Central bank and commercial lenders clash over review of lending formulae

The Central Bank of Kenya wants the Central Bank Rate (benchmark rate) to be adopted as the common reference point for determining lending rates across the country’s banking sector.

The recommendation puts the regulator at odds with commercial banks, which advocate for the use of the Interbank Rate as the standard benchmark.

In its proposal, CBK argues that the Interbank Rate, while reflective of real-time market activity, is highly susceptible to volatility, particularly during periods of tight liquidity.

The regulator in its call for public comments on the consultative paper on the Review of the Risk-Based Credit Pricing Model, maintains that such instability could undermine pricing consistency and transparency for borrowers.

“CBK proposes the use of the policy rate (Central Bank Rate) as the common reference rate for determining lending rates in the Kenyan banking sector. The Central Bank Rate (CBR), as the common reference rate, reflects the cost of funding to the banks,” said the regulator.

Banks however maintain that using the interbank market rate as the base for lending would see customers benefit speedily from changes in the Central Bank’s policies.

They believe this would work better, especially after limits were set on the interest rates banks charge each other for short-term lending.

However, in the paper CBK says lack of transparency and effective disclosure by banks was identified as a key contributor to high lending interest rates in Kenya.

This was primarily due to limited information on credit products, which prevented the public from comparing and seeking more affordable credit options.

Under the new framework, CBK also introduces a refined structure for determining the interest rate premium, known as "K".

This component will factor in banks’ operating costs associated with lending, the return expectations of shareholders, and the borrower’s individual risk profile.

Crucially, the CBK acknowledges that a bank’s cost of funding may vary from the benchmark rate.

In such cases, banks will be required to incorporate the difference — whether higher or lower — into the “K” premium. These adjustments will be subject to CBK’s review and oversight.

“The lending rates will be determined by adding a premium (“K”) to the CBR. CBK will publish the components of each bank’s lending rate premium (“K”) on its website, the Total Cost of Credit (TCC) website, and in two newspapers of nationwide circulation,” the paper reads in part.

This approach appears designed to directly address longstanding concerns in the sector. Banks have repeatedly cited the cost of funding as a key obstacle in passing on rate cuts to borrowers, despite previous reductions in the CBR.

By embedding funding costs into the premium, the CBK aims to ensure greater transparency and responsiveness in loan pricing.

According to the CBK, the updated model will take effect immediately for all new loans issued from the effective date.

In a phased approach, existing loans will be transitioned to the new model over a period of three months from the same effective date.