Interest rate ceiling

Overview

An interest rate ceiling (also known as an interest rate cap) is a regulatory measure that prevents banks or other financial institutions from charging more than a certain rate of interest.

Interest rate caps and their impact on financial inclusion

Research was conducted after Zambia reopened an old debate on a lending rate ceiling for banks and other financial institutions. The issue originally came to the fore during the financial liberalisations of the 1990s and again as microfinance increased in prominence with the award of the Nobel Peace Prize to Muhammad Yunus and Grameen Bank in 2006. It was over the appropriateness of regulatory intervention to limit the charging of rates that are deemed, by policymakers, to be excessively high. A 2013 research paper asked

Where are interest rate caps currently used, and where have they been used historically? What have been the impacts of interest rate caps, particularly on expanding access to financial services? What are the alternatives to interest rate caps in reducing spreads in financial markets?

Understanding the composition of the interest rate

The researcher decided that to assess the appropriateness of an interest rate cap as a policy instrument (or whether other approaches would be more likely to achieve the desired outcomes of government) it was vital to consider what exactly makes up the interest rate and how banks and MFIs are able to justify rates that might be considered excessive. He found that broadly there were four components to the interest rate:

Cost of funds Overheads Losses on non-performing loans Profit

Cost of funds

The cost of funds is the rate of interest that the financial institution must pay to borrow the funds that it then lends out. For a commercial bank or deposit-taking microfinance institution this is usually the interest that it pays on deposits. For other institutions it could be the cost of wholesale funds, or a subsidised rate for credit provided by government or donors. Other MFIs might have very cheap funds from charitable contributions.

Overheads

The overheads reflect three broad categories of cost:

Outreach costs: the expansion of a network or development of new products and services Processing costs: the cost of credit processing and loan assessment, which is higher with greater information asymmetry. General overheads: general administration and overheads associated with running a network of offices and branches The overheads, and in particular the processing costs, can drive the price differential between larger loans from banks and smaller loans from MFIs. Overheads can vary significantly between lenders, and overheads measured as a proportion of the loans made are an indicator of institutional efficiency.

Non-performing loans

Lenders must absorb the cost of bad debts and recoup it from the interest rate that they charge. If a lender's credit screening processes improve in future, it should be able to bring down interest rates, while reckless lenders will be penalised.

Profit

Lenders will include a profit margin that again varies considerably between institutions. Banks and commercial MFIs with shareholders to satisfy are under greater pressure to make profits than NGO or not-for-profit MFIs. Institutions require capital in order to operate, and whatever the source of this capital, the cost of providing it must be recouped.

The rationale behind interest rate caps

Interest rate caps are used by governments for political and economic reasons, most commonly to provide support to a specific industry or area of the economy. Government may have identified what it considers being a market failure in an industry, or is attempting to force a greater focus of financial resources on that sector than the market would determine.

Loans to the agricultural sector to boost agricultural productivity as in Bangladesh. Loans to credit constrained SMEs as in Zambia. The researcher found it is also often argued that interest rate ceilings can be justified on the basis that financial institutions are making excessive profits by charging exorbitant interest rates to clients. This is the usury argument and is essentially one of market failure where government intervention is required to protect vulnerable clients from predatory lending practices. The argument, predicated on an assumption that demand for credit at higher rates is price inelastic, postulates financial institutions are able to exploit information asymmetry, and in some cases short run monopoly market power, to the detriment of client welfare. Aggressive collection practices for non-payment of loans have exacerbated the image of certain lenders. The researcher says that economic theory suggests market imperfections will result from information asymmetry and the inability of lenders to differentiate between safe and risky borrowers. When making a credit decision, a bank or a microfinance institution cannot fully identify a client's potential for repayment. Two fundamental issues arise:

Adverse selection - clients that are demonstrably lower risk are likely to have already received some form of credit. Those that remain will either be higher risk, or lower risk but unable to prove it. Unable to differentiate, the bank will charge an aggregated rate which will be more attractive to the higher risk client. This leads to a raised probability of default ex ante. Moral hazard - clients borrowing at a higher rate might be required to take more risk (hence higher potential return) to cover their borrowing costs leading to a higher probability of default afterwards. The researcher claims that traditional ‘microfinance group lending methodology’ helps manage adverse selection risk by using social capital and risk understanding within a community to price risk. However, interest rate controls are most often found at the lower end of the market where financial institutions (usually MFIs) use the information asymmetry to justify high lending rates. In a non-competitive market (as is likely to exist in a remote African village), the lender likely holds the monopoly power to make excessive profit without competition evening them out. The financial markets will segment so large commercial banks service larger clients with larger loans at lower interest rates and microfinance institutions charge higher rates of interest on a larger volume of low value loans. In between, smaller commercial banks can find a niche serving medium to large enterprises. Inevitably the missing middle, individuals and businesses will be unable to access credit from either banks or MFIs. The researcher found it intuitive that basic interest rate caps are most likely to bite at the lower end of the market, with interest rates charged by microfinance institutions generally higher than those by banks and this is driven by a higher cost of funds and higher relative overheads. Transaction costs make larger loans relatively more cost effective for the financial institution. If it costs a commercial bank $100 to make a credit decision on a $10,000 loan then it will factor this 1% into the price of the loan (the interest rate). The cost of loan assessment does not fall in proportion with the loan size and so if a loan of $1,000 still costs $30 to assess, the cost which must be factored in rises to 3%. This cost pushes the higher rates of lending on smaller loans. The higher prices are usually paid because the marginal product of capital is higher for people with little or no access to it. In implementing a cap, government is aiming to incentivise lenders to push out the supply curve and increase access to credit while bringing down lending rates, assuming the cap is set below the market equilibrium. If above then lenders will continue to lend as before. The researcher thinks such thinking ignores the actions of the banks and MFIs operating under asymmetric information. The imposition of a maximum price of loans magnifies the problem of adverse selection as the consumer surplus that it creates is a larger pool willing borrowers of unidentifiable creditworthiness. Faced with this problem, he proposes lenders have three options: - Increased lending, meaning lending to more bad clients and pushing up NPLs - Increased investment in processing systems to better identify good clients, increasing overheads - Increased investment in outreach to clients, identified as having good repayment potential, increasing overheads All options increase costs and force the supply curve back to the left, detrimental to financial outreach as the quantity of credit falls. Unless financial service providers can absorb the cost increases while maintaining a profit, they may ration credit to those that they can readily support at the prescribed interest rate, refuse credit to other clients and the market moves. The researcher asks if the story of interest rate caps leading to credit rationing is borne out in reality?

The use of interest rate caps

Though conceptually simple, there is much variation between the methodologies used by governments to implement limits on lending rates. While some countries use a vanilla interest rate cap written into all regulations for licensed financial institutions, others have attempted a more flexible approach. The simplest type of interest rate control puts an upper limit on any loans from formal institutions. This might simply say that no financial institution may issue a loan at a rate greater than, say, 40% interest per annum, or 3% per month. As a more flexible measure, the interest cap is often linked to the base rate set by the central bank in its monetary policy, so that the cap reacts in line with market conditions, rising with monetary tightening and falling with easing. This is the model used in Zambia, where banks are able to lend at nine percentage points over the policy rate and microfinance lending is priced as a multiple of this. Elsewhere, governments have linked the lending rate to the deposit rate and regulated the spread that banks and deposit-taking MFIs can charge between borrowing and lending rates. As some banks look to get around lending caps by increasing arrangement fees and other charges to the borrower, governments have often tried to limit the total price of the loan. Other governments have attempted to set different caps for different forms of lending instrument.

Multi-category caps

Rather than setting a rigid interest rate limit, governments in many countries prefer to discriminate between different types of loans and to set individual caps based on the type of borrower and the type of loan. The rationale for this is that it can bite at various levels of the market, minimising consumer surplus. In South Africa, the National Credit Act (2005) identified eight sub-categories of loan, each with their own prescribed maximum interest rate:

Mortgages: (RR×2.2)+5% per annum Credit facilities: (RR×2.2)+10% per annum Unsecured credit transactions: (RR×2.2)+20% per annum Developmental credit agreements for the development of a small business: (RR×2.2)+20% per annum Developmental credit agreements for low income housing (unsecured): (RR×2.2)+20% per annum Short-term transactions: 5% per month Other credit agreements: (RR×2.2)+10% per annum Incidental credit agreements: 2% per month.

Financial outreach

The researcher identified the major argument used against the capping of interest rates as them distorting the market and preventing financial institutions from offering loan products to those at the markets lower end with no alternative credit access. This counters the financial outreach agenda prevalent in many poor countries today. He claims the debate boils down to the prioritisation of cost of credit over access to credit. He identifies a randomised experiment in Sri Lanka which found the average real return to capital for microenterprises to be 5.7% per month, well above the typical interest rate of between 2-3% that was provided by MFIs. Similarly, the same authors found in Mexico that returns to capital were an estimated 20-33% per month, up to five times higher than market interest rates. His paper states that MFIs have historically been able to expand outreach rapidly by funding network expansion with profits from existing borrowers, meaning existing clients are subsidising outreach to new areas. Capping interest rates can hinder this as MFIs may remain profitable in existing markets but cut investment in new markets and at extremes, government action on interest rates can cause existing networks to retract. In Nicaragua, the governments Microfinance Association Law in 2001 limited microloan interest to the average of rates set by the banking system and attempted to legislate for widespread debt forgiveness. In response to perceived persecution by government, a number of MFIs and commercial banks withdrew from certain areas hindering the outreach of the financial sector. The researcher articulates that there is also evidence to suggest capping lending rates for licensed MFIs incentives, NGO-MFIs, and other finance sources for the poor to stay outside of the regulatory system. In Bolivia, the imposition of a lending cap led to a notable fall in the licensing of new entities, . Keeping lenders out of the system should be unattractive to governments as it increases the potential for predatory lending and lack of consumer protection.

Price rises

The paper states there is evidence from developed markets that the imposition of price caps could in fact increase the level of interest rates. The researcher came across a study of payday loans in Colorado, the imposition of a price ceiling initially saw reduced interest rates but over a longer period rates steadily rose towards the interest rate cap. This was explained by implicit collusion, by which the price cap set a focal point so that lenders knew that the extent of price rises would be limited and hence collusive behaviour had a limited natural outcome.