Parliament this week debated a Bill that will put a cap on bank lending rates at four per cent above the Central Bank Rate (CBR) and a floor on deposit rates at 70 per cent of the CBR.
The CBR is currently at 11.5 per cent, meaning if this Bill were to become law today, maximum lending rates would be at 15.5 per cent and the minimum banks can pay depositors will be 8.05 per cent, an interest rate spread of 7.45 per cent compared to the almost 11 per cent the banks currently enjoy.
Whereas the proposed Bill is well intentioned, it is a knee jerk reaction that will not lead to lower lending rates in the system and that will even be counterproductive.
The goal of the proposed legislation is to force lenders into lowering the interest rates that they offer to high-risk customers.
I say high-risk customers because low-risk customers are already enjoying lower lending rates and don’t need any assistance. The problem with this kind of thinking is fairly clear.
Parliament wants to step in and force a cap on lending rates under the assumption that lenders will simply lower their highest rates while continuing to approve loans at the same rate. They will not.
Unless Parliament will force lenders to approve loans, the proposed interest rate laws would simply result in banks shutting out a sizeable consumer segment.
The interest rate that is charged for a given loan or a customer is based on the perception of the client or loan riskiness and such laws, therefore, will not nudge lenders to offer lower rates but instead will force them to avoid doing business with anyone whose credit risk warrants an interest rate higher than what Parliament has deemed excessive.
Banks will also simply raise loan fees and make lending rates even more opaque.
From the consumer perspective, what Parliament intends to do is to basically now decide for them what interest rate they can or cannot accept when borrowing money without understanding their circumstances when they decide to get a loan.
The proposed law, therefore, assumes that people who currently take loans at 16 per cent interest rate simply don’t know any better.
The truth, however, is that most people who take loans with high interest rates do so because they need the money. And with this kind of law, that money will not be available when they need it most.
Take the example of the butcher in King’eero who needs to borrow money to expand his business.
The problem is, his credit history indicates that he is likely to get approved for a loan with a 15 per cent interest rate. If an interest rate cap of 10 per cent happens to be in place at the time, the bank would consider him too much of a risk to legally receive a loan.
They would turn him down and he wouldn’t get the money. He will go to loan sharks in neighbouring Mwuimuto or his business will not expand and as a result, his income would go down, making it difficult for him to pay other bills.
His already insufficient credit is further put in jeopardy. Repeat this scenario for so many in the already credit-denied real sector of the economy and you will find out that these kind of laws create unintended consequences.
Disdain for bankers
There is generally a lot of resentment towards banks because they most of the time report huge profits at the end of each year.
Those pushing these laws, therefore, know Kenyans who have developed such a disdain for bankers, are on their side. But we must understand that not all bank profits end up in shareholders pockets.
Banks are highly leveraged institutions and shareholders would generally demand a high return on their equity to compensate them for the high intermediation risks they assume.
Banks also need a certain level of profits if they are to continue to provide loans to the economy and keep capital in line with their loan books.
This is usually a significant component of the spread and given the risky environment in which banks in Kenya operate, the percentage contribution of profits to the spread has traditionally been high.
Interest rate controls which could negatively impact on profitability will, therefore, not only pose financial stability risks to the system but will also scare good investors away from the industry.
What MPs need to do is to come up with good policies and laws that will compel banks and other financial institutions to direct credit to the real sector of the economy at market prices.
They need to come up with policies that will help create banking efficiency and other financial system reforms that will reduce intermediation costs.
Banks face high lending risks including inadequate collateral, inefficient Judiciary to deal with loan security matters, inadequate borrower identification and generally high loan default rates.
These factors lead to high non-performing loans on the banks’ books and increase their costs which are then passed on to the borrowers.
Kenya first needs to address these basic structural issues to reduce credit risk in the system. That is what MPs should be focusing on. They also need to force the government come up with policies to spur competition in the financial system, bringing down the spread.
A lot more emphasis should be put on developing the non-bank financial sector to create competition for the banks.
The lack of depth in the financial system and the too much reliance put on lenders for financing means there is little or no pressure on them to lower their lending rates.
The absence of a robust capital market means there is little competition with the banks coming from outside of the banking sector for credit.
Reducing bank lending rates is a long-term process. Shortcuts and lazy or anger legislation like interest rate controls is not the way to do it.
While these proposed laws make MPs look like they are in touch with the average person, in the end, they’re not actually lowering interest rates for anyone.
Instead, they are merely preventing borrowers with higher inherent credit risk from getting loans which they may desperately need. This is a line of thinking that we, as a free market economy, cannot afford to take.
The restrictions imposed by these proposed laws are bad on all sectors of the economy, and MPs pushing this must understand that. If they don’t, the President must use his veto power for the greater good of the economy.
Mr Wehliye is the senior vice president and manager, market and liquidity risk management department, at Riyad Bank, Saudi Arabia.