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November 20, 2018

Banks should give rate cap law time

The Central Bank of Kenya. Photo/Monicah Mwangi
The Central Bank of Kenya. Photo/Monicah Mwangi

The banking amendment act that brought in a cap on interest rates for loans and a floor for deposits has been in effect for only seven months. The act fixed the maximum interest margin on loans, which is the difference between the loan and deposit rates. Currently, this stands at 7%. Prior to this, interest margins were at an average of 17 to 18%, and as much as 25% for SMEs.

Granted, this has met outright opposition from the banking fraternity, and understandably so. It is a matter of self-interest. It means less money is available to meet operating costs and a reduction on profits. As previously pointed out in this column, banks have reacted in two main ways. One is cutting credit to the very high-risk SMEs. Two, faced with excess funds, they have increased lending to the government.

For some unexplained reason, the government is willing to borrow at high interest rates, even when the market is holding excess liquidity. There is no significant reduction in the government borrowing rates to correspond with a low interest rate regime. Expectations are that the government borrows at less than 5%, as happened in the second half of 2003 and first half of 2004 when the Treasury bill rates averaged 2%. This is complicating the transition to a low interest rate regime.

Fortunately, these two reactions are short term in nature. They are in line with expectation of any transition from a high to a low interest rate regime. One, lending to government is not sustainable, neither does it fit into a banking business model. It is a short term in nature and depends fully on the government deficit and borrowing program. A long-term strategic outlook would limit the amount of money a bank lends to government and lend more to the real economy. The implication is that given sufficient time, banks will increase lending to the real economy. A key driver will be a reduction in the government borrowing rates. This needs to happen sooner than later.

Banks will require a change in the business model to accommodate the low interest margins. It involves a reduction in the price of risk, low profit expectation and efficient operations. Already, two bank acquisitions are in progress, a good case of adaptation to the new regime. More second and third-tier banks are likely to follow this route.

The enacting of the act was a last case scenario after other efforts to lower interest rates had failed. Removing it will lead the market back to high interest rates that do not promote the growth of SMEs and the economy. More importantly, it will legitimise high interest rates in the market. The long-term benefits of waiting for the transition to go full swing outweigh the short-term gains that may accrue if the act is removed.

Kandie is a financial and risk consultant with First Trident

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