The Kenyan president has signed legislation imposing lending rate caps and deposit rate floors on banks. This decision comes on the background of continued discomfort about high interest rate spreads in Kenya (as in many African countries).
Having worked myself for many years on this issue (while being in the World Bank and afterwards) and having discussed this problem extensively with policy makers in Kenya (including the finance committee of the Kenyan parliament), this is a disappointing
development. Experience across the globe has shown that interest rate caps do not just not work, but they might actually do damage to the inclusion agenda that many policymakers including in Kenya are interested in. The development is also disappointing, given
all the positive policy developments over recent years in Kenya, including the establishment of a credit registry, regulations of microfinance institutions and cooperatives (SACCOs) and most importantly, the mobile money revolution in the form of M-Pesa. And
these positive policy reforms have also been reflected in positive developments in indicators of financial deepening and inclusion, with the number of depositors and borrowers rising and even interest rate spreads showing a decline over recent years (for the
latter, see Figure 9 in this CBK publication).
Yes, interest rate spreads are absurdly high in
many African countries, including in Kenya. Whereas in many developed countries spreads between average lending and deposit rates vary around two percent, they are often up to ten percent in developing countries. It is important to understand, however,
the factors behind such high spreads. One simple explanation is size. This applies both on the system-level and the client-level. Given that part of a bank’s cost basis is fixed, smaller operations incur higher average costs per dollar. This
applies on the account (and loan) level, bank-level and even financial system level. Empirically, there is a strong negative correlation between the size of a financial system (in dollar terms) and interest rate spreads. A second important factor is
risk, which is still higher in many developing economies than in developed economies, relating both to macroeconomic and to borrower-level risk. There is an important interaction between size and risk, as banks in smaller financial systems have a harder time
diversifying borrower-level risks. Third, institutional deficiencies related to enforcing claims in courts and creditor rights in general are important factors. Some of these factors can be influenced by policymakers, such as improving institutions and
providing for a stable macroeconomic environment. Competition and transparency (e.g., publications of interest rates and fees) can be important factors that reduce spreads. But these are long-term factors, with little short-term improvements to
be achieved. Finally, there is the issue of inclusion and interest spreads. As banks expand towards riskier clients (as data indicate they have done in Kenya), marginal interest rates should increase, which increases also average spreads. While this
might be off-set with overall efficiency improvements reducing interest spreads, one would need borrower-level data to actually assess the relative strength of both factors.
I would like
to stress that I am not against interest rate caps under any circumstances. The UK has introduced such caps in the wake of extremely high interest rates charged by payday lenders in the UK. However, here the concerns are different – specifically,
a certain segment of the population gets stuck in a vicious debt cycle due to predatory lending practices. In this specific case, the challenge is, however, whether such borrowers are pushed towards informal loan sharks – so any such caps would
have to be accompanied by intense consumer literacy programmes. The more general question on interest rate caps is how binding such caps are for “regular” borrowers, such as small enterprises, and middle–class mortgage borrowers. And
on the first look, the Kenyan interest rate caps (and floors) seem quite binding, with lending rates capped at 4 percentage points above the central bank’s benchmark rate, while the floor for deposit rates is at 70% of the same rate. While with the current
benchmark interest rate of 10.5% this results in a spread of 7.15 percentage points, which seems still quite high, this cap might very well become binding for marginal borrowers. It might also become more binding for longer-term loans, effectively also
undermining attempts of lengthen maturities in the banking system.
What will be the effect of such caps and flows? One easy response by bankers is: fees – where interest rates do
no longer reflect costs and risks, banks will find other ways to reflect costs and risks. Another possible response will be rationing of customers, effectively excluding marginal borrowers and depositors, where the former will not receive any loans and the
latter will be priced out of the market with high fees and documentation barriers. Neither of these reactions is favourable to the inclusion agenda nor fosters transparency and efficiency in the financial system.
Note: a recent paper by my co-author and former colleague
Samuel Maimbo discusses how wide-spread interest rate regulations still are across the globe and weighs the different arguments in favour and against. I have written several papers on interest rates spreads in Kenya (with Michael Fuchs and with Bob Cull and others) as well this
paper on neighbouring Uganda (with Heiko Hesse).
Overall, a sad day for financial sector development in Kenya and the region!