Interest rates on personal lending should be capped by law at 20%
Last updated: March 2, 2017
Team South Africa is over the moon to be proposing this most orgasmic of debate motions ;)
The context is clear: the world is barely emerging from a banking crisis that caused near-irreparable damage in countless local economies, and the international banking system more generally. The causes, and corresponding interventions, are manifold. We are not seeking to identify all the causes, let alone dealing them all a death blow.
We humbly propose to make one useful contribution towards increasing the chances of avoiding similar bank crises in future.
The problem: commercial banks, for prima facie business reasons, are often tempted to give personal loans to clients at high interest rate. This can be unduly risky - for banks, clients & society.
Our solution: banks should legally be mandated to offer loans to their clients at a maximum of 20% interest rate. This 20% is to be understood as inflation adjusted. [ For example, if inflation is, say, 10%, then the interest rate should enable banks to make a [real, not nominal] return on the loan of 20% ... so nominal interest rates under our policy could be higher than 20%, but not so the real interest rate]
Geography: we have in mind this policy being adopted by all countries. In many countries it might be legally or politically tough, but our case is a general one bout why it is DESIRABLE that all countries should succeed in getting such a law passed.
So, let's get on with the justificatory details.
Banks have a dangerous degree of power over the interest rate
The interest rate is a recognition of the risk that the bank takes in (temporarily) parting with its wealth, particularly in light of inflation. The borrower gets some spare cash for immediate personal use, and the lender makes a medium- or long-term profit on their lending. All seems good, right?
Well no, not necessarily, and most certainly not in the current economic climate.
The problem is that banks have dangerous amounts of power. If a lender, or potential lender, is desperate for cash, then banks can hike the interest rate charged on a loan, given their monopoly on bargaining power in such a situation, and the lack of competition in most banking sectors [[http://www.bankingtimes.co.uk/26082009-personal-loan-margins-increase-tenfold/]]. Crucially, it must be remembered that banks are not an homogeneous entity, but a collection of self-interested bankers who make personal profit from giving out high-risk high-interest rate loans.
Invariably it is the poor, or working class slightly above them, who bear the brunt of such an unregulated lending policy, and who are manipulated by self-serving bankers [[http://www.glitec.co.uk/2008/03/interest-rates-on-personal-loans-continue-to-rise/]] [[http://www.glitec.co.uk/2009/04/rates-on-personal-loans-continue-to-increase/]]. Why? The poor represent a 'demonstrable' risk to banks - there is less guarantee that a poor or working class person will repay a loan than a wealthier person. More specifically, the bank has a better shot at legally obtaining outstanding debt from a rich person with assets that could be attached via a court order... than being able to recoup its outstanding debt from a poorer client who has fewer assets. Poorer people also generally have less legal accountability (because they cannot afford to hire lawyers) and thus are seen as easy targets for high return interest rates.
Of course, there can also be high risk present in lending to the rich: the not-so-frugal lifestyle, and business habits, of the rich make even their capacity to otherwise honour a loan, uncertain.
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. While this may be somewhat intuitively fair, three losers will still result from unserviceable and unserviced debts: banks, clients & society.
Banks who cannot make the full return on their loans, courtesy of bankrupt clients, thereby suffer direct economic loss. High interest rates come home to roost. It is not so much the individual banker who loses, but the entire collective.
Clients whose assets are attached suffer direct material, and often concomitant emotional and social, setback. They also get bad credit records that hamper future ability to obtain credit - impacting future financial health, in addition to immediate loss. Over the last few months many thousands of Americans lost their homes because they were bought on unserviceable loans, incurring huge personal loss and emotional trauma.
Society, collectively, suffers: unprofitable banks collapse, driving down credit liquidity (precisely what interest rates are meant to preserve!). Lehman Brothers, Northern Rock, and a number of other American and European banks are now literally history, not least because unserviceable loans were granted. The collapsed, or even partially collapesed, banking systems have resulted in a global recession with grave negative social impact everywhere: job losses, decreases in govt coffers for socioeconomic projects, etc.
So, unregulated lending rates need to end, and we propose that a 20 per cent cap is an excellent measure.
This is, as we said, not the SOLE worry when we think of the current recession. But, as Tesco's motto goes, 'Every little helps'.
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.
A 20 per cent cap is precisely what is required
The motion says 20% because it is in fact a great idea, and here's why.
A 20% cap on the interest rate for personal loans benefit all concerned parties: banks, borrowers & society.
On the part of banks, a 20% cap still enables them to make a decent profit on loans. The economic incentive for banks to offer personal loans is therefore not taken away. Our policy will, at most, influence the SIZE of the loans and the frequency of BAD loans. But that is precisely our policy objective: limiting the magnitude of financial risk being undertaken by effectively encouraging lower, more managable principal amounts to be lent to clients.
In addition, of course, banks have sources of revenue other than personal loans (corporate loans), and these often count for a large slice of their overall income. So banks are not going to be crippled by a policy regulating their personal loans-policy. In fact, banks' financial health is safeguarded by encouraging them and their employees to temper any imprudent risk-taking instincts they may have.
Clients, too, benefit: 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. This can only be a good thing. Obviously, as we intend, a client might now access slightly smaller amounts of personal loan than under systems allowing them to borrow at any rate... but that's okay. In the medium- and long-terms, clients are better served by not getting into a debt spiral. Debt spirals invariably start from clients taking out loans that can often take years to pay back. This is a pervasive problem, affecting countries from South Africa [[http://www.highbeam.com/doc/1G1-175223761.html]] [[http://www.indigenousjournal.com/IIJEASVolIIIss1Mashigo.pdf]] to the USA [[http://bbs.chinadaily.com.cn/viewthread.php?tid=624511]]. So while it may seem immediately gratifying to buy, say, a porsche, and use your house as collateral by taking out a loan with a 40% interest rate, say, in the long term such a client becomes economically less healthy since the budgetary pressures skyrocket when trying to maintain monthly payments. Our policy incentivises, in a creative way, more responsible financial planning, and more prudent behaviour that protects a client from their own penchant to think of now, rather than tomorrow. Long live homo economicus!
Society, finally, benefits too: a society in which the amount of debt held by citizens is as low as possible, with a greater percentage of wealth having been saved, and perhaps even carefully invested, is a society better able to deal with economic crises that might nevertheless result from other, exogenous factors [[http://ideas.repec.org/p/wii/wpaper/45.html]].
This is not to deny the usefulness of consumer consumption for the overall economy's sake: hence the balance we strike by making it economically meaningful for banks to continue with personal loans, but at a capped interest rate.
Everyone wins: banks still make a profit; clients can still ask for loan assistance in times of trouble; and society has a bulwark against the potential effect of uncontrolled, excessively risky, high-interest lending.
How can anyone NOT sign their name to our proposal?!
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.
Our policy balances the free market and state intervention
A benefit of our policy is that it is an illustration of how to get the mix between regulation and hands-off liberalism, correct.
Our policy is based on the ideological conviction that the state has a political and ethical mandate to ensure that social disasters, like economic recessions, are either avoided, or that steps are taken to minimise the impact of recessions that do arise. Given that our mechanism, as already proven, is an effective tool for minimising the possibility, and certainly the impact, of a banking crisis - it is therefore a policy that exhibits responsible government.
Yet, at the same time, the policy falls short of being unduly, and unacceptably, prescriptive. Banks are still left with a fundamental capacity to make autonomous economic decisions within the reasonable constraint imposed by our policy. Thus our policy is consistent with economic freedom, and the recognition of the importance of allowing economic agents, banks included, the space to play freely with each other - ensuring the textbook benefits of economic liberalism, but with a safety valve necessitated, ultimately, by our inherent human capacity to be self-destructively imprudent.
A vote for Team South Africa is therefore a vote for responsible government within a liberal economic frame.
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.
Rebuttal: Understanding the problem outlined by Proposition
Right, so let’s deal with the three points.
First, as we will show later, banking sectors in many countries are *not* competitive and are in fact oligopolies which exhibit collusive anticompetitive behavior. They extract massive profits from clients, and are not in any way a paragon of free market perfect competition.
Second, it is absurd to think that banks do not need to be protected from themselves. The economic crisis has engulfed a number of financial institutions who were implicated as part of the initial problem. The mistake that opposition makes is that they assume: (a) banks are omnipotent, and (b) banks are homogenous. The reality is that banks, just like most businesses, have highly constrained information sources. This implies that they often make decisions that appear silly in hindsight. Banks are also not homogenous, but incentivize bankers to make high paying risky loans. Of course banks need to be protected from themselves – all of the new regulations proposed by the Obama, Merkel and Brown administrations, speak to this fact.
Third, our examples were not intended to show the burgeoning risk of rising interest rates, but to show that the people who are targeted by high interest rates are invariably the poor. That is all! Our argument was *never* that this policy will prevent another Great Depression. We were very explicit right the way through – this is a small issue that affects a small number of cases, but it is a crucial issue in *those* cases.
Furthermore, despite opposition's boasting about 'knowing economics' they evidently showcases the motto, ' a little knowledge is a dangerous thing'. To claim that the point of interest rate is to compensate for the risk of insolvency on the part of a client [ which is correct ] but to then persist that prop's characterisation of the *vulnverability* of borrowers lacking power when both 1) in desperate need to borrow (as in current climate) and 2) being suspectible to whatever interest rates a bank sets, smacks of naivety at best, and dishonesty at worst. It is PRECISELY because the otherwise legitimate aim of compensating for the potential insolvency risk that it may suffer, that a bank can overzeaolusly set unduly high interest rates.
Hence opp's exposition of economics 101, if anything, underscores the legimitacy of the problem that prop's mechanism goes on to solve.
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.
Rebuttal: On contradictions
First, opposition suggests that the real problem in risky loans is incorrect risk assessment. Sure, we concede that in many cases this is the case. Happily our policy does actually help in these cases – if the risk assessment model is wrong, reducing the number of loans at the risky end of the spectrum (20 per cent plus) will reduce the overarching risk problem! More importantly, we know that a lot of excessively risky loans (with very high interest rates) are actually caused by selfish and greedy bankers trying to make money. And here, of course, our policy helps tremendously. It prevents risky loans from being licensed – they *cannot* be made because they are institutionally not viable. Crucially, and we must stress this over and over again, we do not believe that our policy is an exclusive one-size-fits-all solution - it’s part of a bigger solution.
Second, opposition believes that we will be encouraging a society that lives on credit. We have a couple of responses. The first is that this is a cap at 20 per cent, not a cap at 5 per cent – we propose a responsible cap that weighs up the importance of self-set interest rates and the danger of excessively risky loans. The second is that we have stressed, consistently, that we will be discouraging lending, not encouraging lending at low interest rates. And it is here that the contradiction in opposition’s case becomes so evident! In one breath they are arguing both that (a) the number of loans will remain constant at lower interest rates, and that (b) most people will suddenly no longer be able to borrow. Well, which is it opposition? This tension runs throughout their case, and they had best resolve it as soon as possible!
Finally, we are happy to note that the opposition agrees that banks are not harmed by our policy (even if they don’t agree that they are benefited).
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.
FIRST, is there a problem?
SECOND, is the proposed mechanism an effective answer to the problem?
THIRD, are there additional considerations supporting, or militating against, the proposition’s policy proposal?
The problem, as we have consistently argued and demonstrated, is that high interest rates that lead to odious personal debt leave the borrower, the bank, and in the end society, worse off. Opposition’s callous response has simply been that the emotional and financial loss that a borrower would suffer is outweighed by them making an informed choice. This ignores, as we pointed out, the patent lack of effective freedom that destitution – especially in the current economic climate – imposes on a borrower. Knowing you are acting under conditions of perfect information staring you in the face is small comfort when desperation motivates self-destructive financial imprudence.
Opposition also contended that the banks are not facing a genuine problem here at all: they simply accommodate for risk with a high premium. My goodness! Did Team Lithuania not hear of a banking crisis that started, in part, because of unserviced, and unserviceable, debt? Banks, and borrowers, are therefore FATALLY susceptible to financial and emotional (on the part of borrowers) loss in a high interest rate environment. Add to this the 3rd agent in the equation, that not-so-abstract beast called ‘society’, and it is VERY CLEAR that proposition has laid out a genuine, and timely problem: dangerous levels of interest rates that license unjustifiably risky personal loans. So, on this first major point of contention, proposition comes out stronger.
The solution we proposed (note - not the ONLY solution to ALL the economic problems we currently face) is a cap of 20% interest on personal loans. Opposition, fresh from econ 101 lectures on some planet unrelated to the Earth, scoffed at the mechanism on two grounds, if you strip the rest of the theoretical knot of its superflouous density: First, they claimed that banks will lose out because a) they will not lend to anyone and b) they will bemoan their inability to make returns on high risk loans; and second, borrowers of all credit histories will no longer be able to access loans.
These retorts to our mechanism have not outlived the debate round. Two reasons: a 20% cap on interest rates still make lending a profitable business; and it is utter nonsense to pretend that risk profiling will suddenly result in ALL, or even most, would-be lenders coming out not qualifying for loans. Team proposition never once suggested a price-setting system, and, so long as the interest rate remains under 20 per cent, the government will have no input whatsoever into the setting of interest rates. At worst – or best, in fact – the loan conditions, and the magnitude of the loans, will be more prudently set, and negotiated, safeguarding both the long-term interests of banks and borrowers alike.
Last, are there other extraneous facts beyond our core analysis that impact the case? Opp thought so: 1) claiming that even if we made some gains in improving this aspect of banking, this has sweet nothing to do with recessions; and 2) belatedly claiming that, if anything, low interest rates started a recession.
These were desperate attempts to stay in the debate.
First, we EXCPLICITLY stated that we are not pretending to guarantee that our mechanism will prevent another global recession. We claimed, and still do, that we are tackling one of the many elements that drove the recession: irresponsible lending mechanisms. Given that inability to service debt partly led to the US housing market collapse, our contention that the problem in this debate is PARTLY constitutive of the bigger problem – though not wholly constitutive of the bigger problem– is clearly correct.
Second, it is overzealous to remind us that more than one cause led to the crisis e.g. derivatives. That simply ignores a concession we already made in the context-description of the debate some 72 hours agol! Lithuania should have read carefully rather than imputing a false burden to us. What they SHOULD have proven is that our mechanism will not work, or that it will do some harm. Neither of these burdens were ever discharged by Lithuania.
They have categorically failed to show us that: (a) our policy does no good at all, and is therefore a waste of time and effort, or (b) our policy actually does substantial harm to banks, borrowers, or society. Instead they strategically erred by simply proving that we will not make the world a completely better place.
Well, we’re sorry. Next time we’ll try both to win the arguments in favour of the motion, and say something to soothe extraneous fears from Team Lithuania.
For now, we’ll simply take the win and e-march into the inaugural virtual semis!
Interest rates are there for a reason
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.
Banks are profit making machines which automatically illustrates that at best we have a highly imperfect form of competition taking place. In fact, oligopolistic competition often leads to collusive behaviour, as has been seen in a number of cases, such as Ireland and South Africa and many many more [[http://www.breakingnews.ie/business/irish-banking-sector-is-uncompetitive--study-180411.html]] [[http://www.compcom.co.za/banking/documents/Public%20submissions/Dr%20Ian%20Edwards.pdf]]. The banking sector is particularly vulnerable to collusion because it is a natural oligopoly - entry is heavily barred by the need for institutional trust and (usually) government approval.
More importantly, it is not the case that the alleged forces of competition necessarily operate on individual bankers. In fact, it is clear that the opposition has missed the force of the argument. We suggest that bankers (for reasons of personal gain - an unrebutted point) are keen to make substantial loans as often as they can - the point is that excessive high interest rates license the making of these loans. If interest rates are capped at 20 per cent, bankers cannot make excessively risky loans, full stop. Competition really has very little to do with it.
It seems peculiar that in the current climate the opposition can claim that banks are simply controlled by Adam Smith's invisible hand. The credit crisis itself was due to bad loaning; banks and bankers taking excessive risks to gain excessive profits. This isn't a conspiracy theory, it's reality.
Finally, the opposition the number of people receiving loans with interest rates over 20 per cent will be minute. First and foremost, we disagree with this. It may be the case that a minute number of people take 40 per cent interest rates, but 21, 22 and 23 per cent rates are regular occurances for large sums of money. That's exactly why this is an issue.
The cap would impose a burden on people with good credit
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.
(1) A bank might need to charge an interest rate of more than 20 per cent to allow some people to loan.
(2) Instead of just denying these borrowers credit or cash the bank *might* offload the risk on to people with good credit
(3) Those people with good credit will lose out.
The first point is true, and we endorse it fully from proposition. This is exactly what we have outlined from the start - there are many risky loans that need interests rates of more than 20 per cent to be licensed.
The second point is rather silly. First, it contains a very big *might*. The reality is that banks are far more likely to just deny credit. Why on earth would the bank begin to charge regular good borrowers more instead of simply turning off the 'bad taps'? Second, the premise is somewhat inconsistent with what opposition has been shouting about all along - the amazing competitiveness of the banking sector. Assuming but not conceding that opposition is right, banks won't be able to offload risk onto those with good credit records because they will simply lose them to their competitors.
The cap would deprive individuals with bad credit of possibility to borrow
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 reality is that cleanly spelled out theory does not capture the dangers that risky loans have for both the borrower and broader society (that third party that DOES suffer).
First, the state often intervenes when people make bad decisions that have consequences for themselves (drugs, suicide, sometimes gambling, seat belt usage). We do this because: (a) rationality is very hard to prove - when someone is in a debt spiral they are *not* rational, they are desperate and act out of desperation, as our sources show (and actually as the opposition concedes when they say this is a 'last resort'); (b) those people who are making bad decisions become easy prey for people looking to bleed them dry, and thus they need state protection; (c) damages to an individual's life generally have broader consequences for families and friends who are *not* implicated in the decision making process.
Second, there is tangible third party harm - the harm to society that we outlined at the beginning. Risky loaning is dangerous (as the last 12 months have shown - bankers being ABLE to make dangerous risky loans that are never going to be paid back) and undercuts savings.
Third, the opposition's soft support actions (education and information and transparency) are (a) not mutually exclusive with our policy, and (b) unlikely to be able to help - information campaigns have failed, unequivocally, to prevent the massive growth of drug abuse in most parts of the world (and the spread of AIDS/HIV, and the proliferation of gambling addiction, etc etc etc).
Finally, the reality is that people cannot live and survive on credit or loans, and any society that endorses this is bound to run into problems (blossoming debt crises across the world, as we cited earlier). Eventually debt will come back to bite the borrower, sooner or later. The later it is, the more deadly the venom.
Points on proposition's rebuttal to our arguments
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.
The plan leaves out every person without a credit when central bank interest rate is high
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.
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”.
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.
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.
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.