The Impact of Interest Rate Caps on the Financial Sector

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Public Disclosure Authorized

Policy Research Working Paper

WPS8393 8393

The Impact of Interest Rate Caps on the Financial Sector

Evidence from Commercial Banks in Kenya

Mehnaz Safavian Bilal Zia

Public Disclosure Authorized

Public Disclosure Authorized

Finance, Competitiveness and Innovation Global Practice &

Development Research Group April 2018

Policy Research Working Paper 8393

Abstract

Interest rate caps can have far-reaching consequences on the composition and maturity of commercial bank loans and deposits. This paper carefully documents these impacts on the formal financial sector in Kenya after the recent interest rate caps of 2016. Using bank-level panel data from before and after the caps, the paper identifies a significant decline in aggregate lending, an increase in nonperforming loans, and a change in composition of

lending away from small and medium enterprises and toward safer corporate clients. Banks also shifted away from offering interest on current account deposits to preserve their interest margins. These quantitative findings are supported by qualitative evidence through detailed interviews of commercial bank executives, and have important implications for economic growth and financial inclusion.

This paper is a product of the Finance, Competitiveness and Innovation Global Practice and the Development Research Group. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http:// econ.. The authors may be contacted at bzia@.

The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent.

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The Impact of Interest Rate Caps on the Financial Sector: Evidence from Commercial Banks in Kenya

Mehnaz Safavian and Bilal Zia1

JEL Codes: G18, G21, G28 Keywords: Interest Rate Caps, Financial Inclusion, Banking Sector

1 Both authors are from the World Bank, msafavian@ and bzia@, respectively. This paper is the culmination of a year-long independent study of the impact of interest rate caps in Kenya, commissioned by the World Bank country office in Kenya at the request of the Central Bank of Kenya (CBK). We are very grateful to CBK for providing data from commercial banks that are used in this paper. We also thank the World Bank team involved in the study, in particular Rajiv Daya, Allen Dennis, Sarah Sanya, and Caroline Wambugu. Finally, we thank all financial sector participants who accepted our interview invitations and responded to CBK's data request. All analyses, conclusions, and recommendations presented in this paper are our own, as are any remaining errors.

I. Introduction

In August 2016, Kenya embarked on an ambitious path to regulate the cost of commercial credit by imposing a government cap on interest rates. This paper examines how this policy has affected the financial sector in Kenya, and provides an assessment on whether the cap is likely to achieve its desired objectives.

The cap was imposed when the President of Kenya signed the Banking (Amendment) Bill 2015, which put a cap on interest rates charged on loans and a corresponding floor on the interest rate offered for deposit accounts by commercial banks. This new legislation was in response to the public view that lending rates in Kenya were too high, and that banks were engaging in predatory lending behavior. The interest rate caps were therefore intended to alleviate the repayment burden on borrowers and improve financial inclusion as more individuals and firms would be able to borrow at the lower repayment rates.

Previous global evidence on the effectiveness of interest rate caps is quite mixed (for reviews, see Maimbo and Gallegos (2014); and Ferrari, Masetti, and Ren (2017)). Although more than 70 countries worldwide have enacted interest rate caps to some degree, their various forms and modes of implementation make definitive conclusions on their net impact difficult to assess. In theory, interest rate caps can help reduce the cost of borrowing for consumers and are often used by governments to protect unsophisticated borrowers from predatory lending. Yet, the real economic impacts depend on (a) how banks adjust supply and composition of loans in reaction to the policy; (b) how consumers adjust demand for credit when faced with changes in supply; and (c) the magnitude of the difference between the nominal value of the cap and the market interest rate.

This paper carefully documents the key short-term responses from the banking sector to the interest rate caps. The findings are based on quantitative analysis of loan and deposit data from commercial banks for the panel January 2015 to September 2017. The quantitative analysis is ably supported by detailed qualitative evidence from interviews and consultations with key counterparts on the regulatory side as well as financial sector actors themselves.

Identifying the causal impact of interest rate caps in any setting is quite challenging due to the lack of a counterfactual, since all banks are subject to the policy. Isolating the impact of caps in Kenya is further confounded by events prior to the caps, where the economic and market conditions were already in a downturn due to several reasons: the banking sector crisis of early 2016, the slowdown in loan growth and demand due to severe drought conditions, and the political uncertainty associated with the 2017 general elections.

Due to these reasons, we focus our analysis on identifying key microeconomic changes in loan and deposit trends starting 22 months prior to the caps, and differentiate between the responses of commercial banks to across different bank tiers and different types of clients. For this purpose, we divide the time-series from January 2015-Septembe 2017 into three periods:

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January 2015 to February 2016 representing the pre-downturn period; February 2016 to October 2016 representing the interim period prior to the caps; and October 2016 to September 2017 representing the one-year period after the caps for which data are analyzed in this study.2

Several important findings emerge from the quantitative analysis. First, the data confirm a statistically significant decline in aggregate lending in the Kenyan economy, with a 3.1% decline after February 2016 from an aggregate base of Ksh. 167.65 billion (US $1.64 billion) in the pre-February 2016 period, and a further 2.7% decline after the interest rate caps. Correspondingly, there is a sizable increase in Non-Performing Loans (NPLs), with the size of abnormal loans seeing an increase of almost 53% after February 2016 from an aggregate base of Ksh. 25.67 billion (US $0.25 billion), and an additional 8% after the caps. The increase in NPLs is exhibited across nearly every major sector in the economy.

This precipitous rise in NPLs is reflective of both the prevailing economic and market downturn as well as the interest rate caps. Our microeconomic analysis finds that after the caps, commercial banks started issuing loans of shorter maturity, thus likely contributing to the increase in NPLs. Furthermore, according to two recent Central Bank of Kenya (CBK) Commercial Banks' Credit Surveys for the second and third quarters of 2017, the upward trend in NPLs was expected to continue into the fourth quarter of the year and beyond due to the political uncertainty and economic downturn in the country. The CBK surveys further confirm commercial banks responded to these changes by elevating their risk mitigation measures, effectively rationing out many small and unsecured borrowers. As a result, 54% of the respondents revealed that interest rate caps had negatively affected their lending to SMEs.

Our data analysis confirms that commercial banks indeed responded to the interest rate caps by shoring up their corporate clients. Both tier 1 and tier 2 banks exhibited a significant flight towards corporate clients after the interest rate caps, which came at the expense of lending in other sectors such as SME loans.

Tier 3 banks exhibited a flatter trend initially but an eventual flight to corporate clients after the interest rate caps. These banks also sharply reduced their SME lending. Our discussions with counterparts suggest that tier 3 banks were relatively less successful in immediately shoring up their corporate books, as these clients were taken up by higher tier banks. Instead, the smaller tier 3 banks were forced to maintain their portfolios in SME and consumer lending, but, as the data show, with time even smaller banks reduced lending to the SME sector.

The analysis also focuses on debt maturity and deposit composition to understand changes in the types of products offered by commercial banks after the interest rate caps. While tier 1 and tier 2 banks expanded their long- and medium-term loan books, likely signifying their desire to fulfill demand from good quality clients, tier 3 banks were the only ones that exhibited an increase in short-term loan offerings. These changes in debt maturity likely have negative

2 The bill was signed in August 2016, and came into full effect in mid-September 2016.

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consequences for small firms requiring longer-term capital investment from tier 1 and tier 2 banks.

On the deposit side, the analysis confirms a significant shift towards offering interest only on longer term deposits and eliminating any interest offerings on current accounts. This shift is most evident among tier 3 banks where interest bearing accounts dropped precipitously to nearly zero percent of portfolio in response to the interest rate caps, down from a previous average of 36%. These changes in deposit composition are indicative of the banking sector's response and their preference for maintaining their interest margins.

These changes in loan and deposit books have important implications for financial inclusion. First, our findings suggest that the interest rate caps certainly did not attenuate the upward trend in NPLs, and therefore did not aid financial inclusion. Instead, we find a continued rise in NPLs after the caps.

Second, a vibrant and growing SME and consumer sector is an important cornerstone of a typical developing economy. Yet, the data from the CBK-regulated commercial banking sector and commercial bank surveys show no loan growth in the SME sector and an expectation of further loan rationing in the future.

Third, the documented flight towards corporate clients, tightening of risk mitigation measures, and offering of loans with shorter maturities in tier 3 banks all have potential consequences for financial inclusion of smaller firms and consumers and could reverse the recent gains in financial access achieved in the last decade. Unable to access credit from traditional financial institutions, riskier borrowers are forced to turn to the unregulated market, such as informal money lenders, that charge much higher rates and lack consumer protection.

Overall, these findings suggest that the interest rate caps were largely unsuccessful in mitigating the downward trends in financial inclusion due to prevailing market and economic conditions, at least in the short run.

The rest of this paper proceeds as following. Section II presents a short background and context for interest rate caps in Kenya and poses hypotheses for the empirical analysis. Section III discusses the assessment challenges associated with identifying the impact of interest rate caps. Section IV presents the qualitative evidence, and Section V the quantitative evidence for this study. Finally, Section VI concludes with policy recommendations.

II. Background and Hypotheses

Background In August 2016, the President of Kenya signed the Banking (Amendment) Bill 2015, which came into full effect in mid-September 2016.3 The law caps the maximum interest rate charged

3 See Appendix A for the complete text of the signed bill.

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for a credit facility in Kenya by banks at no more than 4 percent of the base rate set by the Central Bank of Kenya (currently at 10 percent); and provides a floor for the deposit rate held in interest earning accounts to at least 70 percent of the base rate.

This new legislation was in response to the public view that lending rates in Kenya were too high, and that banks were engaging in predatory lending behavior. Interest rate spreads in Kenya averaged 10.1 percent between 2001 and 2015, with profits (48 percent) and overheads (40 percent) accounting for a large portion of these margins (World Bank, 2016).

The policy dialogue around the imposition of interest rate caps has been ongoing in Kenya for quite some time, dating back to 2008. Interest rate spreads have long been high, and threats from the government and politicians to impose caps have emerged periodically, especially near election cycles. Prior to the caps, many attempts were made by government and financial sector regulators to engage the banking sector to promote a market-based solution designed by the sector itself. For example, in 2012, the National Treasury constituted a Committee on the Cost of Private Sector Credit and Mortgage Finance to identify policy reforms that could address the high cost of credit in the country. Key reform recommendations from this committee included strengthening the system for movable collateral, increasing the scope of credit reporting, and promoting consumer protection measures. Such reforms have been effective in lowering the cost of credit in other countries (Martinez Peria et al. 2017), and it was anticipated they could have an attenuating effect on the cost of credit in Kenya as well.

While the policy reform debate continued, CBK took separate initiatives to insert a degree of transparency and competition into lending practices, with the goal of arming consumers with better information so they could make more informed choices across banks and loan products. For example, CBK started publishing the average lending rates for various loan products by banks as well as the overall average weighted lending rate.

Policy reforms in the movable property and credit information space did move forward and the CBK initiatives were implemented simultaneously, but none of these measures resulted in lower interest rates. While commercial banks did agree in principle to take steps to bring down interest rates, no specific initiatives were offered. Ultimately, the general fatigue among the public and policy makers, combined with political pressure during an upcoming election year finally pushed politicians into passing the Banking (Amendment) Bill of 2015.

Hypotheses Understanding how Kenya's decision and experience with interest rate caps compares to similar initiatives implemented in other jurisdictions can help generate empirical hypotheses on the impact of this policy initiative.

To the best of our knowledge, no other country has imposed as restrictive a cap on the financial sector as Kenya. First, the interest rate cap of 14 percent was set very close to the risk-free rate of public sector borrowing, which at the time was 12-14 percent on long term money. Having the nominal interest rate so close to the government risk free rate meant that banks had little

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incentive to provide financing to risky market segments. Instead, commercial banks directed their investments to government treasury bills. Given that banks of different size have different levels of access to public debt, we expect to see larger banks moving to the risk-free space proportionally more than smaller banks.

Second, the bill provided very little implementation guidance, which resulted in confusion and irregular application. For example, it was unclear if the bill solely applied to banks, or to all regulated financial institutions, including MFIs and SACCOs. There was little guidance as to whether the bill also covered mobile loans and mobile service providers. No part of the bill, or any corresponding regulation, indicated whether the bill was retroactive, so that all current loans would need to be refinanced, or if it would only apply to new loans originated after the bill's adoption.

At the time of this paper, some of these questions remain unresolved. For example, the mobile money and mobile loan space does not seem to be included in the bill's implementation, and remains an open question. While all banks are adhering to the cap on their conventional loan products, many mobile loans continue to carry effective interest rate charges of over 100% per annum. Additionally, the consensus is that MFIs and SACCOs are not subject to the cap, creating an uneven playing field across the lending and credit markets, and informal sector lenders are purported to have increased their rates substantially, even as demand for credit has increased.

Given these ongoing out of equilibrium changes, assessing permanent impact of the caps becomes particularly challenging. Past literature on the impact of interest rate caps is fairly thin as well, and what exists records several potential detrimental effects of such policies (Maimbo and Gallegos, 2014). Despite their intentions, interest rate caps can in fact reduce credit availability and increase costs for low-income borrowers, and reduce financial product transparency and diversity (Ferrari, Masetti, and Ren, 2017). In South Africa, for example, several financial institutions evaded the interest rate caps by charging credit life insurance and other service fees, which reduced the transparency of the total cost of credit. In West African and Monetary Union (WAEMU) countries, the imposition of interest rate caps on microfinance loans led microfinance institutions to withdraw lending to the poorest borrowers and to remote areas. Similarly in Nicaragua, microfinance institutions reduced lending and left urban areas due to high operational costs and risks. They also responded by adding fees to circumvent the interest rate cap. Elsewhere, in Japan, the supply of credit appeared to contract, acceptance of loan applications fell, and illegal lending rose. Finally, in France and Germany, interest rate ceilings decreased the diversity of products for low-income households; and in India, the interest rate caps in 2011 led to a slowdown in borrowing and lowered formal financial access.

We hypothesize that the lack of clarity on the caps in Kenya could potentially magnify such negative effects. It is clear that the broad scale of interest rate caps can have far-reaching implications within the Kenyan economy, including impacts on banking sector stability, banking investments, financial inclusion, consumer and SME finance, as well as impacts on

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