CHAPTER ONE
1.0 INTRODUCTION

1.1 Background of the Study

The banking sector plays a critical role in the economy. The banks play a financial intermediation role where they act as intermediaries between the net savers and net borrowers. The Financial sector acts as a link between those with excess finances and those with financial deficits. The banking sector is a key sector of any economy worldwide. According to Mushtaq and Ahmed (2016), the banking sector is the backbone of any country’s economy and size of bank deposits are the major tool of success for banking sector. A bank is a commercial entity in the business of borrowing money at a lower rate and lending the same at a higher rate to make or generate income. The profits and cost incurred is denoted by the margins between the two rates (Were &Wambua, 2014).
To sustain their operations and pay returns to shareholders, banks charge interest rate (Miller, 2013). Interest rates is a key monetary tool that can and has been used to spur economic growth or achieve desire economic goals in most economies. When the government seeks to enhance economic growth, it incentivizes the commercial banks to lower their interest rates and thus enhancing liquidity in the economy which promotes credit access and consequently economic performance. In times of inflation, the government through its regulatory arm, increases interest rates which reduces money supply and consequently achieve macroeconomic goals and objectives.
One of the expected benefits of financial liberalization in recent times and maturing of the financial sector is the reducing of the interest rate margins and spreads, i.e. the rates charged on money loaned out to borrowing customers and what is paid out on interest earning accounts (Were &Wambua, 2014). Were and Wambua found that the same is based on the understanding that financial liberalization increases efficiency and competition in the financial sector. Therefore, Were and Wambua argued that a wide margin between the deposit and the lending rate indicates to an inefficient financial environment and also reflects the level of financial development.
In free and liberated markets, the government often allows market forces of demand and supply to regulate and set interest rates. Nevertheless, in some occasions governments often set interest rates ceilings and floors to attain set macroeconomic goals and objectives. Some of the objectives that can prompt governments to introduce interest rates ceiling and floors. Miller (2013) posits that these reasons could include: the need to support industrial growth in cases of market failure, in cases of information asymmetry, moral hazard or adverse selection. Other reasons that could prompt interest rates caps include where information in the market make it impossible to differentiate high and low risk borrowers (Miller, 2013).
Interest rates caps often lead to market distortion leading to adverse biases by banking institutions where the focus on providing credit to low risk clients which culminates in financial inefficiencies in the intermediation process (Ramsey, 2013).Ramsey further notes that interest rate caps often lead to discriminatory behavior by commercial banks where those who desperately need financial assistance are locked out due to their perceived high risk (Helms &Reille, 2004). Another consequence of interest rates caps is the introduction and rise of alternative lending platforms and avenues. Furthermore, interest rates caps could lead to commercial banks focusing on other low risk ventures such as non-funded incomes, withdrawal of the commercial banks from the market especially those perceived to have high default risk (Helms &Reille, 2004).
The world over, governments have utilized interest rates caps as a strategy towards achieving set economic and monetary policy objectives. In Japan, interest rates caps were implemented under the Capital Subscription Law at a maximum of 20% from 29.2%. This was aimed at enhancing access to credit by Japanese SME’s. The directive ordered by the Supreme Court decision was initially opposed by commercial banks who felt that it would lead to losses in the banking sector. Nevertheless, reports by the financial services agency showed otherwise with the banks reporting profits in excess of 1 billion yen (Honda& Kuroki, 2006).


In most African countries, interest rates ceilings have been implemented with varying degrees of success and failure. Nevertheless, it has been the government’s argument that the implementation of interest rates ceilings was a result of high interest rates charged by banks and the need to spur economic growth. Reports by World Bank in a study by Djibril (2013) showed that over 17 countries in Sub Saharan African countries had introduced interest rates caps in one way or another. In the West Africa Economic and Monetary Union block, the interest rate ceilings introduced in 1997 was reduced by 3% with a maximum of 15% for commercial banks and 24% for Microfinance institutions. The interest rate caps were introduced in the countries of Chad, Congo, Equatorial Guinea and Gabon. In Sub Saharan Africa (SSA) (Were &Wambua,2014) most countries still experience double digit interest rates despite structural adjustment reforms having been initiated and undertaken by them which led to interest rates liberalization in the region among several countries.