The recent introduction of an interest rate cap of 2.8% per month (33.6% annually) for Tier IV Microfinance Institutions and Money Lenders in Uganda has ignited significant debate among stakeholders in the financial sector. Enacted by the Ministry of Finance, Planning, and Economic Development, this cap aims to curb exorbitant interest rates and enhance financial protection for borrowers.
While the initiative seeks to make retail credit more affordable, its impact on various stakeholders—financial institutions, borrowers, and policymakers—is complex and multifaceted. This article delves into the diverse dimensions of this policy, analyzing its advantages and drawbacks, and drawing lessons from similar measures implemented in other countries.
The Pros
Enhanced Consumer Protection. The cap shows the government’s commitment to consumer protection, ensuring that borrowers are not exploited by predatory lenders who have previously charged exorbitant rates.
Relief for Borrowers. By limiting the interest rate, the cap reduces the financial burden of low-income individuals who rely on Tier IV FIs for credit. This could help improve financial inclusion.
Reduced Over-Indebtedness. The exorbitant pricing model of some Tier IV FIs often led to unsustainable borrowing, which, usually resulted in borrowers falling into debt traps. The cap could help in partly preventing this by ensuring that the repayment amounts are more manageable.
The Cons
Reduced Access to Credit. There’s potential for a general reduction in credit availability. Tier IV FIs and Money Lenders may become reluctant to lend to borrowers whose risk is perceived to be high and hence defeating the intended purpose of financial inclusion. Key to note is that FinScope Survey 2023 reveals that Tier IV FIs are the primary credit providers for a significant portion of rural and low-income Ugandans, making the effects of this regulation critical to monitor and prepare for.
Increased Informal Lending. A limitation in the supply of credit by Tier 4 FIs might push borrowers to informal lenders who are not regulated and often charge even higher rates, thereby undermining the intent of the policy or cap.
Threat to Institutional Sustainability. Drawing from our learnings on the MSERF, Tier IV Financial Institutions tend to have proportionally high operating costs, especially in remote areas where credit assessment and recovery are challenging. The cap might threaten their sustainability by limiting their ability to generate sufficient revenue to cover these costs, potentially leading to a contraction in lending activities or even institutional closures.
Undermines Risk-Based Pricing. Risk-based pricing is increasingly being established as the future of lending in developing countries like Uganda that seek to adopt data driven pricing models. The interest cap can be perceived as self-defeating in this regard given that it places all borrowers on the same pricing scale regardless of their risk profile.
The Potential Risks
To better understand the potential risks posed by the interest rate cap to the sustainability of Tier 4 FIs, we examine the relationship between capped interest rates, operational costs, and profitability. The diagram below illustrates the financial pressures that are potentially going to be faced by one of our partner financial institutions on the MSE Recovery Fund.
Visual representation of the threat to Institutional Sustainability
The illustration above sheds light on the challenges faced by Tier IV Financial Institutions in Uganda, especially their reliance on interest income to cover high operational costs. By capping interest rates, these institutions see their profit margins shrink, making it harder to sustain their operations. This could lead to a reduction in credit supply, particularly affecting underserved populations who depend on these institutions for financial access. Ultimately, the illustration highlights the risks to financial inclusion and the urgent need for targeted solutions to prevent these institutions from downsizing or leaving the market entirely.
Is this a Political Solution or an Economic Problem?
The interest rate cap may be interpreted as a political solution to an economic problem. In response to the public outcry over high borrowing costs and generally predatory lending practices, the government has opted for an interest rate ceiling, a move likely to be popular among the general public.
However, while the cap provides an immediate, visible response to the issue of high lending rates, it fails to address the underlying challenges, such as:
- the high cost of funds
- inadequate borrower information, and
- the risks associated with lending to mostly informal sectors / marginalized groups of people
These systemic issues require structural reforms and improvements in financial infrastructure, rather than a simple cap on interest rates.
It is also important to note that the stipulation does not in any way affect digital loans channeled through mobile network operators (MNOs) like MTN and Airtel Uganda, whose interest rates (currently averaging at 9% per month) are also effectively high. Reason being that these loans are mostly funded by Tier I Financial Institutions.
This exclusion/oversight raises questions about consistency in consumer protection efforts and could be perceived to be an anti-competitive practice that essentially makes ‘kings’.
Lessons from Kenya, Ecuador, Japan and Nicaragua
Uganda’s decision to implement an interest rate cap bears striking similarities to Kenya’s experience with interest rate capping on their credit industry, which was implemented in 2016. In Kenya, the interest rate cap was set to protect borrowers from high lending costs, but it led to unintended consequences:
- Reduction in Access to Credit. Following the introduction of the cap, banks in Kenya significantly reduced lending to small and medium enterprises (SMEs) and individuals deemed risky. The number of loan accounts declined sharply, and banks prioritized lending to larger, established firms and government securities. This led to a decline in financial inclusion and stunted economic growth, particularly for SMEs that are crucial for job creation.
- Increased Focus on Non-Interest Income. Kenyan banks shifted their focus to non-interest income streams, such as fees and commissions, to compensate for the reduced interest margins. This diversification ultimately affected the overall cost of financial services, which did not necessarily translate into affordability for borrowers.
- Impact on Monetary Policy. The interest rate cap limited the Central Bank of Kenya’s ability to use interest rates as a monetary policy tool, ultimately affecting the stability of the financial system.
- Capital Flight. Shares of the largest Kenyan Banks listed on the Nairobi Exchange plummeted by 10% in response to the news of the introduction of the interest rate cap. This was mainly due to loss of investor confidence.
Furthermore, it was evident that interest rate caps also resulted in a slowdown in credit growth in countries such as Ecuador and Nicaragua. The drop in credit growth was as a result of Banks tightening of their credit parameters to reduce credit risk. This resulted in the high-risk borrowers being excluded from the formal financial system.
In Nicaragua, the annual growth in credit dropped from 30% to just 2% after the interest ceiling was introduced in 2001. Likewise in Japan the supply of credit appeared to contract, and acceptance of loan applications fell with the introduction of a cap on interest rates.
Although the interest rate caps are still in place in Ecuador, the International Monetary Fund (IMF) has recommended that the country migrates from interest rate caps to a usury rate to improve financial inclusion and credit allocation.
Nonetheless, Kenya’s experience also provides a positive lesson on consumer protection. The cap succeeded in lowering interest rates for borrowers who had access to credit, thus making loans more affordable. Eventually, the cap was lifted in 2019, allowing for more market-driven interest rates, but it highlighted the importance of balanced regulatory frameworks that protect consumers while supporting the financial sector’s sustainability.
Call to Action: A Balanced Way Forward
To ensure that interest rate cap delivers on its promises without stifling credit access, a balanced approach is necessary:
- Evaluate and Revise the Cap Periodically. The interest rate cap should not be a static policy. Regular evaluations are necessary to assess its impact on financial inclusion, credit access, and institutional sustainability. Based on these assessments, gradual adjustments should be made to ensure that the cap remains relevant and beneficial to all stakeholders.
- Facilitate Access to Cheaper Funding. The government could facilitate access to cheaper funding for MFIs, such as concessional loans or grants, to help offset the reduced revenue from capped interest rates. This would enable MFIs to continue lending to high-risk borrowers without jeopardizing their financial health.
- Establish a Credit Guarantee Fund for Risk Sharing. Develop a government-backed guarantee fund specifically for Tier 4 FIs. This fund can absorb a portion of the default risk, enabling MFIs to lend to high-risk borrowers while operating within the capped interest rates. This mechanism would preserve access to credit for vulnerable populations and encourage financial inclusion.
- Implement Tiered Caps Based on Risk Segmentation. Consider introducing a flexible, tiered interest rate cap that adjusts according to borrower risk profiles. For example, lower caps for lower-risk borrowers and slightly higher caps for riskier borrowers within reasonable limits. This would provide FIs with greater room to balance risk and revenue.
- Strengthen Regulatory Oversight. The government should focus on strengthening the capacity of UMRA or the relevant department in MoFPED to effectively monitor and regulate the activities of Tier 4 MFIs, ensuring compliance while also supporting their sustainability.
- Strengthen Consumer Protection Frameworks Across All Channels. Ensure that consumer protection measures extend to all credit providers, including Banks in partnership with MNOs, to achieve a uniform standard of affordability and fairness in the financial sector.
- Invest in Capacity Building for FIs. Provide technical assistance and training programs for Tier 4 FIs to improve operational efficiency and adopt innovative lending practices. This could include digital tools for credit assessment, loan tracking, and cost management to counterbalance revenue losses from capped rates.
Authored by Pius Ruhunda
Analyst, Access to Finance Programs
