The peak in lending rates was reached in April 1994 when the rates were 32.28 per cent with the spread reaching a high of 16.22 per cent in February 2000. However as the debate rages and as members of parliament think about controls, it is important to put some of the common misrepresentations into perspective.

Lending rates have been going down. One of the main arguments for the recent attempts by the MPs to cap the rates is that lending rates and the spread have been high and rising. Contrary to this opinion and even though the lending rates have been high; they have been going down since 1994 and more gradually since 2003. As a result, the spread between the lending and deposit rates has been going down.

Lending rates had fallen from a high of 32.28 per cent in April 1994 to 13.88 per cent by May 2011. This downward trend is mainly attributed to financial sector reforms instituted since early 2000. Lending rates could therefore be expected to reduce further as financial sector reforms and innovations take root forcing competition in the financial market.

The second distortion in the debate concerns the trends in the deposit rates. Arguments have been made that deposit rates have been going down. A look at the data reveals that deposit rate, contrary to this opinion, have in fact been going up. The deposit rates had risen from a low of 1.96 per cent in April 2004 to a high of 5.75 per cent by November 2011.

There was a brief period of decline in the deposit rates in 2011 which could largely be attributed to the general decline in all interest rates in the market around that time caused by monetary and fiscal policy expansions. However, with the tight monetary policy currently in place, the trend has already been reversed and deposit rates have started to rise again. And interest spreads have been on a downward trend.

The argument that we should instead therefore be making is whether the spreads at their current level is too wide or not. The question is empirical and cannot just be answered by mere comparisons with spreads in other countries, without looking at cost structures in those countries.

The general argument has been that interest rate spreads are wide because the banks earn and want to maintain super profits. But other than bank profits, the arguments most of the time seem to overlook some of the most important determinants of the spread. The determinants we rarely talk about are inflation and inflationary expectations.

The relationship between the spread and inflation is very simple to see. From the monetary side, an increase in inflation will trigger the monetary authority to respond by tightening its policy. The CBK uses, among other tools, the Central Bank Rate (CBR) and the cash ratio to influence monetary policy.

The CBR is an indicator instrument and impacts on the commercial bank lending rates when and if commercial banks borrow overnight from the Central Bank. An increase in CBR is therefore expected to push up the lending rates. An increase in the cash ratio on the other hand during times of inflation means that commercial banks must keep higher proportions of their deposits at the CBK as non-interest-earning reserves.

A rise in cash ratio will force the banks to reduce deposit rates and/or raise lending rates. Raising of cash ratio also leaves the banks with less money to lend and therefore the price of the remaining loanable funds would go up. Inflation that forces a monetary policy tightening therefore inevitably causes a rise in the lending rates and the spread.

When lending rates rise, most commentators forget the role of inflation in the problem. To deal with the spreads therefore, we must tackle inflation. The question then is; how do we deal with inflation? This is mostly a fiscal policy issue that requires more investment in production including irrigated agriculture than a monetary policy issue since inflation in Kenya mostly results from supply constraints. Other factors that problem includes government’s overreliance on domestic debt to finance budget and to a lesser extent asset quality.

Back to profits: In terms of return on assets and return on equity and again contrary to general misconception that Kenyan banks are raking in huge profits, 5-year bank returns on assets (2006-2010) averaged 3 per cent, while returns on equity over the same period averaged 26 per cent, both not very different from the regional average of 2.8 per cent and 22.9 per cent respectively.

Return on equity is almost comparable though this is also much larger for big listed companies compared to that of the banks generally. The question again is whether these profits are sufficient to keep the financial sector stable and inclusive. Trends from the FinAccess survey of 2009 show that formally banked people stood at 22.6 per cent in 2009. Meaning that about 77.4 per cent of the population does not use formal banking as at 2009; which is a disastrous statistic. There is therefore need for banks to continue to invest further to tap into this group for meaningful growth.

And who gets the bank profits? Available data shows that the government of Kenya receives 28 per cent of bank profits in taxes, 46 per cent of profits are retained and re-invested or used for business expansion including opening of new branches while shareholders get only 26 per cent of the profits in direct payments. It does not therefore seem from the data that the bank profits are obscene.

The suggested controls, if instituted will not make the country food secure and therefore lower food prices and lower inflation. The controls will not solve the government’s appetite for domestic debt. They will only lead to retrenchment, credit rationing and stifle growth in the financial sector which has recorded impressive results without controls. The current rise in lending rates is temporary in response to monetary policy tightening. Lending rates are therefore expected to decline as inflation reduces and monetary policy eases.

Dr Oduor heads the Centre for Research on Financial Markets and Policy at the Kenya Bankers Association.