Last week, the Central Bank of Kenya (CBK) published the revised risk based pricing model for bank loans, which is expected to remove opacity in the costing of loans for borrowers.
The model uses the overnight interbank rate as the basis for a common reference rate for all variable rate bank loans.
This is a departure from the former version in which banks were free to set their own base, which led to large variations in cost of credit across different lenders with little clarity on how the lenders arrived at their reference floor.
The Business Daily looks at the evolution of the reference rate over the years, the rationale behind the new rate and what it means for a borrower taking up a bank loan.
What are the characteristics of the revised pricing model?
The new risk based model is anchored on a new reference rate known as the Kenya Shilling Overnight Interbank Average (KESONIA), which is calculated from the overnight rate at which banks lend to each other on short term basis.
To arrive at the common reference rate, the CBK and banks will compound the overnight rate each day over an interest period, generating an index that will provide the one-day and one-month KESONIA rates.
When calculating total cost of credit for a customer loan, banks will use KESONIA as a base rate, add a premium (known as “K”) which covers cost of funding and borrower risk, and then fees and charges which include loan origination, arrangement, commitment, default, and late payment fees.
The new model will apply to all variable rate loans issued by banks. The only exceptions are foreign currency denominated loans and fixed rate loans.
Banks have been given a three-month window before fully applying the KESONIA rate on new loans, and six months for the transition of existing facilities.
How will the premiums be determined, and are they uniform for all borrowers?
A bank will calculate the premium (“K”) for each borrower separately, largely based on three broad considerations.
The first is a bank’s operating costs related to lending, which include staff salaries and allowances, directors’ remuneration, repairs, maintenance, depreciation, rent and other operating expenses.
Secondly, the bank will be allowed to load a charge to cover the expected return to shareholders from the lending business.
Lastly, the lenders will be allowed to load a risk premium on loans, based on each borrower’s risk profile or credit rating. They will however be expected to provide the CBK a detailed credit scoring model that covers the qualitative and quantitative aspects which they used to determine the borrower’s creditworthiness.
Which other loan benchmarks have been used in Kenya in the past?
The banking sector’s first benchmark rate was the Kenya Banks’ Reference Rate (KBRR), which was introduced in July 2014 and updated every six months.
It was calculated as an average of the Central Bank Rate (CBR) and the two-month weighted moving average of the 91-day Treasury bill rate.
Banks were then allowed to load a premium to cover borrower risk and the cost of processing loans and collateral.
KBRR fell into disuse and was eventually abandoned after the introduction of the rate cap on customer loans in September 2016. Under this regime, lending rates were capped at four percentage points above the CBR, while deposit rates had a floor set at 70 percent of CBR.
The rate cap law was repealed in November 2018, ushering in the Risk-Based Credit Pricing Model (RBCPM) in 2019, which was implemented gradually over the next five years. Under this model, each bank was allowed to set its loan base rate, and then add a premium for each customer based on their credit scoring. The CBK however had to approve the base and premium for each lender.
Speaking on Tuesday about this 2019 model, CBK Governor Kamau Thugge said: “In its operation, we realised that it had major shortcomings…it was not very transparent, and we also realised that it was biased towards the banks and against borrowers. When it was necessary to raise rates, banks did so very quickly, however, when we lowered the benchmark rate, it took some time for banks to lower their rates.”
These challenges have now led to the consultative review that has yielded the revised risk pricing model.
Will the new pricing model lead to lower interest rates for borrowers?
The new model is not targeted at lowering interest rates on loans, but rather to improve the transparency on pricing of credit, and to bring a closer alignment between cost of credit and the CBK’s monetary policy stance.
Under the older RBCPM, banks were reporting different base rates for loans, citing differing costs of funding despite a fairly transparent interbank market.
A CBK review also found that some banks were failing to regularly update the variables used to determine the various components of their RBCPMs, while others applied premiums based on customer segments rather than the risk profile of individual borrowers. These are some of the challenges the revised model is looking to address.
Are there tools available to help borrowers compare premiums and charges across different banks?
In order to enhance transparency, banks and the CBK will revive the Total Cost of Credit website which was launched in 2017 but has since then fallen out of date.
The CBK said the revamped site will show banks’ weighted lending interest rates, weighted average premiums, and all fees and charges for all their loan products. The site, which comes with a loan comparison calculator and educational content on credit costs, will also be optimised for use on mobile phones.
