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Are we on the right path? Why countries around the world have capped costs of borrowing

By Dominic Omondi | August 2nd 2016

If MPs’ proposal to put a ceiling on interest rates becomes law, Kenya will join 74 countries that have capped borrowing charges.

Just as similar legislation does in these countries, the objective of the Banking (Amendment) 2015 Bill is to protect borrowers from paying high costs for loans.

Capping interest rates to cushion consumers from predatory lending from financial institutions is a well-trodden path globally.

Sometimes this path has led to success, but some of the countries that taken this route have seen their economies plunged into an undesirable abyss of failure.

The National Assembly wants the maximum interest rate chargeable on a credit facility to be no more than 4 per cent above the Central Bank of Kenya’s (CBK) benchmark rate.

CBK’s Monetary Policy Committee (MPC) recently set the CBK rate at 10.5 per cent. Thus, should the Bill become law, interest rates would decline by almost half to 14.5 per cent.

For ordinary borrowers, on the face of it, this sounds like great news. After all, ordinary Kenyans have been labouring to make ends meet, sometimes being forced to grudgingly arrange dates with commercial banks and microfinance institutions to beg for credit to survive.

The interest rates financial institutions charge Kenyans would be catastrophic in other parts of the world. As a result, local banks often report profits that few other sectors can match.

This prevailing interest rate regime that tends to benefit a few shareholders is frowned upon not just by religious faiths like Islam and Christianity, but also liberal economies in parts of Europe, the United States and in Japan.

In the US, usury, which is the practice of giving unethical or immoral monetary loans that unfairly enrich the lender, is controlled by individual states. These states specify the maximum legal charges above the lawful interest rate.

If a lender charges above the lawful interest rate, a court will not allow it to sue a borrower to recover the debt as the interest was illegal.

And although the federal government has not been actively involved in capping interest rates, it is a federal felony to lend money at an interest rate more than twice a local state’s usury limit.

Types of ceilings

Several other countries have put ceilings on interest rates to protect consumers from unbridled profiteering by financial institutions. However, these controls have been specific in terms of the type of loan, the amount of money borrowed and the type of financial institutions.

Chile, for instance, has nine categories of ceilings based on size, currency and term.

There are 12 types of caps on interest in France based on the amount and type of credit. In Uruguay, the cap depends on the amount of the loan.

Caps can also be placed on specific institutions.

In Zambia, there is one ceiling for banks, another for microfinance institutions and a third for non-banking financial institutions.

In Ireland, there is a ceiling for credit unions and another for private money lenders.

In the Kyrgyz Republic, a cap is only placed on microloans. In Poland there is a unique cap on consumer loans.

To protect consumers, as Kenya intends to do, countries place caps on products that the poor tend to access, such as micro credit, or on the financial institutions they frequent, like Saccos and microfinance banks.

Kenya’s interest rate is pegged on exogenous benchmark rates, that is the Central Bank Rate (CBR) and Kenya Banks Reference Rate (KBRR), which is similar to the situation in Brazil, Belgium, Mauritania and Spain.

Brazil’s interest rate is two times its benchmark Celic rate; Poland’s is four times its Lombard rate; the Netherland’s rate is set on the basis of the European Central Bank rate plus a fixed margin of 12 per cent.

As of 2014, 24 countries in sub-Saharan Africa — or 50 per cent of the region’s nations — had some form of interest rate controls.

According to a 2014 World Bank research working paper, Interest Rate Caps around the World: Still Popular, but a Blunt Instrument, these countries include Eritrea, Ethiopia, Ghana, Guinea, Mauritania, Namibia Nigeria, South Africa, Sudan and Zambia. Others are Benin, Burkina Faso, Cote d’Ivoire, Guinea Bissau, Mali, Senegal, Togo and Niger.

In Asia, China, Japan, Laos, Myanmar, Philippines, Thailand, Vietnam, Bangladesh, India and Pakistan have some form of interest rate caps.

Illiberal act

In Latin America and the Caribbean, Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Guatemala, Honduras, Nicaragua, Paraguay, Republican Dominican, Uruguay and Venezuela have capped interest rates.

In the Middle East and North Africa, Algeria, Egypt, Libya, Malta, Syria and Tunisia have put a ceiling on how much banks can charge for loans.

Even advanced economies like France, Germany, the United Kingdom, Ireland, Italy, Portugal, Spain and Switzerland have engaged in the illiberal act of taming interest rates, as have Australia and Canada.

According to the World Bank, most of these countries have put caps on borrowing rates to protect consumers. Others like Estonia and Zambia put in place ceilings to prevent indebtedness. The Netherlands capped interest rates to decrease the risk-taking behaviour of credit providers.

“Interest rates caps are used to prevent people from getting into runaway debt situations. The best known global example is the housing crisis of the late 90s when people who simply couldn’t afford to take on credit were encouraged to take credit and got into problems of debt traps. Credit ceilings and credit caps help resolve this,” said Adrian Saville, a visiting professor of economics at the Gordon Institute of Business Science (GIBS) in Johannesburg.

Zambia put caps on interest rates to ensure finance was available for low-income borrowers.

According to the World Bank report, financial controls such as interest caps are sometimes done to support a specific industry or sector of the economy where market failure exists, or where a greater concentration of financial resources is needed.

Caps are also useful mechanisms for providing short-term credit to a strategic industry or for supporting a sector until it can sustain itself. The Republic of Korea did this successfully between 1956 and 1994.

Debate on financial controls was reopened after the 2008 crisis when banks in the US adopted a laissez-faire policy that led to one of the world’s largest financial meltdowns.

In the years that followed, Zambia (in 2013), El Salvador (in 2012), the Kyrgyz Republic (in 2013) introduced fresh caps on interest rates. Japan also imposed more restrictive caps.

But there have also been arguments against capping, with some noting it is an inefficient tool for lowering interest rates, especially in the long run.

The downsides

Interest caps limit access to credit, reduce transparency and decrease product diversity and competition, analysts have warned.

They could also weaken demand for formal credit and affect companies’ productivity by limiting their access to finance for expansion.

Caps could also distort the market, pushing lenders to cherry pick borrowers with high collateral, thus creating inefficiencies in financial intermediation, which means poor borrowers get left out.

Moreover, banks may withdraw from certain regions, such as rural areas, if the caps are set at unprofitable levels. This can then spawn unlicensed moneylenders, such as shylocks, who charge even higher interest rates.

But not all economists see trouble with capping.

Joseph Stiglitz, an American economist and Nobel Laureate, is a passionate critic of the policy of liberalisation in developing countries.

In his book, Globalisation and its Discontents, he castigates the International Monetary Fund (IMF) for forcing down the gospel of liberalisation in the developing world, including freeing up interest rates even when developed countries at some point capped their interest rates.

Prof Stiglitz noted that even advanced countries like the US and Japan “built up their economies by wisely and selectively protecting some of their industries until they were strong enough to compete with foreign companies.”

Stiglitz has attributed the difficulty in job creation in developing countries like Kenya to the IMF’s insistence on developing countries maintaining tight monetary policies.

Job creation

These policies, he said, have led to “interest rates that would make job creation impossible even in the best of circumstances.”

According to Godwin Murunga, in the book Kenya: The Struggle for Democracy, the liberalisation in the country that eliminated price controls and deregulated foreign exchange rates was done without bearing in mind the anti-competitive nature of the banking sector.

“The interest rates had been completely deregulated by the Banking Act of 1993. But the deregulation was in an environment of fiscal instability that was characterised by weak Central Bank supervision,” he notes.

But according to XN Iraki, an economics lecturer at the University of Nairobi, capping interest rates can be counter-productive.

“Capping interest rates appears good on paper until you think of the unintended consequences,” he said.

“With low interest rates, there will be less funds available for lending because banks and other financial institutions will make less profit. Looking at the global nature of finance, that money can be lent else. Capping interest rates is like looking at a telescope from the other end.”

Dr Iraki is supported by Treasury Cabinet Secretary Henry Rotich and CBK Governor Patrick Njoroge.

Further, according to Thomas Ross, a professor at the University of British Columbia, capping rates might just be a sign we are running away from the real issues ailing the banking sector.

“Such a policy raises two key concerns for me. First, it distracts us from working on the real costs of the higher rates, whether this is a lack of competition or high costs of lending or something else,” he told Business Beat in an email interview.

“Addressing the core problem is likely to be a better long-term way to improve the functioning of lending markets.”

Indeed, the banking sector is already under the microscope of the Competition Authority of Kenya (CAK) for non-competitive behaviour.

The sector’s oligopolistic state dates back to the 80s and 90s, and informed the enactment of the Donde Bill in 2000, which attempted to regulate interest rates.

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