APR Caps Often Have Unintended Side-Effects

Jun 14, 2019 | Banks & Credit Unions, News, Online Lending

Earlier last year, economists from the World Bank published a report entitled, “Interest Rate Caps: The Theory and the Practice.” It finds that capping interest rates not only reduces average lending rates, but often has other adverse and unintended side-effects, including reduced price transparency and lower credit supply for society’s most vulnerable residents.

The report relies on the Global Microscope on Financial Inclusion database from the Economist Intelligence Unit, which includes detailed interest rate information on 55 emerging and developing countries. The authors also use data from central banks and federal regulators to gather interest rate information for another 42 countries, bringing the total number of countries analyzed to 97.

Overall, the authors found that capping interest rates can reduce the cost of credit and limit predatory practices by certain lenders, but interest rate caps often have adverse and unintended side effects, including “increases in non-interest fees and commissions, reduced price  transparency, lower credit supply and loan approval rates for small and risky borrowers, lower number of institutions and reduced branch density, as well as adverse impacts on bank profitability.”

When countries set interest rate caps below market value (i.e. lenders would lose money when lending under the rate cap), financial institutions typically increase non-interest fees and other costs for the loan. Without such fees, lending would stop altogether since financial institutions would lose money when lending under the rate cap. Although lending will continue with the increase in non-interest fees, it will lead to reduced price transparency, meaning it is now more difficult for consumers to understand the cost of a loan than before the rate cap.

Setting interest rate caps below market value will also reduce credit supply, especially for society’s most vulnerable, high-risk borrowers. Although this may seem obvious (i.e. an increase in price leads to a reduction in supply), proponents of APR caps often do not understand that reducing access to credit does not reduce the need for credit.

Still, policymakers can set high interest rate caps, which could lead to beneficial results, including limiting predatory practices. However, it is important that the interest rate cap is above market value, allowing reputable lenders to still profit from lending.

Rather than setting APR caps which often have such detrimental impacts on society, the authors of the study proposed several alternatives to interest rate caps to lower the cost of credit, such as fostering competition in the financial services sector, and promoting  credit bureaus and the use of alternative data that can help lenders better understand a borrower’s risk profile, which could also lower interest rates.

In the end, policies that cap interest rates often have adverse impacts that outweigh the benefits, leaving a society worse off than before the rate cap. Policymakers should seriously consider alternatives to rate caps when considering ways to reduce predatory lending.

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