Com¬mercial growth by protecting consumers from excessive interest

Com¬mercial banks play a major role in the economy through their economic role of financial intermediation that performs both a brokerage and a risk transformation function (Hara, 1983).Commercial banks as financial intermediaries have the duty of accepting deposits from the general public and giving loans for investments with the aim of earning profit. From financial statements of different commercial banks we established that the main asset of commercial banks which are used to generate revenue are loans and advances to customers, therefore it indicated that their main source of revenue is the interest revenue received from them.

Since Interest revenue has a linear relationship with the profits of banks in that an increase in interest revenue would lead to an increase in profit and a decrease in interest revenue would lead to decrease in profit the capping on interest rate will significantly affect the financial performance of commercial banks In 2016 through a bill which passed into law, interest rate capping was introduced in Kenya. Interest capping is a form of government control in the financial sector. There are many reasons as to why a government may choose to cap interest rates most of which are political or economic.

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In Kenya’s case the government wanted to ensure credit accorded to its citizens would be cheap to enhance economic growth by protecting consumers from excessive interest rates enabling more people to gain access to them and reducing business failures due to expensive loans, this would enable them to sustain themselves for a long period of time. In short the government wanted to generally reduce the cost of credit.Even though interest capping may have good intentions, it they can hurt low income population by limiting their access to finance and reducing price transparency. This is because if the ceilings are set too low, commercial banks would not be able to cover their costs or break even and even make profit, this will lead to little or no growth for them, decrease service delivery in rural areas and other costly markets, make commercial banks hide information about loan costs and even exit the market entirely (Nyakio, 2017).In 2010, CGAP mapped countries with interest rate caps and it showed that 17 countries in Sub-Saharan Africa had introduced interest rate caps. There are different theories on interest rate and financial performance these are; the liquidity preference theory which suggests that people prefer liquidity, this is whereby people like cash money more than investing in any other assets, and this shows that there is a high demand for cash thereby increasing interest charged to attain cash, then there is the interest rate parity theory which suggests that interest rate, market exchange rate and inflation are highly correlated in that high interest rate will attract foreign investment/capital which will increase the currency value and the impact of the high interest rate will be mitigated by inflation and finally the time preference theory which examines the nature of consumerism and what makes consumers delay their current consumption expecting greater returns by receiving high interest on their savings.

There are 42 licensed and operating commercial banks in Kenya. They generally finance trade and commerce with short term loans. They charge high rate of interest from the borrowers but pay much less rate of interest to their depositors with the difference being their main source of revenue. Before 2016 when the bill capping interest rate was passed banks generally used to maximize on the lack of regulation by charging high interest rate on their loans reaching an all-time high of 84.67% in July of 1993 and paying low interest rate on deposits by customers, ensuring they maintained large interest rate spread to increase on their revenue which in turn ensured they performed well with high net profits. This lead to exponential growth in the banking sector.

Upon introduction of the law its impact has been generally negative on the banking sector with significant drops in profits (Mulunda 2017).This study seeks to determine whether interest rate capping has affected the performance of commercial banks.1.1.1 Interest Rate CapInterest rate capping is the insertion of a ceiling upon which interest rate charged on financial services should not surpass. Many reasons motivate the use of interest rate caps; one of them is to help a certain industry or sector within the economy where a market failure exists or where a greater concentration of financial resources are needed.

Miller (2013) stated that those market failures result from lack of equal access to information and financial institutions not being able to differentiate between risky and safe clients therefore interest caps may be a useful control for providing short term credit to a strategic industry for supporting a sector until it is sustainable by itself. Interest rate cap also ensures access to cheaper credit by bank customers.Interest rate capping requires a reference point. For example in Kenya, the Central Bank Rate (CBR) is used as the reference point; the minimum interest rate that a commercial bank would pay for a savings account is 70% of the base rate set by the Central Bank of Kenya, and the maximum interest charged on loans should be 400 basis points above the CBR.1.

1.2 Financial PerformanceFinancial performance is whereby any business concern is evaluated in terms of profitability and financial strength (Kennedy and McMullen, 1986). Financial performance shows how well a firm has used its assets from its core operations to generate revenue within a certain financial period (Brealey, Myers and Marcus, 2009)Financial performance can be measured using different methods; one can use accounting ratios, residual income, economic value addedThe main limitation of financial performance measurement is that they can be manipulated to ensure positive outcomes by management.

This will lead to the books of accounts not portraying a true and fair view; financial statements can be altered by management to ensure that they show shareholders and other stakeholders that they have met their targets which may not be the case. In this study we used accounting ratios as a measurement of financial performance because it uses several measures to determine financial performance; which are profitability, liquidity and solvency.1.1.

3 Interest Capping and Financial PerformanceTheoretically, interest rate capping reduces/ decreases financial performance or it leads to stagnation of financial growth. This is because the interest rate spread is the main source of income for commercial banks and it has a direct relationship with the financial performance of commercial banks, an increase in interest rate spread leads to an increase in financial performance therefore if you reduce the interest rate spread you reduce he financial performance and that is what interest rate capping does i.e. it reduces financial performance. Discussed above were the different theories on interest rate and financial performance, first was the liquidity preference theory which suggests that people prefer liquidity, this is whereby people like cash money more than investing in any other assets. This shows that there is a high demand for cash thereby increasing interest charged to attain cash.

Secondly was the interest rate parity theory which suggests that interest rate, market exchange rate and inflation are highly correlated in that high interest rate will attract foreign investment/capital which will increase the currency value and the impact of the high interest rate will be mitigated by inflation. The other theory is the time preference theory which examines the nature of consumerism and what makes consumers delay their current consumption expecting greater returns by receiving high interest on their savings.1.

1.4 Commercial Banks in Kenya A commercial bank is an institution that provides services such as offering basic investment products, providing business loans as well as accepting deposits. Commercial banks provide financial services to the general public, business and companies, ensuring economic and social stability and sustainable growth of the economy.

Credit creation is thus the most significant function of commercial banks. They accept various types of deposits from the public especially from its clients including saving account deposits, recurring account deposits and fixed deposits.As stated above, there are 42 licensed and operating commercial banks in Kenya. This banks through the Kenyan Bankers Association opposed the amendments that introduced interest rate capping because they saw that one of the consequence of the proposal was that it meant that banks now have to assess the risk profile of the borrowers and it is only those borrowers who fit within that risk profile that is legislated in the law that will then be accessible to credit and this will make the ones who do not fit under such criteria go to informal sectors o access loans and it would bring a rise in shylocks and other unregulated lenders. They also said that there would be a risk that the lending rate caps would lead to some borrowers resorting to foreign currency denominated loans, which could lead to a weakening of the shilling.

Up to date the banks still oppose the interest rate caps.Discussed earlier we saw how banks performed before the bill capping interest rate was passed and made law. They generally used to maximize on the lack of regulation by charging high interest rate on their loans reaching an all-time high of 84.67% in July of 1993 and paying low interest rate on deposits by customers, ensuring they maintained large interest rate spread to increase on their revenue which in turn ensured they performed well with high net profits. This lead to exponential growth in the banking sector. After introduction of the law its impact has been generally negative on the banking sector with significant drops in profits (Mulunda 2017). This in turn has stagnated or reduced the financial performance of the banking sector.

1.2 Research ProblemInterest rates determine the profitability of commercial banks. Under general conditions, bank profits increase with increasing interest rates. Banking system as a whole is helped rather than hindered by increase in interest rates (Samuelson, 1945).In the previous regime, 1992 to 2016, commercial banks simply piled premiums on their base rate. The subsequent increments in payments by increasingly stressed borrowers enabled the banks to maintain ever-booming profits and the whole banking sector was awash with booming profit growth.In 2016 Parliament passed a law that capped interest at four per cent above the Central Bank Rate, and deposit rate at 70 per cent of the same rate.

The law came into effect in October 2016.The effects of the interest rate cap rate on the performance of individual institutions show a sector that has been completely scattered as individual banks were forced to confront the realities of the harsh new regime, and the effect on their viability and profitability (Kaara, 2017).The impact has been undeniably painful for banks with significant drops in profits attributable to this law (Mulunda, 2017).The new regime of interest caps has created an every-bank-for-itself attitude. With a maximum rate beyond which they cannot charge, keeping costs tamed has become difficult. The full effect can be seen clearly from the third quarter trading results of the year to September 2017 that were released by the institutions recently. They follow no given pattern. From banks that grew their profits as usual, to those that grew the marginally, to those whose profits slumped, and those that registered losses (Kaara, 2017).

There were those that saw a marginal drop in profitability. Co-operative Bank’s profit dropped by 9.5 per cent to Sh9.5 billion, Equity bank dropped to Sh14.6 billion while Barclays Bank saw its profit down 12 per cent to Sh5.

3 billion. Some banks experienced significant drops in profitability. United Bank for Africa dropped to Sh14.4 million, a 74.9 per cent cut, Housing Finance’s profit dipped 80.9 per cent to Sh159 million and Standard Chartered Bank’s profit dropped 39 per cent to Sh4.7 billion. On the other hand several banks were in the negative territory.

Consolidated Bank of Kenya posted Sh301 million loss, a 48 per cent drop, Jamii Bora Bank’s loss widened to Sh337 million while Sidian Bank dropped 225 per cent to post a Sh274 million loss (Kaara, 2017).The theory behind Interest rate caps is analyzed at a high level by looking at their composition, usage historically and currently as well as their impact particularly on expanding access to financial services. They are composed of; (i) Cost of funds which is the amount that a financial institution must pay to borrow the funds then lends out. For commercial banks, this is usually the interest that it gives on deposits, (ii) Overheads which reflect three broad categories; general administration, cost of credit processing and loan assessment, and outreach costs.(iii) Profit margin whereby banks are under greater pressure to make profits.Rationale behind interest rate caps is that they are used by government for a range of political and economic reasons. They are used as an attempt to force a greater focus of financial resources on that sector than the market would determine. It is 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 and government intervention is required to protect vulnerable clients from predatory lending practices (Miller, 2013).Studies have been conducted on interest rate caps and their impact on financial performance. Bank earnings are affected by unanticipated changes in interest rates (Robinson 2005). The impact of interest rate cap on performance of commercial banks has been a concern of policy makers and bankers for a long time. Capping interest rates has a tendency to distort the market and cause adverse biases with financial institutions tending to favor their lending to low risk clients which leads to insufficiencies in the financial intermediation process (Mbua 2017). Financial institutions could however still remain profitable in the midst of interest rate capping by the government by venturing into other sources of income such as cutting their costs. While these studies have provided insights on the effects of interest rate cap on financial performance, they only provided information from a broad perspective and did not cover the effect that capping interest rates can have on the banking sector in a deeper level.

It is essential that this gap be filled hence the study should be carried out to understand whether the effects anticipated with the coming of the interest rate capping law are being achieved.This study assessed the effects of capping interest rates on the financial performance of commercial banks in Kenya.1.3 Research ObjectiveTo determine the effects of interest rate capping on the financial performance of commercial banks in Kenya. 1.4 Value of the studyThe study will enable commercial banks to understand the effect of interest rate cap on their financial performance.

The study will also assist the Government of Kenya through the Central Bank of Kenya in setting the interest rate cap to ensure that both commercial banks and its customers are not exploited and that everyone has a clear understanding of how the interest rate cap works. The findings of this study will help parliamentarians to evaluate whether the bill which introduced interest rate caps served its purpose. The conclusion of the study will help all commercial banks and members of the public better understand the concept of interest rate capping. This study will also help the academic community by acting as a source document for knowledge on interest rate capping and also future research on the same topic.CHAPTER TWO: LITERATURE REVIEW2.1 IntroductionThis chapter ideally reviews and explains different theories and literature that explain the relationship between interest rate capping and financial performance.

It looks at the existing literature related to interest rate capping and specifically covers the major theories that explain the relationship between financial performance and interest rate cap.2.2 Theoretical ReviewDifferent authors have developed theories on interest rate. They try to explain the relationship between interest rate and other variables. Below we will discuss some of the theories2.2.1 Liquidity Preference TheoryThe liquidity preference theory suggests that people prefer to have cash compared to other assets. This is whereby they prefer liquidity than investing in other assets (Keynes, 1936).

Interest rate is purely a monetary phenomenon, it is the payment received for relinquishing liquidity for a specified period (Keynes, 1936). Just like other commodities prices, interest rate is determined by supply and demand of money. This theory suggests that at any given time the demand of money will always be high thereby interest rate charged on the money will also be high therefore financial performance of commercial banks will also be high because they will part with their cash for a specified period and they will expect a reward in return.

Interest rate capping is introduced to ensure accessibility to money when demand arises by reducing how expensive money is, this will in turn affect financial performance of banks adversely.2.2.3 Interest Rate Parity TheoryInterest rate parity theory suggests that interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.

Where one country offers high interest rate than another its currency value would increase over time. The theory suggests that high interest rate would increase cash inflow from foreign investors thereby increasing the currency value of the country.This high interest rate would mean expensive loans which would increase the financial performance of commercial banks. Capping may be introduced as a form of protection to consumers to ensure affordable credit. This would reduce the financial performance of commercial banks.

2.2.2 Time Preference TheoryThe time preference theory dictates that people would prefer to spend money in the present over the future. Meaning people are impatient to spend. To motivate consumers to postpone consumption they are to be compensated by earning interest on their money (Irving 1936). Interest is the price of time (Irving 1936).

Consumers would delay their current consumption expecting greater returns by receiving high interests on their savings. Capping interest on savings would ensure high returns for consumers thereby promoting saving in the society. This would increase expenses for commercial banks and reducing their financial performance.2.3 Determinants of Financial Performance of Commercial BanksThe determinants of financial performance of commercial banks can be classified into internal factors and external factors. Internal factors are those factors that are influenced by internal decisions of management and the board. They are individual bank characteristics which affect the banks performance. External factors are the external variables that determine the output.

The external factors are sector wide or country wide factors which are beyond the control of the company and affect the profitability of banks.2.3.1 Internal factorsThese internal factors include capital size, size of deposit liabilities, size and composition of credit portfolio, interest rate policy, labor productivity and state of information technology, risk level, management quality, bank size, ownership and the like. Scholars have often used the CAMEL framework to proxy the bank specific factors.

CAMEL stands for Capital Adequacy, Asset Quality, Management Efficiency, Earnings Ability and Liquidity.Capital is one of the bank specific factors that influence the level of bank profitability. Capital is the amount of own fund available to support the bank’s business and act as a buffer in case of adverse situation. Capital adequacy is the level of capital required by banks to enable them withstand the risks such as operational risks, credit and market as they are exposed to in order to absorb potential loses and protect the banks debtors.Bank asset is also a variable that affects the profitability of a bank. The bank asset includes current asset, credit portfolio, fixed asset and other investments. Loan is the major asset of commercial banks from which they generate income.

Nonperforming loan ratios are the best proxies for asset quality. It is the major concern of all commercial banks to keep the amount of nonperforming loans to low level. This is so because nonperforming loans affects the profitability of the bank.

Low nonperforming loans to total loans shows the good health of the portfolio of a bank. The lower the ratio the better the bank performing.Management efficiency is represented by different financial ratios like total asset growth, loan growth rate and earnings growth rate. Operational efficiency in managing the operating expenses is another dimension of management quality. The performance of management is often expressed qualitatively through subjective evaluation of management systems, organizational discipline, control systems, quality of staff, and others. The capability of the management to deploy its resources efficiently, income maximization, reducing operating costs can be measured by financial ratios. Operating profit to income ratio can be used to measure management quality.

The higher the operating profits to total income the more the efficient management is in terms of operational efficiency and income generation. Expense to asset ratio is another important ratio used to measure management quality. The ratio of operating expenses to total asset is expected to be negatively associated with profitability. Management quality in this regards, determines the level of operating expenses and in turn affects profitability.Liquidity is another factor that determines the level of bank performance. Liquidity is the ability of the bank to fulfill its obligations, mainly of depositors.

Customer deposit to total asset and total loan to customer deposits are common financial ratios that reflect the liquidity position of a bank.2.3.2 External factors/ macroeconomic factorsMacro-economic factors will affect the performance of the commercial banks in an economy in a significant manner, since they determine the kind of operating environment available.

An economy with favorable macro-economic conditions, will in turn ensure that commercial banks thrive from increase in business activities and therefore increased profitability (Bodie, et al., 2005). These Macro economic factors include Growth Domestic Product (GDP), Interest rates, Political stability, Inflation rates amongst others.

GDP is used to measure the performance of an entire economy in a particular country. Growth in GDP has been linked with increased economic activity in a country. Increased economic activity means there is increase in the standards of living of the people, which means more people will be able to engage in banking activities. This will means more business for the commercial banks as they are the intermediaries in of money exchange in such economies and this will lead to improved financial performance and profitability (Bikker and Hu, 2002)The stability or instability of interest rates will affect the performance of commercial banks. An increase in interest rates will increase the profitability of commercial effects, however this will also reduce lending as it will be expensive for the borrower. Governments thus have to work to ensure that there is stability of interest rates.Clair (2004) established that the most important macroeconomic determinants of the performance of commercial banks were changes in interest rates, exchange rates, unemployment, and aggregate demand.2.

4 Empirical Studies Empirical studies have been carried out in both locally and internationally to determine the impact on commercial banks, in regard to interest rate capping.Maimbo and Gallegos (2014) undertook a study on the interest rate capping as a common form of government financial control. Governments began undertaking this control after the last global economic crisis.

Many governments undertook interest rate controls as a tool for consumer protections, for example Spain. Other countries such as Greece and the United Kingdom undertook capping of interest rates because banks exploited consumers due to the freedoms they enjoyed. Zambia on the other hand imposed interest rate caps to mitigate the risk that was being caused high levels of debt in the country that were being caused by high credit levels. Their findings found out that at least 76 countries undertook interest rate caps on loans-all with varying degrees of effects, including the withdrawal of financial institutions from the poor or specific segments of the market, an increase in the total cost of the loan through additional fees and commissions among others.According to Helms and Reille (2004) in some countries interest rate caps on microfinance loans caused microfinance institutions to withdraw from poor and more remote areas and to increase the average loan size to improve efficiency and returns because the interest rate ceiling was considered extremely low. They also found out that in South Africa, some financial institutions evaded the interest rate caps by charging credit life insurance and other services which reduced the transparency of the total cost of credit other services, which reduced the transparency of the total cost of credit.

Blitz and Long state, “Legal rate ceilings may reduce the price of personal loan credit to some borrowers, but when ceilings are sufficiently low to affect the observed market rate in a significant way, there is a substantial reduction on the number of borrowers included in the legal market. Relatively low risk borrowers who remain in the legal lending market appear to benefit from the lower cost loans made when higher risk potential borrowers are excluded” Other studies that support this showed that in Japan, interest rate capping led to increase in illegal lending and the most affected are the low income and middle income households .A draft paper by the Central bank of Kenya March 2018, has shown that interest rate capping have yielded negative effects and they include the following ” First and foremost, the capping of interest rates has infringed on the independence of the central bank and complicated the conduct of monetary policy. It is found that under the interest rate capping environment, monetary policy produces perverse outcomes.

Secondly, there is evidence of reduced financial intermediation by commercial banks, as exemplified by the significant increase in the average loan size arising from declining loans accounts, mainly driven by the large banks, thus shunning the smaller borrowers. Thirdly, banks have shifted lending to Government and the large corporates. Whereas demand for credit immediately increased following the capping of lending rates, credit to the private sector has continued to decline. Fourthly, while the structure of revenue of the banks has started to shift away from interest income, some banks have exploited the existing approval limits to increase fees on loans in a bid to offset loss in interest income. Fifth, although the banking sector remains resilient, small banks have experienced significant decline in profitability in recent months, which may complicate their viability. Sixth, rationing out Micro, Small and Medium Enterprises (MSMEs) from the credit market by the commercial banks is estimated to have lowered growth in 2017 by 0.4 percentage points.

However on the other side, banks have started adjusting their business models towards enhancing efficiency.”2.5 Summary of Literature ReviewFrom the study, the researcher looks at prevailing conditions before the caps and compares that with the emerging issues after the capping and concludes that although capping rates is a good short-term goal, it may have very severe long-term effects which may not be reversed easily.

It is also established that the transparency goal that the law seeks to achieve may not be achieved since the banks lacks a clear policy on their transparency objective which should determine how much they are eligible to charge to achieve their set margins. Interest rate is the most visible and palpable power source of many modern commercial banks and which the Central Bank of Kenya uses to control the fiat money as necessary. Looking at liquidity, the focus on aligning the finance and accounting role in the strategic plan of a financial institution is very crucial, hence the need to understand the interest rate. A bank is willing and able to charge at any given time. While looking at the study on capping interest rates and the effects it will have on the financial institutions, the researcher focused on banks profitability, the loan portfolio in the banks, the effects on the workforce as well as how it will bring variations on accessibility and acquisition of mortgage to the population.

Since the introduction of the capping law there has been little research on the impacts of the law to the country’s economy. However, it is evident that KBA has issued a report on the intended consequences of the law however; there have been some emerging challenges within the financial institutions and to the economy at large. It is also important to undertake a considerable research on the major outcomes which will emerge as a result of the capped interest.


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