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2.1
INTRODUCTION

This
chapter reviews literature on the effects of interest rate capping on credit
growth in Kenya. The literature review investigated the effect of capping
interest rate on credit uptake, the effect of interest rate capping on bank
profitability and the effect of interest rate capping on the portfolio of
non-performing loans.

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2.2
EFFECT OF INTEREST RATE CAPPING ON CREDIT GROWTH RATE

A
capped interest rate is an interest rate that is allowed to fluctuate, but
which cannot surpass a stated interest cap. The capped rates are supposed to
provide the borrower with a hybrid of a fixed and variable rate loan. The fixed
part comes from the capped rate itself, while the variable part comes from the
loans ability to move up or down with market fluctuations.  (Maimbo, Henriquez& World Bank group 2014.)

Countries
need to know the importance of setting formal interest rate corridor so as to
strengthen the monetary policy frame work. Capping can complicate monetary
policy and adversely affect the banking sector profitability and the uptake of
credit. Although the adverse effects of the controls are manageable in the near
term, if maintained, they could potentially pose a risk to financial stability.
Systems should be put in place that prevents predatory lending and transparency
in the banking sector.  International
experience however shows that capping is ineffective and can have significant consequences.
I t will links deposit and lending rates to the policy rate limiting the
central banks capacity to maintain price stability and support sustainable
economic growth.(IMF’S Executive Board)Countries need to consider carefully
which method of regulation works best in the context of the institutions of the
country, rather than copying a method from the developed world. (Parker and
Kirkpatrick (2005).

The
major argument used against the capping of interest rates is that they distort
the market and prevent financial institutions from offering loan products to
those at the lower end of the market that have no alternative access to credit.
This runs counter to the financial outreach agenda that is prevalent in many
poor countries today. The debate can be boiled down to the prioritisation of
credit or access of credit. Imposition of price caps could in fact increase the
level of interest rates. An interest cap exacerbates the problem of adverse
selection as it restricts lenders ability to price discriminate and means that
some enterprises that might have received more expensive credit for riskier
business ventures will not receive funding. There has been an attempt to link
this constraint in the availability of credit to output. (Baqui Khalily, M.A
and Khaleque, M.A Access to credit and productivity of enterprises)

 

Many
countries in Africa have established interest rate caps to protect consumers
from high interest rates charged by micro lenders. Interest capping is often
the response of governments facing political or cultural pressure to keep
interest rates low. The general idea of capping is that interest rate ceilings
limit the tendency of some financial service providers to increase their
interest yields (all income from loans as a percentage of the lenders average
annual gross loan portfolio) especially in markets with a combination of no transparency,
limited disclosure requirements and low levels of financial literacy. Despite
good intentions, interest rate capping can hurt low income populations by
limiting their access to credit and reducing price transparency. If the
interest rate cap is too low financial service providers find it difficult to
recover costs and are likely to grow more slowly, hence reducing service
delivery in rural areas and other more costly markets, become less transparent
about the total cost of loan and exit the market. (Djibril Maguette Mbengue, The
Worrying Trend of Interest Rate Caps in Africa 2013)

Mambo,
Samuel Munzele and Henriquez Gallegos, Claudia Alejandra did a study on capping
of interest rates. In their findings they found that capping led to withdrawal
of financial institutions from the poor or from specific segments of the
market, an increase in the total cost of the loan through additional fees and
commissions among others .however, if capping is still considered a useful policy
tool for reducing interest rates for loans and access to finance, they should
be implemented in accord to set caveats.

 

 

 There is some evidence from developed
countries that the imposition of price capping could in fact increase the level
of interest rates. In a study of pay day loans in Colorado, the imposition of a
price ceiling was initially seen to reduce interest rates but over the longer
term rates were seen to steadily rise towards the interest rate cap. This was explained
by implicit collusion, by which the price 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. (De Young, Roberts and Philips Pay day
Loan Pricing 2009)

Interest rate
capping distorts risk and return and reduces economic growth rates. Interest
rate caps constrain private lending to borrowers who are perceived to be high
risk such as small businesses and the poor. The focus of any capping measure
should be on what is reasonable and affordable for consumers and will not cause
harm to vulnerable consumers. If a product cannot be offered at such a rate
then it is arguable then it should not be offered at all. (Baldwin & Cave).To
be effective a cap must be accompanied by effective enforcement which, it
should be acknowledged is likely to be costly. The main way in which ceilings
are accommodated is that interest rates become less important as a component of
the total price of credit.

There are possible
implications of interest rate capping which include credit will only be
concentrated amongst large borrowers, banks will prefer lending the government
than small households and poor people, and it will discourage the supply of
funds to the financial system encouraging informal mechanisms. Non-financial
market players will see an incentive to increase sales through credit under
more stringent terms to the detriment of the customers.

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