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CHAPTER TWO
LITERATURE REVIEW
2.0 Introduction
This chapter will review past literature written about the study and specifically about relationship between interest rates and loan demand.
2.1 Relationship between interest rates and loan demand
2.1.1Interest Rates
Interest rates, it may be argued, may perhaps be the single most key motivation that influences credit markets and the access to issuance of credit facilities by lending institutions. The Monetary Policy Committee usually sets the benchmark lending rate on a monthly basis, and commercial banks reference this is setting out the interest rates to issue out credit at to the markets. Since the early 1990’s up to August 2016, there was a liberal interest rates regime in the country, whereby banks would determine their preferred basis point above the set out rate by the MPC. However, since September 2016, this has changed, as banks a required by law to set out their interest rates at a maximum of four basis points above the base rate set by the MPC.
2.1.2 Credit Risk
This refers to the risk that arises when a comparison of non-performing loans Vis a Vis the total loans issued is done. Coyle (2000) defines credit risk as the loss suffered due default in the repayment of credit granted to customers, this can be done intentionally or due to one just not being able to pay back what is owed, and according to the terms of agreement. Banks closely monitor this ratio with a view of taking corrective action in cases of adverse outcomes. If the ratio goes up, then banks will raise up the interest rates charged to borrowers in order to cushion themselves against losses, and if the ratio goes down, then banks may lower interest rates. Banks may also limit credit issued out to risky clients when the ratio is high, and may be open to issuing out more credit when the ration is low, thus opening up opportunity to more riskier client’s.
2.1.3 Liquidity Risk
Watanabe (2012) argues that a banks weaker (stronger) balance sheet such as a poorer (greater) capital adequacy and lower (higher) liquidity has a positive effect on the banks’ lending rate, as this may help the bank push down on the rate of interest that will be charged to customers, hence able to attract more customers, issuing more loans as opposed to the vice versa whereby higher rates of interest would draw away customers.
2.1.4 Operating Costs
Were and Wambua (2013) argued out that a rise in the operational expenses and costs of commercial banks will have an effect of driving up interest rates in an effort by the banks to cover up as much of the operational costs as possible. The higher the rates of interests charged, the more potential customers are driven further away, and this may severely limit the amount of credit issued out by commercial banks. When the interest rates lower, demand for credit goes up, and commercial banks may be in a position to issue more credit. Lower operating costs translating to lower interest rates on the other hand will have the positive impact of opening up an opportunity for more customers to access credit facilities, and this will drive up the levels of credit advanced by commercial banks.
Credit drives economic activities usually by enabling businesses, households and other economic entities to have investments that are beyond their cash on hand. Individuals and households are able to do purchasing without having at present all the entire cost of their purchase. Saunders (2010) explains that the driver of economic growth is the demand for loanable funds, as this enables individuals as well as institutions to undertake productive economic activities even when they don’t have enough funds or savings. Governments also seek for credit from both local and international sources in order to fund infrastructure and development projects, as well as to meet other rising obligations. Financial markets are the key providers for credit in any market and economy. They provide a protection to investors, households and governments against urgent and abrupt needs for funds. Financial institutions are central and at the core of the economy as they offer to provide liquidity both through offering line of credit and offering demand deposits that offer withdrawal at any given time.
According to Amonoo et al., (2003), credit helps in the bridging of the gap that may exist between enterprise owner’s financial assets and what may currently be the required financial assets an enterprise. As in most instances there exists an imbalance between the two, then forcing a demand of credit by enterprises. According to Aryeetey et al., (1994), categorization of demand for credit can be put into three; demand that is perceived, potential demand and demand that is revealed. Demand that is perceived may arise in situations whereby enterprises that assume to be in need of finances mention cash as a constrain. On the other hand, Potential demand may arise in instances whereby an imperfection in the markets and institutions make it impossible to actualize the desire for credit. Demand that is revealed is the written application for financial support based on a given rate of interest prevailing at the time of application. Gale (1991) defines effective demand as what lending institutions are willing and able to disburse to borrowers.
There has been a continuous and endless debate on what really is the impact that interest rates have on the level of personal loans advanced by commercial banks and other financial institutions. Besley (1994) argued that loan seekers may face adverse selections occasioned by high interest rates. Financial institutions charge individuals perceived as being of higher risk and higher rates in order to cover for default risk. There are however, those who differ and argue that the rates of interest charged do not have an impact on levels of personal loans advanced or demanded in an economy. According to Aryeetey et al., (1994), the level of interest rates was not a major concern for SME’S seeking credit from financial institutions.
According to Pandula (2011) and Carreira (2010) banks may prefer certain sectors having lower risks and defaults, high growth rates and high cash flows. Lending decisions are highly influenced by the policies and procedures laid down by banks (Burns, 2007). According to Yehuala 2008, borrowers may be put off by lending terms that are too stringent, even when viable investment opportunities are available to them. Besley (1994) indicates that interest rates may end up affecting the average quality of lenders loan portfolios, as well as playing an allocated role in that they may equate demand and supply for loanable funds.
Interest rate restrictions are among the oldest and most prevalent forms of economic regulation (Glaeser and Scheinkman, 1998, 1). Studies about the effects of the regulation to payday loans have been mainly studied in United States, where states can independently regulate the payday markets. Pew Charitable Trusts (2012) have identified three categories of state payday loan regulation. Permissive states are least regulated and allow initial fees of 15 percent of the borrowed principal or higher. Hybrid states are a little more tightly regulated, having rate cap, restrictions on the number of loans or allowing multiple pay periods for borrowers to repay the loan. Restrictive states prohibit or have price caps low enough to eliminate payday lending in the state. Restrictions in United States are not directly comparable to the restrictions made in Finland, but similarities between the regulations of instant and payday loan markets can be found.
Various studies with different viewpoints have been conducted related to interest rate regulation. DeYoung and Phillips (2013) has made an extensive study on interest rate restrictions on payday loan market in Colorado for a seven-year period. Results from the study indicate that the prices of the loans moved towards the price ceiling over time. The strategies in payday loan market changed during the period, from competitive low prices, towards more strategic pricing depending on location and target group. Rigbi (2013) found out in his research that interest rate restrictions do not deliver the outcomes that have been their main premise. Although higher interest rate limits have only slightly increased the interest which borrower must pay compared to cases with more stringent regulation of interest rates (Rigbi, 2013, 23). On the other hand, some of the researchers have discovered that interest rate restrictions have effectively decreased the price of consumer credit (Peterson, 1979, 39-40, Termin and Voth, 2008, 755). Can be said, that the effects of restrictions on interest rate vary, and depend on the severity and the way of implementing the restrictions
Price regulation has been found to affect the supply of credit. DeYoung and Phillips (2013, 144) stated that the reduction of competition is part of the reason of rising prices in certain payday loan markets. In Australia, the interest rate cap based on maximum annual percentage rate of 48 percent, has been found to decrease the number of instant loan providers in states where the cap is in force (Government of Australia, 2011, 59). In addition, The Oregon policy change, entering force July 2007, constrained consumer loans under $50,000, capping the fees and charges of $100 loan to approximately $10, with minimum loan term of 31 days. Six months prior to the policy change, there were 346 licensed loan providers. The number dropped to 105 providers seven months after the change and further to 82, approximately a year after the policy change (Zinman, 2008, 6).
Overall, interest rate restriction has not been found to substantially reduce consumer lending (iff/ZEW, 2010, 238). Termin and Voth (2008, 744) observed in their study, that the stricter interest rate limit creates discrimination among borrowers, favouring high income individuals and cutting off smaller borrowers bearing higher risk. Also, Study made by Villegas (1982, 953) concludes with an argument that by imposing rate ceilings, high-risk borrowers are prevented from obtaining a loan and going into debt. Further, in Zinman’s (2008) study, the before and after activity of lending was compared between Oregon and Washington, where only the first mentioned state implemented the cap. Results of the study show that payday borrowing decreased by 26 to 29 percentage points compared to Washington. Borrowers compensated the payday loans with other, more expensive credits (Zinman, 2008, 10). On the other hand, increasing the rate cap has increased the probability of granting the loan (Rigbi, 2013, 1).
Interest rate regulations do not only affect the availability, but also the product range in the market. Countries with strict interest rate regulation tend to have fewer different credit products in the market compared to countries with looser or non-existent regulation (iff/ZEW, 2010, 231-232). Termin and Voth (2008, 744, 750) discovered that average loan size and minimum loan size increased strongly. Also, preferences towards indirect, such as commodity- related credit increased if restrictions were strict. This is because such credit can be discounted and retailers absorb part of the risk (Peterson, 1979, 40).
Interest and price regulation causes various effects in the credit market. In many cases, effects are dependent on the regulatory approach. Low and moderate regulations may end up non-existent, whereas highly regulated market can cause significant changes. Especially in instant loan market, the pressure for regulation is enormous. Borrowers in the instant loan market have been found to be vulnerable and the products very expensive. Nevertheless, interest rate restrictions regulate the amount lenders can charge from the borrowers, considering the credit risk the borrowers may have. Regulations define if the market is profitable and in worst case scenario, small loans cease to exist.
The consumer loan portfolio of Finnish households was about 14 billion in August 2015, of which the share of short-term loans was around 100 million (Suomen Pankki 2015, SVT 2015). Short-term financial need is usually fulfilled by using credit card or instalments, since getting a small loan from a bank might be time consuming and not available for everyone. Short-term loans were invented to fill that gap, to provide the small financial aid which was troublesome to obtain. There is no official legal term for short-term loan in Finland, but among legal scholars and legislators the definition of Määttä (2010, 265) is used where the short-term loan is quickly achievable, unsecured, less than three months, minor consumer credit, and which is attainable via internet or text message. The amount of short-term loan is typically from around 20 euros to couple hundred euros, and the price is based on fixed costs rather than variable interest rate. Obtaining the credit through computer or mobile devices is easy and fast, and the loans are not bound on buying commodities. Depending on the amount of loan and payback time, the annual percentage rate varies from around 200 to over 1000 percent (Valkama, Muttilainen, 2008, 14). In terms of annual percentage rate, short-term loans are very expensive compared to conventional consumer credit. Before the interest rate cap, the average APRC of short-term loans averaged 920 percent (HE 78/2012).
Credit card is considered as a form of consumer credit granted by the bank or financial company. The amount is unsecured and starts from one thousand euros, which the consumer can use to pay the bills. Depending on the lender, the cost of credit varies. The cost consists of the credit interest including the reference rate and the marginal, annual fee, and billing fee. Payment of the loan is possible in installments or in full by the due date of the credit. The interest rates of credit cards vary from less than ten percent to a few tens of percent (Suomen rahatieto, 2017).
To obtain a credit card, the consumer should be adult, have fixed income and no payment default entries. (Danske bank, 2017)
Another way to finance short-term needs is through hire purchase. Hire-purchase refers to a system by which one pays for a commodity in regular installments from which one or more of the installments is paid after the commodity is handed over to the customer. Further, the seller has reserved the right to take back the commodity or hold the ownership until the commodity is paid (CPA, 38/1978, 7:7). Pricing in Hire-purchase is similar to the one in credit cards and the requirement for fixed income is common.
Municipalities in Finland have voluntary option to give social credit to inhabitants. The purpose of social credit is to prevent economic exclusion, over-indebtedness, and encourage independent living. Target group for this service is low income, underprivileged individuals, who are otherwise excluded for getting a reasonable loan, but who can pay back the social credit (Ministry of Social Affairs and Health, 2017, Makkonen, 2010, 118). Considering the financial situation of municipalities, cost of credit and the amount of work required to provide such services, the target group of social credits is narrow. Social credit should be considered as a part of social security rather than free financial markets.
Closely related product to short-term loans is called a payday loan which is popular in United States. In traditional payday loan, the borrower will write a future dated check to the lender. For example, a check for 235 dollars in exchange for 200 dollars, which the borrower gets in advance. Usually the period for the check is two weeks or until the borrower’s next payday, when the lender gets the borrowed amount back and a reward of 35 dollars. In many cases, the borrowers pay only the financial charge, renewing the loan for another two weeks. Similarities to the Finnish short-term loans are that the loan is granted fast, it is unsecured and for a short period, and high annual percentage rate of charge. Unlike the short-term loans in Finland, payday loans are usually acquired from offices, or in other words, pawnshops. Payday lending is a relatively new business: At the beginning of 1990s, there were less than two hundred payday loan offices but in 2001 the number was already about 10000 (Caskey, 2002). Similarities among the products of consumer credit are short time period, pricing strategy and the use of the product. Social credit is very limited form of credit and available only for few people. Credit cards and hire purchases require fixed income, and in many cases an assurance before it is granted. That is why they cannot be considered as a direct alternative for instant loan. Compared to more traditional form of consumer credit, instant loans take advantage of technology, which makes the granting and taking a loan simple and fast.
2.2 Conceptual Framework
Independent Variables Dependent
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Variable
Figure 2.1: Conceptual Framework
Summary of Literature review
It is evident from the review of literature that much has been done on the issue of interest rates and their relationship to levels of credit issued and commercial banks levels of non-performing loans, locally and internationally as well.
For example, Njenga and Wanyoike (2014) studied of the effects of risk factors on unsecured loans, while the research done by Were and Wambua (2013) focused on factors that are bank-specific, and which play a major role in the determination of a bank’s interest rates spread.. Kimutai and Jagongo (2013) focused on what influences commercial banks in Kenya on credit rationing.
