An interest rate ceiling (also known as an interest rate cap) is a regulatory measure that prevents banks or other financial institutions from charging more than a certain rate of interest.
Interest rate caps and their impact on financial inclusion Research was conducted after Zambia reopened an old debate on a lending rate ceiling for banks and other financial institutions. The issue originally came to the fore during the financial liberalisations of the 1990s and again as microfinance increased in prominence with the award of the Nobel Peace Prize to Muhammad Yunus and Grameen Bank in 2006. It was over the appropriateness of regulatory intervention to limit the charging of rates that are deemed, by policymakers, to be excessively high. A 2013 research paper asked
Where are interest rate caps currently used, and where have they been used historically? What have been the impacts of interest rate caps, particularly on expanding access to financial services? What are the alternatives to interest rate caps in reducing spreads in financial markets?
Understanding the composition of the interest rate The researcher decided that to assess the appropriateness of an interest rate cap as a policy instrument (or whether other approaches would be more likely to achieve the desired outcomes of government) it was vital to consider what exactly makes up the interest rate and how banks and MFIs are able to justify rates that might be considered excessive. He found that broadly there were four components to the interest rate:
Cost of funds Overheads Losses on non-performing loans Profit
Cost of funds The cost of funds is the rate of interest that the financial institution must pay to borrow the funds that it then lends out. For a commercial bank or deposit-taking microfinance institution this is usually the interest that it pays on deposits. For other institutions it could be the cost of wholesale funds, or a subsidised rate for credit provided by government or donors. Other MFIs might have very cheap funds from charitable contributions.
Overheads The overheads reflect three broad categories of cost:
Outreach costs: the expansion of a network or development of new products and services Processing costs: the cost of credit processing and loan assessment, which is higher with greater information asymmetry. General overheads: general administration and overheads associated with running a network of offices and branches The overheads, and in particular the processing costs, can drive the price differential between larger loans from banks and smaller loans from MFIs. Overheads can vary significantly between lenders, and overheads measured as a proportion of the loans made are an indicator of institutional efficiency.
Non-performing loans Lenders must absorb the cost of bad debts and recoup it from the interest rate that they charge. If a lender's credit screening processes improve in future, it should be able to bring down interest rates, while reckless lenders will be penalised.
Profit Lenders will include a profit margin that again varies considerably between institutions. Banks and commercial MFIs with shareholders to satisfy are under greater pressure to make profits than NGO or not-for-profit MFIs. Institutions require capital in order to operate, and whatever the source of this capital, the cost of providing it must be recouped.
The rationale behind interest rate caps Interest rate caps are used by governments for political and economic reasons, most commonly to provide support to a specific industry or area of the economy. Government may have identified what it considers being a market failure in an industry, or is attempting to force a greater focus of financial resources on that sector than the market would determine.
Loans to the agricultural sector to boost agricultural productivity as in Bangladesh. Loans to credit constrained SMEs as in Zambia. The researcher found it is also often argued that interest rate ceilings can be justified on the basis that financial institutions are making excessive profits by charging exorbitant interest rates to clients. This is the usury argument and is essentially one of market failure where government intervention is required to protect vulnerable clients from predatory lending practices. The argument, predicated on an assumption that demand for credit at higher rates is price inelastic, postulates financial institutions are able to exploit information asymmetry, and in some cases short run monopoly market power, to the detriment of client welfare. Aggressive collection practices for non-payment of loans have exacerbated the image of certain lenders. The researcher says that economic theory suggests market imperfections will result from information asymmetry and the inability of lenders to differentiate between safe and risky borrowers. When making a credit decision, a bank or a microfinance institution cannot fully identify a client's potential for repayment. Two fundamental issues arise:
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