This article first appeared in my weekly column in the Business Daily on August 14, 2016
As a development economist I have a natural interest in Microfinance Institutions (MFIs) because they have been an important story in Kenya’s financial inclusion story. In a previous article I argued that interest capping for banks in general is a dubious bet rife with risk that may harm Kenyans and the economy more than it can help. But a key question has emerged in this debate: Are interest rate caps going to be applied to MFIs should it be effected?
This question is pertinent for two reasons firstly the ‘common man’ (mwananchi) in whose interest MPs apparently passed the bill tend to borrow more from MFIs than commercial banks. Secondly due to the business model of MFIs, interest rates and more importantly annual percentage rates (APRs) are particularly high. Indeed last year (which is the latest year where such data readily available), Central Bank of Kenya (CBK) data showed that micro-lenders were on average charging 22.6 percent on loans compared to 16 percent by banks; more in this later. Finally, there is a growing grey area that prevents the classification of entities as either strictly commercial banks or strictly MFIs. If one looks at the CBK list of what is classified as commercial banks, some on that list brand and market themselves as MFIs and target similar customer groups as MFIs. Thus if such ‘commercial’ banks will potentially be affected by interest rate capping, why shouldn’t MFIs in general? Further it could be argued that the demographic group that tends to borrow from MFIs are low income and thus, of everyone, need capped interest rates the most. But as you will see, capping MFI interest rates is just as bad an idea as capping interest rates for commercial banks.
The MFI question is important because if only commercial bank interest rates are capped, it may engender a shift of loans from the MFI docket to the commercial bank docket as Kenyans seek the best deals possible. However in that shift, thousands of low income Kenyans may leave a docket that was designed with them in mind particularly with regards to loan size, into one that does not have them front on centre. So either Kenyans will be trapped with MFIs with much higher interest rates but the right loan size, or they risk moving to a bank that has a lower interest rate but does not have a loan size which is manageable or relevant thereby locking them out of credit. This seems like a raw deal for mwananchi either way.
On the other hand if the interest rate cap applies to MFIs it will compromise their ability to serve low income Kenyans. This is because MFIs typically process very many small loans when compared to commercial banks because low income Kenyans can typically service only small loans. Because of this, MFIs tend to have higher overheads in terms of outreach, and processing costs and overheads is a key component that informs interest rates. Larger overheads place upward pressure in terms of interest rates offered. Secondly, is the issue of non-performing loans (NPLs) where again the argument is that as MFIs target a less financially secure and less wealthy income group, the risk of NPLs is higher than a commercial bank that focuses on corporate clients for example. Thus again, upward pressure is exerted on interest rates in MFIs.
These factors partially explain why the CBK data showed that micro-lenders (MFIs) charge more on loans than regular banks. Thus if capping interest rates apply to MFIs there will be pressure to lower overhead costs which may compromise how many loans can be processed which will likely translate a lower volume of loans being awarded thereby contracting credit supply particularly for low income Kenyans. Further, MFIs will be less able to take on riskier clients as there will be very limited wiggle room in terms of NPLs. So again, how does the ‘common man’ benefit from interest rate capping?
There is need for more clarity on which institutions will be affected by interest rate capping in order to better manage potential ramifications so that Kenyans, especially low income Kenyans, get the best deal possible.
Anzetse Were is a development economist; firstname.lastname@example.org