IMPACT OF CAPPING OF INTEREST RATES: LESSONS FROM ACADEMIA

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1 IMPACT OF CAPPING OF INTEREST RATES: LESSONS FROM ACADEMIA

2 INTRODUCTION interest rates caps are necessary in ensuring financial support for crucial sectors of the economy where market forces fail and where young industries cannot afford commercial credit at prevailing rates

3 INTRODUCTION interest rate caps can be used to protect consumers from exploitation by guaranteeing access to credit at reasonable rates

4 INTRODUCTION it has been argued out that because the prices charged for access to credit can be erratic and anticompetitive and therefore be higher than the true cost of lending, setting a lower cap on interest rates will provide an excellent environment for lenders to operate.

5 Lessons from academia: On MFIs Lend to small borrowers who require money for a variety reasons such as consumption and financing of a business and who cannot afford credit from the commercial banks. Interest rates will be high leading to high economic profits.

6 Lessons from academia: On MFIs - More employment (usually of graduates) to serve the many borrowers - More borrowing for those who need to further their education - More funding to small businesses leading to growth innovation, invention and entrepreneurship

7 Lessons from academia: On Banks When the interest is capped the banks are likely to face two main risks: Adverse selection as the demand for credit increases, they will not be able to differentiate to between higher risk and lower risk borrowers. The banks therefore charge an aggregated rate which is more attractive to the higher risk borrowers leading to high risk of default. Moral hazard: When an investor borrows at a high rate they may make riskier investments in order to cover their borrowing costs leading to high risk of default.

8 Lessons from academia: On Banks When interest rates are capped at very low levels, banks reduce the level of lending, increase processing costs, and introduce new products -Retrenchment of staff - banks reduce the level of lending to those who would want to further their education

9 Lessons from academia: On Banks - On the Supply of loans to Educational institutions may increase as they may have necessary collateral - banks may reduce funding of research due to reduced profitability.

10 Lessons from academia: On Banks - High growth of black market as borrowers look for quick monies leading to market distortion - Low deposit levels as the banks do not want to hold excess funds they cannot lend out. This leads to failure of understanding of the linkage between policy setting and practice

11 Lessons from academia: On Banks - NPLs go up which may lead to bankruptcy. This will require a lot of learnings around policy making and risk (measurements & impact) modelling

12 Lessons from academia: On Banks - Investments in terms of deposits may go up especially where the return is higher than those offered by alternative investments in the market. - The constrained credit product mix in price capped markets leads borrowers to use products which are less suited to their needs and expose them to greater risk

13 Lessons from academia: On economic growth Reduced profitability of banks coupled with low lending levels do not stimulate investment and business growth and hence economic growth. - Policy intentions must be clearly evaluated as they can lead to contrary results from expectations

14 Lessons from academia: On stock markets When rates are capped at levels that can provide investors with a moderate sure return on investment, they will shift their investments to the banks as deposits other than investing in stock markets. Stock markets may not be the best proxy to measuring economic outlook of a country.

15 Lessons from academia: On Investments Capping of rates may stimulate investments when properly done but it may also discourage investments when proper thought has not gone into the decision to cap.

16 Lessons from academia: On Employment May go up or down. Thank you