Free-market principles have been put to test in the recent past especially in many developing and underdeveloped countries. Many agree that complete a lack of regulation is no longer desirable but the alternative of having excessive Government regulation in any part of the economy could backfire. So what is the balance?
Usually, it is the governments role to protect its citizens from being exploited by the predatory practices of some lenders. That is what our parliament tried to do by passing the banking amendment bill in 2016 which was meant to cap the lending rates at 4.0% above the Central Bank Rate (CBR).
As mentioned above, when the Government interferes with any part of the economy, the reaction is felt by the citizens of that country. Below are some of the ripple effects that the capping interest rates bill with have on both the economy and individuals.
- Most lenders will be locking out SMEs and other “high risk” borrowers: Lenders will start withholding their money and making it extremely difficult to get funding for projects. They shall also start withdrawing from the low end markets which are mostly associated with the poor. This in turn will limit access to credit rather than increase access to credit which is the main aim of capping the interest.
- There will be an increased emergence of shadow banking systems: There is a saying that goes, ‘If it looks like a duck, quacks like a duck, and acts like a duck, then it is a duck!’ But what about an institution that looks like a bank and acts like a bank? Can we call it a bank? Most likely not a bank but a shadow financing institution. A shadow banking system refers to the financial intermediaries involved in facilitating the creation of credit across the financial system but whose members are not subject to regulatory oversight. The lack of regulation in this system poses a lot of financial risks and especially to the borrower.
- There will be a steady rise in the interest rates: In the long run the price cap which was set to reduce the interest rates might just increase it. How? This is because lenders that could or were willing to offer lower interest rates will no longer do so and will set it at the highest rate allowed by the law. This will in turn reduce the borrowers bargaining power.
Interest rate caps may be a good policy decision for governments. Where insufficient credit is being provided to a particular industry that is of strategic importance to the economy, interest rate caps can be a short term solution. However, while often used for political rather than economic purposes, they can help to kick start a sector or incubate it from market forces for a period of time until it is commercially sustainable without government support.
Having an interest rate cap also promote fairness. This is so long as the cap is set at a high enough level to allow for profitable lending for efficient financial institutions to everyone including the ‘higher risk’ borrowers.
Where lenders are known to be very profitable then it might be possible to force them to lend at lower rates in the knowledge that the costs can be absorbed into their profit margins. Caps on interest rates also protect against usurious lending practices and can be used to guard against the exploitation of vulnerable members of society.