Inevitably, bank rates must come down

Central Bank of Kenya Governor Patrick Njoroge and Diamond Trust Bank CEO Nasim Devji during a past forum on interest rates. The rates have been capped at four per cent above the Central Bank rate. FILE PHOTO | NATION MEDIA GROUP PHOTO | SALATON NJAU | NATION MEDIA GROUP

What you need to know:

  • Years ago, banks in Kenya believed that the poor should not have bank accounts.

  • One bank came and changed that.

Kenyans are waiting to see whether President Uhuru Kenyatta will assent to the Bill that seeks to cap bank loan interest at no more than 4 per cent above the Central Bank of Kenya's reference rate.

For many years, Kenyans have lamented the high interest rates charged by banks on loans and the low interest that customer deposits earn. The fact that there are about 22,000 mortgages in a country of over 40 million with a serious housing shortage is a key indicator of the unaffordability of loans for most Kenyans.

The growth of savings and credit cooperative societies (Saccos) and savings groups (chamas) in the past few years is also another indicator that many average Kenyans would rather borrow from alternative cheaper sources of loans than commercial banks. Yet these alternative sources remain inadequate as many Kenyans continue to troop to banks for expensive loans that they can barely afford. The situation has resulted in high default rates, as evidenced by the increasing provisions for bad loans that banks have booked in the past few years.

Banks argue that it is necessary to charge high interest rates to cover the risk of loan defaulters. It is an argument that goes round in a circle, that is, loan interest rates are high because of the high default rate associated with the high interest rates. In other words, the reason for the reason is the reason.

Banks’ position is: if interest rates are capped, it will not be possible to lend to as many people. They will be forced to cut back on high risk loans. They argue that access to bank loan financing will be more restricted and the supply of money could slow down if banks hold on to their funds. They expect this to result in reduced spending in the market (reduced demand) leading to reduced production and consequently contraction of the economy with decline in employment.

While the bank’s argument may appear true, it is one-sided. The main undeclared reason for banks opposing the capping of interest rates is the expected reduction in revenue from loan interest.

BAD LOANS

For banks that have been making adequate provisions for bad loans, as required by the Central Bank, the effect on profit will be minimal as reduced interest income will be countered by a reduction in costs associated with bad loans.

For banks that have not been making adequate provisions, their profits will certainly drop. This is a good thing because such banks have been flaunting Central Bank regulations and maintaining an overstated loan book.

Regulation in itself is not desirable for a competitive market. The forces of demand and supply should work out a competitive equilibrium interest rate. Unfortunately, this is not the situation in Kenya. While banks appear to advocate a competitive market, the trend of interest rates speaks otherwise.

In a competitive market supernormal profits do not exist. Supernormal profits are what is left after all the factors of production have been paid, including the cost of capital, which for banks is the interest paid on customer deposits and borrowings from the Central Bank. After paying all their factors of production (including the risk premium), the large Kenyan banks are in competition as to who reports the highest supernormal profits. This is at the expense of the borrower.

If interest rates are capped, banks will not make losses. They will still have enough normal profit to remain in business and even attract new entrants. The supply of money will not slow down, and certainly not production-related demand. Import-related demand could slow down and this could actually be good for the economy. For example, it will be difficult for many bank customers to access unsecured personal loans for purposes of importing used Japanese vehicles that they cannot afford in the first place.

Once interest rates come down, banks will realise that there is a great number of low-risk customers who have been avoiding bank loans. They will get more clients from this pool who could be serviced at a lower cost of operation by leveraging on technology in service delivery. These are the many Kenyans who would take an affordable mortgage or the many employees with stable income who opt for Saccos instead of banks.

Years ago, banks in Kenya believed that the poor should not have bank accounts. One bank came and changed that. Any smart banker in Kenya today will realise that supernormal interest rates will come to an end regardless of whether the President assents to the present Bill or not. It is just a matter of time.

 

Peter Chando is an auditor with the Nation Media Group; [email protected].