Why cutting bank lending rate is tricky business

A customer inserts a visa card into an ATM. Banks take big risks with depositors’ money. FILE  

By BD TEAM

In Summary

• Profit margin is not straight forward as banks juggle between cost of funds and borrower risks.

At the launch of the Kenya@50 Commemorative Gold Coin on Monday, Deputy President William Ruto prodded banks to cut the margin between their cost of lending and deposit rates to single digits.

While making these remarks, the two key banking industry policy makers, Treasury Secretary Henry Rotich and Central Bank of Kenya governor Njuguna Ndung’u, were keenly listening.

The Treasury chief appears to have taken up the matter seriously, as seen by his recent order to the Competition Authority of Kenya (CAK) to look into supposed cartel-like rate-setting behaviour by banks.

While you can only speculate on whose side the CBK governor’s weight is, the battle-lines have now been drawn. Two attempts have been made, unsuccessfully, to control the pricing of loans.

First was the famous Joe Donde Bill which was rejected by former President Moi in 2001. Second was the 2012 Finance Bill which, among other things, sought to regulate lending rates.

The two failed attempts sought to introduce a cap on lending rates and a floor on deposit rates. The argument here is that banks collect deposits cheaply, by paying interest as low as two per cent and lending the same deposits at rates as high as 14 per cent, thereby pocketing a huge spread of 12 percentage points.

But is the banks’ profit margin really that straight forward? In reality, banks juggle between two important variables in their lending business, which is cost of funds, and borrower risks.

Here’s how they play out: First, banks do not pay the two per cent interest rate on all deposits that they hold. This two per cent interest is paid only to small account holders, who typically have less than Sh100,000 in their accounts and do not have negotiating power since they lack volume. At the close of 2012, the small account holders only accounted for six per cent of total deposit accounts.

Banks do not therefore rely on this segment of the deposit market to fund their loan books. Instead, they draw the bulk of their funding from the more expensive, big volume institutional and high net worth account holders.

This segment has the negotiating power and often asks for high interest returns, as high as 10 per cent (at some point in the beginning of 2012 they were asking for 30 per cent).

A bank cannot therefore lend money on which it is paying an interest of 10 per cent at single digits, otherwise it will be making losses. Second, banks take big risks with depositors’ money. The best way to price a borrower with no credit history and collateral is to put a premium on the lending rate.

For borrowers with credit histories and collateral, there are two key challenges. Banks typically ask for developed land as collateral. The process of registering the charge on the property to the bank at the Ministry of Lands has never been an easy one for banks and is often riddled with ambiguities.

Apart from that, the kind of credit referencing Kenya is having at the moment is too generic and not exhaustive, and cannot be useful in pricing a borrower.

Currently, credit reference bureaus only list negative information on borrowers, specifically loan defaulters. The high risk premium added onto lending rates is more a function of structural inefficiencies in the economy than collusion or cartel behaviour.