Interest rate capping: lessons from Kenya
When regulators look the other way or seem ‘captured’, politics will fill the void!
Kenya has written a law that puts a cap on lending rates at 4% above the Central Bank Rate (CBR), among other clauses. This means that banks will not be allowed to lend at interest rates above the CBR+4%. For example, the current CBR in Kenya is 10.5%. This means that it will be illegal for banks to issue new loans above 14.5%.
This new amendment in Kenya’s Banking Act has stirred a hot debate within Kenya, the East African region and globally. Since 1990s, the global economy has reduced control of economic indicators. The world has never seen the level of economic freedom enjoyed nearly everywhere. In the years gone-by, government used to control nearly everything.
Uganda’s economy, for example, has evolved from the pre-colonial medieval economy, through the ‘enclave economy’ under the British imperialist government, to the post-independence ‘control model’ under Idi Amin and Obote II.
Prior to the 1990s, Uganda’s economy, just like many other economies in the region, used to be controlled. Nearly all economic indicators – prices, interest rates, exchange rates – were controlled or fixed by government. Upfront, should I say ‘controlled’ life is not fun to live at all!
High interest rate spreads
Economists often refer to control as economic distortion. Why? Because government intervention tends to lead to a departure from the allocation of economic resources in such a way that each agent maximises his/her own welfare.
For example, when government controlled prices in the 1970s and ‘80s, traders hoarded their goods which affected the buyers’ access to the goods and the economy’s overall performance.
When it capped interest rates, banks had no incentive to lend because their profits were very low. This created shortage of credit which led to other undesirable outcomes such as credit rationing (banks selecting who to lend to or not basing on noneconomic criteria).
This is what economists refer to as government failures. It is also what informed the decision to liberalise most of the economies, starting in early 1990s. The proponents of liberalisation promised two things: efficiency and growth. However, people doubted the two have been achieved.
In the case of banks, one of the parameters used to measure efficiency is the interest rate spread (the difference between the lending rate banks charge borrowers and the deposit rate offered to savers). The higher the spread, the less efficient the banking system is.
For the past 20 years, the average interest rate spread (IRS) in Uganda has stagnated above 16.7% while Kenyan banks have been enjoying interest rate spreads of about 11.4% on average, themselves way above the world average of 6.6%. Therefore, liberalisation did not bring the promised efficiency.
The banks attributed the high rates they charge to high risks of default among borrowers due to information asymmetry, high cost of doing business as well as governments’ internal borrowing. However, when the credit reference bureaus were created, providing better credit history on individuals and thus reducing default risks, interest rates did not fall.
What about growth? True more banks have since joined the market under liberalisation. Problem is; few of these banks control a very large market share, meaning there is limited competition. There is also possibility of some collusion or cartel-like behaviour.
Apart from these, a recent investigation by a committee of both government and private sector here in Uganda unearthed several “questionable bank practices” which would point at what economists call predatory lending behaviour.
These included, “mismatched products, staggered disbursements, high and uncontrolled penalties, multiple valuations for same asset, poor communication, and highhandedness.” These and other unscrupulous actions are carried out by banks to have the borrower fail to repay the debt so they can strip him/her of their collateral whose value is often higher than the loan.
Self-regulation has failed
For a long time people have raised these and other challenges they face while dealing with banks. To their chagrin, the central bankers who are mandated to regulate the banks say, “under a liberal economic system we cannot anything to coerce banks.”
This statement has frustrated politicians and their supporters. My view is that the desperate move by Kenyan politicians to cap interest rates should provide a good lesson to our own central bankers at Bank of Uganda (BOU), and the banks they ought to regulate.
Truth is, the market for banks has failed to self-regulate. Banks are insensitive to people’s outcries. Structural factors aside, banks cannot justify the lending rates they continue to charge and the long lags in their response to the CBR.
There also cases that point squarely to poor supervision and monitoring by the BOU. For example, the committee cited above found interesting practices that happen in our banks. There is a bank that extended a loan of Shs.150m to some businessman in May 2014 for completion of 4 apartment units.
The business proposal estimated income at Shs.2m per unit, totaling Shs.8m per month. To enable project completion, the client was three months later advanced another Shs.70m, then another Shs.70m in September and finally another Shs.60m in March 2015. The advances totalled Shs.200m in additional to the original Shs.150m. This loan required the borrower to pay Shs.13m in interest per month.
On completion the apartments, the ‘investor’ could only earn Shs.1.3m per unit totaling Shs.5.2m from the four units. One wonders how the bank expected someone to pay monthly interest of Shs.13m, with gross income of Shs.5.2m before deducting operating expenses!
In this case the bank staff negligently recommended a loan, which was destined to be non-performing right after the first disbursement. The loan product was a mismatch to the client’s need. Ideally the client was entitled to a construction loan aligned to the term and project income stream. Where is supervision?
Obscene profits for banks
Another case is more interesting. A big supplier in town secured a loan of Shs.220m in August 2014 using collateral with a market value of Shs.520m. Three months later, he got a new business contract and requested the bank for an overdraft of Shs.85m to perform the contract. The bank asked for a fresh title to back up the overdraft. The new title was valued at market value Shs.700m.
The borrower cleared the overdraft of Shs.85m in January 2015 after he received payment from the contract. He requested for return of second title and the bank refused, claiming that borrower had defaulted on the original loan’s monthly installments. The bank went ahead advertised both titles.
The borrower secured a court injunction but the bank lawyer irrespective of injunction went ahead and sold the property. What is even more bizarre is that the bank’s sale agreement of the client’s property was dated a month earlier than the advert for sale was run!
More so the bank’s documents submitted in court showed that the bank’s lawyer had bought the property from the bank! How does the bank lawyer purchase the collateral, when he is a trustee of both the bank and the bank client? Secondly, how does the bank justify keeping both titles valued at Shs.1.2bn for a loan, which was less than Shs.200m?
When the BOU receive such cases, how does it respond? They are really common in Uganda. There is a banker in town that is notorious for fleecing people of their property through predatory lending. The regulators at BOU cannot claim that they are not aware of this. Even school kids know about him.
For years banks have posted obscene profits year-in-year-out. Mr. Mutebile one time asked, “What is wrong with banks making money?” Well, a bystander may also ask, “What is wrong with banks making money reasonably?”
But of course “reasonable” is a subjective concept. Given a chance, everyone would love to act unreasonably, because it is always lucrative to cheat if cheating is permissible.
I will be the last to support capping of interest rates; but I would like to see whether the sky will fall over Kenya. When regulators look the other way or seem ‘captured’, politics will fill the void!