Capping interest rates is not the solution, argues top World Bank official

By Johannes Zutt

When the Central Bank of Kenya raised the interest rate that it charges commercial banks last year, it was doing the right thing. It needed to raise rates to check inflation, which was then approaching 20 per cent.Capping interest rates can be harmful, argues bank official

But then the commercial banks followed suit, charging their borrowers more and so creating new hardships for them. From October through December, commercial interest rates went from about 14 per cent to 25 per cent. The already high rates suddenly seemed punitive. How could Kenyans cope with such rates?

It is in this context that some Kenyan policymakers now want to reduce that hardship by imposing interest rate caps on the banks. They also want to determine what banks need to pay depositors in interest for keeping their money.

President Moi’s last government approved such arrangements in 2000. But that legislation was, and would again be, a bad idea. Evidence from around the world shows that attempts to control interest rates almost always backfire.

There are three reasons for these unintended outcomes. First, when banks have interest rate caps imposed on them, they usually respond by lending much less — and only to firms and individuals who are very low risk (including the rich) or, perhaps worse, have the right political connections. Loans do not necessarily go to the most productive investments.

Second, since banks will be lending much less, and since there will nonetheless be firms and individuals who need loans but are unable to get them from the banks, lenders outside the formal markets will step in to lend — but they will also charge much higher interest rates to do so. The poor will be disproportionately part of this parallel market.

Third, in the long run, interest rate caps will force banks to pay less for deposits, and so firms and individuals will put less money into the banks. At the same time, some smaller and less efficient banks will find that they are no longer able to attract enough deposits to cover their costs and make a profit, with the result that they will be forced to close.

This means that there will be fewer banks over time, with less money to lend out, exacerbating the other problems and resulting in even less financing for Kenya’s development.

The desire to lower interest rates is perfectly understandable. But the best way to lower the price of money is not a distortive interest rate cap, but open competition.

Kenya needs banks that compete for depositors as well as for borrowers in a banking-friendly environment, so that banks become more efficient, reduce their overheads, and offer loans at lower prices for the same amount of risk.

If members of Parliament want to lower interest rates, they should do everything in their power to increase competition in the banking sector. And there are a number of things that they can do:

One, they can make it easier for banks to obtain collateral, and also make it less costly and cumbersome to realise collateral when a borrower defaults. Particular attention should be paid to improving the land registry, which is notoriously unreliable.

Two, they can require banks to make interest rates, fees, penalties, and other charges more transparent so that potential borrowers can shop around for the best deal.

Three, they can support the establishment of effective credit bureaus to enable banks to “know their customer”.

Four, they can help the government to divest itself fully from the banks where it still has an interest. Capping bank interest rates will do more harm than

Kenya has come a long way since I first lived here 20 years ago. Then, macroeconomic management was appalling; the financial sector was spoiled through political interference. Today, the government has earned a reputation for responsible macroeconomic management.

It has also significantly strengthened the financial sector, while also improving access and stability. At the same time, banks reduced non-performing loans, raised their capital adequacy ratios, and achieved profitability.

Kenya is now well placed to exploit opportunities in regional financial integration. It would be unfortunate for Kenyans if these great achievements were now discarded through enacting a poorly conceived and counter-productive interest rate cap. The outcome is not likely to please Kenya’s friends.

Mr Zutt is the World Bank Country Director for Kenya