Interest rate caps: The theory and the practice
This blog was originally published on the World Bank Blogs' website.
Ceilings on lending rates remain a widely-used instrument in many EMDEs as well as developed economies. The economic and political rationale for putting ceilings on lending rates is to protect consumers from usury or to make credit cheaper and more accessible. Our recent working paper shows that at least 76 countries around the world, representing more than 80% of global GDP and global financial assets, impose some restrictions on lending rates. These countries are not clustered in specific regions or income groups, but spread across all geographic and income dimensions. However, interest rate caps in high income countries are mostly introduced to protect consumers from usury, while in low income countries they are more commonly introduced to make credit cheaper and more accessible. In Sub-Saharan Africa (SSA) interest rate caps are used by at least 17 countries. This includes upper middle-income countries such as South Africa, lower middle income countries such as Kenya, as well as low income countries such as Chad and Senegal.
Interest rate caps are not static, but are an actively used policy tool. Since 2011, we find at least 30 instances when either new interest rate caps have been introduced or existing restrictions have been tightened. Over 75% of those changes occurred in low- or lower-middle-income countries. In SSA, new caps were implemented in Kenya and existing caps tightened in WAEMU. This outweighs the five instances globally, including Zambia, when restrictions have been removed or eased and indicates that countries increasingly limit the maximum level of lending rates.
A taxonomy of interest rate caps Interest rate caps come in many different forms. Restrictions used across countries vary substantially regarding what they cover and how they work. An innovative taxonomy presented in this paper classifies interest rate caps according to the following features:
• Scope. A primary form of variation is the type of credit instrument/ institution and/or borrower they apply to. Caps can affect only a narrowly defined segment of the market (e.g. payday loans, credit cards, mortgages), cover loans by certain institutions (e.g. MFIs or credit unions) or cover all types of credit operations in the economy. WAEMU for example has a broad interest rate cap, while Nigeria applies a narrow cap that only affects mortgage rates.
• Number of ceilings. Countries use either a single blanket cap for all transactions or multiple caps based on the type of the loan and/or socio-economic characteristics of the borrower. South Africa for example has multiple caps, while Kenya has a single ceiling.
• Type. The level of the cap can be either defined as a fixed, absolute cap or as a relative cap that varies based on the level of a benchmark interest rate. An example for an absolute cap is the WAEMU, where the cap is set at a fixed 15 percent for banks and 24 percent for MFIs (and other credit institutions). In contrast, Kenya uses a relative cap set at 4 percentage points above the central bank’s rate.
• Methodology. The level of the relative cap can be either defined as a fixed spread over the benchmark, as in Kenya, or as a multiple of the benchmark rate.
• Benchmark. Most countries using a relative cap link it to the level of an average market rate, for example, the average lending rate over the past six-months. Alternatively, the ceiling can be defined as a function of the central bank’s policy rate. In Zambia, like in Kenya, the benchmark was the central bank rate, while for CEMAC it was the average market rate.
• Binding. Independently of the type of benchmark used, caps can be binding or non-binding, i.e. they are below or above market rates. In countries where the primary aim is to prevent usury the ceilings are usually fixed at levels that affect only extreme pricing but leave the core market to operate with minimal implications. In contrast, if interest rate caps are used as a policy tool to achieve certain socio-economic goals, such as lower overall cost of credit, ceilings are set at binding levels intended to influence the market outcome. The caps in Kenya and the one used in Zambia are examples of binding caps, which were set at levels below prevailing market rates. In contrast, the various caps in South Africa are set at high levels.
• Fees. Some interest rate caps also explicitly regulate non-interest fees and commissions of the loan. This is either done by setting separate limits on non-interest costs or by defining the interest cap in terms of an annual effective rate (APR) that includes all fees and charges. The first approach is taken by the South African Reserve Bank, which publishes a comprehensive list of maximum fees applicable to different types of credit in addition to the respective interest rate caps.
This taxonomy is illustrated in the figure below:
Effects of interest rate caps Establishing the causal effects of interest rate caps is challenging due to the heterogeneity of caps used and endogeneity concerns, but economic theory points to several possible side effects. Country case studies on Kenya, Zambia, Cambodia, the West African Economic and Monetary Union (WAEMU), India, and the United Kingdom show that effects and side-effects depend on the type and specification of the cap.
• Caps set at high levels do not seem to affect the market and can help limit predatory practices by formal lenders. Non-binding caps, i.e. caps set well above market rates, affect only extreme pricing with little impact on the overall market. If interest rate caps include regulations on non-interest fees and the non-regulated lending market is limited, then caps are a potential way to remove predatory lenders in the formal sector.
• The effectiveness of caps is often undercut by the use of non-interest fees and commissions. The increased use of non-interest charges often reduces price transparency and makes it more complicated for borrowers, especially those with limited financial literacy, to assess the overall costs of the loan.
• Binding caps set well below market levels can reduce overall credit supply. The extent of the decline depends on the scope of the restrictions. Whereas narrow caps affect primarily a clearly defined market segment, broad restrictions can reduce overall credit supply in the economy. Blanket caps further affect the distribution of credit as they result in a particularly large decline of unsecured and small loans, as well as in credit to SMEs and riskier sectors. Average loan size increases, suggesting a reallocation from small to large borrowers, in many cases to the government.
In light of the possible unintended consequences of interest caps, alternatives and complementary measures to interest rate caps should also be considered. These include measures to foster competition, reduce risk perception, overhead costs, and cost of funds. Consumer protection and financial literacy measures are also important measures, especially if interest rates are meant to protect consumers from usury rates.
About the Authors
Aurora Ferrari is currently the Adviser to the FCI Senior Director for financial sector issues. Prior she was the manager for Financial Stability, Bank Regulation and Supervision unit of the World Bank (WB). In this capacity she oversaw the WB work in these areas, managed the FSAP program, coordinated the WB participation in Basel and represented the WB at the Financial Stability Board. Before then, Aurora was the manager responsible for financial sector policy advice and programs in Europe and North Africa, which focused particularly on crisis management, bank resolution, and state owned banks. Before joining the WB, Aurora worked at the EBRD in the Financial Institutions Group focusing on investments in banks.
Oliver Masetti is an economist (Young Professional) in the World Bank’s Financial Stability Team. He joined the World Bank in August 2016 and worked for the first year in the Office of the Chief Economist. Previously, he was an economist at Deutsche Bank in Frankfurt covering financial and macroeconomic developments for countries in Sub-Saharan Africa and the MENA region. Oliver holds a PhD in economics from Goethe University Frankfurt and a Master’s degree from St. Gallen University, Switzerland. He was a visiting student at Bocconi University and the Stockholm School of Economics.