Tuesday, August 30, 2016

KENYAN CAPPING OF LENDING RATES, POPULAR BUT NOT NECESSARILY RIGHT

Last week Kenyan President Uhuru Kenyatta signed into law a bill that seeks to cap how much banks charge the public for credit.

The law, passed by parliament a few weeks ago will cap interest rates at four percentage points above the Kenya central bank’s key policy rate which currently stands at 10.5 percent.

The move has proved quite popular in the country and Ugandans are watching with bated breath for their turn. We can expect some noises in that direction in the near future given our own high lending rates.

"The move when effected will have some positive, negative and unintended consequences.
At the center of the equation of course are the banks and the question of how they set their lending rates....

At the bottom of it is the cost of funds, how much does the bank pay for the money it lends out, the interest it pays on deposits. Simple common sense dictates that if deposit rates are high lending rates will be high and vice versa. Also included is the cost of administration – salaries, property rents, fleet costs etc. This may also include the cost of provisioning for bad loans. The more defaulters the higher the lending rates will be to cover the losses caused by the defaulters. And finally the bank has to factor in its own margin.

The Central Bank Rate is a figure announced by the Bank of Uganda, in our case, which reflects their view on, among other things, the prospects for inflation. The CBR rises when inflation is expected and falls when there is little risk of inflation ahead.

The banks use it to benchmark their lending rates, pricing them a few points above this key policy rate.

It has been argued that banks don’t have to price their rates above the CBR if they can still make money. The disincentive against this being a reluctance to live money on the table, a practice shareholders – mostly foreign, would frown upon.

One can expect with the law in place in Kenya bankers are going to have to re-examine their pricing models.

"A trade-off is inevitable. There are many possibilities.  Either they are going to forgo some margin or slap on more transaction costs to bridge the gap or tighten their risk controls – read lend less to the public or slash their costs, especially lower labour numbers, shut branches and optimise the use of technology....

Of course it is near impossible to sympathise with the banks. They have been profitable year in, year out, repatriating most of their profits and generally doing the bare minimum in advancing the national development agenda or distributing the love locally.

On the flip side the government is treading on very slippery ground. They say what is popular is not always right and what is right is not always popular.

The problem of trying to short circuit the market is that distortions are introduced, which affect the smooth running of the economy. Those distortions come with a cost which will have to be paid for eventually and often times after the political actors who introduced the distortion have moved on.

"Imagine a situation where the economic realities dictate that an increase in lending rates is necessary but the central bank for reasons of its own – bureaucratic inertia for instance, does not move to raise the CBR what will happen?...

The banks will stop lending, diverting funds to other activities like currency trading and wait either for the central bank to move or for economic conditions to revert to where it makes sense to lend at the lawful rate. In the meantime there will be loss of economic activity.

It is true that the market while it is the best mechanism we have for growing wealth, it is a terrible distributor of the same wealth. The distributor of wealth is government, which provides physical and social infrastructure needed to raise the general welfare of the population after taxing the market players’ surplus.

In our countries, Kenya too, government borrowing has given the banks the excuse to keep lending rates high. Why if the government is borrowing at double digit rates should the banks not follow suit? 

After all government is the “safest” borrower.

"By passing the bill the Kenya government is abdicating its responsibility for the high lending rates and playing to the gallery with this political action....


The history of these political interventions has shown that while offering temporary relief, they eventually come back to bite you. 

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