The issue originally came to the fore during the financial liberalisations of the 1990s and again as microfinance increased in prominence with the award of the Nobel Peace Prize to Muhammad Yunus and Grameen Bank in 2006.
Interest rate caps are used by governments for political and economic reasons, most commonly to provide support to a specific industry or area of the economy.
The argument, predicated on an assumption that demand for credit at higher rates is price inelastic, postulates financial institutions are able to exploit information asymmetry, and in some cases short run monopoly market power, to the detriment of client welfare.
[1] The researcher says that economic theory suggests market imperfections will result from information asymmetry and the inability of lenders to differentiate between safe and risky borrowers.
In a non-competitive market (as is likely to exist in a remote African village), the lender likely holds the monopoly power to make excessive profit without competition evening them out.
The imposition of a maximum price of loans magnifies the problem of adverse selection as the consumer surplus that it creates is a larger pool willing borrowers of unidentifiable creditworthiness.
While some countries use a vanilla interest rate cap[clarification needed] written into all regulations for licensed financial institutions, others have attempted a more flexible approach.
As some banks look to get around lending caps by increasing arrangement fees and other charges to the borrower, governments have often tried to limit the total price of the loan.
[1] In South Africa, the National Credit Act (2005) identified eight sub-categories of loan, each with their own prescribed maximum interest rate: The researcher identified the major argument used against the capping of interest rates as them distorting the market and preventing financial institutions from offering loan products to those at the markets lower end with no alternative credit access.
[1] He identifies a randomised experiment in Sri Lanka [7] which found the average real return to capital for microenterprises to be 5.7% per month, well above the typical interest rate of between 2-3% that was provided by MFIs.
In Nicaragua,[9] the governments Microfinance Association Law in 2001 limited microloan interest to the average of rates set by the banking system and attempted to legislate for widespread debt forgiveness.
[1] The researcher articulates that there is also evidence to suggest capping lending rates for licensed MFIs incentives, NGO-MFIs, and other finance sources for the poor to stay outside of the regulatory system.
If the inverse were true, and that market demand was highly sensitive to small rises in lending rates then there would be minimal reason for government or regulators to intervene.
[1] The researcher showed that Karlan and Zinman[11] carried out a randomised control trial in South Africa to test the received wisdom that the poor are relatively non-sensitive to interest rates.
[1] It gives the case study of South Africa where the National Credit Act was introduced in 2005 to protect consumers and to guard against reckless lending practices by financial institutions.
However they do provide some interesting and positive conclusions, for example, the ratio of operating expenses to total loan portfolio declined from 15.6% in 2003 to 12.7% in 2006, a trend likely to have been driven by the twin factors of competition and learning by doing.
This is a subjective regulatory question, and the aim of a policy framework should be to ensure sufficient contestability to keep profits in check before the need for intervention arises.
[1] The paper shows that the paradigm of classical economics runs that competition between financial institutions should force them to compete on the price of loans that they provide and hence bring down interest rates.
In a survey of MFI managers in Latin America and the Caribbean,[9] competition was cited as the largest factor determining the interest rate that they charged.
The macro evidence supports this view – Latin countries with the most competitive microfinance industries, such as Bolivia and Peru, generally have the lowest interest rates.
Due to the nature of the financial sector, with high fixed costs and capital requirements, smaller players might be forced to levy higher rates in order to remain profitable.
Governments should be willing to adapt and base policy on a thorough analysis of the market structure, with the promotion of competition, and the removal of unnecessary barriers to entry such as excessive red tape, as a goal.
In China, the government supports the financial sector by setting a ceiling on deposits and a floor on lending rates meaning that banks are able to sustain a minimum level of margin.
Following an international sample of MFIs, there is clear evidence from the Microfinance Information Exchange [15] (MIX) that operating expenses fell as a proportion of gross loan portfolio as businesses matured.
While often used for political rather than economic purposes, they can help to kick start a sector or incubate it from market forces for a period of time until it is commercially sustainable without government support.
They can also promote fairness – as long as a cap is set at a high enough level to allow for profitable lending for efficient financial institutions to SMEs, it can protect consumers from usury without significantly impacting outreach.