Grow Profitability, Increase Customer Numbers and Digitalize Lending
Background: The New Regulation
In September 2016, a new law came into effect in Kenya that caps banks’ lending interest rates at four percent above the Kenyan Central Bank rate (currently 10 percent). Under the same law, banks will have to pay depositors 70% of the Kenyan Central Bank rate for their deposits. The Central Bank and government, who created the law, believe that this change will lead to lower lending prices for consumers, making it easier for them to access credit, and without damaging the economy.
Under this law, banks are required to lend to private businesses at the same rate they can get for lending to the government; over the past year, yields on government bonds have hovered around 14%--which is the same as the maximum interest rate allowed under the new law. Given the reliability of government bonds as opposed to the unpredictable nature of loans made to private businesses, it is hard to imagine that for the same profit margin, a bank would make private loans instead of simply lending additional funds to the government. As a result, the effect of the interest rate cap on most businesses is likely to be the drying up of credit as it is simply no longer viable for banks.
After the new law was signed, banks’ stock prices fell sharply on the Nairobi Stock Exchange. Non-bank lenders such as MFIs (microfinance institutions) and SACCOs (Savings and Credit Cooperative Organizations), who are not limited by the new law, are expected to expand their share of business credit in particular, as banks shrink theirs.
Interest Rate Caps Mean Less Small Business Credit
A 2014 World Bank study found that half the countries in sub-Saharan Africa have interest rate caps of one sort or another, including Nigeria and South Africa. In addition, most Western economies have limits on credit rates with more emphasis on the consumer portfolio and less on the business one. In other business lines, the constraint is most often not only capping the interest rate but also increasing the capital requirements needed. Despite that difference, the effect on market dynamics is similar; credit available to business, and small business in particular, dries up as the profit margin does not cover the risk banks incur.
After the 2008 global financial crisis, regulators in the UK and the US tightened their demands on commercial banks, making small business loans unviable for regulated banks. Alternative lenders have identified this market gap and leveraged cutting edge technologies and looser regulatory environments to focus on this niche, offering commercial loans at better terms than banks could provide.
How Banks Can Thrive with the Interest Rate Cap
Since an interest rate cap is not a Kenyan invention, there are strategies that banks in countries with a cap have used to succeed. Kenyan banks can use similar strategies to be successful.
In fact, banks that are innovative and agile can leverage the interest rate cap to improve their competitive position and market share. There will certainly be a transition period when customers may be unable to borrow from their current banks, forcing them to shop around for a new option, and creating an opportunity for banks who are thinking ahead about how to turn this challenge into an opportunity.
Banks in similar changing markets have flourished using the following three-pronged strategy:
1. Cut Credit Origination Costs:
Before the interest rate cap took effect, banks in Kenya that were inefficient could still make a profit from lending, by offering credit at much higher rates to some or all customers. With the cap in place, all banks with existing inefficiencies will have to cut origination costs and improve operational efficiency to remain profitable.
The most effective way to decrease costs is by digitizing either all or part of the lending process, enabling borrowers to complete some, or all, of the lending process through a self-service platform such as a phone or ATM. This has the added advantage of providing customers with better and faster service than they have had access to before, in a way that is more comfortable to them. Even if customers still need to go to a branch to sign paperwork or undergo an interview, cutting the manual elements of the process will significantly reduce costs.
Moving the credit process from manual to digital and transitioning from a branch-based process to a direct channel customers can access without going through bank staff can lower the cost of making loans and convert previously unprofitable customers into profitable ones, particularly for smaller or shorter term loans.
2. Use Analytics to Raise Standards for Customers:
Banks will need to move to using advanced analytics to score customers and make lending decisions, rather than credit committees, or manual decision processes, as has been common practice until now. Those processes tend to be lengthy and expensive, two attributes banks can no longer afford in the new economy.
By contrast, advanced analytics models are able to work instantly, automatically and around the clock, and do not require months to adjust to new loan parameters the way that bank staff do. As the interest rate cap moves, simple adjustments will allow banks to adjust their lending to meet legal regulations and maximize profitability despite those restrictions.
In addition, the use of advanced predictive analytics techniques can speed the process of loan approvals by conducting processes in advance of customer requests, require customers to meet a higher standard (have a higher credit score) to take loans and move the bank away from risk and towards profitability.
3. Partner with Non-Bank Lenders to Meet Customer Needs
With the interest rate cap in place, it will no longer make sense for banks to lend to certain existing customers. Smart banks will want to maintain relationships with those customers, however, and need to be creative as they think through how to maintain relationships with customers which are not based on the provision of credit.
By referring customers to other, non-bank lenders with whom the bank forms a partnership, the bank will be able to do just that. Since non-bank lenders are not restricted by the cap on interest rates, they can lend to the bank’s ineligible customers, meeting customers’ needs. By doing this, the bank will keep the relationship with their customer, and can earn a referral fee from the non-bank lender.
Conclusion: Opportunity for Innovation
At first glance, the new Kenyan interest rate cap looks like it will only be a hindrance to Kenyan banks accustomed to charging high interest rates to compensate for lengthy loan processes or higher risk customers.
For banks who wish to grow their portfolios, however, the interest cap provides a real opportunity to acquire new customers who will look for new sources of credit. It also offers a chance to reduce lending costs, making smaller loans more profitable and thereby expanding the bank’s share of the credit market, as they are able to make more and more types of loans than competitors who will struggle to keep up, or simply announce they are leaving the Kenyan market.
The choice for how to handle the new regulation—whether it is friend or foe—is up to your bank. Will you use the cap as a catalyst for growth and expansion, or will it hobble you and cause customers to look elsewhere?