* Where are interest rate caps currently used, and where have they been used historically?
* What have been the impacts of interest rate caps, particularly on expanding access to financial services?
* What are the alternatives to interest rate caps in reducing spreads in financial markets? ref=== Understanding the composition of the interest rate ===
The researcher ref decided that to assess the appropriateness of an interest rate cap as a policy instrument, (or whether other approaches would be more likely to achieve the desired outcomes of government), it was vital to consider what exactly makes up the interest rate and how banks and are able to justify rates that might be considered excessive.ref
He found broadly there were four components to the interest rate:-
*Cost of funds
*Non performing loans
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* Outreach costs - the expansion of a network or development of new products and services must also be funded by the interest rate margin
* Processing costs - is the cost of credit processing and loan assessment, which is an increasing function of the degree of information asymmetry
*General overheads- general administration and overheads associated with running a network of offices and branchesref
The overheads, and in particular the processing costs can drive the price differential between larger loans from banks and smaller loans from . Overheads can vary significantly between lenders and measuring overheads as a ratio of loans made is an indicator of institutional efficiency.ref==== Non performing loans ====
Lenders must absorb the cost of bad debts and write them off in the rate that they charge. This allowance for [[non-performing loans]] means lenders with effective credit screening processes should be able to bring down rates in future periods, while reckless lenders will be penalised.ref==== Profit ====
Lenders will include a profit margin that again varies considerably between institutions. Banks and commercial with shareholders to satisfy are under greater pressure to make profits than [[NGO]] or [[not-for-profit]] MFIs.ref=== The rationale behind interest rate caps ===
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. Government may have identified what it considers being a market failure in an industry, or is attempting to force a greater focus of financial resources on that sector than the market would determine.ref
*Loans to the agricultural sector to boost agricultural productivity as in [[Bangladesh]].
*Loans to credit constrained as in [[Zambia]].ref
The researcher found it is also often argued that interest rate ceilings can be justified on the basis that financial institutions are making excessive profits by charging exorbitant interest rates to clients. This is the [[usury]] argument ref and is essentially one of market failure where government intervention is required to protect vulnerable clients from predatory lending practices. 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. Aggressive collection practices for non-payment of loans have exacerbated the image of certain lenders.ref
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*Moral hazard - clients borrowing at a higher rate might be required to make riskier to cover their borrowing costs leading to a higher probability of default afterwards.ref
The researcher claims that traditional ‘microfinance group lending methodology’ helps manage adverse selection risk by using [[social capital]] and [[risk understanding]] within a community to price risk. However, interest rate controls are most often found at the lower end of the market where financial institutions (usually ) use the information asymmetry to justify high lending rates. 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.ref
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== The impact of interest caps ===== Supply side ======= Financial outreach ====
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]]. This counters the financial outreach agenda prevalent in many poor countries today. He claims the debate boils down to the prioritisation of cost of credit over access to credit.ref
He identifies a randomised experiment in Sri Lanka ref 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 . Similarly, the same authors found in Mexicoref that returns to capital were an estimated 20-33% per month, up to five times higher than market interest rates.ref
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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. It was a variable cap that discriminated between eight types of lending instrument to ensure the cap bit at different levels.
==== Credit constraints and productivity ====
The researcher observed that an [[interest cap]] exacerbates the problem of [[adverse selection]] as it restricts lenders’ ability to price discriminate and means that some enterprises that might have received more expensive credit for riskier business ventures will not receive funding. There has been some attempt to link this constraint in the availability of credit to output. In [[Bangladesh]],ref firms with access to credit were found to be more efficient than firms with a credit constraint. The [[World Bank]]ref found credit constraints may reduce profit margins buy up to 13.6% per year.ref=== Are interest rates too high? ===
The paper shows a detailed 2009 study by [[CGAP]]ref looked in detail at the four elements of loan pricing for and attempted to measure whether the poor were indeed being exploited by excessively high interest rates. Their data is interesting for international comparison, but tell us relatively little about efficiency of individual companies and markets. 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.refref