How Bank’s Reference Rate and a cap on risk premium can reduce lending interest rate

In my article dated December 26, 2017 titled “Are bank customers in Ghana well informed about cost of credit / Annual Percentage Rate? It is time to have an interactive cost of credit website and app on google play and app store” I noted as below as the second item that I will write on to educate bank customers in Ghana about the cost of credit in Ghana, ways banks can reduce non-performing loans, increase customer experience and proposals to reduce the cost of credit.

“Introduction of the Ghana Bank’s Reference Rate (GBRR) to replace banks setting their own base rates. This will increase transparency in credit lending and enhance the transmission between the Central Bank Rate and banks’ lending rates. It will be calculated as the weighted “average of the central bank rate and the weighted 2 month moving average of the 91-day Treasury bill rates” and should be adjusted every six months barring any extreme conditions in the markets”  

Lending rates play a critical role in a financial system through allocation of resources in an economy. The rates have the capacity to play intermediary role between potential lenders and borrowers (Kinyua, 1997).A high lending interest rate for borrowers translates to high borrowing costs which discourages potential borrowers due to the fact that it leads to high cost of production which has a negative effect on returns (Kinyua, 1997).Therefore, lending rate has to be favorably low so as to attract borrowing for investment (Kinyua, 1997).

A recurring issue among borrowers in Ghana is concern over perceived high bank spreads in Ghana. The Governor of Bank of Ghana from a transcript of the 77 Monetary Policy Committee (MPC) new conference in Accra on July 24, 2017[1] indicated that the large spreads are caused by three factors: A relatively large share of non-performing loans (NPLs), High Profit margins and High operating costs.

As a believer in free market, this is one of the article that I have put forth that I wrestled with several times with my recommendations.  I initially thought of writing this article in 2017 and decided to defer to 2018.  I have consulted widely on several literatures and research.  What keep hunting me is the frustrations a lot of Ghanaians have around the cost of credit and the applicable interest rates on their hard–earned deposits. I certainly believe some bankers in Ghana will not share this view. But desperate times need desperate actions, and based on what I believe will work and borrowing experience from Kenya and other part of the world that experienced high interest rate for a very long time, my recommendation is that in order to reduce interest rate and achieve transparency in loan pricing in Ghana, the government should pass amendment to the  Banks and Specialized Deposit-Taking Institutions (SDIs) 2016 (Act 930) as follows

 

A bank or a SDI shall set —

(1) (a) the maximum interest rate chargeable for a credit facility in Ghana at no more than five  per cent, the base rate set and published by the Bank of Ghana called Ghana Bank’s Reference Rate (GBRR) and

(b) The minimum interest rate granted on a deposit held in interest earning in Ghana to at least seventy per cent, the base rate set and published by the Bank of Ghana.

(2) A person shall not enter into an agreement or arrangement to borrow or lend directly or indirectly at an interest rate in excess of that prescribed by law.

 

In addition to the above, as suggested in my article called” Are bank customers in Ghana well informed about cost of credit / Annual Percentage Rate? It is time to have an interactive cost of credit website and app on google play and app store” , I will like the Ghana Bankers Association (GBA) and Bank of Ghana (BoG) to collaborate to launch an interactive website for cost of credit in Ghana. This website should offer a comparison tool where a consumer is able to compare total cost of credit from different competitors. Therefore, one can approach a number of banks and get the APR quotes and make an informed decision. This will increase the competition across the various loan products that banks offer.  An example of such website was recently launched by the Kenya Bankers Association and the Kenya central bank. See this link for the website:  http://www.cost-of-credit.com

 

What determines lending interest rate?

Howels (2008),defines the rate of interest as a payment from borrowers(deficit units) to lenders(surplus units) which compensates the savers cum lenders for parting with their funds for a definite some time usually expressed in days, months and or years and at some risk.

Lending rate is a percentage charged for the use of borrowed money. It is the opportunity cost of money .Howels (2008),defines the rate of interest as a payment from borrowers(deficit units) to lenders(surplus units) which compensates the savers cum lenders for parting with their funds for some time usually expressed in days, month or years and at some risk. Ngugi and Kabubo (1998), states that the purpose of interest rate is to assist in the mobilization of finances and ensure proper and efficient use of resources.

Lending rate includes the rates paid for deposit (deposit rate) and the rates applied on loans to deficit units (lending rate) for a given period of time. Deposit rates include call, savings and time deposit rates whereas lending rates comprise of rates charged on overdrafts(overnight borrowings) and the term loans otherwise known as long-term borrowings(Ngugi &Wambua,2004).

The rate of interest that is attached on the loan is dependent, to some extent by the risk of default. Borrowers that appear equally risky in the opinion of the bank have a higher chance of suffering from rising interest rates. This phenomenon is due to the fact that banks tend to incorporate risk factor in the portfolio of loans that normally carries a higher rate of interest (Funkor, 2000).

Real interest rate is the rate harmonized with either realized or expected inflation rate is the relative price of consuming now rather than later. It is a key variable in vital theoretical models employed in finance as well as microeconomics-such as the consumption based asset pricing model (Lucas, 1978).According to Keynes (1936), lending rate represents the cost of borrowing capital for a specified time period. The determination of positive interest rate (lending in excess of inflation) is viewed as a prerequisite for successful and sustainable finance (Buckler, 1999).

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Determinants of cost of lending in Ghana

Lending rate is a percentage charged for the use of borrowed money. It is the opportunity cost of money. Howels (2008),defines the lending rate as a payment from borrowers (deficit units) to lenders(surplus units) which compensates the savers cum lenders for parting with their funds for a defined period of time more often than not expressed in days, months or years and at some risk. Interest rates paid for deposits (deposit rate) and the rates applied on loans to deficit units (lending rate) for a given period of time. Lending rates comprise of rates charged on overdrafts (overnight borrowing) and term loans otherwise known as long-term borrowings (Ngugi & Wambua, 2004).

Every bank in Ghana price their products using their own base lending rates. Every bank had its own base rate

Structures of banks and operations differs, nevertheless, interest on loans charged by banks is determined by two things i.e. bank specific and customer specific characteristics. Banks cost and price their products based on their cost of funds. Both retail and wholesale deposits influence the costs. What influence loan interest rate to a great extent are the wholesale deposit rates. Organizations essentially require a high return on the deposits they keep with the banks. The banks in turn charges their products based on wholesale deposits and put a margin that covers their cost of operation costs, risk and return for shareholders or profit

When banks lend, they evaluate customers based on their ability to pay back their loans. This is known as customer risk profile. There is a price associated with either payment or default of loan. Banks are required by the Credit Bureau Act to make use of credit reports from Credit Reference Bureaus (CRB)  to determine the profile of the customers. CRB provides credit history of the customers, liabilities and repayment records. Based on the type of the products, there would be associated cost and risk the bank will incur by selling the product

 

Current cost of lending in Ghana

Currently BoG publishes the Annual percentage rate (APRs) of each of the products of the banks in Ghana on monthly basis.  In addition to the above, on February 10, 2017, Bank of Ghana issued a guideline called “disclosure and product transparency rules for credit products and services”[2]. Bank of Ghana issued the guideline in pursuance of Section 7 of the Borrowers and Lenders Act, 2008 (Act 773).  The guideline together with section 18 of Act 773 requires disclosure of APR, finance charge, amount financed and total payments in the pre-agreement between banks and its customers.

The December 31, 2017 Bank of Ghana published cost of lending in Ghana is in the table below[3]

Factors influencing the high cost of credit in Ghana

A recurring issue among borrowers in Ghana is concern over perceived high bank spreads in Ghana. The Governor of Bank of Ghana from a transcript of the 77 Monetary Policy Committee (MPC) new conference in Accra on July 24, 2017[4] indicated that the large spreads are caused by three factors[5]:

  • A relatively large share of non-performing loans (NPLs). – As of October 2017, NPLs comprised 21.6%[6] of total advances of banks in Ghana.
  • High profit margins. – Banks have relatively high profit margins on lending. A certain percentage of this can be attributed to “captive clients”, i.e. Clients who are loyal to the bank, and do not hold accounts with or take loans from other banks, and lower competition (further explained in the section related to all asset debentures).A percentage of this margin can be directly attributed to difficulties in using collateral. The absence of efficient judicial procedures to facilitate loan recovery may also increase the margins.
  • High operating costs. – Overhead costs are the most important component of interest rate spreads. This high overhead cost is related to low productivity and overstaffing. Banks in Ghana have more employees for a given amount of assets, loans and deposits than other banks in emerging market countries.

 

Why the introduction of Ghana Bank’s Reference Rate (GBRR?) and the fixed risk premium

Introduction of introduction of Ghana Bank’s Reference Rate (GBRR) will increase transparency in credit lending and enhance the transmission between the Central Bank Rate and banks’ lending rates.

The primary function of GBRR should be to ensure clearness in costing and setting loan prices. This is should be made possible through GBRR framework that requires banks to open up to customers and explain to them GBRR and any additional premium, “k”. This premium is to be broken down to enable clients to comprehend its components. This also allows government to make targeted policy interventions to lower premium.”

Based on experience of other countries including Kenya, Banks reference rate alone will not solve the high lending rate and cap has to be placed on the additional risk premium, in this case, I am recommending maximum of 5%.

How the Ghana Bank’s Reference Rate should be calculated

I suggest that GBRR should be s arrived at as the average of (i) Bank of Ghana monetary policy rate and (ii) the 2-month weighted moving average of the 91-day T-bill rate.

The 91-day T-bill reflects risk free rate, Rf whereas Bank of Ghana monetary policy rate reflects monetary policy stance. Customers should look forward to be charged a lending rate of GBRR+ “k”. The GBRR should be seen as a minimum price for banks to take part in the credit market. Therefore, the value of “K” above GBRR will depend on various factors such as lender’s perceived customer risk profile, efficiency of security at the lands ministry, and due diligence process cost.”

 

The experience in Kenya shows that mandating a Base rate will not reduce interest rate but in addition risk premium should be capped

Bank of International Settlement (BIS) in a report recommended to Central Bank of Kenya (CBK), to introduce a base rate to be used to price loans, the study therefore recommends that central bank should use KBRR as base rate to price loans. Moving ahead with BIS study and recommendations, the Kenya Bank’s Reference Rate was introduced in July, 2014 following a discussion between institutions, Central Bank of Kenya (CBK), Kenya Bankers Association (KBA) and The National Treasury. For banks to participate in credit lending, KBRR should be the base rate according to CBK, 2014.

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Studies and research shows that despite the introduction of KBRR in 2014, the lending rates in Kenya have been increasing. Lending rates went as high as 18.3%. Lending rates apt to react in proportion to the increase on KBRR and slowly to the decrease of KBRR by Monetary Policy Committee of the CBK. It became clear that lending rate was not pegged on KBRR. The results show that KBRR doesn‟t significantly affect the lending rate of commercial Banks‟ as determined by individual Bank is significant in determining the lending rates. KBRR was seen as an insignificant determining lending rates .‟K‟ is significant hence the study concludes that banks will always charge a higher premium ”K” no matter what the KBBR is.

The main objective of introducing KBRR in July 2014 was to lower interest rates as borrowing is still expensive and not readily available to the private sector. Since KBRR is just the base rate, commercial banks have the freedom to charge the amount of premium „‟K‟‟ they want without violating any law. To mitigate the shortcomings of KBRR, in 2016 a law was passed to cap Interest rate in Kenya through Banking Amendment Act 2016 will help regulate „K‟[7]

 

In signing into law the capping of interest rate, the President of Kenya had this to say[8]

“This is the third time that the National Assembly is attempting to reduce interest rates to affordable levels. In the previous two instances, dialogue and promises of change prevailed and banks avoided the introduction of these caps. In those instances, banks failed to live up to their promises and interest rates have continued to increase along with the spreads between the deposit and lending rates.

Despite having one of the most efficient and effective financial markets, Kenya has one of the highest returns-on-equity for banks in the African continent. Banks need to do more to reduce the cost of credit and ensure that the benefits of the vibrant financial sector are also felt by their customers.

Upon weighing carefully all these considerations, on balance, I have assented to the Bill as presented to me. We will implement the new law, noting the difficulties that it would present, which include credit becoming unavailable to some consumers and the possible emergence of unregulated informal and exploitative lending mechanisms.

We will closely monitor these difficulties, particularly as they relate to the most vulnerable segments of our population. Whilst doing so, my Government will also accelerate other reform measures necessary to reduce the cost of credit and thereby create the opportunities that will move our economy to greater prosperity.

We recognize that banks have done much in the last decade in terms of innovation and promoting financial inclusion and look to their doing more in that direction.

We also reiterate our commitment to free market policies in driving sustainable economic growth, to which we owe much of our success”

Uhuru Kenyatta, CGH
President of the Republic of Kenya
Wednesday 24th August 2016

 

 

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Central of Bank Kenya. (July, 2014). Maintaining Stability in the Monetary Policy Path. Monetary policy Committee Meeting, 8th July, 2014.

De Bondt,G. (2005).”Interest Rate Pass-Through;empirical results for the euro area.”German Economic Review 6:37-78.

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FSD Kenya (2009). Definition of a standard measure for Consumer Interest Rates in Kenya.

IMF (2013).Monetary Transmission mechanism in the East African Community; An empirical Investigation.IMF working paper

 

Johannes P.S. (2013). Interest Rate Pass-Through in Namibia. Journal of Emerging Issues in Economics Finance and Banking (JEIEFB) .Volume:2 NO.2 August.

John.M.and Pokhariyal G.P. (2013).Two stage Interest rate Pass Through in Kenya.Journal of Emerging Trends in Economics and Management Sciences (JETEMS) 4(1) 54-61.

Kwapil,Claudia and Johann Scharler,2010,”Interest Rate Pass-Through, Monetary Policy Rules and Macroeconomic Stability,” Journal of International Money and Finance,29,pp.236-251.

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[1] https://www.bog.gov.gh/privatecontent/MPC_Press_Releases/Transcript%20of%20MPC%20Press%20Briefing%20-%20July%202017.pdf

[2] https://www.bog.gov.gh/privatecontent/Public_Notices/Fin%20Stability/DISCLOSURE%20ON%20CREDIT%20PRODUCTS%20FINAL%2020%20Feb%202017.pdf

[3] https://www.bog.gov.gh/privatecontent/Public_Notices/Copy%20of%20APR%20and%20AI%20Publication%20for%20Dec%202017.pdf

[4] https://www.bog.gov.gh/privatecontent/MPC_Press_Releases/Transcript%20of%20MPC%20Press%20Briefing%20-%20July%202017.pdf

[5] Martin Cihak and Richard Podpiera. Bank Behavior in Developing Countries: Evidence from East Africa, IMF Working Paper 05/129 (June 2005). https://www.imf.org/en/Publications/WP/Issues/2016/12/31/Bank-Behavior-in-Developing-Countries-Evidence-from-East-Africa-18245

[6] https://www.bog.gov.gh/privatecontent/MPC_Press_Releases/Banking%20Sector%20Report_November%202017.pdf

[7] https://www.centralbank.go.ke/uploads/banking_circulars/1456582762_Banking%20Circular%20No%204%20of%202016%20-%20The%20Banking%20Amendment%20Act%202016.pdf

[8] https://www.nation.co.ke/business/Full-statement-on-Bill-capping-interest-rates/996-3356250-djngf3z/index.html

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