Only time will tell how caps on bank interest rates will play out

The Central Bank of Kenya building in Nairobi. All loans by commercial banks will be priced off the Central Bank Rate and not the Kenya Bankers Reference Rate. FILE PHOTO | SALATON NJAU |

What you need to know:

  • The implication was that CBA was going to price its loans at 12.9 per cent — the lowest rate since the caps were introduced.
  • In our context, the CBR is especially vulnerable to changes in the exchange rate and fluctuations in the cost of imports.
  • Section 36 (1) of the Central Bank Act, which establishes the CBR, says: “CBK shall publish the lowest rate of interest it charges on loans to banks.”
  • Interest rate caps are widely used in the world mainly with consumer protection laws.

All loans by commercial banks will be priced off the Central Bank Rate and not the Kenya Bankers Reference Rate (KBRR), as some banks had assumed.

This is according to a circular sent out by the Central Bank of Kenya to commercial banks on Tuesday.

But what difference does it make between applying either the KBRR or the CBR as the applicable rate to set a cap on loans?

From the standpoint of one CEO of a commercial bank, this is a very big deal because it could be the difference between meeting the pre-tax profit target set by your shareholders and a wipe-out of billions from your balance, especially if you are one of the big banks with a loan book running into billions of shillings.

The pronouncement by the Central Bank that CBR — currently at 10.5 per cent — is the applicable formula has saved the big banks, which would have lost billions had the Central Bank decided that the KBBR — currently at 8.9 per cent — was the applicable rate.

The Central Bank’s clarification comes in the wake of an announcement by Commercial Bank of Africa (CBA), which broke ranks with other banks to announce that it had opted to apply the KBRR.

The implication was that CBA was going to price its loans at 12.9 per cent — the lowest rate since the caps were introduced. Indeed, most of the big banks had gone ahead and purchased advertising space to announce that they would price their loans at 14.5 per cent.

With the Central Bank’s unequivocal announcement, customers who were expecting cheap loans from CBA will now have to wait as the law does not allow a bank to price loans lower than what it has dictated.

There was confusion in the market on Tuesday last week when the Central Bank issued a statement on its Twitter page that announced that the KBRR was the reference rate to be applied in determining the caps. Hours later, the tweet was removed and the CBK apologised.

FLEXIBLE RATE LOANS

In a sense, CBK’s decision to pronounce the CBR as the applicable rate is surprising. In the first place, CBK circular No 4 of 2014, which operationalised KBRR and has the force of law, is still in place.

The circular says: “All banks and mortgage finance companies will price the flexible rate loans using KBRR as the base rate. The interest rate they charge shall be KBRR+K.”

Thus, with the new Banking Amendment Bill having introduced a cap on “K”, it was always assumed that the question of the applicable rate for determining the caps was a settled issue.

I cannot wait to see how a system of caps — defined as a margin over the CBR — will operate, especially in the event the economy finds itself in the middle of deteriorating inflationary trends and pressures on the exchange rate.

What happened in Zambia is a case in point. The government introduced a cap of 9 per cent above the CBR in 2012.

Three years later, inflation hit the roof. In an effort to bring down inflation to a single digit, the Bank of Zambia decided to tighten monetary policy by raising the CBR by a wide margin.

Even with the caps, lending rates hit the roof. In November last year, the government of Zambia was forced to abolish the caps.

In our context, the CBR is especially vulnerable to changes in the exchange rate and fluctuations in the cost of imports.

We must also not forget that Section 36(1) of the Central Bank Act, which establishes the CBR, says: “CBK shall publish the lowest rate of interest it charges on loans to banks.”

Indeed, it is the rate at which the CBK lends money to banks when the monetary authority is conducting lender-of-last-resort operations. It has no connection to operations between commercial banks and their customers.

Interest rate caps are widely used in the world mainly with consumer protection laws. Where they apply, they are made specific to certain products (consumer loans), or certain providers (micro finance), rather than the whole financial sector.

Let us see how the new regime plays out.