Interest rate controls – Positive and Negative effects

Introduction to interest rate controls

Interest rate controls
Interest rate controls

Interest rate controls protect consumers of credit from high interest rates charged by the financial institutions. On the other hand, a price control refers to a deliberate attempt by the government to set either a minimum or maximum price for a commodity or service in the economy. Maximum prices are set with the aim of protecting the consumer from exploitation by the producer while minimum price control is set to guarantee the producer a certain minimum income and hence protect the producer especially in a period of declining prices in the market.

Price controls

Minimum prices (price floor) are imposed above the equilibrium price since the government considers that the price determined by the forces of demand and supply are too low and if let to prevail it may lead to the exploitation of the producers.

Maximum prices (price ceiling) are imposed below the equilibrium since the government considers that the prices determined by forces of demand and supply are too high and if let to prevail they may lead to exploitation of the consumers.

In August 2016, many countries introduced price controls on interest rates charged by commercial banks through the signing into law of the Banking Amendment Act 2016. Effectively, USA joined the league of close to forty countries that exercise such controls across the globe. According to the new law:

  1. A bank or financial institution shall disclose the charges and the terms relating to the loan before granting a loan to a borrower.
  2. A fine of one million shillings and/or a jail term of one year for the Chief Executive of the financial institution for violation.
  3. Full information disclosure and affordability of credit reduces the cost of default since consumers are fully informed of the actual cost and duration of payment.
  4. Access to cheap credit aids the growth of the small and medium enterprises hence supports the industrialization agenda of the country.

The passing of this law was aimed at protecting the consumers, more especially the uninformed low-income consumers of credit facilities from the exploitation by financial institutions through high interest rates and other hidden charges that are not disclosed to the consumers at the time of entering into the loan contract. The law equally limits the spreads made by financial institutions depending on the base rate set by The Federal Reserve System. However, critics of interest rate controls argue that the negative effects of such controls are more detrimental to the economy than the ills that the law seeks to remedy.

According to Chairperson Jerome Powell, “Capping the cost of loans has sapped energy from banks hence slowing down growth.” He further adds that “once the full effect of the law becomes clear, the push to have the law revised would gain momentum.”

The proponents of regulating interest rates on the other hand argue that the financial markets are imperfect and cannot regulate themselves adequately. Leaving the determination of interest rate to the free forces of demand and supply would lead to the exploitation of consumers since commercial banks would collude to charge the consumers exorbitant rates.

Positive effects of controlling interest rates

  1. Protects the consumers of credit from high interest rates charged by the financial institutions. Thus, it makes credit affordable to the consumers.
  2. Access to cheap credit by consumers would lead to increased investment hence increased economic growth.
  3. Interest rate control helps in managing increased inflation in the economy.
  4. Instills discipline in the banking industry as it avails full information to the public on the expected repayment value on credit.

Negative effects of controlling interest rates

According to Powell, “The introduction of interest rate controls is an outcome of an interplay of many factors some structural and others policy. If high interest rates persist in the economy, the remedy lies in addressing the policy and structural issues. Capping of interest rate does not address a market failure problem but rather it introduces several other negative effects in the economy.”

Such negative effects include:

  1. It discourages innovativeness aimed at developing credit facilities targeting the high-risk borrowers.
  2. Households and business firms would rush to the banks to access cheap credit which leads to credit rationing. This is especially to the detriment of the small and medium enterprises.
  3. Banks may introduce tight credit conditions so as to price risk within the limits of the caps.
  4. Interest rate controls discourage the supply of funds to the financial system thus encouraging black markets where loans are issued at high interest rates with stringent conditions.
  5. Banks may introduce additional charges or modify the loan terms hence effectively increasing the cost of credit.
  6. Leads to credit concentration among the large borrowers with sufficient security.
  7. It has the effect of reducing access to credit and this may ultimately hamper economic growth.
  8. Interest rate controls complicate the application of the monetary policy. This is due to the fact that for the effect of the monetary policy to be felt, the interest rates have to be flexible.
  9. If the interest rate is too low, it may not cover the cost of credit hence banks may be suffering losses. This may threaten the survival of small banks.
  10. It may have a negative effect on the stability of the capital markets since commercial banks control up to thirty percent stake of the stock market.
  11. Interest rate controls slows down credit to the private sector and the small firms. This may lead to plant closure, layoff of employees and relocation of some shared functions especially in international banks.
  12. Poor performance of industries that rely on credit such as the motor vehicle industry.
  13. It may lead to crowding off effect. This occurs when the commercial banks prefer to lend to the government as compared to lending to private firms and individuals. The increased demand for loanable funds by the government will shift the demand curve rightwards and upwards increasing the real rate of interest. This increases the opportunity cost of borrowing money decreasing the amount of interest sensitive expenditure such as investment and consumption. Thus, the government crowds out private investment.

Concluding on interest rate controls

While introduction of interest rate controls may have the benefit of improving access to information and making credit affordable to the consumers, it should be noted that it has the effect of limiting access to credit especially by the risky small-scale borrowers. This would eventually lead to the emergence of black markets where credit will be offered under very stringent measures.

Equally, it is important to note that very low interest rates may not cover the overall cost of credit and this may discourage investment in the banking industry which may eventually hamper economic growth. Thus, the government and other stakeholders need to consider other innovative methods that may ease the cost of credit hence lowering the interest rates in the market. The stakeholders should also consider the publication of interest rates by all the commercial banks. This would improve access to credit information and hence consumers will make informed choices. In the long run this will lead to increased competition and low interest rates.

 

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