Interest Rate Capping and Credit Flow to Private Sector

In this article we would like to add our opinion to the many that are already in place on the rate cap and what actions need to be taken going forward. This, especially taking into account news indicating that the rate cap has not had the desired effect, increased uptake of credit by the private …

In this article we would like to add our opinion to the many that are already in place on the rate cap and what actions need to be taken going forward. This, especially taking into account news indicating that the rate cap has not had the desired effect, increased uptake of credit by the private sector.

The Banking Amendment Act No. 25 of 2016 took effect on September 14, 2016. Under this amendment, banks were limited to charging a maximum interest rate for a credit facility at not more than 4% and the minimum interest rate granted on a deposit held in interest earning account to at least 70% of the base rate set and published by the Central Bank of Kenya. The objective was to promote a savings culture among the Kenyan public but most importantly to lower cost of credit, resulting in growth of credit flow to private sector.

Case Studies

In countries where rate caps have been introduced, the main reasons are; to protect consumers from excessive interest rates, to increase access to finance, and to make loans more affordable.

Countries including European Union (EU) member states (Spain, Portugal, Belgium et al), African countries (Nigeria, Ivory Coast, Mali, Zambia, South Africa et al) the United States as well as some Asian countries (India, Pakistan et al) have regulated interest rates. The objectives were varying; Portugal’s was to protect the weakest parties. France, Belgium & United Kingdom (UK) were protecting consumers from predatory lending and excessive interest rates. In Greece the objective was to stop abuses arising from too much freedom. In the Netherlands it was to decrease the risk-taking behavior of credit providers. In Thailand the objective was to make finance affordable for low-income borrowers. In Zambia, it was to mitigate the perceived risk of over indebtedness and the high cost of credit, as well as to enhance access to the undeserved.

Effects of Rate Caps

Interest rate caps largely had a negative impact in the economies in which they were introduced.

In South Africa, some financial institutions evaded caps by charging credit life insurance and other services, which reduced the transparency of the total cost of credit. In West African Economic & Monetary Union (WAEMU) countries, the imposition of interest rate caps on microfinance loans caused microfinance institutions to withdraw from poor and more remote areas and to increase the average loan size to improve efficiency and returns because the interest rate ceiling was considered too low. As a result of lower caps on interest rates in Japan, the supply of credit appeared to contract, acceptance of loan applications fell, and illegal lending rose.

In Armenia, banks and microfinance institutions imposed fees and commissions, thus avoiding the ceiling and reducing the transparency for consumers. In Poland, interest restrictions reduced both access to credit and welfare. In France and Germany, interest rate ceilings decreased the diversity of products for low-income households. In France, lenders have used revolving credit to reach lower-income households, while in Germany many low-income and high-risk borrowers are excluded from credit.

In the United States access to credit for high-risk borrowers is greater when interest rate caps are higher but that the high cost of credit increases the probability of default. In Zambia, the cap was reversed in 2015 however, in an effort to bring down the annual inflation rate.

The Kenyan Case

Kenya Bankers Association (KBA), the banking industry umbrella body, has been vocal on repealing of the law. A consumer survey dated 22nd March 2017 commissioned by KBA and conducted by Nielsen states that 88% of the borrowers in the sample population did not change their borrowing behavior as a result of the rate cap. However, the same research also states that 77% of the sample would prefer a lower cost of credit than a higher deposit rate. This speaks to the need to increase affordability for the borrowing public.

KBA wants the law repealed on account of lack of growth of credit to private sector. However, it is important to note that credit to the private sector was already on a downward trend prior to the law coming onto effect as is evident from the graph 1 below.

Graph 1; Growth of Private Sector Credit

Source; Central Bank of Kenya – Monthly Economic Bulletin, Feb 2017

Since the rate cap was introduced, growth of credit to private sector has stagnated at single digit levels of circa 4% over the past 6 months as evidenced by graph 1. It seems to have bottomed out.

State of the Private Sector Economy

While cost of borrowing is a determinant to the level of borrowing, other factors come into play when looking at the quantum of borrowing. Economic activity affects the growth and amount of borrowing by the private sector. To the extent that aggregate demand for goods and services is high and increasing, the private sector will have a high appetite for borrowing.

The Monetary Policy Committee (MPC) Market Perception Survey conducted in March 2017 showed that private sector respondents expect a decline of growth in 2017, on account of the prevailing drought conditions and slowdown in private sector credit growth.

The Markit Stanbic Bank Kenya Purchasing Managers’ Index (PMI) dropped to 49.9 in May 2017 from 50.3 the previous month, falling below the 50.0 level which separates growth and contraction. The contraction is attributed to challenges in private sector access to credit, weak consumer demand arising from the drought impact and uncertainty over the forthcoming elections. The drought impact was best captured by the May 2017 inflation numbers which stood at 11.7%.

Bank lending is stronger when the economy is growing as firms and households request more loans and can repay them more easily. Economic growth in Kenya is currently dominated by public sector spending on infrastructure projects and not necessarily by private sector activity.

Asset Quality

According to the MPC press release from the meeting of 27th March 2017, a survey of commercial bank credit officers indicates that their expectations are that while demand for credit would increase with the interest rate caps, actual credit granted would remain constant as a result of tighter credit standards.

Banks have started to take less risk as a result of the increase in credit risk. The banking industry is doing so in the light of deterioration in its portfolio of past loans. Taking less risk leads banks to reduce their credit lines and thus show a slower growth rate in gross loans. In an effort to restore stability in the banking industry CBK has introduced new requirements for lenders especially in terms of provisioning for bad loans. 

Graph 2; Ratio of Non-Performing Loans to Gross Loans

Source; Central Bank of Kenya – Monthly Economic Bulletin, Feb 2017

Graph 2 shows the ratio of Non-Performing Loans (NPLs) to Gross Loans over a two year period.  There has been a historical pile up of bad loans in the pre interest rate cap era. The ratio was at 5.8% in early 2015 before rising to 9.5% in August 2016 a month to the rate capping. Post capping, it has been on a general decline hitting a low of 8.9% in January 2017 before rising to 9.6% in February 2017. The magnitude of this ratio has led to banks scaling back lending particularly to the customers who they perceive to be high risk.

Flight to Safety

Graph 3 shows the growth in credit to the public sector after the capping law came into effect. The growth peaked at 16.7% in January 2017 and at 31% in February for central government and county governments respectively. Commercial banks increased their stock of public debt in an effort to allocate funding to a ‘safer haven’. According to the banks, the rate cap limits credit allocation to the riskier segment of the market. The public sector’s appetite for funding has also worked in the banks’ favor.

Graph 3; Growth of Public Sector Credit

Source; Central Bank of Kenya – Monthly Economic Bulletin, Feb 2017

Summary

Private sector credit growth in the interest rate cap regime has been constrained by the following factors:

  1. A historical accumulation of bad debts by banks in the period leading up to the rate cap legislation. The ratio of NPLs to Gross Loans hit a high of 9.5% in 2016. In an effort to enhance asset quality, banks have been overly cautious in lending to the private sector.
  2. Weak private sector economy as evidenced by the contraction in the Purchasing Managers Index witnessed in May 2017. Businesses will only borrow when there is high demand for their goods and services. With low demand, appetite for credit dissipates.
  3. Crowding out effect by the public sector which is a result of government’s increased demand for funding. This can be seen by Treasury bill offers which have increased to a total of Kes 24 billion in 2017 from Kes 16 billion in 2016 across the three tenors of 91, 182 and 364 days. In the last Treasury bond auction which also included a tap sale (a tap sale is used to borrow more money at the same face value, maturity and coupon rate as the initial issue except price), Central Bank picked funds at 12.5% and 13.1% respectively for what are effectively 3 and 7 year papers. With lending rates capped at 14%, banks are better off lending to government than to the private sector.

Takeaways

Fiscal Discipline

In the current financial year, the government has been staring at a fiscal deficit of 8% and a domestic borrowing target of Kes 295 billion a revision of 59 billion from the initial target of Kes 236 billion. The revision was attributed to increased spending as well as missed revenue targets. These fiscal excesses will definitely short circuit the objectives of the rate cap due to the crowding out effect of government borrowing. Fiscal discipline is therefore required. Further government through Treasury should also target and commit to a low and normal yield curve. This is because private sector credit is priced off the risk free rate. If the risk free rate is near the cap, then banks will definitely lend to government.

Enabling Environment

Government should create a favorable environment to enhance competition in the banking sector leading to lower cost of and access to credit. This includes stable macroeconomic conditions, an appropriate legal and regulatory framework, price transparency, consumer financial literacy, availability of credit information, and strong financial architecture, such as credit bureaus and credit agencies. Efforts towards this include the setup of credit bureaus to facilitate credit rating and credit information sharing. However, this move is yet to have the desired impact. There is also the requirement for publication of the Annual Percentage Rate (APR) by banks to promote price transparency.

References;

Central Bank of Kenya – Monthly Economic Bulletin, Nov 2016

Kenya National Bureau of Statistics; CPI & Inflation Rates May 2017

Markit Stanbic Bank Kenya Purchasing Managers’ Index (PMI) May 2017

World Bank Group Policy Research Working Paper 7070 Interest Rate Caps around the World

 

Written by Steve Ogada who is an investment banker with over 10 years’ experience in the East African capital markets. He’s a Principal at InVhestia Africa Ltd, a boutique corporate & project finance advisory entity. InVhestia is also a specialist in financial modelling, having adopted the FAST Standard  and is the only firm in Africa accredited as a FAST standard provider of financial modelling training.