The banking sector and CBK’s market-based compromise represents the right path forward. If policymakers want to support or subsidise vulnerable borrowers, they should implement other well-designed interventions.
The Loan Pricing Debate in Kenya
In recent weeks, a noteworthy debate has emerged in Kenya regarding the most suitable loan pricing model for credit facilities.
In the red corner stands the Central Bank of Kenya (CBK), advocating for a standardised, transparent model anchored on the Central Bank Rate (CBR). In the blue corner are commercial banks, defending a market-driven, risk-based pricing approach.
Both sides present compelling arguments for why their approach is most realistic and practical for Kenya. They champion fundamentally different philosophies – one emphasising policy alignment and consumer protection, while the other prioritises flexibility and market dynamics.
This debate is not only important but also timely, with significant consequences for Kenya’s lending market.
The Compromise on Loan Pricing
The Kenya Bankers Association (KBA) opposed the CBK proposal, arguing that a fixed, CBK-determined benchmark rate would effectively and indirectly reintroduce interest rate caps.
The positive outcome is that the CBK has since agreed with the bankers, compromising on using interbank interest rates in the short-term market as the benchmark. Commercial banks will then add a risk margin to determine the final lending rate.
The Impact on SMEs and Borrowers
At the centre of this debate is the impact of resulting interest rates on credit facilities for Small and Medium Enterprises (SMEs) and other borrowers. It has been argued that SMEs are the backbone of the economy, yet they still face daunting challenges in accessing affordable credit.
Generally, these entities are perceived as high-risk businesses, which has always led to larger risk margins in lenders’ loan pricing models.
It is against this backdrop that the CBK has consistently attempted to influence the direction and thresholds of lending rates to this key economic sector. Access to credit remains a critical factor in spurring economic growth.
The struggle over interest rate control is as old as banking itself. Banks are profit-driven institutions that will always seek pricing models that adequately balance credit risk, cost of funds, and expected profits.
Conversely, governments and central banks strive to ensure banks don’t overcharge vulnerable borrowers while maintaining credit flow into the economy – the foundation of economic growth.
After the disastrous outcome of the 2016 interest rate caps, the CBK’s retreat was a welcome move. The interest rate cap policy implemented in Kenya in 2016 limited bank lending rates to 4 percentage points above the CBR and set a floor on deposit rates at 70 percent of the CBK rate.
Lending Rates and the Rise of Non-Performing Loans
Studies have established a clear relationship between lending rates and non-performing loans (NPL), with one fundamental conclusion demonstrating that increases in bank lending rates consistently result in higher NPL levels.
This outcome stems from two primary factors: first, the increased financial burden on borrowers through higher debt servicing costs that strain repayment capacity; and second, the phenomenon of “debt fatigue,” where sustained high interest rates lead to greater default probabilities as borrowers become overwhelmed by debt obligations.
Balancing Profitability and Credit Risk
These findings reveal the delicate balance Kenyan banks must maintain between pursuing profitable lending rates and managing associated credit risk exposure that impacts their loan portfolio quality.
The banking sector and CBK’s market-based compromise represents the right path forward. If policymakers want to support or subsidise vulnerable borrowers, they should implement other well-designed interventions.
Conclusion
This approach has worked in the past, particularly with the creation of the Youth and Women Enterprise Funds. The loan pricing debate should conclude once and for all in favour of nimbler, market-driven and evidence-based solutions. No amount of regulatory force can sufficiently substitute the sway of market dynamics.