What Uganda can learn from Kenya’s interest rate capping

Tuesday September 20 2016

Kenya President Uhuru Kenyatta signing into law

Kenya President Uhuru Kenyatta signing into law the 2015 Banking (Amendment) Bill at State House recently. The law will regulate applicable rates to bank loans and deposits thereby capping the interest that banks can charge on loans and deposits. 

By Ramathan Ggoobi

Kenya has written a law that puts a cap on lending rates at 4 per cent above the Central Bank Rate (CBR), among other clauses. This means that banks will not be allowed to lend at interest rates above the CBR+4 per cent. For example, the current CBR in Kenya is 10.5 per cent. This means that it will be illegal for banks to issue new loans above 14.5 per cent.
This new amendment in Kenya’s Banking Act has stirred a hot debate within Kenya, the East African region and globally. Since 1990s, the global economy has reduced control of economic indicators. The world has never seen the level of economic freedom enjoyed nearly everywhere. In the years gone-by, government used to control nearly everything.

Uganda’s economy, fore example, has evolved from the pre-colonial medieval economy, through the ‘enclave economy’ under the British imperialist government, to the post-independence ‘control model’ under Idi Amin and Obote II.
Prior to the 1990s, Uganda’s economy, just like many other economies in the region, used to be controlled. Nearly all economic indicators – prices, interest rates, exchange rates – were controlled or fixed by government.
Economists often refer to these controls as economic distortions. Why? Because government intervention tends to lead to a departure from the allocation of economic resources in such a way that each agent maximises his/her own welfare.
For example, when government controlled prices in the 1970s and ‘80s, traders hoarded their goods which affected the buyers’ access to the goods and the economy’s overall performance. When it capped interest rates, banks had no incentive to lend because their profits were very low. This created shortage of credit which led to other undesirable outcomes such as credit rationing (banks selecting who to lend to or not basing on noneconomic criteria).

This is what economists refer to as government failures. It is also what informed the decision to liberalise most of the economies, starting in early 1990s. The proponents of liberalisation promised two things: efficiency and growth. However, people doubted the two have been achieved.
In the case of banks, one of the parameters used to measure efficiency is the interest rate spread (the difference between the lending rate banks charge borrowers and the deposit rate offered to savers). The higher the spread, the less efficient the banking system is.
For the past 20 years, the average interest rate spread (IRS) in Uganda has stagnated above 16.7 per cent while Kenyan banks have been enjoying interest rate spreads of about 11.4 per cent on average, themselves way above the world average of 6.6 per cent. Therefore, liberalisation did not bring the promised efficiency.

The banks attributed the high rates they charge to high risks of default among borrowers due to information asymmetry, high cost of doing business as well as governments’ internal borrowing. However, when the credit reference bureaus were created, providing better credit history on individuals and thus reducing default risks, interest rates did not fall.
What about growth? True more banks have since joined the market under liberalisation. Problem is; few of these banks control a very large market share, meaning there is limited competition. There is also possibility of some collusion or cartel-like behaviour.
Apart from these, a recent investigation by a committee of both government and private sector here in Uganda unearthed several “questionable bank practices” which would point at what economists call predatory lending behaviour.

These included, “mismatched products, staggered disbursements, high and uncontrolled penalties, multiple valuations for same asset, poor communication and highhandedness.” These and other unscrupulous actions are carried out by banks to have the borrower fail to repay the debt so they can strip him/her of their collateral whose value is often higher than the loan.
For a long time, people have raised these and other challenges they face while dealing with banks. To their chagrin, the central bankers who are mandated to regulate the banks say, “under a liberal economic system, we cannot do anything to coerce banks.”
This statement has frustrated politicians and their supporters. My view is that the desperate move by Kenyan politicians to cap interest rates should provide a good lesson to our own central bankers at Bank of Uganda, and the banks they ought to regulate.

Truth is, the market for banks has failed to self-regulate. Banks are insensitive to people’s outcries. Structural factors aside, banks cannot justify the lending rates they continue to charge and the long lags in their response to the CBR.
For years, banks have posted obscene profits year-in-year-out. Bank of Uganda governor Emmanuel Tumusiime Mutebile one time asked: “What is wrong with banks making money?” Well, a bystander may also ask: “What is wrong with banks making money reasonably?”
But of course “reasonable” is a subjective concept. Given a chance, everyone would love to act unreasonably, because it is always lucrative to cheat if cheating is permissible. I will be the last to support capping of interest rates; but I would like to see whether the sky will fall over Kenya.

The author is an economics lecturer at Makerere University Business School.

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