Interest rate ceiling

An interest rate ceiling (also known as an interest rate cap) is a regulatory measure that prevents banks or other financial institutions from charging more than a certain level of interest.

Research was conducted after Zambia reopened an old debate on a lending rate ceiling for banks and other financial institutions. The issue originally came to the fore during the financial liberalisations of the 1990s and again as microfinance increased in prominence with the award of the Nobel Peace Prize to Muhammad Yunus and Grameen Bank in 2006. It was over the appropriateness of regulatory intervention to limit the charging of rates that are deemed, by policymakers, to be excessively high.

A 2013 research paper asked

The researcher decided that to assess the appropriateness of an interest rate cap as a policy instrument, (or whether other approaches would be more likely to achieve the desired outcomes of government), it was vital to consider what exactly makes up the interest rate and how banks and MFIs are able to justify rates that might be considered excessive.

He found broadly there were four components to the interest rate:-

The cost of funds is the amount that the financial institution must pay to borrow the funds that it then lends out. For a commercial bank or deposit taking microfinance institutions this is usually the interest that it gives on deposits. For other institutions it could be the cost of wholesale funds, or a subsidised rate for credit provided by government or donors. Other MFIs might have very cheap funds from charitable contributions.

The overheads reflect three broad categories of cost.

The overheads, and in particular the processing costs can drive the price differential between larger loans from banks and smaller loans from MFIs. Overheads can vary significantly between lenders and measuring overheads as a ratio of loans made is an indicator of institutional efficiency.

Lenders must absorb the cost of bad debts and write them off in the rate that they charge. This allowance for non-performing loans means lenders with effective credit screening processes should be able to bring down rates in future periods, while reckless lenders will be penalised.

Lenders will include a profit margin that again varies considerably between institutions. Banks and commercial MFIs with shareholders to satisfy are under greater pressure to make profits than NGO or not-for-profit MFIs.

Interest rate caps are used by governments for political and economic reasons, most commonly to provide support to a specific industry or area of the economy. Government may have identified what it considers being a market failure in an industry, or is attempting to force a greater focus of financial resources on that sector than the market would determine.

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