Interest rate capping: Will it work in Kenya?

interest

Once the law comes into force, interest rates will drop to a maximum of 14.5 per cent given the CBR’s current standing at 10.5 per cent.

By MICHAEL WACHIRA

Kenya has 42 commercial banks, but the six largest ones popularly known as Tier One control 52.4 per cent of the entire industry. This leads to only a few banks controlling the market, just like any other economy across the globe. Banks act as middlemen through whom we deposit monies and get advances and loans. They make money from the differences between the rate which they pay the depositors and the one they charge the borrower. This difference is called the interest rate spread.

The Banking Act, Banking (Amendment) Bill 2015 is now law and it marks a new era for the banking industry in Kenya. On Wednesday 25th August 2016, the president signed into law the bill that caps interest rates for bank lending and deposits. The new amendments caps banks lending interest rates to no more than four per cent above the Central Bank Rate (CBR) currently at 10.5 per cent.

Once the law comes into force, interest rates will drop to a maximum of 14.5 per cent given the CBR’s current standing at 10.5 per cent. Banks will also pay depositors 7.35 per cent on their money, forcing upon them the narrowest spreads since Kenya liberalised its financial markets in 1990s. It may be worth observing normalcy within the oil sector that is attributed to monthly price controls that are prescribed by the Energy Regulatory Commission against similar run-away pricing model and envisage the same in the financial sector.

The Banking Amendment law

The Banking Amendment law was started by Joe Donde, former Member of Parliament for Gem Constituency, in what was then christened as Donde Bill in 2001. There was an attempt to amend the CBK Act and cap the lending rate at four per cent above the 91 day Treasury Bill and the deposit rate at four per cent below the 91days Treasury Bill. In 2013, the Kenya parliamentary budget office proposed the pegging of the deposit rate to the lending rate.

The political leadership in the current government has been on its knees pleading with bankers to reduce the lending rate, and all that has been widely ignored. For the past 20 years Kenyan banks have been enjoying interest rate spreads of about 11.4 per cent on average way above the world average of 6.6 per cent.

There is consensus, even among banks and the Central Bank of Kenya (CBK) Governor Dr Patrick Njoroge who is on record acknowledging that indeed interest rates in Kenya are too high and not good for that matter. Capping was not the best way to do it, but the government was running out of options. However, the measure presents opportunities for consolidation and for smaller banks, this is going to be bad news. If they can’t charge higher rates anymore, it’s going to be tough for them to survive.

Default risk

The Kenya Association of Bankers (KBA) has opposed regulation of interest rates, saying banks can regulate themselves. It has said in the past that when interest rates are capped, banks will lend only to those with less risk of default and avoid high-risk borrowers such as small and medium businesses which need the money to grow their venture and stimulate the economy. Analysts observe that individual banks are likely to react differently and rules are ruling out mass credit access.

Somehow, the proponents of the amendment agree with bankers that interest rate ceiling prevent naïve and ignorant borrowers from agreeing to loan terms on which they will eventually default. Interest rate ceiling is a good way of limiting access to credit to some impaired and low-income consumers, because they help avoid social harm.   

Interest income from loans and advances is the largest source of revenue for banks. The CBK data shows, the amount earned from these products is KSh273.11 billion for the banking sector accounting for 60 per cent of the total KSh 448.03 billion income made by the bankers during the year 2015.

Kenya now joins a group of 40 developing and transitional countries as well as European countries including the estranged United Kingdom, Germany, and France which have the interest rates capped and is reviewed quarterly. There are now 27 countries that tend to comply and pass the benefits of the low rates to the consumers.

Kenyan banks have been recording high profits even as other sectors struggled. Last year, banks posted an average return on equity of 24 per cent even as more than 18 companies listed at Nairobi Securities Exchange issued profit warnings to the public. Kenya’s largest bank by customers’ base, Equity bank, posted a return on equity of 47.2 per cent in 2015, that’s according to a CBK report. Large banks have failed to pass the benefits of economies of scale to their customers.

Worked and not worked 

There are some down side to this piece of legislation in that the government is not coming in with very clean hands. One of the major contributor to high interest rate is treasury through its borrowing instruments such as T-bills and Treasury bonds. In order to sustain their margin, banks will increase their lending to the government given the increased appetite for funding the national budget.

For the new law to achieve its intended purpose, the government will have to cut down on its domestic borrowing. When the government sets to sell a 10 year bond at an average yield of 15 per cent which is risk free, you do not expect banks to lend to a risky business and individuals at 14.5 per cent. The point is, there is a need for a fiscal adjustment as well.

We are heading for interesting times ahead. The quality of banking services will evolve and how they will adapt to the new regime of interest rate caps, floors and ceilings remain to be seen. Banks will need to review their business plans and change to adopt to the new environment. They will have to break down customers into risk categories and increase the prominence of credit reference bureaus so that they provide both bad and good information. Some banks will definitely lose businesses that lack collateral to savings and credit cooperatives and to microfinance institutions.

While interest capping has failed in countries such as Nigeria and India, it has worked in some countries. France, Zambia, Canada and Argentina have successfully resorted to such measure in order to protect its people against the market failures.

Email: mikhaelwachira@gmail.com

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