The innovative introduction of the Kenya Banks Reference Rate to be used as the base rate by all banks introduces significant changes to loan pricing. The good news is, this has the potential to lower interest rates. The bad news is, other factors are required to unlock the potential.
High interest rates are a burden to the economy, no doubt. Take for instance a businessman that pays 20 per cent interest rate per year on his loan. It means he has to make a gross margin of at least 50 per cent in order to pay the loan at 20 per cent, meet his operating expenses with at least another 20 per cent and make a profit margin of 10 per cent. This means a packet of maize flour costing Sh100 gets marked up to Sh150 to keep the business going.
This not only increases the cost of living, it also increases the cost of doing business and overall productivity of the economy.
Previously, setting the base rate was left to specific banks to decide. The banks would set the base rate as an aggregate of the cost of funds, the cost of equity, the operating costs and provision for bad and doubtful debts. Some banks would also include a minimum profit margin in the base rate.
The new rate will be a market determined rate and not specific to any bank and all banks will be using this rate. It will be an average of the Central Bank Rate and the 91-day Treasury bill rate, and will be revised every six months.
Initially, the Central Bank Rate was introduced as the policy rate to signal the direction that interest rates would take in the economy. However, the rate has not been as efficient as was expected and the industry has barely recognized its significance. As a matter of fact, even if the rate has remained constant since
Going forward however, the Central Bank Rate will take a new significance because any changes will directly affect interest rates.
The new formula however allows the individual banks to add a markup on the base rate in form of risk premium in arriving at the interest rates to charge. The level of the risk premium to be charged will depend on the level of risk that has been assessed on the individual customer.
It is at the discretion of the banks to decide on how they will arrive at the risk premium to be charged. This is where we expect the level of risk premium to take into account their cost of funds including equity, the cost of operations and provision for bad and doubtful debts. These were costs that were previously included in the base rate.
The implications for this are that banks will need to be quite thorough because industry practice is such that risk premium, once set at beginning of the loan, is not changed in the course of the life of the loan. So if the cost of operations increases for instance, the bank cannot revise the risk premium to compensate itself. Previously, increases in the cost of operations could be compensated by the bank revising its base rate.
What therefore we will have is a situation where once a rate has been set let's say at base which is currently 9.13 per cent plus a risk premium of 5.87 per cent, then this overall rate of 15 per cent will remain until the next time the KBBR is revised. The interest rate of an existing loan will therefore be increased or decreased based on the KBBR rate.
We should therefore expect interest rates to change every six months depending on the level the level of KBBR.
As to whether the introduction of KBBR will lead to reduction of interest rates, it's highly debatable. However, we can say that KBBR will lead to a more transparent base rate, and transparency can contribute to an overall reduction in interest rates.
Interest rates are influenced by many factors. Some of the factors are economic-wide, some are industry based while others are bank specific.
With the introduction of KBBR, some factors will become more significant. Among them is the level of government borrowing. If the level of government borrowing is high, this will cause the 91-day Treasury bill rate to increase, and the KBBR will increase. This will directly affect the level of interest rates, since an increase in KBBR will translate directly to an increase in interest rates. On the other hand if the government reduces its domestic borrowing, the 91-day Treasury bill rate will reduce and the benefits will be passed on directly to the borrowers through a reduction in the base rate.
The other factor that will become critical is the Central Bank Rate which is determined by the
So whereas the general expectation is that interest rates will reduce with the introduction of the KBBR, they may not. Whether or not they rates will come doing depends on a multiplicity of factors.
Consequently, several factors have to exact pressure on the interest rates in order to bring them down. One, the government has to reduce domestic borrowing in order to influence the Treasury bill rate. Secondly, the
Hopefully, all the factors will work in tandem to lower the interest rates for the benefit of the economy.
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