The Current Interest Rate Environment: How We Got Here & Where We are Headed

By @MihrThakar

On 24th August 2016, borrowers cried tears of joy; the Kenyan Banking Amendment Bill, 2015 was signed into law by the President of the Republic of Kenya, effectively capping bank interest rates at 4% above CBK’s benchmark rate. The intentions of the Bill were to promote business growth by loosening profit margins for entrepreneurs and established corporations, protecting consumers from exploitation and easing their repayment obligations as well as increasing the accessibility of credit.

According to a World Bank report, overall, 76 countries around the world impose some form of interest rate caps on loans. Some countries provided more specific objectives, such as protecting the weakest parties (Portugal); shielding consumers from predatory lending and excessive interest rates (Belgium, France, the Kyrgyz Republic, Poland, the Slovak Republic, and the United Kingdom); stopping the abuses arising from too much freedom (Greece); controlling over-indebtedness (Estonia); and decreasing the risk-taking behaviour of credit providers (the Netherlands). Similarly, in Thailand authorities stated that the purpose of the caps was to make finance affordable for low-income borrowers. Finally, Zambia’s authorities introduced the caps to mitigate the perceived risk of over indebtedness and the high cost of credit, as well as to enhance access to the underserved (not undeserved).

It doesn’t make sense importing 500 metric tons of aluminium ingots from China at an end cost of Kshs. 50,000,000, aspiring to sell at a price of Kshs. 60,000,000, while 85 percent of the cost (Kshs. 42,500,000) would bear a one-year total interest expense of approximately Kshs. 9,000,000. Most people know overheads are a significant diluter of gross profit and the viability of many ventures is nil when faced with the additional problem of exorbitantly priced finance (especially unsecured).

The effects of the rate cap were exactly the opposite of the roseate predictions of its supporters. Banks, despite receiving more applications from money hungry applicants, approved fewer than ever before. The lenders demanded security for even simple transactions like discounting invoices that businesses had issued to established, tried and tested customers, including those listed at the KRA Large Taxpayer’s Office (L.T.O). Consumer spending decreased as the spendthrifts became window shoppers. These banks cannot be blamed. Directors are stewards of shareholder’s investments and cannot allow bad loan provisions to eat into profitability without adequately pricing for risk. Asset quality is deteriorating substantially with every year, showing a spike in nonperforming loans for most banks.

The decreased interest income has led to massive lay-offs and branch closures in most banks. Those that tried to show benevolence to their employees would experience massive profit drops. CEO’s were forced to exercise ruthlessness. Small and Medium sized banks suffered the most as the riskier lending to SMEs led to depleted bottom lines and questionable liquidity.

Mr. Lamin Manjang, Regional CEO at Standard Chartered Bank and Chairman of Kenya Bankers Association then said, “As KBA we are committed to help in bringing down the cost of borrowing and enhancing access to credit at affordable rates, without having to resort to legislation as a control mechanism. We believe there is a collaboration approach that can be used to address the issue of high lending rates. We have sat down and reviewed this matter in detail and we have come up with a Memorandum of Understanding that we will all sign up to and submit to the Central Bank of Kenya. This will cover immediate steps and other actions that we will commit to implement that will ultimately lead to lower and affordable interest rates in the market.”

One of the initiatives by the Central Bank and the Kenya Bankers Association (KBA) on addressing the high interest rates was the launch of a portal which provides borrowers with information on the total cost of credit (TCC) and features a simple Cost of Credit calculator, which loan applicants can use to estimate the total cost of a bank loan. Banks are required by the Central Bank of Kenya to provide seekers with a Total Cost of Credit breakdown as well as a loan repayment schedule.

Banks price loans based on the following factors:

  1. Their Cost of Funds – this includes wholesale and retail deposit rates e.g. Currently most banks offer a term deposit rate of 7.5% to retail customers
  2. Customer risk profile – a bank will use a Credit Report provided by a licenced Credit Reference Bureau. The Credit Report covers the customer’s Credit History (an account of debt obligations and repayment track record).
  3. Type of product – e.g. Secured or unsecured

The TCC will include the bank interest rate based on a reference rate plus a premium that covers the Cost of Funds component not covered by the reference rate, the operational costs, risk factor and profit margin. TCC also includes other bank fees and charges directly associated with the loan. Third Party Costs directly associated with the loan are also covered in the TCC, these include legal fees, insurance, valuation, and government levies.

When taking up a loan, a borrower often focuses on the bank interest rate; however, this is just one of the loan cost components. Therefore, to better determine the total cost, a formula should be used to compute the various elements into a numeric representation (a percentage rate). When this percentage rate is based on a 12-month period, it is called the Annual Percentage Rate (APR).

Other initiatives taken in collaboration with the Central Bank to reduce the cost of credit to smoothen out the creases left in the fabric of the banking industry are:

  1. The Credit Information Sharing initiative which will enable banks to price their loan products based on individual customers’ risk profile
  2. KBA has proposed reforms at the Lands Ministry. Stalled transactions at the notoriously slow Lands Office contribute significantly to higher interest rates, blocking payments due to delayed issuance of title deeds and a tortoise like crawl in carrying out the subdivision of land.

Devolution, which was introduced to enable self-governance of counties, promoting efficiency, effectiveness and economy, has also had the unintended consequence of increased corruption. Unscrupulous county officials demanding bribes for issuance of building permits and occupation certificates has also delayed the completion of transactions well beyond timeframes the concerned entrepreneurs had aspired to achieve. It is expected that increased automation in most official bodies and regulatory authorities will curb unscrupulous behaviour.

Our next article in this series will touch on decreased profitability in the banking industry, effects of the rate cap on the share prices of listed banks and how innovation and technological development has taken over the sector.