Interest Rate Capping and Commercial Banks’ Lending to Private and Public Sectors in Kenya

Kenya liberalized her financial sector in the 1990’s allowing the cost of capital to be determined by the market forces. This led to interest rates that were higher in Kenya than her peers, a general perception that commercial banks were exploiting borrowers and that credit was too expensive. The interest rate capping law was enacted in September of 2016 to correct this situation. The expectation was that the capping would ensure cost of credit remained low thus increasing financial inclusion and reducing the perceived exploitation by commercial banks. However, the capping of interest rates may have had negative unintended consequences on the level of lending to both the private and public sectors. In fact, the interest rate capping law was reversed in the year 2019. This paper set out to establish two objectives. The aims of this study were to first determine how interest rate caps affect commercial banks’ lending to the private sector and then to determine how they affect commercial banks’ lending to the government. The study used the Autoregressive Distributed Lag and Vector Error Correction Model estimation methodologies in a time series analysis before and after the rate capping in order to accomplish these goals. Lending to the public and private sectors was one of the study’s dependent variables. The Central Bank Rates, interbank rates, interest rates, inflation rates, and Treasury bill rates by the Central Bank of Kenya were the independent variables that were employed. The results of the study showed that interbank rates had a negative significant influence on private sector credit, while Treasury bills and central bank rates had a positive significant impact. The research additionally demonstrated that interest rates have a significant positive influence on the quantity of loans made by commercial banks to the private sector; hence, the rate-capping rule had an effect on this lending. Furthermore, during the post-interest rate capping law era, commercial banks’ lending to the public sector was significantly influenced by Treasury bill rates and private credit. The study’s policy recommendations said that, given the strong correlation between interest rates and private sector credit, steps should be taken to guarantee that credit from commercial banks is easily accessible in order to prevent the public sector from becoming overshadowed. Furthermore, while rate caps help the public sector borrow money, the government should implement policies that diversify borrowing sources so as to avoid hurting the private sector and promote economic growth across the board.