Interest rate controls: A popular tool with potentially important negative consequences

The Covid-19 crisis has led to the most severe economic crisis since the second world war. Since 1870, we have never had a year with so many economies facing a decline in their income per capita. As a result, governments around the world are implementing unprecedented policies to support their economies.

Interest rate controls (IRCs) and other financial repression policies are a commonly used strategy to keep down the cost of borrowing in support of economic activity. Understanding how IRCs are being used is crucial  for policymakers to better assess the tradeoffs of this instrument.

A recent World Bank survey of 108 countries aimed at documenting official IRCs in lending and deposit markets showed a wide use of this tool across regions and countries.

• Which countries have IRCs? A total of 63 countries have IRCs in place, without clear differences between high-income countries and low- and middle-income countries. The share of countries with IRCs remains roughly unaltered when countries are divided according to their law system, though there is relatively higher prevalence of IRCs in common-law countries. Geographically, IRCs tend to be more popular in regions such as South Asia, Latin America, and sub-Saharan Africa.
• What tools do they use? Caps on lending rates and floors on deposit rates are the most frequent types of IRCs. Most of the countries imposing IRCs have ceilings on lending rates, regardless of the level of income of the country, and are typically applied to commercial banks and often to microfinance institutions. Floors on deposit interest rates are mostly used in low- and middle- income countries.
• What are the targeted markets? Limits on lending rates are usually imposed across all business and retail lending products across countries, without difference by level of income of the country. In retail markets, IRCs are mostly applied to consumer loans and microcredit, though in high-income countries these are also applied to credit cards and residential real estate loans.
• How are IRCs set? In most occasions, IRCs are not anchored in a variable reference rate but set as fixed or absolute limits. Half of the countries with IRCs, especially those with lending-rate ceilings, also impose restrictions on administrative and servicing fees, which aim to curtail the ability of financial intermediaries to increase the effective cost of lending
• Why countries introduce IRCs? Consumer protection is the main stated objective of most countries, especially by those with ceilings on lending rates. Financial stability is also a driving factor indicated by many countries, especially among those administering a ceiling on deposit interest rates. Other reasons, such as financial inclusion or strengthening the monetary policy transmission channels are reported by countries setting a floor for deposit interest rates.

The goals mentioned above are valid ones; however, IRCs don’t achieve their intended objectives in most cases. When IRCs are set at binding levels that are out of equilibrium with market rates, they have unintended negative consequences which can leave people worse off and reduce access to financial services. Although market failures may justify government intervention in some markets, the use of IRCs is rarely the right instrument, as they discourage both savings and investment and ultimately impede the efficient risk-based allocation of capital.

A clear example of the unintended consequences that binding IRCs generate, especially when imposed on credit markets, is the reduction in the overall supply of credit. This hits poorer borrowers hardest.  In many countries, the existence of IRCs encourages financial intermediaries to reallocate credit from small, risky borrowers to large commercial borrowers and the public sector, as well as to reduce the provision of financial services to underserved segments and regions.

While full liberalization of interest rates might lead to negative outcomes in countries without the minimum competitive and efficient conditions, it is very important that policymakers choose the right tools to address market failures. An essential first step would be to develop money-market instruments with the capacity to influence the marginal costs of funds of financial intermediaries. Prudential regulation and supervision, as well as consumer protection frameworks, should be strengthened to ensure the resilience of the banking sector to changes in interest rate levels and structure and to protect consumers from uncompetitive practices. The banking competition policy framework would need to be assessed and, if needed, strengthened to ensure market responsiveness to interest rate changes. Finally, distortive government interventions in credit markets would have to be minimized, including reforming state-owned banks and state-owned enterprises.

At first glance, IRCs might seem like an easy fix for keeping costs of borrowing low during a difficult time, but the consequences they might have could be long lasting, with very negative implications for private sector development and overall welfare.  Policy actions should focus on creating vibrant, healthy and efficient financial markets.