Interest Rate Cap Two Years On: Outcomes for Kenya’s Economy
On 14th September 2016, the interest rate cap law came into effect, aiming at making credit affordable to the ‘common man’. The law puts a ceiling on lending rate by banks and other financial institutions to at most 4% above the Central Bank of Kenya (CBK) base rate, known as the Central Bank Rate (CBR). This was because of high cost of borrowing which deterred access to credit by a large section of the population and persistently high interest rate spreads. In early 1990s, Kenya’s financial sector was liberalized to allow market-driven interest rates. Financial sector liberalization should result in narrow interest rate spreads through competition. Despite this, interest rate spreads in Kenya were way above 10% even in the post-liberalization period.
The banking sector in Kenya is ‘oligopolistic’ in nature. With 42 licensed commercial banks, a significant share of the market is dominated by five (5) large banks. The few large banks are perceived to be stable and account for over 50% of the market share (deposits and loans). Therefore, they can attract large deposits at low deposit rates and many loan applications at higher rates, resulting in higher spreads. Such market ‘inefficiencies’ may warrant government intervention, which can be directly by being a player in the market or indirectly through legislation. This is meant to protect consumers in most cases and to ensure macroeconomic stability. Consequently, the government intervened to correct the inefficiencies in the financial sector by making into law, the Bill that caps interest rates.
Effects of Interest Rate Cap in Kenya’s Banking Sector
Interest rate levels and spread
Both interest rate and spread have significantly decreased after the cap. The interest rate for commercial banks loans and advances fell from 17.66% in August 2016 to an average of 13.7% between September 2016 and December 2017, which was 3.7% above the CBR of 10%. Further, with the CBR lowered to 9% in July 2018, the interest rate dropped slightly to an average of 12.8% in August 2018. The cap has resulted in lower interest rate spread from 11.2% in August 2016 to 4.9% in August 2018. This is evidenced in lower lending rates and increase in deposit rates from 6.4% in August 2016 to 7.9% in August 2018.
The ratio of non-performing loans (NPLs) to gross loans has generally increased across all economic sectors. NPLs in the trade sector increased from 12.7% in the second quarter of 2016 to 20.9% in the second quarter of 2018, the largest among the economic sectors (see figure below). Before being overtaken by the trade sector, building and construction generally had the largest share on NPLs from the first quarter of 2016 (17.2 %) to the first quarter of 2018 (20.6 %), which is attributed to delayed payments by both the private sector and government. NPLs have generally been on an upward trend in all the key economic sectors with a sharp rise witnessed in the first two quarters of 2018. The trend is mainly attributed to delayed loan repayments resulting from slowdown in business.
Share of NPLs to gross loans in key sectors (%)
Data Source: Central Bank of Kenya
Interest rate cap has resulted in a decline in commercial banks’ profits. Many commercial banks recorded decreased profits resulting from reduced interest rate spreads. In 2017, the average pre-tax profit for commercial banks was Ksh 73.39 billion compared to Ksh 85.35 billion in 2016, a 14% drop. However, in 2018, profitability in the banking sector has improved owing to a decrease in general expenses. Pre-tax profits increased by 2.1% between the first and second quarter of 2018. Similarly, pre-tax profits increased by 3.2% from Ksh 36.5 billion in the fourth quarter of 2017 to Ksh 37.7 billion in the first quarter of 2018.
Interest vs non-interest income
Non-interest income rose while interest income fell. To compensate for the decline in profits, commercial banks resorted to measures to increase their non-interest incomes. Consequently, they increased their commissions and fees, introduced new charges such as loan insurance on overdrafts and increased investments in government securities. For example, net fees and commission income increased by 35.8% in 2017 compared to 7% in 2016 for Equity Bank and 16.4% in 2017 compared to 10.3% in 2016 for KCB Bank. Net interest income for Equity Bank fell by 16.4% in 2017 compared to an increase of 23.3% in 2016 while for KCB Bank, it grew by only 2.9% in 2017 compared to 19.7% in 2016. Overall, non-interest income for commercial banks increased from 12.4% in September 2016 to 15.2% in June 2017, implying a shift to non-interest income. Further, the share of interest income in total operating income declined to 68.5% in December 2017 from 71.2% in December 2016 while non-interest income rose from 28.8% in December 2016 to 31.5% in December 2017.
Uptake of government securities
After the cap, commercial banks increased their lending to the national government which they perceive as less risky compared to small borrowers in the private sector. The share of government securities owned by commercial banks increased from 52.5% in 2015/16 to 55% in 2016/17 before slightly falling to 52% in 2017/18. This implies that as of June 2018, commercial banks were the largest holders of government securities.
Effects on Private Sector Credit and Economic Performance
Demand for credit
Demand for credit shot up immediately after the cap before taking a downward trend in February 2017. The ratio of advances to deposit rose from 85.7% in September 2016 to an all-time high of 89% in January 2017 after which it took a downward trend and to 79% in June 2018 owing to tighter financial conditions (see figure below).
Ratio of advances to deposits (%)
Data Source: Central Bank of Kenya
Credit Growth and Structure in Key Sectors
Growth of commercial bank credit to various sectors improved in the first two quarters of 2018 compared to 2017. In the first quarter of 2018, building and construction, finance and insurance, households and business services sectors recorded positive demand for credit compared to the same period in 2017 which was negative. Agriculture, and mining and quarrying sectors recorded negative growth rates in demand for credit in the first quarter of 2018. However, this was an improvement compared to a similar period in 2017. In the second quarter of 2018, other than mining and quarrying that had a decline of 8.4%, all the remaining ten economic sectors had a growth in credit, better than the performance in the same period of 2017 and reflecting recovery in private sector credit. It is expected that interest rate cap will have little effect on demand for credit in the third quarter of 2018.
Trend in Private Sector Credit
Growth in private sector credit has declined since the law came into effect. However, the effects were more severe in 2017 than 2018. The annual growth of credit to the private sector between the year 2016 and 2017 reveals significant disparities. For example, growth in credit to the private sector in January 2016 was 17% compared to 4.4% in the year 2017; in July 2016, it was 6.4% compared to 1.4% in 2017 (see figure below). Small borrowers were the most affected due to increased risk mitigation measures which have led to tightening of credit standards by commercial banks. The financial sector is, however, revealing signs of recovery with growth in credit to private sector in 2018 showing greater improvements compared to 2017.
Figure 3: Growth in credit to private sector in Kenya: 2016-2018
Data Source: CBK
Other than implementation of interest rate ceiling, the decline in private sector credit is also attributed to other factors, namely: liquidation of three commercial banks namely Chase Bank, Dubai Bank and Imperial Bank and prioritization of loan recovery by banks.
Despite the cap, growth in total domestic credit in 2017 was higher than in 2016. Even with the decline in credit to the private sector, total domestic credit grew by 7.9% in 2017, 1.5% higher than in 2016. This is specifically attributed to a 12.1% growth in credit to the national government, implying that the growth in credit to national government was stronger than the decline in credit to the private sector. Further, the share of national government credit in total domestic credit grew from 20% in 2016 to 24% in 2017 while the share of private sector credit fell from 77% in 2016 to 73% in 2017.
Overall economic performance in Kenya worsened in 2017, partly attributed to a fall in private sector credit. In countries with efficient banking sector, access to credit by the private sector is likely to promote economic growth as it results in stimulation of economic activities. Economic growth as measured by real GDP decreased from 5.8% in 2016 to 4.9% in 2017. This is linked partially to the effects of poor weather conditions, prolonged electioneering period and a decline in growth in credit to the private sector. Limited access to credit by the private sector is likely to reduce private sector investments, which can have adverse effects on growth.
In 2018, the economy has been on a positive trajectory and portraying signs of recovery. Quarterly GDP growth rates in 2018 are higher than those of 2017. For example, in the first two quarters of 2018, the economy grew by 5.7% and 6.3%, respectively, compared to 4.7% in similar quarters in 2017. Improved economic performance in 2018 can be partially attributed to increased uptake of bank credit by manufacturing, construction and service sectors.
The interest rate cap brought some negative effects on the general economy, with the effects more severe in 2017 than in 2018. However, some recovery has been witnessed in 2018 with increases in growth of credit to the private sector, and general economic growth. Market power in the banking sector is likely to influence interest rate spreads, with the few large banks likely to have the advantage. Nevertheless, the law has generally succeeded in bringing down interest rate spreads. The CBK needs to be granted exclusive powers to implement both the monetary policy rules in Kenya and come up with policies that ensure competitive and efficient banking industry.
Author: James Ochieng, Policy Analyst, Macroeconomics Department