For the fourth time in six years, Parliament wants to regulate interest rates. Interest rate regulation is essentially price regulation.
In a market economy, price plays a crucial role in determining how market players respond to the supply and demand of goods and services.
So when you regulate prices, the law of unintended consequences kicks in. For one, market players can respond in ingenious ways to circumvent these price controls.
For example, commercial banks can increase fees and commissions, acquire microfinance banks, or shift to lending in the opaque private debt market.
The latest proposed Bill looks to set the floor of deposit interest rates at 70 per cent of the Central Bank Rate (CBR) and the lending rate ceiling at not more than 4 per cent above the CBR.
The proposed interest rate regulation will have drastic implications on the flow of liquidity and credit in the market, with severe repercussions to the economy.
If regulation makes it expensive to hold deposits that have limited profitable outlets, banks will be forced to dump deposit accounts.
This will affect liquidity availability, payment processing, and financial inclusion in the economy. Loans will be recalled due to lack of deposit funding and thousands will lose their jobs due to the contraction in bank operations.
LARGE BANKS DOMINATION
The World Bank recently released a report that confirms what the Central Bank governor has been saying all along - that the banking sector is dominated by the large banks, which maintain wider interest rate spreads than would be the case if the sector was more competitive.
The solution lies in assisting the market to address this failure.
Banks are involved in two functions: transaction facilitation and financial intermediation. The transactional function enables us to open bank accounts to process deposits and payments.
As we all don’t need our deposits at the same time, banks then perform a financial intermediation function by lending our surplus deposits to the productive sectors of the economy.
So banks use short-term deposits (liabilities) to create longer term loans (assets), which creates a classic asset-liability mismatch.
This mismatch is the source of a lot of anxiety at banks as it makes them vulnerable to interest rate and liquidity risks.
Interest rate risk means that banks can become unprofitable whenever short-term rates rise above those that they charge on their loans.
Liquidity risks mean that banks cannot satisfy the simultaneous withdrawal of all deposits. These two risks also partly inform our persistently wide interest rate margins.
Interest rate risk is aggravated by the volatility of key benchmark interest rates, deposit rates paid to large depositors, and monetary policy.
Firstly, short-term market interest rates in Kenya have been volatile at some key points in the past few years. Banks, therefore argue that they need to keep adjusting their lending rates in response to the fluctuations in short-term rates to remain profitable.
Secondly, large depositors usually demand to be paid high rates. This results in a sharp jump in interest expense for banks, but it takes longer for increased lending rates to kick in because of the legal notification periods.
So, in a period of higher market interest rates, bank margins will be squeezed, especially for the smaller banks that rely on large deposits from institutions.
Generally, monetary policy is used to suppress or encourage overall demand so that the economy does not overheat or underperform.
In our particular instance, it is also used to address supply side shocks, for example food inflation.
This causes adjustments to short-term policy rates that might catch banks off guard, hence another reason for maintaining wide interest rate spreads.
According to the World Bank report, the six large banks control about 50 per cent of deposits. We have a structural crisis of deposit distribution in our banking system and the small banks are endangered.
It is vital to address this structural imbalance in order to spur competition.
In the short term, the MPs can introduce an intervention fund to address the funding needs of the medium and small banks.
These funds can be lent directly to the banks or used to guarantee their bond issuance at subsidised rates.
Other alternatives worth exploring are higher deposit insurance terms for deposits with the smaller banks or lower cash reserve ratios for them.
The writer is the director of structured finance at Standard and Mutual. [email protected]