Capping Loans In Kenya: Touchy Amendment Provokes Vigorous Debate

Kurt Davis Jr.
Written by Kurt Davis Jr.

Ask local Kenyans about the new banking bill signed by President Uhuru Kenyatta on Aug. 24. The responses are strongly split with both sides using harsh language to condemn those who support the amendment or oppose the amendment.

Ask an economist and it is hard for her to hold her tongue.

Under the new law, lending rates will be capped at 4 percentage points above the benchmark central bank rate, which is currently 10.5 percent. Deposit rates must be at least 70 percent of the benchmark rate.

The policy is controversial. Opposition has come from various corners of power in the country. Central Bank figures is strongly opposed to the policy. Banking industry professionals were also quick to show contempt for the policy.

The Kenya Bankers Associations (KBA) steadfastly criticizes the move as a draconian populist policy. Its greatest concerns are the long term effects around loan availability. KBA CEO Habil Olaka said a majority of individuals and small and medium-sized enterprises are at a higher risk of default.

The discrepancy in risk between the bill and reality, argues Olaka, will cause banks to limit their lending focus to blue-chip firms and high-net-worth individuals.

Speaking to the media on Aug. 25, Olaka railed against the bill that caused many of the large banks in Kenya to fall 10 percent at the start of trading. Investors fear decreased lending as banks account for default risk and choose to bail on certain markets.

Those local Kenyans supporting the bill are asking the KBA to suggest a better rate if this bill is not correct.

Default risk and interest rates

It is a fair question. Let’s say the cost of capital is 10 percent. A default risk of 25 percent will suggest a break-even interest rate higher than 25 percent, give or take associated costs for lending operations. Providing loans at such an interest rate works against the banking system. A significantly high interest rate only makes the risk increase for borrowers.

Microfinance research shows us that there is a balance between interest rate and risk that must play out at certain levels of income. Shrewd borrowers stay in the system at 10-to-15 percent interest rates while only gamblers and chancers play at 30 percent interest rates. The argument here is that the potential borrower willing to fork out extra cash for a loan is not necessarily the most legitimate borrower. Finding the balance for rates effectively becomes an exercise in keeping prudent and low-risk borrowers in the system and forcing the gamblers out of the system.

This analysis also suggests that a cap on interest rates brings potentially riskier borrowers into the system. The 30 percent interest rate borrower, who is more gambler than shrewd businessman, will enter the system with a 14.5 percent interest rate and still default. Nothing has changed in his situation (or thinking) but the interest rate he is paying.

Industry analysts argue that a cap at 14.5 percent and cost of capital at 7.5 percent indicates a default risk at around 6 percent. SMEs and individuals with a default risk higher than 6 percent, of which there are many, are either going to receive loans that they are still likely to default on or be rejected because they are deemed too risky and quintessentially not loan worthy. It is best to assume the latter, where many potential customers no longer receive loans, based on the language from Kenyan banking officials. The next question becomes whether interest can be dressed as fees. Mobile micro-lenders will be asking this question in the short term if they want to still lend to certain customers.

Politics and the econony

Various banking officials suggest politics is at play, arguing that Kenyan President Uhuru Kenyatta is looking to next year’s election. The claim is that he is making a populist move that he hopes will boost the economy in the short term. If this is the case, he will have to hope banks keep lending to all classes despite a misalignment of risk-return.

Secondly, he will have to ask whether a cut in lending to the general public is coming, as a few larger banks suggest, and whether this will effectively hurt the economy. Low interest rates do not always help boost an economy.

Below-zero interest rates in Japan have not helped the country’s economic outlook. Kenya is more upward bound in economic growth compared to Japan. But Japanese history shows how it assumed an eternity of economic success then made a few bad changes in the ’80s and ’90s and has not fully recovered. Maybe there is some irony in Japanese Prime Minister Shinzo Abe’s arrival on Aug. 25 for the Sixth Tokyo International Conference on African Development (TICAD VI). Maybe debt and borrowing came up for discussion.

Kurt Davis Jr. is an investment banker with private equity experience in emerging economies focusing on the natural resources and energy sectors. He earned a law degree in tax and commercial law at the University of Virginia’s School of Law and a master’s of business administration in finance, entrepreneurship and operations from the University of Chicago. He can be reached at kurt.davis.jr@gmail.com.