CBN caps on Lending and Deposit Interest Rates: An exercise in futility?

Yesterday the Governor of the Central Bank of Nigeria (CBN): Professor Charles Soludo announced that interest rates on deposit and loans in Nigerian Banks are now subject to a maximum of 15% and 22% respectively.

While I am not unmindful of the destabilizing effects of rising interest rates and I fully appreciate the need to put in place measures to stem the trend, I am convinced that this particular measure is an exercise in futility. I believe that one of the lessons the current market crisis has thought us is that bankers can hardly be forced into doing anything, America's Congress has not been able to get banks to increase lending despite the fact that the American Taxpayers are basically responsible for the continued existence.

Nigerian Bankers, and bankers everywhere, are quite famous for acting in their perceived self-interest and for being able to creatively work around regulations that have potentials to reduce their profits. I am sure that by now, each bank will have worked out its strategy of beating the 22% maximum lending rate restriction. What we are likely to see is that each bank will obey the restriction in theory, but will resort to filling their credit offer letters with all sorts of hidden and open charges that will ensure that their lending rates inch up to the rates they will like to lend at (and not what the CBN wants them to lend at!).

Furthermore, the maximum deposit rates of 15% can also be easily breached in practice as banks desperate to attract sizable deposits from their competitors will devise new products that will ensure that they can offer depositors interest rates in excess of 15% and still not breach the letter of the law. For example, instead of offering 180-day fixed deposit products, a bank may simply issue a 180-Day Commercial paper yielding say 18% to a potential depositor. This commercial paper, though technically not a deposit, has the same effect liquidity-wise on a bank. It may even be more attractive to a potential investor since they are discount instruments which do not attract interest payments (which are subject to withholding tax), the implied interest is capitalised and is realised through the capital gains at redemption. Since capital gains are not taxable in Nigeria, the depositor (because that's what he effectively is) will have received tax-free "interest" from the bank and the bank will also have "stolen" depositors from other banks (maintaining 15% deposit rate limits).

In addition to this, the cap will also limit credit creation in the industry, which is a situation we really cannot afford in a slowing economy. For instance, there are quite a number of companies who can still access financing from banks, but they can only do that at high interest rates such as 25-26% in view of the risks perceived by the banks. Setting an interest rate cap (of 22%) may result in banks cutting off credit to these categories of borrowers who may then reduce operations or lay off workers.

In conclusion, I believe reactionary measures such as the one currently being proposed by the CBN will not solve the crisis in the banking sector but only create avenues for "black markets" and rule dodging. Since market forces have pushed up interest rates in our banking system, we need to also find a market-based approach to solving the interest rate crisis not just wish them to stay at a rate through fiat!!.