Post signing of the Banking (Amendment) Bill 2015, Kenyans were full of hope and expectations of lower interest on their loans and higher earnings on deposits.
Like with so many regulatory actions, the outcome for the people will depend on the implementation of the law. In this case, the fate of the law will rely heavily on financial institutions, and implementation might impact the economy as well. Interest rate caps are one of those things that sound too good to be true. What can we expect?
Let’s break down the proposed changes in the Banking (Amendment) Bill 2015 into two major pieces. First, it requires disclosure: financial institutions have to disclose all terms and charges to consumers. Second, it sets an interest rate cap on loans at four percentage points above the base rate published by the Central Bank of Kenya (CBK) and a minimum interest rate on deposits of 70% of the same base rate. Failure to abide by these caps is, well, illegal.
The disclosure requirements are necessary and very welcome. Most financial institutions do not charge only interest rates on loans, but also fees. Similarly, they do not simply pay interest on deposits but some also charge withdrawal fees.
All of the six largest banks in Kenya, which together hold 87% of deposit accounts and 76% of loan accounts, charge fees on at least one of their loan products over and above the quoted interest rate. In some cases, these fees are as high as 2.5% of the total loan amount. Similarly, all of them charge withdrawal fees on at least one of their savings accounts with fees that are as high as Sh120 per transaction.
With the new law, consumers will have clarity on what they are paying over and above a base rate, which is a commendable step towards consumer protection. In fact, the CBK has been leading from the front by creating the Kenya Bank Reference Rate (KBRR) and publishing on their website lending rates across all banks.
The KBRR is the average of the lowest interest rate charged by the CBK on loans to banks and the 91-day Treasury Bill rate, which can be thought of as the equivalent of the risk free rate in the economy. It allows consumers to have a low risk benchmark when comparing the pricing of loan products.
[caption id="attachment_17936" align="alignnone" width="577"] Kenyan shillings[/caption]
Exorbitant and unconscionable
What has been discussed and followed with greater fervor are the proposed interest rate caps. Interest rate caps are used widely across the world, with half of the countries using this tool in Sub-Saharan Africa.
The majority of countries are using caps to curtail exorbitant and unconscionable interest rates on loans (frequently referred to as usury). Hence, interest rate caps could be considered as a policy intervention to drive down the cost of loans for consumers. This sounds desirable. But, what are the implications of using such an intervention?
The worst case may lead to a credit crunch further disenfranchising those who benefit the most from loans and who should be incentivised to save. Recent research shows that access to easy and effective saving mechanisms is important for the poorer segments of society.
Currently, the average lending rate in Kenya is 18%. The 91-day Treasury Bill rate is 8.6%. Given that Treasury bills are the lowest risk asset in the economy, the difference between these and banks’ lending rates are the price on the riskiness of loans. Are these rates high? Yes. However, are these rates in dire need of a policy intervention?
It is important to ask what problem the interest rate capping is trying to solve. Policy should be used to rectify a specific market failure and without truly understanding the market failures, our policies might just be a case of shooting from the hip. The Kenyan banking sector has a number of market failures including poor incentives to lend, fraud and lack of transparency, among many others.
The Banking Bill does address transparency as discussed above. But it is questionable to assume that interest rate caps as a policy tool will adequately address some of the key market failures in Kenya, specifically poor incentives to lend. What are the implications of capping interest rates at four per cent higher than a base rate determined by the CBK? One scenario is that nothing will change, neither on the true pricing of loans nor on returns on deposits.
Banks may respond by re-orientating their charges towards fees to make up the difference. This will be bad for consumers in the longer term as they may have trouble aggregating and understanding these fees, i.e. it would run counter to increasing transparency, the other major goal the Banking Bill seeks to achieve. But as long as banks just recover the difference in these fees and keep effective prices the same, the credit and deposit markets will be unaffected. Interestingly, one could think of this as the best case scenario.
But what if the banks do not fully adjust the gap through a new fee structure? The incentive to lend will decline even more, verging on a credit crunch that will affect especially high risk customers or those that are costlier to reach. These customers may be disproportionately in the poorer segments of the population or among SMEs, where loans have potentially the highest return on the local economy.
In addition, this credit crunch will be further fuelled by banks having less incentives to take deposits — remember that 72 per cent of bank liabilities are from deposits. You may ask why banks won’t just comply with the policy and adjust interest rates? Ask yourself the following question: If you had to lend money to someone at 12.9 per cent (current KBBR rate + 4%) at risk of losing the money or lend to the government by buying Treasury bills at an almost guaranteed return of nine per cent, what would you do?
It seems as if the best prognosis may put Kenyans between a rock and a hard place. The best case is that nothing changes. The worst case may lead to a credit crunch further disenfranchising those who benefit the most from loans and who should be incentivised to save. Recent research shows that access to easy and effective saving mechanisms is important for the poorer segments of society.
It is fair to assume that the wording of the law will be improved over time. For example, it is not clear what the base rate as stated in the law refers to. Today, we have the CBR and the KBBR rates, which currently differ by 1.6 percentage points. What happens to products such as M-Shwari which do not charge interest rate but a facility fee of 7.5% on a monthly loan? Will M-Shwari be illegal?
Maybe a better policy decision would have been to focus on creating transparency around the true interest rates consumers face today. Fees must be disclosed as part of the cost of a loan or the return to a deposit, and in a transparent way.
Second, we should be focusing on how to expand formal financial services (loans and deposits) to the less fortunate in the economy. Caps are likely to restrict financial services further to these very people, as seen in many other countries especially in Sub-Saharan Africa. Over the last decade, financial exclusion has more than halved as we moved from 26.7% of Kenyans being formally included in 2006 to 75.3% in 2016 — and we are sure it is in no one’s interest to reverse this amazing achievement.