Capping interest rates

Capping interest rates may not be the answer

In the early 90’s the Government carried out a comprehensive review of Uganda’s banking sector.The sector was fully liberalized allowing for more private sector players to participate.  Today, Uganda’s banking sector is more open and dynamic with high prudential standards, more efficient with an improved service quality and product range. Liberalisation has attracted many foreign banks, while at the same time helping local banks to strengthen their capabilities and expanding their branch network and range of products. However, despite all these developments, the interest rates have remained very high.

So is capping the interest rate a bank can charge on loans the solution to the problem of high interest? In my view No. What is needed are long term solutions to address the money supply side constraint as well as dealing with the issue of Government borrowing and the relatively high cost of doing business in Uganda. Legislating for a cap on the interest a bank can charge on its loans, may be populist from a political perspective but will not improve the current problems we have in Uganda with regards to access to affordable finance.

The role of banks in our economy

Banks play an important role in our economy. They are the intermediary, or go-between, in Uganda’s financial system. They perform this role by carrying out three main functions. First, Banks are institutions where people can safely deposit their savings, and in return earn interest on these savings. Banks are also the collection agent for the Tax authority, since all taxes are paid through banks.  Secondly, banks are responsible for the payments system which we all rely on to pay salaries, pay bills, to trade and do business. Of late, electronic payments are becoming more important as people use less cash. This means that banks are processing a lot more electronic and online payments such as credit card payments, telegraphic transfers, direct debits, etc. Thirdly, and most importantly in my view, banks issue loans to the general public. This includes loans to individuals like you and me, to companies, institutions, corporations and to the government. Without banks, it would be very hard for people to start a business, build homes, or for companies to make investments, or even for the government to finance its budget. To put this into proper context, as of June 2016, the total amount of money lent out by banks in Uganda to the general public was Shs 11 trillion. That is the equivalent of about 15% the country’s total GDP.

Where do the Banks get money from?

The money that a bank raises to lend is often called the capital. Banks raise capital mainly in three ways. The first is capital raised from its shareholders in form of share capital. According to the law in Uganda, every bank must have a minimum of Shs 25 billion as capital contributed by its shareholders and fully paid up, before it can be licensed to provide banking services in Uganda. This a legal and regulatory requirement. The second major source of capital or funding for a bank is money mobilized from depositors in form of bank deposits. This money may be in the form of cash deposits on the bank’s customers’ current accounts, savings accounts or fixed deposit accounts. Currently in Uganda, 52% of all the bank’s deposits are on current accounts, 29% are on time deposits fixed accounts and 19% are on savings accounts. The third major source of capital or funding for the banks is borrowings from either the financial markets or from Bank of Uganda.

How does a Bank make money?

Banking is a business. Just as any businessman and woman sells his or her products or services as their main line of business, a bank is in the business of mobilizing money from savers in form of deposits and lending money to its customers. To understand how banks raise capital to carry own their business, let us think of money as the stock for a bank’s business. Just like a trader or wholesaler such as a supermarket or hardware store has to buy its stock from a factory in Uganda or travel to abroad to import its stock, to sell to its customers and make a profit, a bank has to mobilize its stock, which is money, to sell (or lend) to its customers and make a profit.

A bank’s main source of income is the revenue it earns from the interest a bank receives on the money it lends to its customers. To put it very simply, banks earn money by charging more interest on loans than that they pay on savings. In banking language this is referred to as the net interest spread. A bank’s net interest spread is kind of similar to a manufacturer or trader’s gross profit margin. When you borrow money from the bank the amount you pay back is dictated by the interest rate, charged by the bank. Interest is the cost of borrowing money. It is typically expressed as an annual percentage of the loan. When you borrow money from a bank, you’ll pay back the original amount of the money borrowed, called the ‘capital’ plus the interest. For example if you borrow Shs 1,000,000 from a bank, at interest rate of 20%, for one year, you will have to pay back the Shs 1,000,000 original amount borrowed plus 20% interest of Shs 200,000. So in total you will pay back Shs 1,200,000 after one year.

Assuming the Shs 1,000,000 the bank lent to you was capital the bank raised from the bank of Uganda, it means that the bank would also be required to pay interest to the bank of Uganda at the CBR rate which is currently 14%. This means that at the end of the year, the bank will have to pay back the Shs 1,000,000 original amount borrowed to the Bank of Uganda plus 14% interest of Shs 140,000. So in total the Bank will pay back Shs 1,140,000. The difference between the interest income the bank earns from the borrower and the interest expense the Bank pays to the Bank of Uganda, (in this example Shs 60,000) is the bank’s gross profit which is referred to in the industry as the Bank’s net interest income.

It is out of this net interest income that a Bank finances its operating costs, covers the losses it incurs on loans that are not repaid at all or not repaid in full, pay the bank's overheads, such as staff salaries and wages, fund its capital expenditure such as electronic banking platforms, pay taxes and if there is any left, then pay its investors a dividend as a return on their investment.

Besides interest income, Banks also make money from other banking transactions and services, by charging its customers bank charges and fees.

So what determines the interest rates that Bank’s charge on their loans?

There are many factors that a bank takes into consideration when determining the rate it charges to its borrowers. These factors include the cost of funds, the lending risk, the Treasury bill rates on the risk free public sector borrowing, rate of savings relative to borrowing, the fundamental macroeconomics indicators like inflation and exchange rates, the level of non-performing loans and the Bank’s administrative and operating costs.

These very many factors can be categorized into two, the external factors which are beyond the Bank’s control and internal factors that are within the Bank’s control. The external factors include the Central Bank Rate (CBR), the Treasury Bills rate, the rate of inflation within the economy and the cash reserve requirement by the Central Bank. The CBR rate is periodically set by the Bank of Uganda, depending on the Bank of Uganda’s forecast of future inflation and other economic variables like estimated growth of the economy. The CBR rate is policy signal on the relative cost of credit, and it’s aimed at influencing the lending behavior of commercial banks. Currently the CBR rate is 14%.

In addition to the external factors, there are also other internal factors. These include, the Bank’s operating costs, that is the cost the Bank incurs in maintaining its banking infrastructure including payments of salaries and wages to its staff; the cost of funds in form of the interest the Bank pays for the deposits held, the costs relating to non-performing loans or bad debts and the liquidity premium costs which the Bank incurs to ensure funding is always available to its customers at any time.

Why are borrowing rates in Uganda very high?

The high interest rates in Uganda is a reflection of the Uganda Government’s policy with regards to how much it is borrowing from the local market, the country’s risk rating from an investor perspective and the high cost of doing business in Uganda. All these three factors together influence the rate at which banks lend to their customers. 

Is a cap on the interest rate the solution?

No. What is needed are long term solutions to address the money supply side constraint as well as dealing with the issue of Government borrowing and the relatively high cost of doing business in Uganda. Interest rate caps will be taking us back to the old times of Government price control. Interest caps are based on the notion that caps on loan prices will protect borrowers from excessive interest rates thereby increasing credit affordability and access to finance. Capping takes several different forms. It could be in form of an absolute cap say maximum rate of 30% or relative to a benchmark say the CBR rate plus a maximum of say 6%.

Some countries in Africa have legislated for interest rate caps to protect borrowers from high interest rates charged by banks. Such legislation is often as a result political pressure exerted on governments to keep interest rates low. This is done on the assumption that interest rate caps will result in lower and affordable interest rates for borrowers. The objective of an interest cap is to protect borrowers from excessive credit interest rates, to make loans more affordable and to improve access to credit. Despite these good intentions, interest rate caps can actually hurt low-income populations by limiting their access to finance. If the interest rate cap is set too low, banks will find it difficult to recover costs and will most likely reduce service delivery in rural areas and other more costly markets.

What has been the experience from other countries?

Interest rate caps have resulted in a slowdown in credit growth in countries such as Ecuador and Nicaragua. The drop in credit growth was as a result of Banks tightening of their credit parameters to reduce credit risk. This resulted in the high risk borrowers being excluded from the formal financial system. In Nicaragua the annual growth in credit dropped from 30% to just 2% after interest ceiling was introduced in 2001. Likewise in Japan the supply of credit appeared to contract and acceptance of loan applications fell with the introduction of a cap on interest rates.

Introduction of an interest cap in a fully liberalized capital market results in capital flight. A very good example is what happened in Kenya. Shares of the largest Kenyan Banks listed on the Nairobi Exchange plummeted by 10% in response to the news of the introduction of the interest rate cap. This was mainly due to loss of investor confidence and capital flight.

Introducing an interest rate cap in Uganda might hurt the poor most, as they will be denied access to finance. This has been the case in Ecuador after introduction of rate caps in 2007, This also happened in the West Africa WEAMU countries. When an interest rate cap was introduced, microfinance institutions withdrew from poor and more remote areas of the countries.

Interest rate caps can also lead to less transparency in the sector. For example in South Africa lenders introduced so many extra fees and commissions in response to interest-rate caps that loans became more expensive overall. A cap on interest will also discourage supply of funds to the financial system, thus encouraging informal loan shacks. This will result in a black market for credit. The best way to illustrate this is point is to use the example of the olden days when we used to have foreign exchange controls. Back then, the Government used to fix the rate at which the public would buy US Dollars. We used to have an official Government rate, at which US Dollars were hardly accessible to the public, and a black market (kibanda) rate at which the public used to freely access the US Dollars. This is what will happen to the market for credit.

Banks may also scale down on investment with unprofitable and non-strategic branches and distribution channels being closed thereby denying customers access to financial services especially in the up country remote areas. It will discourage the current level of innovations in the banking sector which is aimed at high risk and low scale credit segment of the population. This sector includes mainly the SMEs and low income and first time borrowers. This will in turn slow down the progress the Government has made towards financial inclusion and the uplifting of the grass root communities through operation wealth creation.

Interest rate caps also poses a danger to the employment of the over 10,000 employees currently working for the banking sector in Uganda. For example, when interest rate caps were introduced in Zambia two financial institutions laid off close to 50 people within a period of one month. Banks in Uganda collectively contributed close to Shs 600 billion in tax revenue last year. That is nearly 5% of the total tax collected by the Government for the whole year.

So what do we do to address the problem of the high rates of interest?

One of the biggest challenge banks in Uganda face is lack of long term source of funding. This is because the capital market in Uganda is very shallow and under developed. There is a huge mismatch in funding in our banking sector. Most of the banking sector’s source of funding is short term in form of current and savings account. This comprises of 71% of the entire banking industry’s source of funding. On the other hand most borrowers are looking to the bank to provide long term financing.

For example, out of the total money lent by Banks in Uganda, 81% is in form of long term loans. This includes mortgages, personal and household loans, building and construction loans and others. As a result of this funding mismatch Banks have to find alternatives sources of funding to bridge the gap, and this comes at high cost..

There is need to mobilise more long term capital from the market through pooling of funds and long term savings and the deepening of the capital markets. This may require the Government to consider introducing a tax incentive to encourage a culture of long term saving. As of now, Ugandans are taxed when they earn, taxed when they save and taxed when they consume.

Promoting financial inclusion and bring the informal economy into the financial system, through agency banking also needs to be fast tracked.

Consumer awareness and protection needs to be strengthened through investing more in financial literacy. There is also need to reduce credit risk in the market by strengthening of the Credit Reference Bureau and information sharing mechanisms to include other service providers such as utility and phone companies.

Banks need to reduce their operating costs by undertaking collaboration projects that involve shared technology platforms to bring down the cost delivery of services while increasing outreach, foot print, and presence across the country. This has happened in the telecoms sector where mobile phone operators now share telephone masts and other passive infrastructure. Banks can learn from this. In fact banks have a lot to learn from mobile phone operators. 

Borrowers also need to be more disciplined. According to a recent survey by Bank of Uganda. One of the main reason why non-performing loans have increased to the highs of 8% as is the case now is because borrowers divert funds from their intended use. For example a person my borrow money to start a business, and instead divert the funds to build a personal house or buy a car. This poor credit culture makes credit more expensive for all borrowers.

The Government must also improve its efficiency with regards to delivery of big infrastructure projects which have the potential of reducing on the costs of doing business and also result in multiplier effects that will help spur economic growth and financial inclusion.

Government should also commit to pay its suppliers on time. According to the Bank of Uganda survey referred to above, the major cause of financial stress for many of the local companies that are currently struggling to service their loans is due to delayed payments by the Government.

In conclusion while it is in the wider interest of any economy to have a low cost of credit, it is more critical to focus on the drivers and the underlying causes of the high cost of credit as opposed to attempting to fix the price of credit by legislation. The legislation may cap or fix the interest rate to make it seem affordable, but in so doing it will deny many borrowers access to credit. What borrowers want is both affordable and accessible credit. 

In my view we will achieve more if the current ongoing debate on interest rates (which is very good and informative) shifts to addressing the causes of the high rate of interest in Uganda and propose solutions to these causes especially with regards to the supply side. To ensure that the discussion and debate is well balanced and represents the interests of all stakeholders, it is important that all key players namely the banks, regulators, the Government, legislators, civil society as well as the users of financial products in their various groupings are all involved and well represented. I rest my case.