Why banks are salivating on interest cap removal

Local banks’ bid to have the interest cap on loans removed seems almost a done deal.

I tell my students that our problem is not the interest rate but how we package our business. Interest rate is an issue when debt capital is used to finance the business.

Those businesses that avoid debt by use of equity capital to finance their assets avoid financial risk. They do not have to worry about fluctuations in interest rates.

Managers must decide on whether to use debt capital.

It is not advisable using debt when interest rates are too high and also when the economy is in a recession.

There is no doubt that worldwide, bank capital is important to businesses due to the ease of access. Parliament imposed a cap on commercial lending and borrowing rates in 2016, and most businesses other than banks supported that action.

At that time, the cost credit was too high, with some banks charging interest at the rate of 25 per cent. The genuine criticism against the cap then was that it was arbitrary and that inadequate research was done to identify the interest rate that supports our target economic growth.

We lacked a sound explanation as to why pre-capping interest rates was wrong.

In developed economies, it is the Central Bank that caps interest by setting ceilings and floors of interest rates.

Macroeconomic indicators

This is done via the discount window and interest on reserves. Furthermore, well-informed economies do not put macroeconomic indicators such as the level of interest rate to a vote in Parliament.

They leave such decisions to bureaucrats and the regulators.

I wonder what would have happened if Parliament was to vote on demonetisation.

What MPs should do is to set up structures and institutions that ensure prevailing interest rates support growth for the economy.

The major undoing of interest rate capping was the inherent assumption that money is lent to individuals and not to projects. If Parliament could have been made aware that borrowed money is invested in different projects with different risk profiles, they would have realised the absurdity of capping the interest rate, specifically their choice of the four per cent rate margin.

The theory of interest rate capping requires that a capped rate is allowed to fluctuate but must be based on a starting interest rate.

The variability of the capped rate might not be in line with the changes to the economy. At the project level, credit managers and Parliament must accept that different projects have different risk profiles and returns.

The implication is that projects with similar return profiles differ in the capacity to service a loan and must borrow at adjusted rates. The borrower can service the loan from the cash flow generated by the project financed and not interest rate that should be the focus.

This explains why it is futile controlling interest rates. Even the reason that banks advance to support rate cap removal is not supported by their actions.

Small business

Banks should have lowered the borrowing interest rate to as low as five per cent to signal their support to businesses.

Instead, the banks claim the remove of the rate cap is necessary so that they can charge small business high interest. How can someone help you by increasing your cost of doing business?

Why is it that in the US, the basic interest rate is between 0.75 per cent and 1.5 per cent, such that if one borrows Sh100,000, the basic interest will be Sh1,500 compare to Kenya’s Sh9,500 on the same cash?

This high-interest rate goes beyond borrowing. They even adversely impact the exchange rate. The other negative aspect of capping the interest rate is that it interferes with the monetary operations of the Central Bank, meant to ensure that changes in the interest rate reflect changes in the business cycle and inflation.

For example, the model used by CBK to control interest rate requires a change in the money supply but is dampened by the capping of the interest rate.

The key to the effective interest rate is to drive the economy towards business expansion.

Managers must generate internal revenue to reduce their reliance on bank capital.

Increased number of goods and services being produced translate to higher income and retained earnings that can finance a firm’s growth.

An effective interest rate regime turns citizens into savers instead of driving them into bankruptcy. Many people have had their assets auctioned due to a bank loan.

-The writer teaches at the University of Nairobi