Opposition Summary

1) The first “big” issue that the government raised has been that banks posses a significant market power and thus can set unreasonably high interest rates for personal lending. However, interestingly, all the 3 sources that have been as some “hard evidence” only indicate a substantial increase in personal loan interest rates. However, by no means do they state that this increase has been determined by the lack of competition in the banking sector. Indeed, on the opposition side we have repeated again and again that a vast amount of empirical evidence indicates that the banking sector has all features of a healthy monopolistic competition. Here is yet another source supporting this idea by stating that: “for all 23 countries considered, estimations indicate monopolistic competition“1. Certainly, we do concede that banking s may not be characterized by perfect competition, because it is a theoretical concept, which doesn’t exist in reality in any industries. However, the existing level of competition is sufficient to prevent banks from setting unreasonably high interest rates, thus the first big concern raised by the government falls. Furthermore, we have shown that even if competition is not sufficient in some cases, a much better way to address this problem is to regulate margins. Why is it so? Ultimately if the government imposes cap only for those loans with interest rates higher than 20% (substituting only a very small fraction of all loans), the remaining 98% of all loans are still unregulated and subject to monopolistic behavior (if such thing generally exists). This problem is gone once you start regulating the margins. Even more importantly, high interest rates alone do not indicate that a particular bank enjoys a substantial market power and thus puts on excessively high margins. Notably, interest rates are determined by a vast array of other “legitimate” factors, which may make the interest rates high yet still making a bank operate under very thin margins. Given the latter observation, in addition to our claims about sufficient competition, we have presented a thorough analysis of the determinants of interest rates. The first and the foremost of them, is the default risk of a borrower. Indeed, the government has agreed that bankers give “high-risk high-interest rate loans“, thus conceding that high interest rates are a compensation a bank gets for the risk it assumes while giving the loan to customers with low credit rating. In addition to this compensation for probable default, a bank charges premiums for other risks involved. They include liquidity risk (currently banks hoard liquid assets, because they are afraid that too many borrowers will default, leaving the bank illiquid), solvency risk (a possibility that the value of a bank’s assets may drop below its liabilities). Furthermore, one needs to understand that rates of commercial banks move in accordance with the base interest rate set by the Central Bank. Finally, given the macroeconomic situation banks may simply decide be more cautious and thus become more risk averse, which means that they may require higher return for the same amount of risk. The government has to take all these factors into account when determining the reasons behind the increase of interest rates, rather than just naively concluding that they rise due to “a dangerous degree of power that banks have”. *** 2) The second “big” claim the opposition makes that banks, by issuing loans with interest rate above 20%, take up excessive risk, which makes them bankrupt thus causing wide spread economic crises (like the current one). In other words, the government tries to pursue a mission of “protecting banks from themselves”. We have huge problems in finding the needed logical links in order to believe this claim. The first link the government failed to explain has been how and why banks take up excessive risk. Trying to support it they stated that a bank is not “a homogeneous entity, but a collection of self-interested bankers who make personal profit from giving high-risk loans“. However, they did not provide any anglysis of how and why such perverse incentives appear. We tried to help the government by claiming that theoretically there might have been corporate governance problems (such as inappropriate reward system), which may have incentivized banks managers to act not in the best interest of the shareholders. However, we have three things to say on that. First, most corporate governance problems happened because it was very hard to objectively determine the value of complex financial instruments that certain bank divisions were playing with. Thus, it was much easier for evil self-interested employees to escape the oversight of their shareholders. Personal loans are totally because they are far less complex, easier to control. Second, the imperfections in internal control mechanisms of banks, just call for their improvement, rather than regulation of how much risk banks should take. Indeed, it is very unclear how capping interest rates would help to solve the problem. The notion “excessive risk” is a very relative term. For one institution a very little risk in absolute terms may be already “excessive”, since that institution doesn’t have a high risk bearing capacity. On the other hand, for other institutions giving loans to very risky customers (with interest rates well above 20%) is not a big deal, since they have sufficient reserves, diversification opportunities, high percentage of capital etc. If incentives do not change, than excessive risk in certain institutions can be take even when issuing loans with interest rates well below 20% Third, and most importantly, the government disregards the fact that banks actually have very strong incentives not to engage into imprudent lending, since it threatens to their very existence. And if there are “evil” employees who do not abbey to this overriding goal, than it is primarily in the banks interest to discipline them. Actually, if the banks thought that their employees have such perverse incentives and capping interest rates was an effective policy to deal with it, they would implement such policy themselves. The second link that the government failed to provide is this: Even if we conceded that bakers issue high risk loans solely due to their own profit seeking interests, it is totally unclear how such loans could play a role in causing economic crisis (such as we have currently). The cause of current financial turmoil was the over-leveraged miscalculations of extremely complex (read: incomprehensible) derivative financial instruments. Lehman Brothers and the Northern Rock did not collapse due to miscalculations of personal loans; they collapsed because little was known about these new instruments. Personal loans are not complex and therefore easier to value. Besides, they constitute very small part of banks’ loan portfolio. Even if the valuation system for the loans is wrong, it would be wrong also at interest levels below 20%. If the contract is valued at 5% while the real risk is 7%, the bank then takes *excessive* risk and can still lose massive amounts of money. If the valuation system works quite well, as we contend, there is no need to arbitrarily cap the rates to reduce ‘excessive’ risk taking. Finally, we argued that the government‘s intention to reduce interest rates in order prevent further is theoretically faulty. It is because low interest rate is exactly causes excessive borrowing, thus creating economic bubbles, explosion of which leads to severe recessions. *** 3) Finally we would like to touch upon the micro-level of this debate – the individuals involved. The government told that is usually poor people who take high interest loans and that those people sometimes end up in debt spirals. As a way to help those people, the plan would, most likely, remove high interest loans from the market. What the government did not tell us is why the benefits of removing high interest rate loans from the market outweigh the cost of removing the product. In fact, we did not hear much about the benefits. We have shown that quite often borrowing at high interest rate for individuals with bad credit rating could be a choice of last resort. Namely, people take small credits not for lavish expenditure, but to sustain themselves and their family by being able to buy such necessities as food or pay a flat rent. For these reasons the opposition is reluctant to limit the ability to choose a high interest loan. People make cost-benefit analysis and decide whether to take a loan. We say that this is fair enough, even, as in any other area of life, they could make more informal decisions if they were more financially savvy. *** Generally, the government had to prove that a significant market failure exists and thus the intervention is needed. They failed to do so on all ground they have attempted. First, they did not establish that high interest rates are currently charged due to significant market power the bank posses. Second, they did not show that banks are indeed in need of being protected from excessive risk taki and that capping interest would be an effective tool to do so. Finally, on individual level, the government did not convince that benefits of restricting individual choice would be so much higher than the harms imposed by reducing the opportunities for people to obtain the needed funding.