May 13, 2018
We revisit the interest rate cap following the recent announcement by the Treasury that they were in the process of completing a draft proposal that will address credit management in the economy. Treasury Cabinet Secretary, Henry Rotich, stated that the draft law would not only be centered on the cost of credit, but will also present some consumer protection policies. “The package of reforms is expected to address the real cause of the high credit cost in Kenya, and eventually lead to the elimination of the law capping interest rates,” said Henry Rotich during the launch of the 2018 Economic Survey Report in Nairobi. A repeal of the law was one of the promises made to the IMF, for the extension of the USD 1.5 bn stand-by credit and precautionary facility. The IMF said in a statement, “On March 12, the executive board of the IMF approved Kenyan authorities’ request for a 6-month extension of the country’s stand-by arrangement to allow additional time to complete outstanding reviews”. The availability of the credit facility was tied to the Treasury’s fulfillment of the promise it made to cut back on the fiscal deficit through a raft of budget consolidation measures, including cutbacks on public spending, together with a repeal of the interest rate cap law. We therefore revisit the issue of the interest rate cap, focusing on;
Section I: Background of the Interest Rate Cap Legislation - What Led to Its Enactment?
The enactment of the Banking (Amendment) Act, 2015, that capped lending rates at 4.0% above the Central Bank Rate (CBR), and deposit rates at 70.0% of the CBR, came against a backdrop of low trust in the Kenyan banking sector about credit pricing due to various reasons;
This fueled anger from the Kenyan public, who accused banks of unfair practice in the quest for extremely high profits at the expense of the borrowers and savers. As a result, banks in Kenya had been making one of the highest profits in the region, as shown in the charts below for the period between 2012 and 2016:
Source: World Bank
This culminated in the interest rate cap bill being tabled in parliament, and due to its populist nature was passed and signed into law by the President on August 24th, 2016, and it was enforced from September 14th 2016.
Our view has always been that the interest rate cap regime would have adverse effect on the economy, and by extension, to the Kenyan People. We have previously written about this in five focus notes, namely:
Having now been in effect for 21-months, plans to review the law have been gaining traction because there is significant evidence that its intended objectives have not been achieved. On the campaign for review are banks, private sector players, organizations such as the IMF, and the Central Bank of Kenya (CBK). The CBK has mentioned that according to its research, the interest rate cap has failed to achieve the objectives it was drafted for, mainly access to credit at favorable pricing. Instead, the cap has (i) inhibited the growth of private sector credit in the economy, and (ii) made it difficult for the enforcement of monetary policy action, as any action on the benchmark CBR would trickle down to credit pricing. The IMF has also been vocal in its recommendation of a repeal of the law. The IMF noted that the rate cap had the effect of locking out a lot of Small and Medium Enterprises (SMEs) from accessing credit, and with SMEs being the largest proportion of the private sector, this translated to reduced economic output. A repeal of the law was also part of the commitments made by the National Treasury when seeking an extension to use the USD 1.5 bn credit and precautionary facility by the IMF. The facility is normally used in case of any economic shocks that may affect the economy. The Cabinet Secretary thus indicated that a draft proposal that will address credit management in the economy would be tabled in parliament in June this year.
On the flip side, some organizations have come out in support of the interest rate cap, namely the Institute of Certified Public Accountants of Kenya (ICPAK). The organization has raised concerns that a repeal of the interest rate cap would lead to a return to the previous regime characterized by exorbitant borrowing costs. They argue that although the concerns raised are genuine, it is still too early to assess the impact of the rate cap to the economy, and that the challenges experienced are not directly attributable to the rate cap. ICPAK together with the Consumer Federation of Kenya (CoFEK), are of the view that we need to address the challenges that led to the enactment of rate cap, mainly the high cost of borrowing, and ensure that there is a better balance between the interests of the market players and those of the consumers.
Section II: A Review of the Effects It Has Had So Far In Kenya
The interest rate cap has had the following four key effects to Kenya’s economy since its enactment:
Private sector credit growth in Kenya has been declining, and the enactment of the Banking (Amendment) Act, 2015, had the adverse effect of further subduing credit growth. The law capped lending rates at 4.0% points above the CBR. This made it difficult for banks to price some of the borrowers within the set margins, a majority being SMEs, as they were perceived “risky borrowers”. Banks thus invested in asset classes with higher returns on a risk-adjusted basis, such as government securities. As can be seen from the graph below, private sector credit growth touched a high of 25.8% in June 2014, and has averaged 14.0% over the last five-years, but has dropped to 2.0% levels after the capping of interest rates.
According to the September 2016 CBK Credit Officer Survey, banks tightened their credit standards immediately after the interest rate cap was enforced in Q4’2016. The sectors mainly affected were Agriculture, Financial Services, Energy, Trade, Transport, Personal/ Household and Manufacturing. Tighter credit standards have persisted, and private sector credit has not accelerated since the cap was effected, coming in at 2.1% in March 2018. The resultant effect is that the legislation has not achieved its primary objective of improving credit growth to the private sector.
Immediately after the enactment of the Banking (Amendment) Act, 2015, banks saw an increase in demand for loans, as the number of loan applications increased by 20.0% in Q4’2016 according to the CBK Credit Officer Survey of October-December 2016. This was due to borrowers attempting to get access to cheaper credit. However, this demand was not matched with supply of loans by banks as evidenced by:
The enactment of the Banking (Amendment) Act, 2015, saw banks changing their business and operating models to compensate for reduced interest income (their major source of income) as a result of the capped interest rates. Furthermore, the enactment of the law saw increased cost of funds, as deposit rates were floored at 70.0% of the CBR, which meant increased interest expense to banks. With the reduction in income (interest income), and increased cost of funds, the banks’ profitability margins were set to reduce. Thus, banks adapted to this tough operating environment by adopting new operating models in several ways:
Banks’ profitability thus generally reduced after the enactment of the cap, as evidenced by the return on equity and return on assets that declined to 19.8% and 2.3%, compared to the 5-year averages of 29.2% and 4.4%, respectively. The listed banking sector recorded a decline in earnings by 1.0% in 2017, from a growth of 4.4% in 2016. Banks have adjusted their business models to mitigate against the effects of the legislation, rather than reduce credit costs or increase access to credit, which were the initial objectives of the law. The “punishment” that the public wanted meted out to the banks has been mitigated by the sector using the above changes in operating model. We are of the view that any repeal or amendment will also be mitigated by the dynamic banking sector, hence the best approach to addressing banking sector dominance and overreliance in the sector is to stimulate alternative funding sources.
The Banking (Amendment) Act, 2015, has made it difficult for the Central Bank to conduct its monetary policy function. This is majorly because any alteration to the CBR would directly affect the deposit and lending rates. During the period of enactment of the interest rate cap law, private sector credit was on a declining trend. Inflation was also low and was expected to decline. Therefore, the Monetary Policy Committee (MPC) decided to lower the CBR so as to inject growth stimulus into the economy. This however had the opposite and unintended result as credit growth declined further. Thus, the monetary policy decision failed to yield the expected results of improving credit growth. Expansionary monetary policy thus is difficult to implement since lowering the CBR has the effect of lowering the lending rates and as a consequence, banks find it even more difficult to price for risk at the lower interest rates, leading to pricing out of even more risky borrowers, and hence further reducing access to credit. On the other hand, if the CBK was to employ a contractionary monetary policy, so as to reduce inflation and credit growth for example, then raising the CBR would have the converse effect of increasing the supply of credit in the economy since banks would be able to admit more riskier borrowers. Therefore, the monetary policy function of the Central Bank cannot be effectively executed in a regime with capped interest rates, and especially where the pricing is pegged on the Central Bank Policy rate such as the CBR in this case. This hampers the CBK’s ability to carry out its mandate of ensuring price stability in the economy under a capped interest rate regime.
Having taken the above four effects into consideration, it is clear that the legislation has not achieved its intended effect. The IMF has maintained that with the rate cap in place, lending to Micro, Small and Medium Enterprises has been inhibited, and since they are significant contributors to the country’s output, then GDP growth is negatively affected.
To grant the extension to the precautionary credit facility, IMF set conditions for both fiscal consolidation and modification of interest rate controls. The National Treasury as a result agreed to the conditions set by the IMF and has a 6-months grace period to effect these conditions. The stand-by facility is especially important in the event the economy experiences external shocks that may put upward pressure on the Kenya Shilling.
This leaves the inevitable proposition of a repeal of the rate cap law, just as was the case in Zambia. However, it will be difficult owing to the populist nature of the law, even though it makes economic sense to repeal it. Consideration however has to be made of the challenges that lead to the initial enactment of the law.
Section III: Case Studies of Other Interest Rate Cap Regimes in Sub Saharan Africa
We are not surprised that the interest rate cap regime has not been effective, given the history of such policy action in other countries. We present two quick case studies:
The Central Bank of Zambia introduced a cap on the effective interest rates charged by banks at 9% above the Central Bank Rate in 2012. This led to the Non-Bank Financial Institutions (NBFI) that mainly included microfinance institutions, leasing finance institutions and building societies, thriving by providing credit to people who were perceived ‘‘risky borrowers’’ and could not be priced within the interest rate cap. Borrowing costs rocketed, with microfinance institutions in the country charging an average effective annual rate of 109.2% on the loans issued. These high costs led to increased public unrest, which culminated with the Central Bank of Zambia introducing another interest rate cap on the effective interest rates charged by Non-Bank Financial Institutions. Thus, the maximum effective annual lending rate for all companies designated as Microfinance institutions was capped at 42% p.a. and all other NBFI had the maximum annual effective lending rate at 30% p.a. The second interest rate cap resulted in a reduction in lending, especially to the middle and low-income group, that initially benefited from access to these loans. Furthermore, access to credit from more established institutions such as commercial banks was also reduced, since most people seeking credit were already highly leveraged and already falling into a debt trap. Thus, they could not be priced within the set margins of commercial banks at 9% of the Central Bank Rate. This had the effect of reducing overall credit to personal and household entities, together with small businesses, leading to reduced economic output. As a result, the Zambian Government repealed the interest rate caps, and replaced the cap with a raft of consumer protection policies in November 2015. The policies focused on reducing the opacity in the pricing of the loans by ensuring full disclosures to the borrowers. The conditions for the repeal stipulated tough sanctions for any institutions defying the set out consumer protection policies. The Central Bank even went a step further and issued a disclosure template that will be issued to the prospective borrower by the issuing institutions, so as to provide full disclosure and more clarity on the borrowing terms. This has aided in reducing the overall cost of borrowing from the high average of 109.2% p.a. before to 65.2% p.a. as at 31st March 2017, albeit this is still too high.
The WAEMU is a combination of eight countries in the West African region that comprises of Benin, Burkina Faso, Cote d’Ivoire, Guinea-Bissau, Mali, Niger, Senegal and Togo. The region had witnessed a proliferation of microfinance institutions. A huge proportion of the funding for a majority of these institutions was from grants obtained from international financial institutions and their respective governments. Despite the cheap cost of funding, the cost of credit skyrocketed and as a result, there was public outcry for the reduction and capping of the borrowing rates and for regulation in terms of how microfinance institutions price credit. The region’s Central Bank capped lending rates at 15% for banks and 24% for non-banking institutions in 1997. However, after the imposition of the rate cap, many microfinance institutions withdrew from areas mainly occupied by low income households, their main clientele. This saw reduced credit accessibility by these households as microfinance institutions were unable to price these borrowers within the margins set by the Central Bank. This had the overall effect of locking out low-income borrowers, since these institutions adopted strict lending policies and focused on secured lending to larger and more “secure” borrowers, as opposed to the small borrowers that form the majority of the population. Thus, the cap had the opposite intended effects as credit accessibility was reduced for low earners. However, the interest rate cap remains in place to date. The World Bank has repeatedly called for the WAEMU to consider amending the interest rate caps, either in a partial or phased liberalization plan, coupled with increased transparency requirements and standardized disclosures, as the caps have also constrained the offer of innovative digital credit and savings products to the unbanked, thereby limiting the growth of financial inclusion.
Section IV: Our Views on the Way Forward:
It is clear to us that we need to urgently repeal or at least significantly review the Banking (Amendment) Act, 2015, given the current regulatory framework, as it has hampered credit growth, evidenced by the continued decline of private sector credit growth, which is at 2.1% as at March 2018, below the 5-year average of 14.0%; but a repeal ought to contain several components as there is no single silver bullet. We are however concerned that the repeal is more focused on banks, yet to manage bank dominance and funding reliance we have to focus on expanding capital markets as an alternative to banks. We see a combination of the following 7 measures as necessary as part of the repeal:
In conclusion, a free market, where interest rates are set by market participants coupled with increased competition from non-bank financial institutions for funding, will see a more self-regulated environment where the cost of credit reduces, as well as increased access to credit by borrowers that have been shunned under the current regime. Consequently, a repeal is necessary, but the repeal needs to be comprehensive and contain the 7 elements above for it to be effective, but the center-piece of the legislation should be stimulating capital markets to reduce banking sector dominance, yet this key piece seems to be missing in the current draft discussions.
Disclaimer: The views expressed in this publication are those of the writers where particulars are not warranted. This publication, which is in compliance with Section 2 of the Capital Markets Authority Act Cap 485A, is meant for general information only and is not a warranty, representation, advice or solicitation of any nature. Readers are advised in all circumstances to seek the advice of a registered investment advisor.