Lending is a tough business and, with the current environment, only the toughest will prevail.

In the past few days, there has been a heated debate on the impact of the recently introduced interest rate caps on bank loans in Kenya. President Uhuru Kenyatta assented to the Bill that proposed the reintroduction of interest-rate caps that were abolished in 1991.

The amended Banking Act now requires banks to peg interest margins at 400 basis points above the base lending rate, which is the Central Bank Rate (CBR). It also sets a floor of 70 per cent that must be paid by banks on customers’ deposits.

Of course, the banks put up a spirited fight to block this action and even promised some measures to help push the rates downward. They even signed a memorandum of understanding with the Central Bank of Kenya to implement these measures. However, it seems, people were tired of the promises and like the ancient Roman Virgil wrote, “Beware of Greeks bearing gifts.” These goodies did not stop the clamour for the legislative route to capping the rates.

Now most banks are back to the drawing board to determine the changes that need to be swiftly implemented in order to remain in business. One school of thought — that seems to carry the day — argues that with low interest rates, credit will be more accessible to the majority and that debt fatigue that led to defaults caused by punitive interest rates will reduce.

The other school opines that negative effects such as a slowdown of the flow of private credit, denial of credit to some specific sectors perceived to be riskier, and increased transaction fees and commissions to compensate for the expected decreased earnings should be expected. They further argue that there is a better way of forcing banks to lower the lending rates such as encouraging more innovation, increasing financial literacy, improving the credit information-sharing platform and encouraging more public disclosures on bank interest rates.

For starters, let us break down how a typical bank defines the lending rate. Many borrowers find it hard to comprehend issues; why different customers are charged different rates of interest; and why secured loans are often cheaper than unsecured loans.

It is possibly the ambiguity around pricing of loans that results in a lot of hullaballoo on what is the ideal interest rate for a specific product or customer in a certain market. Without clear disclosure on the components of the lending rates, this ambiguity persists.

There are various methods of pricing loans; among the most prevalent is the cost-plus loan-pricing model. The model assumes that any interest rate charged has four main components:

• First is the cost of funds that a bank incurs to raise funds for lending. This implies that the cheaper a lender is able to raise the cash, the lower the interest rates.
• Second, the transactional costs as well as the other operating expenses such as rent and staff costs.
• Third, risk premium or margin to compensate the bank for possible default and other credit risks. Any borrower can default especially where circumstances change. Take for instance an employed executive who loses a job and had taken an unsecured loan in a bank. The possibility of future default is always one of the major headaches of the lenders. If you do not manage your credit risk well, you will always exaggerate the risk premium, which consequently increases the lending rate.
• Lastly, the profit margin. Each bank wants to make profit. Banks are not charitable organisations and are expected to report a decent return to the owners of capital.

Drastic times call for drastic measures. For banks to survive in the interest-capped environment, they must re-engage, re-strategise and reinvigorate their modus operandi. It cannot be business as usual. They need to be more innovative, must diversify and be more cost conscious. Unfortunately, under the regulated environment, there are only a few measures that banks can take to tip the balance.

Recently, the CBK was categorical that no bank will be allowed to arbitrarily introduce new products in the market or just hike fees without the requisite approvals.

If you revisit the components of the lending rate, one of them stands out: The risk premium. Any bank that wants to survive must adopt robust credit risk management strategies to reduce the levels of non-performing loans and consequently the risk premium. Sometimes some banks price in operational inefficiencies in the risk premium thereby locking themselves out of competition.

Financial lending institutions must get it right as far as some key fundamentals are concerned. Financial analysts use the acronym CAMELS while evaluating the stability and performance of a financial institution: C- Capital; A- Asset Quality; M- Management; E- Earnings; L- Liquidity and S- Sensitivity to the market.

Credit risk management

Banks must invest in a sophisticated and well-resourced credit risk management function. Like water is to fish so is a robust credit risk management strategy to a financial institution. Maintaining good asset quality is now beyond the traditional 5Cs of Credit: Capacity, capital, collateral, conditions and character. Of course, it requires meticulous due diligence on the potential customers, scrupulous monitoring of the loans, and stable macroeconomic environment among other key factors.

Credit risk refers to the probability that a once good borrower may default and fail to meet the agreed upon loan interest and principal repayments. The art and science of assessing, measuring and mitigating the credit risk is known as credit risk management and also takes into consideration the adequacy of the bank’s capital and loan loss provisions.

The global financial crisis that led to the collapse of banks once perceived to be “too big to fail” crumble like house cards was possibly the real turning point in risk management.

Banks are now expected to implement stringent risk management frameworks including adopting the Basel II and III regulations that help in a better management of the risk capital. Banks are expected to also put in place more advanced credit scoring models including probability of default and Loss Given Default models.

In a nutshell, strong credit risk management gives a major opportunity to significantly improve institutional financial performance, thereby assuring it of a distinct competitive advantage. Banks that will quickly re-strategise, secure low-cost funds for lending, maintain low cost to income ratios and robustly implement risk management frameworks will still do good business.

Macharia Kihuro is a financial risk practitioner based in Nairobi. [email protected]