Interest rates on personal lending should be capped by law at 20%

On the opposition’s side, Team Lithuania is more than happy to oppose the motion.

The contention that the banking sector suffers from a lack of competition is completely out of reality. It is based on the premise that evil bankers will exploit consumers, because they have monopoly power over lending. While we certainly agree that the interest rates have risen recently, it has happened because banks are less secure about the solvency of the borrowers. Since the borrowers are more likely to default in current economic conditions, the bankers have to charge a risk premium to compensate for possible losses. This has nothing to do with competition – in fact, competition in the sector is so strong so that it has driven the interest rates down recently despite poor economic outlook – it is supported by the source which proposition has showed to us to prove lack of competition (and there is completely nothing about the lack of competition in there) [[http://www.bankingtimes.co.uk/26082009-personal-loan-margins-increase-tenfold/]]. The whole notion that competition is weak is really absurd when you just look around and see what is happening around: an average country has many commercial banks, credit unions and similar financial intermediaries whose purpose is to lend money.

We are quite nice, so we agree with some of the statements of the proposition, for instance, this one: “It seem, on the face of it, that banks have a plausible right to compensate for this risk by charging risky clients high interest rates.” But we certainly disagree with the superficial analysis that proposition makes when trying to prove how the cap would benefit all of the stakeholders.
1) The notion that banks suffer from making loans to high-risk customers does not make sense. If it were so, they would simply not give these loans. They charge interest rates which reflect borrowers’ probability of default. If one defaults, bank will not be in trouble, because it will be offset by other clients who repay debt.
2) The claim that a person suffers emotionally when she defaults on her debt is arguably true. However, by capping the interest rates you would simply take away opportunities from people, because banks will not lend to them at all – the expected return will not be enough taking into account the default risk. Just having this opportunity to borrow can be very valuable for some people – so valuable, so that they would be willing to take the risk of being emotionally and financially harmed later on in case something bad happens, and as a government you do not have the moral right to deny the individual her right.

We also want to point out that the whole government’s line in the debate simply does not make sense. They identify the current economic crisis as the problem. Then they contend that by capping interest rates on personal lending to 20% further crises could be prevented. Note that there is absolutely no logical link here; at least government has not provided us with any mechanism how the cap would reduce the possibility of the economic crisis. And since we know quite a bit about economics, we think that there is no link indeed. The government’s whole statistics show increasing interest rates in recent times. Here they mix up causes and consequences. They see rising interest rates now and think that capping them would help to prevent crisis, while actually to understand how to prevent crisis one should go back to the past and examine policies at that time. We see that in the US the interest rates (federal funds rate) were held at extremely low levels, arguably inducing unsustainable lending [[http://www.bankrate.com/brm/news/fed/fedchart.asp]]. The majority of the economists agree that this was one of the main reasons of rising house prices and consequent boom and bust. Another reason, obviously, was abundant use of financial derivatives which were not valued properly, because they were very complicated financial instruments. Also, the amount of personal loans with interest rate over 20% is small and it could not have a strong impact on the economy even if we believed that there is some link between the two (and we do not believe that anyway). Arguing that high interest rates charged by the banks caused the crisis is an original idea, but also a weird one and we do not see why we should believe it.

We see a contradiction in the government’s line of thought. They claim that the policy shall reduce incentives for excessively risky lending to take place and yet the policy they propose is capping the interest rate, which does not deal with the source of the problem. If excessive (unjustifiably high) risk is taken, it comes primarily from incorrect risk assessment models. If the model is wrong, then at ANY risk level the results are incorrect and therefore pricing of any risky contract is incorrect. Take the Long Term Capital Management [[http://papers.ssrn.com/sol3/papers.cfm?abstract_id=169449]] funds or the infamous credit default swaps – they were mispriced because the formulas did not incorporate the factor of “things getting way worse”. If excessive risk problem exists, capping is not the way to reduce this problem. The cap may reduce the number of “bad” high interest loans, but the very fact that those “bad” loans are made possible would point to deficiencies in the system and would require other policy measures.

The government also draws a bright picture: in their happy low-interest-kingdom people will pay less interest on their loans and therefore will be better off. Just like in the Soviet Union, where prices were artificially low, but there was deficit for most things. In reality, most people would be prevented from getting the loans in the first place. Government fails to understand that loans for different people, as well as different maturity, are different goods. A $2k one-year personal loan cost less for a lawyer for an unemployed bachelor, because their ability to repay differs substantially. The proposed policy would just remove risky personal loans from the market and thus effectively deprive the bachelor from taking the loan. We believe that it is the person who should assess her willingness to pay for a debt, not the government.

We agree that debt spirals are not the most pleasant thing to be in, but more importantly we acknowledge that individual should be able to make a free choice of taking such a risk unless she harms someone else. For instance, we do allow people to gamble in casinos although it also poses potential harms to them.

Also, the government is confused about the effect of interest rates for the economy. High interest rate is exactly the factor that prevents people from lavish spending, because they impose tangible costs. On contrary, lending at low interest rate (what government is exactly promoting) is what actually encourages people to live on credit, spend more; just because they know that it’s so easily accessible. As mentioned before, economic bubbles are exactly caused by abundant bank lending and lax monetary policies of governments. An example of sub-prime mortgage crisis: People took such loans because they offered low interest rates in the beginning (two-three years). Afterwards, such loans could be refinanced with yet other ones that again offered low interest rates at the beginning of repayment period. If there was no scheme that allowed offering low interest rates to people, no sub-prime lending would have taken place. Although the cap per se does not promote more borrowing (this is proven in our first substantive argument), the government is completely mistaken that it will allow people to borrow more cheaply.

Lastly, here we also agree with the govt on some points! Yes, banks could stay afloat with the cap. Yes, society benefits from careful investment – this is true by definition. However, how the plan will increase the investment levels remains unknown.

Claiming that a policy is good just because it encompasses both free market ideas and government intervention is ridiculous. We evaluate policies by making cost and benefit analyses – when the benefit of the policy exceeds the cost of it, we implement it. Whether it is a free market policy or an interventionist policy is irrelevant.

We have proven that crises and caps on personal loans are not related in our rebuttal to the first proposition’s argument, so the main benefit the plan would allegedly bring is inexistent. We will elaborate on the costs that this policy would impose in our substantive case.

Many things have to be clarified about the competitiveness of the banking sector. First, we never said that the banking sector is characterized by perfect competition (which is a purely theoretical concept and we cannot find ANY examples of it in real life). However, we contended that competition is present and it drives the behavior of banks. That competition is present is supported by what we can see around us. Generally interest rates that we observe are low; so are bid-ask spreads. Take a random country and you will find a lot of commercial banks operating in it. The banks promote themselves via various means, you find new bargains available to you, the range of products they offer is wide (various types of deposits, etc.). Of course this is not a perfect competition where every bank is a homogeneous entity, but it is impossible to have it anyway.

We could argue to which extent the financial sector is competitive for ages. We could question a very strange document, referenced to us by proposition in their rebuttal to our first point, which rhetorically asks us: “Is it not possible to offer a qualitative banking service to all South Africans without any bank charges?”. We could give our own references about the competitiveness of the banking sector. It would take ages and neither side would prove anything, at best, we could agree on the extent to which a sector is competitive in each particular country in comparison with another country or another industry, because there is no such thing as an absolutely competitive industry.

The important thing for the debate is that even if we accept the notion that banks are very uncompetitive entities, it is not clear why the cap of interest rates should be preferred over the regulation of margin, which is the standard practice of regulating industries with weak competitive forces, or some other regulatory measures. Ultimately, if you put a cap of 20% on private loans, probably some 98% of all loans are still unregulated and subject to monopolistic behavior since the bankers are so evil and can exploit you. This problem is gone once you start regulating the margins, which is a more sensible approach to the problem.

The proposition seems to be convinced that pricing of high-risk personal loans is such a big rocket science that banks cannot possibly value them and they need to be prevented from doing that. Even if we accept the premise (banks are stupid), it remains a mystery why exactly loans for private customers should be capped. Their plan implicitly assumes that banks are smart enough to value loans for corporate clients (at any risk level) and low-risk loans for private clients. Why high-risk private loans are so different and what is so complicated about their assessment, we do not know. If they are different because they are given to poor people (which does not change the valuation part), proposition’s plan does not help them in any way – it simply denies these people the opportunity to take the loans in the first place (as is proven in our first substantive point).

To prove that banks are stupid, the proposition uses the current economic turmoil as an example. We certainly agree that banks are not omnipotent (nobody is) and they make mistakes. However, using the current crisis as an example is not the best idea ever. The main reason for the crisis was the widespread use of financial derivatives whose risk was difficult to assess. Since these derivatives were a new thing and they had complicated payoff schemes, banks and other financial institutions did not possess the adequate tools to value them and made mistakes. The point here is to understand that valuing a financial derivative whose value depends on another financial derivative which, in turn, is dependent on a mortgage pool that was valued poorly by a third party (a rating agency) is quite a dodgy thing, especially taking into account that you have not done this before. However, valuing a loan for a private customer when you have been doing this for ages is not such a big rocket science. If bankers cannot do this, they cannot do anything.

If the proposition does not think that their plan would prevent another crisis, perhaps they could avoid statements like this: “We humbly propose to make one useful contribution towards increasing the chances of avoiding similar bank crises in future.” Now it seems that the proposition started the case with one idea (or no clear idea at all), but once it did not work out, they started to change the direction of the debate.

First and foremost, we do not agree that banks use incorrect risk assessment models for high-risk private loans (as is proven in our previous rebuttal). Furthermore, even assuming bad risk assessment, your proposed model deals with a very small amount of loans because others would still be made with bad assessment, so it is not clear why to limit ourselves to such a small part of all loans.

We are extremely content that the proposition benefited from our Econ 101 lessons and finally acknowledges that their cap would prevent risky (but not excessively risky) loans from being made, because previously (in their second argument) they claimed that “by capping the interest rate on a principal sum, the total amount of money a client repays the bank, will be less than it otherwise might be”. Knowing this contradiction, we can easily explain why they think that we are contradicting ourselves. Since the proposition so sincerely believed that their policy would allow poor people to pay less in interest, we simply outlined that low interest rates in general stimulate spending, which is contrary to what they wanted in the first place. We never believed that this policy would encourage credit taking – we simply pointed out that by believing that once you cap interest rates, risky loans will be made at these rates, the proposition would be implicitly promoting more borrowing (although that would not be successful). We explicitly stated that the cap per se will not promote borrowing and we are happy to repeat that once more. Hence, the proposition sees contradictions in our line just because they are unable to see their own ones.

Since this is an economic debate, we believe that as an opposition we have a duty to clarify several things about the basics of economics since it was not done properly by the proposition.

First, what determines interest rate? Reading government’s case one could get a false impression that evil bankers exploit consumers and charge as high interest rates as possible. Sure, conspiracies are fun, but this is very far from reality. In essence, interest rate reflects transfer of consumption possibilities over time. If you want to consume now although you do not have the wealth now, you have to borrow against your future income. In frictionless world, that would be it. Since there are risks involved in our world, there are premiums that have to be charged additionally. For instance, when a borrower can default, she will be charged a premium. Let’s take an example. As a lender, you want to have a real return of 5%. You lend 100 dollars for a person with no probability of default with 5% interest rate, because expect her to repay with 100% confidence – and in the end the interest rate will bear you 5% real return. However, if a person has a 50% probability of defaulting, you have to lend to her 100 dollars with 110% interest rate! Because 210 dollars taking into account the 50% probability to get them is exactly 105 dollars. Additionally, there could be other premiums – for example, for inflation or currency risk. If we take a look at current economic conditions, the interest rates are high because they reflect high liquidity risk. Banks hoard liquid assets, because they are afraid that too many borrowers will default, leaving the bank illiquid. So, risk is essential in determining the interest rate for a loan and even the proposition acknowledged that (“banks are … a collection of self-interested bankers who make personal profit from giving out high-risk high-interest rate loans.”). Now what ensures that bankers do not charge any arbitrary amount for their loans? Competition! Banks and other institutions compete very much against each other to offer the best possible deals for the customers – the deals which would still be profitable for them in the end and would cover their cost of capital.

The most possible consequence of the cap on interest rates is loans not being given for people who would have more than 20% rate. On the side of the proposition there was an assertion that “Our policy will, at most, influence the SIZE of the loans and the frequency of BAD loans”. The assertion is completely out the blue and was not supported with any reasoning why it should influence only these things. And we have quite strong evidence to believe otherwise, and here’s why. You don’t have to be a genius to figure out that loans with very high interest rates are given for people who cannot report any source of income or accumulated wealth. Furthermore, these loans have very small notional amount, because when a customer defaults, the financial intermediary would still have some chances of recovering losses (because the notional amount was relatively small). Lending large sums of money with interest rate over 20% to people with no income and wealth is an economically disastrous decision and will never work out – for this reason nobody does that. So, let’s say there is a group of customers who possess a default risk that is reflected by 40% interest rate. It is still beneficial for the bank to lend, because while some people will default, others will pay back with 40% interest, and the profits generated will be enough to cover the cost of capital. Once you cap the rates to 20%, the return on the loans would not be sufficient so as to cover for the cost of capital when some people start defaulting. The proposition might claim that reducing the interest rates would decrease the risk of default. This would be just unsupported rhetoric – if lending at 20% would be also financially beneficial, it would have been made already due to fierce competition in the lending sector. We do not deny that there might be exceptional cases where the cap would only reduce the size of the loan (e.g. when the customer has quite a lot of assets), but taken at the face value, the cap would simply deny the loans to individuals.

On the side of the opposition we believe that it is beneficial when banks are able to set the interest rates freely. Since the lending sector is characterized by intense competition, it ensures the most efficient pricing of assets. Those who have good credit can have loans at low interest rate, while those possessing bad credit have to pay extra for their risk. This encourages market discipline – as an individual you will be striving to improve your record over time to get better borrowing conditions. The pricing mechanism has been like this for quite some time and has been efficient – pricing of personal loans is relatively easy.

Once you introduce the cap, there will be a burden on clients with good credit. It should be realized that the most likely real case when interest rates may be above 20% is that of short term borriwing when using credit cards. Very often, the agreement implies that the credit card interest rate changes whenever client’s credit worthiness changes (could be decided upon various objective factors such as repayment of other loans, loss of employment, salary decrease). Such flexibility is indeed crucial because it allows to evaluate the default risk of a client whenever she decides to take a credit. Potentially there are customers whose credit worthiness may drop to such extent that they should be charged more than 20% interest rate. Once the cap is put (according to the government’s plan), the banks won’t be able to charge approapriate interest rate to ofset the high level of default risk. As a result, two scenarios are likely to occure. First, if agreement allows, a bank may simply deny lending to its customer (consequences of this scenario are analysed in the argument below). However, under second scenario, it is very likely that banks may not be able to throw their existing credit card users away and should provide them with a possibility to borrow. If the banks are not able to charge enough so as to reflect the risk, they will have to charge somebody else to compensate for potential losses. As a result, the averege interest rate charged from all customers will be increased. This will affect people with good credit, the ones who have been prudent and careful in spending.This is exactly the scenario that could be observed in insurance industry, whenever an insurance provider is not allowed to have full flexibility in setting different level pricing for customers having varying levels of risk. We do not see this as fair; in fact, we see this as especially unfair, because prudent behavior is punished and imprudent is rewarded.

We find it very important that it is not the state, but the individuals who make decisions about their future, because they are the ones who know the most about their own situation and circumstances. We consider that people are able to make rational decisions and they should be allowed to do so in this case. Consider a person who wants a loan for some purpose, but has a very bad credit history and very few valuable assets at her disposal. There are plenty of banks, but none would lend anything to him at lower than 30%. It is not because of the greediness of the bankers, it is because her profile is extremely risky and risk needs to be compensated with a higher return. But as long as the person rationally agrees to borrow on this rate we do not find any reason why the government should forbid this exchange, because she is the one who can most accurately weigh the benefits of the loan with comparison to the financial and emotional costs of defaulting.

The state could interfere here if there would be tangible third party harm, however, in a lending contract there are only two sides – one side borrows what another side lends. We find that it is completely up to these people to determine any price for the lending (which is interest rate) since any case have different risk, maturity, and number of other factors. In addition, high interest rates deter excessive borrowing; therefore, it would never boost any bubble or cause another sub-prime mortgage crisis, as was previously alleged by the proposition. High interest rates serve for contraction purposes and allow economies to get to their fundamental values. There is no third party harm here, whatsoever.

Instead of limiting a choice by banning some options state may ensure that more information is provided for individuals. In the case of quick credits sometimes people are just not aware of the interest rate they will be paying. So the government could increase transparency and allow individual people to make more informed decisions. For instance, regulations could require explicit statement of absolute amount of interest. Also, it is a good idea to require all loan companies to clearly show annualized interest rates in their advertisements to avoid any confusions.

Finally, we contend that sometimes borrowing at a high rate for individuals may be a choice of the last resort. For example, a person needs a small credit for basic needs: food, rent and to be able to take care of her family. The pay for her job is due only in a week so short term loan despite the high interest rate is simply the best choice. If interest rates are capped, then that person would not get a loan, since her risk profile does not correspond to the interest the lender gets. We see both parties – both the lender, and the borrower worse off in this case.

– The proposition claims that we did not tackle their point that the bankers (ant not the banks) are interested in making excessively risky loans. However, they themselves failed to present it properly. They did not explain the mechanism how such perverse incentives appear and how they lead to excessive risk taking. More importantly, the government did not show how high risk taking may make banks go bankrupt and consequently cause economic crisis. On contrary, we claim that it is not high risk taking but the miscalculation of risk and thus setting insufficient required return.

Even if we agreed that perverse incentives to take to high risk exist among banks’ employees and high risk taking may be harmful, it is just a good enough reason to improve control mechanisms preventing such behavior. Indeed, corporate governance should be tackled first – for instance, creating a pay mechanism for management which would not encourage excessive risk taking sounds like a good idea (bye bye, executive stock options). If we accept the proposition’s premise that the bankers are taking excessive risks, putting a cap of 20% on interest rates is not a solution to the problem – they will continue taking excessive risks as long as the underlying incentives arising from poor corporate governance remain.

However, the imperfections of internal control mechanisms is not a sufficient reason for the government to intervene by imposing arbitrary limits on how much risk an institution can take. Indeed, risk bearing capacity of a financial institution depends on a number of factors such as amount of reserves, leverage etc. As a result, “one size fits all” idea can not be applicable in this case as the government believes.

We want to emphasize that banks are in a much better position than the government to evaluate how much risk they should take and can bear. The whole purpose of financial intermediation is to allocate scarce resources spatially and over time. We create banks, because they are more efficient and they are capable of allocating these resources. We create them, because due to their size and diversification capabilities they are able to manage high risk, unlike single individuals. Prudent management of high risk projects/loans has a high societal value, and we appreciate that – it allows people to borrow, creating value for them. On the other hand, the government doesn’t really posses the knowledge of how financial resources could be efficiently allocated. The cap will lead to suboptimal outcomes, by preventing financial institutions, who can bear higher risk, from doing so while at the same time restricting individuals from access to financial resources.


– The rebuttal to our second point is just a short version of our own argument with emphasis on other points. Sure, we agree that the banks might deny credit and that this is most likely. Our main point is that due to already present contractual agreements they might not be able to do so; hence, transfer the costs on clients with good credit.

– It is true that we believe that individuals are capable of making the best decisions on their own. However, we never demanded educating people. The proposition was implying with their case that individuals are not capable of making wise decisions and should be prevented from doing that. We simply proposed a handy list of alternatives that are so much better than restricting people from a free choice. We never demanded them being implemented.

– While making the rationality analysis, the proposition neglects the positive effects of loans to individuals. The fact that the individual wants to borrow automatically implies that she expects the benefit from the action to outweigh the costs. We do not see any single reason why the individual should not be able to borrow 100$ now to return 104$ a week later after she gets her monthly pay. In this case the transfer of consumption possibilities is very valuable: the person bought food for the money. Consumption of food, unfortunately, is not very transferable over time which sort of makes it a priority.
Just because some people were unfortunate enough to get into debt spirals is not a sufficient reason to deny the possibility to borrow for other people. Since the decision is made under rational mind (the individual is not intoxicated, furthermore, the decision is not addictive – as are drugs and gambling, which are given as an example by the proposition), she knows best about possible gains and possible consequences of the loan that she is considering taking.

– Third party harm is not sufficient here. We can find negative “broader consequences” of something in each and every action. Emergence of a new business hurts incumbents. Technical innovations leave people temporarily unemployed. A claim that proposition’s case in the debate is not very strong might hurt their feelings. However, we allow all these things, because we generally value the right of people to act freely when there is no direct tangible harm to the third party. If the proposition is so keen on intangible harms for the society, perhaps they could consider revising their plan, because denying the loans can force individuals to get money from not so legal sources (stealing), which is also a harm for the society.

In modern economies, central banks have a high degree of power over the interest rate in the economy. By being able to manipulate the money supply, they can either decrease or increase interest rates in the economy. If the central bank of a country pursues a very contractionary monetary policy to control inflation or for another reason (high real interest rates and high inflation are not mutually exclusive), the obvious result is that the base interest rate in the economy will be very high. One needs to understand that rates of commercial banks move in accordance with the base interest rate (ceteris paribus). The commercial banks can either put deposits into central bank and enjoy high interest, or give out commercial loans that would need to have higher interest rates (more risk as compared to the deposit within the central bank). As the base interest rate approaches 20%, the banks will be automatically prevented by giving out any loans to customers of any risk and they will put everything into deposits within the central bank.

Even if we would accept the notion that banks should be controlled, a more reasonable approach would be to control the spread between central bank interest rate and personal lending. Our example includes central bank interest rate approaching 20% which occurs quite rarely. However, a situation when the base interest rate is 1% at one period and 6% in the next period is more than common. Hence, the clients that have a risk profile which approximately corresponds to 20% interest rate will be sometimes eligible to take loans and sometimes not. So, if a person got a loan of 20% when base interest rates was 1%, she will not be able to get it anymore when it will be 6% (25% would be required for her riskiness). In these cases getting a loan depends simply on economic conditions in a country.

1) The first “big” issue that the government raised has been that banks posses a significant market power and thus can set unreasonably high interest rates for personal lending. However, interestingly, all the 3 sources that have been as some “hard evidence” only indicate a substantial increase in personal loan interest rates. However, by no means do they state that this increase has been determined by the lack of competition in the banking sector.

Indeed, on the opposition side we have repeated again and again that a vast amount of empirical evidence indicates that the banking sector has all features of a healthy monopolistic competition. Here is yet another source supporting this idea by stating that: “for all 23 countries considered, estimations indicate monopolistic competition“1. Certainly, we do concede that banking s may not be characterized by perfect competition, because it is a theoretical concept, which doesn’t exist in reality in any industries. However, the existing level of competition is sufficient to prevent banks from setting unreasonably high interest rates, thus the first big concern raised by the government falls.

Furthermore, we have shown that even if competition is not sufficient in some cases, a much better way to address this problem is to regulate margins. Why is it so? Ultimately if the government imposes cap only for those loans with interest rates higher than 20% (substituting only a very small fraction of all loans), the remaining 98% of all loans are still unregulated and subject to monopolistic behavior (if such thing generally exists). This problem is gone once you start regulating the margins. Even more importantly, high interest rates alone do not indicate that a particular bank enjoys a substantial market power and thus puts on excessively high margins. Notably, interest rates are determined by a vast array of other “legitimate” factors, which may make the interest rates high yet still making a bank operate under very thin margins.

Given the latter observation, in addition to our claims about sufficient competition, we have presented a thorough analysis of the determinants of interest rates. The first and the foremost of them, is the default risk of a borrower. Indeed, the government has agreed that bankers give “high-risk high-interest rate loans“, thus conceding that high interest rates are a compensation a bank gets for the risk it assumes while giving the loan to customers with low credit rating.

In addition to this compensation for probable default, a bank charges premiums for other risks involved. They include liquidity risk (currently banks hoard liquid assets, because they are afraid that too many borrowers will default, leaving the bank illiquid), solvency risk (a possibility that the value of a bank’s assets may drop below its liabilities). Furthermore, one needs to understand that rates of commercial banks move in accordance with the base interest rate set by the Central Bank.
Finally, given the macroeconomic situation banks may simply decide be more cautious and thus become more risk averse, which means that they may require higher return for the same amount of risk. The government has to take all these factors into account when determining the reasons behind the increase of interest rates, rather than just naively concluding that they rise due to “a dangerous degree of power that banks have”.

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2) The second “big” claim the opposition makes that banks, by issuing loans with interest rate above 20%, take up excessive risk, which makes them bankrupt thus causing wide spread economic crises (like the current one). In other words, the government tries to pursue a mission of “protecting banks from themselves”.

We have huge problems in finding the needed logical links in order to believe this claim.

The first link the government failed to explain has been how and why banks take up excessive risk. Trying to support it they stated that a bank is not “a homogeneous entity, but a collection of self-interested bankers who make personal profit from giving high-risk loans“. However, they did not provide any anglysis of how and why such perverse incentives appear. We tried to help the government by claiming that theoretically there might have been corporate governance problems (such as inappropriate reward system), which may have incentivized banks managers to act not in the best interest of the shareholders. However, we have three things to say on that.

First, most corporate governance problems happened because it was very hard to objectively determine the value of complex financial instruments that certain bank divisions were playing with. Thus, it was much easier for evil self-interested employees to escape the oversight of their shareholders. Personal loans are totally because they are far less complex, easier to control.

Second, the imperfections in internal control mechanisms of banks, just call for their improvement, rather than regulation of how much risk banks should take. Indeed, it is very unclear how capping interest rates would help to solve the problem. The notion “excessive risk” is a very relative term. For one institution a very little risk in absolute terms may be already “excessive”, since that institution doesn’t have a high risk bearing capacity. On the other hand, for other institutions giving loans to very risky customers (with interest rates well above 20%) is not a big deal, since they have sufficient reserves, diversification opportunities, high percentage of capital etc. If incentives do not change, than excessive risk in certain institutions can be take even when issuing loans with interest rates well below 20%

Third, and most importantly, the government disregards the fact that banks actually have very strong incentives not to engage into imprudent lending, since it threatens to their very existence. And if there are “evil” employees who do not abbey to this overriding goal, than it is primarily in the banks interest to discipline them. Actually, if the banks thought that their employees have such perverse incentives and capping interest rates was an effective policy to deal with it, they would implement such policy themselves.

The second link that the government failed to provide is this: Even if we conceded that bakers issue high risk loans solely due to their own profit seeking interests, it is totally unclear how such loans could play a role in causing economic crisis (such as we have currently).

The cause of current financial turmoil was the over-leveraged miscalculations of extremely complex (read: incomprehensible) derivative financial instruments. Lehman Brothers and the Northern Rock did not collapse due to miscalculations of personal loans; they collapsed because little was known about these new instruments. Personal loans are not complex and therefore easier to value. Besides, they constitute very small part of banks’ loan portfolio. Even if the valuation system for the loans is wrong, it would be wrong also at interest levels below 20%. If the contract is valued at 5% while the real risk is 7%, the bank then takes *excessive* risk and can still lose massive amounts of money. If the valuation system works quite well, as we contend, there is no need to arbitrarily cap the rates to reduce ‘excessive’ risk taking. Finally, we argued that the government‘s intention to reduce interest rates in order prevent further is theoretically faulty. It is because low interest rate is exactly causes excessive borrowing, thus creating economic bubbles, explosion of which leads to severe recessions.

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3) Finally we would like to touch upon the micro-level of this debate – the individuals involved.
The government told that is usually poor people who take high interest loans and that those people sometimes end up in debt spirals. As a way to help those people, the plan would, most likely, remove high interest loans from the market. What the government did not tell us is why the benefits of removing high interest rate loans from the market outweigh the cost of removing the product. In fact, we did not hear much about the benefits. We have shown that quite often borrowing at high interest rate for individuals with bad credit rating could be a choice of last resort. Namely, people take small credits not for lavish expenditure, but to sustain themselves and their family by being able to buy such necessities as food or pay a flat rent. For these reasons the opposition is reluctant to limit the ability to choose a high interest loan. People make cost-benefit analysis and decide whether to take a loan. We say that this is fair enough, even, as in any other area of life, they could make more informal decisions if they were more financially savvy.

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Generally, the government had to prove that a significant market failure exists and thus the intervention is needed. They failed to do so on all ground they have attempted. First, they did not establish that high interest rates are currently charged due to significant market power the bank posses. Second, they did not show that banks are indeed in need of being protected from excessive risk taki and that capping interest would be an effective tool to do so. Finally, on individual level, the government did not convince that benefits of restricting individual choice would be so much higher than the harms imposed by reducing the opportunities for people to obtain the needed funding.