Do interest rate controls work? Evidence from Kenya

• DOI: http://doi.org/10.1111/rode.12675
• Author: Niko Hobdari,Rafel Moya Porcel,Emre Alper,Benedict Clements
• Date: 01 August 2020
• Published date: 01 August 2020

910

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wileyonlinelibrary.com/journal/rode Rev Dev Econ. 2020;24:910–926.

© 2020 John Wiley & Sons Ltd

Received: 8 July 2019

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Revised: 13 February 2020

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Accepted: 29 March 2020

DOI: 10.1111/rode.12675

REGULAR ARTICLE

Do interest rate controls work? Evidence from

Kenya

EmreAlper1

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BenedictClements1

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NikoHobdari1

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RafelMoya Porcel2

1International Monetary Fund, Washington,

DC, USA

2European Central Bank, Frankfurt,

Germany

Correspondence

Benedict Clements, International Monetary

Fund, Washington, DC, USA.

Emails: bclements@imf.org;

benedict.j.clements@gmail.com

Abstract

This paper reviews the impact of interest rate controls in

Kenya, introduced in September 2016. The intent of the

controls was to reduce the cost of borrowing, expand access

to credit, and increase the return on savings. However, we

find that the law on interest rate controls has had the oppo-

site effect of what was intended. Specifically, it has led to a

collapse of credit to micro-, small-, and medium-sized en-

terprises; shrinking of the loan book of the small banks; and

reduced financial intermediation. Because of their adverse

effects on bank lending, we estimate that the interest rate

controls have reduced economic growth by ¼–¾ percent-

age points on an annual basis. We also show that interest

rate caps reduced the signaling effects of monetary policy.

These suggest that (1) the adverse effects could largely be

avoided if the ceiling was high enough to facilitate lending

to higher-risk borrowers and (2) alternative policies could

be preferable to address concerns about the high cost of

credit.

KEYWORDS

Africa, deposit floor, interest rate caps, Kenya, monetary policy

JEL CLASSIFICATION

E43; E52; G21

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911

ALPER Et AL.

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INTRODUCTION

High interest rates on loans from the banking sector have been a frequent frustration of policymakers

in developing countries. These high rates are considered an obstacle to greater investment, financial

inclusion, and economic growth. High spreads between deposit and lending rates, in the absence of

effective competition, can also lead to above-normal profits. The handsome profits of the banking

system in some countries also make them a frequent target of populist ire, provoking calls to regulate

borrowing costs by controlling interest rates.

In Kenya, proposals to control interest rates have emerged from time to time over the past two de-

cades. In September 2016, a law on interest rate controls—which imposed a ceiling for lending rates

for loans of all maturities at 4 percentage points per annum above a “reference rate” and a floor on the

interest rate for time deposits at 70% of the “reference rate” (the floor did not apply to demand depos-

its)—received unanimous support from Parliament. The reference rate was subsequently clarified to be

the Central Bank Policy Rate (CBR). At the time of their introduction, Kenya’s interest rate controls

affected more than half of all existing loans and time deposits.1 As such, they were among the most

drastic ever imposed and provide a fascinating case study with lessons for many developing countries.

Studies assessing the actual effect of lending rate ceilings, including usury laws, on consumer

financial markets are relatively sparse, despite the prevalence of such controls across the world. Early

literature, documented by Villegas (1989), looked at the economic rationale of usury laws in the USA

(Blitz & Long, 1965), focusing on two main issues: whether interest rate ceilings under such laws

reduce the quantity of credit to risky borrowers and whether they reduce the interest rates paid by

successful borrowers. On the first hypothesis, an empirical analysis based on the US data suggests

that poorer households received lower point-of sale-credit in the states that implemented usury laws.

Villegas (1982), using auto loan market data in the USA, estimates interest rates paid for motor ve-

hicle loans and identifies potential borrowers most likely to be rationed out by the imposition of rate

ceilings. However, Peterson (1983) argues, based on the evidence from Arkansas, that consumers are

able to circumvent restrictive usury laws by engaging in non-point-of-sale credit obligations including

credit cards. On the second hypothesis, using data from the USA, Villegas (1989) finds no evidence

that successful loan applicants in states with usury laws enjoy reduced cost of financing relative to

loan applicants in other states.

In cross-country studies, ZEW (2010) provides a comprehensive inventory of the types of interest

rate restrictions in the EU member states and argues that interest ceilings lead to alternative forms of

credit outside banking systems. Elison and Forster (2008) consider descriptive evidence on the impact

of interest ceilings from various regulatory approaches in France, Germany, Italy, Japan, the UK, and

the USA and conclude that interest rate ceilings are ineffective in addressing overindebtedness, crowd

out low-income borrowers, and lead to the market entry of unlicensed lenders with predatory pricing.

Helms and Reille (2004) assess the impact of interest rate ceilings on microfinance institutions (MFIs)

using a descriptive approach for 40 developing and transitional countries. They find that such ceilings

generally hurt the poor as they discourage the provision of small loans by making it impossible to

recover the high administrative cost of lending. Using high-quality financial data from 29 institutions

in seven Latin American and Caribbean countries over a period of 4years and drawing on informa-

tion from field visits with clients, Campion, Ekka, and Wenner (2010) explore patterns of cost and

efficiency in MFIs and find that interest rate caps reduce the outreach of these institutions to the poor,

women, and rural clients. Mbengue (2013) notes the increasing use of interest rate ceilings in sub-Sa-

haran Africa. Maimbo and Henriquez Gallegos (2014) provide a literature survey on interest rate caps

and suggest that they create several problems, including reduced financial intermediation, increased

predatory lending, reduced transparency, and elevated risks to financial stability.