Why interest rate caps impair the social contract of banking


Global banking, both as a profession and as an ecosystem, changed materially post-2008 financial crisis leading up to the global economic travesty of 2009 and 2010.

However, given the transmission channels of the crisis to emerging markets, particularly sub-Saharan Africa (“SSA”) were largely muted, SSA charted a path unfettered by the events of Wall Street on that fateful day of September 15, 2008 when Lehman filed for bankruptcy. Despite this insulation, SSA, and particularly Kenya banking has navigated uncharted territories, more globally speaking, in the recent months.

I left my office cubicle at the former Lehman building September of last year, into the global financial services conference in New York, taking a break from the typical 90-hour work week. This was meant to be another afternoon meeting with fellow bankers from across the street for an afternoon downtime, before getting back to office. The content of this conference oscillated around the post-financial crisis pivot, from 10 years back, where the overarching debate was whether banks had learned their lessons, given an observed rally on risk in 2016. This conference was about technical stuff, but I came out it with a simple, almost trite, revelation that has since changed my philosophy of banking and financial markets: That without taking risks banks have no real purpose to the society.

The social contract from after the great depression in 1930 to 2008 between the society and banks was the following; if the bank provides liquid savers a place to keep money, that’s a good thing; if the bank takes those deposits to lend to those who are in need of money, that’s a good thing. That process of lending long term from short term deposits is the economic contribution of banks. So the notion of taking short term deposits and converting them to 5 – 10 year loans – also technically known as maturity transformation, worked for 70 years until the crisis.

The primordial social contract of banks has therefore been very simple and non-esoteric, in that societies are propelled to economic prosperity for most part by commerce, and the oxygen of commerce is finance which permeates through the pipes of banking and financial markets. This inseparable nature of banking and its societal obligation, through commerce, can only be true in an environment where banks can take risk.

In the very simple nature of risk taking, commercial banks take deposits and extend those deposits to borrowers to finance home ownership, education or small business ventures. In so doing, banks assume, as it’s always true, that some borrowers will not pay back their loans. That’s credit risk. Financing a home ownership of any nature involves a view on whether the home value will change in the future, therefore impairing the ability of borrowers to refinance with the bank. That’s market risk. By contract, depositors have a right of access to their money regardless of whether banks have utilised those deposits to on-lend to long-term borrowers. That creates liquidity risk.

When an investment bank helps the government underwrite a bond to finance construction of roads, rail and bridges, with the promise that identified lenders to the government will honour their commitments, that creates residual risks. When banks help oil producing country lock in a future price for oil exports to better manage government revenues from oil sold in foreign markets, that trade creates basis risk. And then there is operational risk, which in itself anchors very basic functionalities of banking; like a cash machine working 24/7, a mobile banking app being active when you need it and a foreign exchange desk accessing information required to support exports for a flower farming business.

Without taking these risks, banks will have no real purpose to the society because finance and commerce will be structurally impaired. This simple fact makes pricing for bank services a very complex affair. It is with no certainty that all aforementioned risks can be quantified into a simple rate for a bank loan, a deposit service fees or a foreign exchange trade commission. Even if it were possible to quantify the precise impact of these risks, the potential future exposure, as a result, is a bit of a numbers game. It is this disconnect between the simplicity of the role of banks to the society,and, the complexity behind pricing bank products and services that renders any form of banking price controls, in any market, ineffective.

Price controls in in-efficient markets have instantaneous distributional consequences given the dislocations highlighted above. Even in markets where such controls have been used to funnel the industry through an efficiency-seeking cycle, such hypotheses have had their usefulness end. Case in point being the one-sided Zambian interest rates cap that was removed in 2015.
Arguing for the existence of interest rate capping laws is not about banks making too much money at the face value of published profit numbers, as that is too simplistic. It’s true that bank returns in Kenya are above 20% but if you benchmark that against cost of capital, which is pegged on the government paper rate – the risk free rate– and assuming market risk and idiosyncratic characteristics of each bank, the value created by banks is somewhere in low single digit of 2 – 5%. In other words, profitability of banks in Kenya is a relative construct, which means a 20%+ return on equity is not good enough given most banks operate with a cost of equity of 18%-20%.In a developing economy like Kenya, cost of equity has more to do with government policy, and the consequent government borrowing rate, than it has to do with how banks are structured or managed. The major component of the cost of capital is systemic, not idiosyncratic. It is a relative consideration that needs to be made when talking of Kenyan banks as being the most profitable. I put it to you that investor fund flows to the Kenyan market have selectively pursued companies with the highest value creation, and banks have not been part of that cohort, even during the pre-capping law era. It is this reality that should lead us to conclude that a published profit number by a bank of say Sh10 billion has very little information, when taken at its face value.

How will banks therefore honour their social contract and deliver value creation for their shareholders, if risk taking is curtailed by the fact that risk cannot be effectively priced? Whilst this question may attract philosophical debates, to my mind, it’s also true that the inability to price for risk has been a wake up call for banks to re-design their business models, the result of which ultimately, is good for both shareholders and the society. There has been a greater good here – as a result of the capping laws – that should not be underestimated.
Given mistakes of the past, speaking more broadly and more globally, corrective policies can be punitive but should not be prohibitive. The distributional consequences of the capping law that we are witnessing are much broader than would have been initially anticipated. And given the interconnectedness of the financial ecosystem, it is hard to predict the precise outcomes for the future as a result of such laws.

An economist recently told me that the impact of the interest rate caps is likely to be 100-150 basis point drop in Kenya’s GDP growth which is roughly USD700m of GDP, or the entire economy of Samoa, wiped off in a year. The more precise backdrop is that private sector credit growth has fallen to 4% from 18%+ a year ago, indicating that Kenya is headed to a balance sheet-lending led recession. Banks have also moved over USD1 billion of customer deposits into government securities since the capping law came to effect, the opportunity cost of which is lending to the real economy. The consequence of all this is that the funding and liquidity spiral, will benefit “risk-free” borrowers and therefore counter-intuitive to the social contract of banks;that of taking risks and supporting the real economy.

Futuristically speaking, the world of maturity transformation which underpins the existing social contract of banks is being challenged globally, and the future is going to be differentiated by how banks look for funds outside customer deposits(through capital markets) to on-lend to long term borrowers at a lower cost.

This will make maturity transformation very risky, if the reality is that banks will become intermediaries in the future, where capital anchoring will be the role of banks in the future society, therefore somewhat evolving the social contract of a deposit taker – and lender, to intermediaries of capital. In either route that banking takes, fundamentally, banks will continue to hold together the underlying fabric of commerce and should be allowed to freely price for risk which is a fairly complex affair.

Formerly Investment Banker on Wall Street and Head of Strategy at Barclays.

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