Jun 23, 2019
This week, we revisit the interest rate cap topic following the proposal by the National Treasury Cabinet Secretary, Mr. Henry Rotich, in the Budget reading for 2019/20 fiscal year, to repeal Section 33B of the Banking Act, which capped interest chargeable on loans at 4.0% above the CBR rate. As highlighted in the Finance Bill 2019, the proposition to repeal the interest rate cap stems from the adverse effects the law has had on credit access, especially by the Micro, Small and Medium Enterprises (MSMEs), which consequently has detrimental effects on economic growth.
In 2018, the Parliament rejected a similar repeal proposition made by the Cabinet in the Finance Bill 2018, electing to retain the lending rate cap ceiling but scrapping off the deposits rate floor, which was set at 70.0% of the Central Bank Rate. According to the Treasury, in order to spur business activity and improve access to credit to the private sector that is largely made of MSMEs, there is a need to repeal the rate cap law. The Central Bank of Kenya (CBK), and the International Monetary Fund (IMF), also support the repeal of the interest rate cap, citing that the law has not achieved its intended objectives.
We, therefore, revisit the issue of the interest rate cap, focusing on:
Section I: Introduction
Controls in the banking sector date back to the post-independence period where between 1963 and 1970, the government pursued a regime of interest rate capping and quantitative credit controls, with the aim of encouraging investment and spurring economic growth and development. The controls fixed minimum saving rates for all deposit-taking institutions and maximum lending rates for lending financial institutions, which resulted in fixed interest spreads for banks. This was largely aimed at improving the aggregate savings level, by incentivizing depositors using relatively higher deposit rates. Control of lending rates, on the other hand, resulted in the suppression of financial intermediation, which consequently changed banks’ operating models, and they became biased towards short-term credit to parastatals and major firms.
The enactment of the Banking (Amendment) Act 2015 in September 2016, 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 due to various reasons:
Section II. A Recap on Our Analysis on the Subject
Our view has always been that the interest rate cap regime would have an adverse effect on the economy and by extension to Kenyans. We have previously written about this in six focus notes, namely:
Section III: 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 stock of credit to SMEs declined sharply by 10% y/y in October 2017 from a similar period in 2016 on account of difficulty for banks to price the SMEs within the set margins, as they were perceived “risky borrowers”. Banks thus invested in asset classes with higher returns on a risk-adjusted basis, such as government securities. Lending to the public sector increased sharply with a growth of over 25% y/y over the same period. Private sector credit growth touched a high of 25.8% in June 2014, and averaged 11.8% over the last five years, but dropped to below 5.0% after the implementation of interest rates controls, rising slightly to 3.4% in February 2019. The chart below highlights the trend in private sector credit growth.
Following the enactment of the Banking (Amendment) Act, 2015, banks recorded a rise in demand for loans, as did the number of loan applications, which increased by 20.0% in Q4’2016, according to the CBK Credit Officer Survey of October-December 2016. This was on account of borrowers attempting to access cheaper credit. However, the supply of loans by banks did not meet this rise in demand 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. Thus, banks adapted to this tough operating environment by adopting new operating models through:
As a result of the private sector credit crunch, there was a rapid rise in the alternative credit markets as evidenced by the Mobile Financial Services (MFS) rising to become the preferred method to access financial services in 2019, with 79.4% of the adult population using the channels up from 71.4% in 2016. According to Global Digital, in 2018, there were about 6.1 mn digital borrowers in the country coupled with 28.3 mn unique mobile users. Players in this segment charge exorbitant interest rates, e.g. M-Shwari charges a facilitation fee of 7.5%, while Tala and Branch offer varying rates depending on the repayment period with a month’s loans offered at a rate of 15.0%, which are very expensive when annualized.
The introduction of interest rate controls has made it difficult for the CBK to adjust the monetary policy rates in response to economic developments. Before the interest rates were capped, the CBK was able to adjust the CBR in relation to changes in inflation and growth. This is mainly because any alteration to the CBR would directly affect credit conditions. Expansionary monetary policy 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 reverse effect of increasing the supply of credit in the economy since banks would be able to admit riskier borrowers.
Section IV: Case Study of Interest Rate Cap Regime in Zimbabwe
Between 1980 and 1999, the financial sector of Zimbabwe was characterized by administrative controls on deposit and lending rates that were frequently adjusted to take into account rising inflation rates. During this period, the average annual economic growth rate was 2.7%, below the population growth rate of 3.0%.
In 2015, an interest rate ceiling was introduced which was effected on 1st October the same year, where the Reserve Bank of Zimbabwe directed that commercial banks cap interest rates at 18.0%, for both existing and new borrowers, as part of measures to deal with the prohibitive cost of finance following dollarization. Prior to the rate cap, local commercial banks were charging interest rates as high as 35.0% similar to what Kenyan commercial banks were charging before the rate cap. The model of the rate charged under the ceiling depended on the risk profiles of customers where prime borrowers with low credit risk were to be charged between 6.0% and 10.0% per annum, borrowers with moderate risk were to be charged between 10.0% and 12.0% per annum and lastly, borrowers with high credit risk were to be charged between 12.0% and 18.0% per annum, respectively. Further, housing finance loans attracted annual interest rates of between 8.0% and 16.0% per annum while loans for consumptive purposes were quoted at between 10.0% and 18.0%. Defaulters, on the other hand, were charged a penalty from 3.0% to 8.0% over and above the interest rates they would have been charged for the loans obtained.
In 2017, effective from April 1st, the interest rate ceiling dropped to a maximum of 12.0% and ranged between 6.0% and 12.0%, respectively, depending on the risk profile of each customer. Further, the charges including application, facility and administration fees were capped at 3.0%. The decline in the interest rate cap was attributed to a move by the Reserve Bank of Zimbabwe to reduce the lending rates to a level that was comparable with the rest of the region. This was driven by aims to improve credit consumption for the purpose of driving production across sectors and other auxiliary activities. The Central Bank also engaged the Banker’s Association of Zimbabwe to reduce interest rates on loans for productive purposes to make lending cheaper for producers with the goal of exporting products.
In February 2019, the Governor of the Reserve Bank of Zimbabwe, John Mangudya, indicated that the Central Bank was in the process of introducing a bank rate which is expected to guide interest rates in the market. The bank rate will be used as a monetary policy instrument to control liquidity in the market. The move comes after the outcry of local commercial banks who complain that the set interest rate of 12.0% had been overtaken by inflation, which was at a high of 56.9% in the month of February, making it difficult for them to lend.
In 2015, bank lending to individuals and manufacturing accounted for 22.0% and 19.8% total loans, respectively. In 2017, however, the distribution of loans to individuals and manufacturing sectors declined to 18.6% and 17.3%, respectively. Total banking sector gross loans & advances decreased by 2.6% from USD 3.9 bn in 2015 to USD 3.8 bn in 2017 on account of reduced lending rates. On the other hand, fees and commission income in the banking industry rose by 51.2% to USD 512.5 mn in 2018 from USD 339.0 mn recorded in 2015, owing to hidden loan charges, despite the 3.0% cap on application, facility and administration fees charged by banks in 2017.
Zimbabwe’s lending rates ceiling generally aimed to target predatory lending that arose when the economy was dollarized in 2009 and banks took advantage of the different currencies in the economy to price their loans based on Zimbabwean dollar and not US dollar based as required. This reduced transparency resulted in local commercial banks charging interest rates as high as 35.0%. The lending cap has impacted the banking industry as evidenced by a credit crunch towards the private sector, similarly observed in Kenya. The private sector credit growth in Zimbabwe was at 4% in 2014 before the rate ceiling, which then slumped to negative 9% in 2016 at the height of the interest rate cap as shown below.
As highlighted, bank lending to individuals and manufacturing in 2017 recorded declines to 18.6% and 17.3%, respectively from 22.0% and 19.8% in 2015 when the rate ceiling was implemented. Specifically, the cap affected the manufacturing sector, with a bias to producers of chemicals and petroleum products, wood and furniture, metal and metal products, clothing and footwear, and non-metallic mineral products, among others.
Section V: Recent Developments
The Finance Bill 2018 was tabled by the Parliamentary Committee on Finance and Planning in the National Assembly during its first reading with proposed amendments to repeal Section 33B of the Banking Act which would result in the elimination of the Central Bank’s powers to enforce an interest rate cap in banks and other financial institutions. During the second reading of the bill in parliament, however, the committee was of the view that:
On 18th March 2019, the High Court suspended the Interest Rate Cap law in a ruling that declared Section 33B (1) and (2) of the Banking Act unconstitutional and gave the National Assembly one year to amend the anomalies, failure to which will mean a reversion to a free-floating interest rates regime. A three-Judge bench determined that the wordings the Parliament used to define the terms ‘credit facility’ and the ‘Central Bank Rate’ as vague and open to multiple interpretations. The anomalies and ambiguity arise in Section 33B (1) of the Banking Act which states that, “a bank or a financial institution shall set the maximum interest rate chargeable for a credit facility in Kenya at no more than four percent, the Central Bank Rate set and published by the Central Bank of Kenya (now at 9.0%)”.
The National Treasury Cabinet Secretary, Henry Rotich, stated that in this year’s Finance Bill, another proposal would be tabled to seek the repeal of Section 33B of the Banking Act 2016, as the interest rates cap has had the opposite effect of reducing credit access by MSMEs, in addition to contributing to the shrinking of small banks’ loan books. The Cabinet Secretary maintains its view that in order to spur business activity and improve access to credit by MSMEs and the private sector in general, there is a need to repeal the rate cap law.
The International Monetary Fund backed the National Treasury and CBK’s call for the repeal of the interest rates cap law. The IMF working paper released in March 2019 termed the interest rate controls Kenya introduced in September 2016 as the most drastic measures ever imposed. According to the paper, the reduction of the interest rate spreads, which initially was intended to increase access to bank credit and boost the return on savings, seems to have the opposite effect evidenced by;
The paper also points out the reduced signaling effect of the policy rate as an indicator of the monetary policy stance due to the increased divergence of interbank rates from policy rates following the implementation of the interest rates cap. The paper proposed that consideration should be given to using other policy instruments, instead of interest rate controls, to increase financial access and address equity concerns related to the high profits of the banking sector.
The Kenya National Chamber of Commerce and Industry (KNCCI) has backed the proposal to repeal the commercial lending rate caps law with the view that that the removal of the cap will provide an added incentive to banks to loosen risk considerations before extending credit to SMEs, thus improving credit access by small businesses.
Section VI: Our Views, Expectations, and Conclusion
The proposal to repeal Section 33B of the Banking Act (2016) by the Cabinet Secretary will be tabled in the form of Bills before it is introduced to the National Assembly, thereafter it will be assigned to a committee where it will be read for the first time. The bill will go through the Second and Third Reading stages before final approval or rejection is given by Parliament. Thereafter, the President will give assent to the Act of Parliament, which subsequently will be gazetted to become law. If the proposal to repeal the rate cap law is successful, we expect to see the following benefits accrue to the economy:
In conclusion, we continue to emphasize the 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 4.9% as at April 2019, below the 5-year average of 14.0%. Some policy measures, other than interest rate caps, that can both protect borrowers from excessive interest rates and limit the negative consequences of interest rate caps include:
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.