price ceiling was initially seen to reduce interest rates but over the longer term rates were seen to steadily rise towards the interest rate cap. This was explained by implicit collusion, by which the price cap set a focal point so that lenders knew that the extent of price rises would be limited and hence collusive behaviour had a limited natural outcome.

Borrower trends

The chain behind implementing an interest cap runs that the cap will have an effect on the wider economy through its impact on consumer and business activities. The key question to be addressed by any cap is whether it bites and therefore impacts borrower behaviour at the margin.

An interest cap exacerbates the problem of adverse selection as it restricts lenders’ ability to price discriminate and means that some enterprises that might have received more expensive credit for riskier business ventures will not receive funding. There has been some attempt to link this constraint in the availability of credit to output.

Alternative methods of reducing interest rate spreads

From an economic perspective, input based solutions like interest rate caps or subsidies distort the market and hence it would better to let the market determine the interest rate, and to support certain desirable sectors through other means such as output based aid.

In the short term, soft pressure can be an effective tool – as banks and MFIs need licenses to operate, they are often receptive to influence from the central bank or regulatory authority. However to truly bring down interest rates sustainably, governments need to build a business and regulatory environment and support structures that encourage the supply of financial services at lower cost.

 Market structure

The paradigm of classical economics runs that competition between financial institutions should force them to compete on the price of loans that they provide and hence bring down interest rates. Competitive forces can certainly play a role in forces lenders to either improve efficiency in order to bring down overheads, or to cut profit margins.

The corollary of this, and the orthodox view, would seem to be that governments should license more financial institutions to promote competition and drive down rates. However it is not certain that more players mean greater competition. Due to the nature of the financial sector, with high fixed costs and capital requirements, smaller players might be forced to levy higher rates in order to remain profitable.

Market information

The evidence suggests that learning by doing is a key factor in building up efficiency and hence lowering overheads and hence interest rates. Institutions with a decent track record are better able to control costs and more efficient at evaluating loans while a larger loan book will generate economies of scale. More established businesses should also be able to renegotiate and source cheaper funds, again bringing down costs. In China, the government supports the financial sector by setting a ceiling on deposits and a floor on lending rates meaning that banks are able to sustain a minimum level of margin.

The implication of this is that governments would be better off addressing the cost structures of financial institutions to allow them to remain commercially sustainable in the longer term. For example, government investment in credit reference bureaus and collateral agencies decreases the costs of loan appraisal for banks and MFIs.

Supporting product innovation

Through the use of a financial sector challenge fund, can bring down the cost of outreach and government support for research and advocacy can lead to the development of demand-led products and services.

Demand side support

Government can help to push down interest rates by promoting transparency and financial consumer protection. Investment in financial literacy can strengthen the voice of the borrower and protect against possible exploitation. Forcing regulated financial institutions to be transparent in their lending practices means that consumers are protected from hidden costs. Government can publish and advertise lending rates of competing banks to increase competition.

Conclusion

There are situations when an interest rate cap may be a good policy decision for governments. Where insufficient credit is being provided to a particular industry that is of strategic importance to the economy, interest rate caps can be a short term solution. While often used for political rather than economic purposes, they can help to kick start a sector or incubate it from market forces for a period of time until it is commercially sustainable without government support.

They can also promote fairness – as long as a cap is set at a high enough level to allow for profitable lending for efficient financial institutions to SMEs, it can protect consumers from usury without significantly impacting outreach. Additionally, financial outreach is not an end in itself and greater economic and social impact might result from cheaper credit in certain sectors rather than greater outreach. Where lenders are known to be very profitable then it might be possible to force them to lend at lower rates in the knowledge that the costs can be absorbed into their profit margins.

Caps on interest rates also protect against usurious lending practices and can be used to guard against the exploitation of vulnerable members of society. However, although there are undoubtedly market failures in credit markets, and government does have a role in managing these market failures (and indeed supporting certain sectors), interest rate caps are ultimately an inefficient way of reaching the goal of lower long term interest rates.

This is because they address the symptom, not the cause of financial market failures. In order to bring down rates sustainably, it is likely that governments will need to act more systemically, addressing issues in market information and market structure and on the demand side and ultimately supporting a deeper level of financial sector reform.