Economic theory suggests that interest rates are best determined by the marketplace, otherwise the forces of demand and supply, rather than by legislation. The supply comes from the lender and the demand comes from the borrower. In its simplistic form, when demand exceeds supply, the price, in this case interest rates will increase. On the other hand, if supply exceeds demand, the interest rates will decrease. This assumes that the market is competitive, with no constraints to limit the responsiveness of both demand and supply side. With perfect competition, a lender should only be able to charge an interest rate that is sufficient to cover the cost of production and earn a fair return. In fact the absence of competition is the only compelling reason for imposing usury ceilings that can be justified by economic theory.
Interest rate ceiling or usury constraint has been adopted in some markets when it is perceived that the market forces are not working the way they should. It is therefore worthwhile, in response to the pending Banking (Amendment) Bill, 2015, to consider whether the local market is sufficiently competitive to prevent lenders from charging high interest rates and earning more than normal returns. The other consideration is whether all options for creating competitiveness have been sufficiently explored.
In reality, supply and demand forces are not the only factors that come into play in the market place. On the supply side, banks want the interest rates to exceed their cost of production. This includes the cost at which they secure funds to lend, overhead costs and transaction costs. There is also the risk factor arising from the possibility that the borrower will default and the loan may not be repaid. The working of the credit reference bureaus is to provide credit information so that more creditworthy customers would benefit from a lower risk premium. For foreign-owned banks, additional risk factors may include foreign exchange risk and country or sovereign risk.
On the demand side, customers too have a responsibility when it comes to creating a competitive market. Knowledgeable, informed customers will compare rates and switch to lenders that are charging lower rates, thus making it harder for banks to charge unreasonable interest rates. That said, although it would perhaps be wrong to say the local market is not working, it is appropriate to explore whether a market dominated by a relatively small number of banks responding to inelastic demand by borrowers can be considered truly competitive.
Karen Kandie is a financial and risk consultant with First Trident
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