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2.0
LITERATURE REVIEW

2.1
INTRODUCTION

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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.

2.2
EFFECT OF INTEREST RATE CAPPING ON CREDIT GROWTH RATE

A
capped interest rate is an interest rate that is permitted to oscillate, but
which cannot exceed 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 capability 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 misrepresent
the market and prevent financial institutions from offering loan products to
those at the lower end of the market that have no other access to credit. This
runs counter to the financial outreach agenda that is widespread in many poor countries
today. The argument can be boiled down to the ranking of credit or access of credit.
Imposition of price caps could in fact increase the level of interest rates. An
interest cap aggravates the problem of adverse selection as it restricts
lenders ability to price discriminate and means that some enterprises that
might have received more costly 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 recognised interest rate caps to shield consumers from
high interest rates charged by micro lenders. Interest capping is often the reaction
of governments facing political or cultural pressure to keep interest rates
low. The broad idea of capping is that interest rate ceilings limit the propensity
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 mixture of no transparency, limited
disclosure requirements and low levels of financial literacy. Despite good objectives,
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 hard to recover costs and are likely to grow more
slowly, hence reducing service conveyance 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 removal of
financial institutions from the poor or from specific sections of the market,
an increase in the total cost of the loan through added 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 executed
in harmony to set cautions.

 

 

 There is some indication 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 originally seen to reduce interest rates but over the longer
term rates were perceived to steadily rise towards the interest rate cap. This
was explained by implicit collusion, by which the price set a central 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 alters risk and return and diminishes economic growth rates. Interest
rate caps limit 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 debatable then it should not be offered at all. (Baldwin & Cave).To be
effective a cap must be supplemented by operational implementation 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
consequences of interest rate capping which include credit will only be focussed
amongst large borrowers, banks will prefer loaning 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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