Why it’s too early to celebrate the law capping interest rates

Wednesday, August 24, 2016 will go down in history as the day Kenyans collectively chose to wet their whistles prematurely in celebration of the presidential assent of the Banking (Amendment) Bill 2015.

But who can blame their souls that were weary from years of punitive interest rates in a regime where demand for credit by far outstripped supply?

Let me begin from the beginning. Banks take your deposits and in turn lend them out to borrowers who range from individuals borrowing unsecured loans on the back of a salary check-off programme, to small, medium and large businesses borrowing to finance their working capital needs or capital expenditure purchases, and who secure these facilities with a piece of property or equipment.

But the Central Bank of Kenya (CBK), like any good regulator who wants to protect depositors, sets out the amount of capital that shareholders of a bank need, in order to lend to these various types of borrowers with varied risk levels.

The requirement for capital is to ensure that banks have “skin in the game” effectively causing the lenders to exercise caution in lending out customer deposits (which then become assets on the bank’s books) to entities that have demonstrated the ability to repay.

So the next time you throw a cursory glance at your bank’s financial statements, cross over to the bottom, a fairly innocuous section called Other Disclosures and particularly the section titled Capital Strength.

This, good people, is where the rubber meets the road. There’s one line, usually section (f) titled Total Risk Weighted Assets. CBK requires banks to allocate capital to all the assets on their books.

But different assets attract different amounts of capital. So, for instance loans to the central government via Treasury bills and bonds attract a zero capital charge.

The same applies to loans guaranteed by the central government as well as OECD governments. If the regular borrower, Wanjiku, also wants to give 100 per cent cash collateral for her loan, that attracts a zero charge as well.

By the way I’m quoting from the CBK Prudential Guidelines, a document whose detail is so technical that it is recommended reading for anyone having trouble falling asleep at night.

The flip side is painful: lending to anyone else — be they an individual who’s provided their Sunday best clothes as security or a corporate whose provided a prime Mombasa Road property as collateral — attracts 100 per cent capital charge.

So a bank has to allocate 100 per cent of its capital (on a weight adjusted basis) which as you know is a finite and fairly expensive resource, for your loan.

It may interest you to know that mortgages which are well secured and performing only attract a 50 per cent capital charge.

Why, you ask? Shelter features fairly high under Maslow’s hierarchy of needs, therefore risk of default is much lower. Because of how much capital a bank has allocated to a loan, it’s much easier to simply place deposits in government paper.

But low risk means low returns and banks have therefore taken the fairly lucrative business of lending to individuals, SMEs and corporates which are higher risk, require higher capital charges but which capital charges are resoundingly compensated by high interest returns.

However, let’s call a spade a spade. Banks in Kenya have been smug and lazy. Since demand outstrips supply, they have chosen to treat all borrowers the same.

Wanjiku who has borrowed 20 loans in the last 30 years, servicing all of them well without a single default, is charged the same 25 per cent rate as Paul, who just got his first job at a government parastatal and can use his payslip to get a check off loan to buy furniture for his new apartment.

The insurance industry is willing to give Wanjiku a no-claims bonus, which is a reduction on her annual insurance policy for her car as a reward for not having any accidents in the past year. But the banking industry wants to treat Wanjiku as if her good repayment record doesn’t deserve a reward.

The reduction in interest rates will force banks to do one of two things: move out of higher risk rated assets as the returns will not be commensurate with the capital charge; and, secondly, begin to provide much needed granularity in the way they have chosen who to lend to based on positive credit reference bureau ratings.

Bad borrowers

I’ve beaten that granularity drum before, but I’m not about to get hoarse. Good borrowers do not warrant the high interest rates that are currently being charged to cover (lazy) banks from bad borrowers. Enough said.

In these dying column minutes let me draw your attention to one thing: the Banking (Amendment) Bill 2015 was horrendously drafted and has as many holes as my grandmother’s favourite crochet table cover.

Section 33B (1) and (2) refer to a base rate set by the CBK. The media is using the Central Bank Rate which is a rate used by the CBK to loan to banks and is not a base rate for lending to the public.

Of course this can be cured when the CBK publishes the regulations required to operationalise the Act, by creating such a base rate which can be set wherever CBK feels is the right point including aligning it to the Kenya Bankers Reference Rate.

Secondly, Section 33B (2) refers to “minimum interest rate granted to a deposit held in interest earning to at least 70 per cent the base rate”.

There seems to be a missing word there after interest earning, perhaps the drafter meant to put the word “account”. Whatever the case, the regulations will now have to prescribe what a “deposit” means for purposes of Section 33B (2).

Chances are that to enable stability in the banking sector, a deposit will have to be an amount placed for a contractual period rather than just any amount in an interest bearing account (such as a savings account).

The result is that banks will set up minimum amounts for which they are willing to enter into “deposit” contracts, perhaps from Sh50 million and above to justify that high interest rate payable.

Finally, if banks move to lending to the government rather than to Wanjiku, the Treasury bills and bond rates will decline dramatically and institutional investors such as pension funds will see a significant drop in their returns, meaning their pensioners will also suffer. Such are the unintended consequences of this Bill.

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@carolmusyoka