A 20% Cap on Mortgage Rates Will Cause a Shortage

Today a friend asked me: "I hear banks are halting mortgage lending?" I said I didn't know, but that it would be perfectly logical, given that the regulator recently capped mortgage rates at 20%.

Only a free market can determine a market price. If prices are capped, the result is a shortage of the good. Later, as soon as price controls are lifted, the price of that good rises, because supply has shrunk in the meantime.

For banks, the interest rate is the cost of the money they trade in, and the laws of economics are the same for every industry: it makes no difference whether it is a bank or a telecom company. Accordingly, when a price is capped, a shortage of supply emerges.

The cost of money in Kazakhstan is heavily distorted by regulation. Banks buy money very cheaply because they enjoy state privileges, which I have written about many times. The ban on paying interest on current accounts effectively gives banks money for free, which they then sell to the market at market rates. Foreign-currency deposits are also subject to a 1% price cap, so banks get another cheap input that they resell at the market price. This allows them to earn unjustified sums thanks to the regulation of the price at which they buy resources. As a result, the average funding cost of second-tier banks is indeed significantly lower than the market cost of money, and the regulators can see this.

The government's thinking on this issue is most likely based on the idea that banks have access to cheap resources (thanks to free current-account balances) and can therefore offer mortgages at up to 20% per year, since over a long horizon the base rate will fall and, overall, the banks will make money on these loans. I disagree with this logic, and I will try to explain how banks think.

In pricing, banks are guided not by margin and funding cost but by the market cost of money, which the National Bank sets through the base rate. Through the base rate, the National Bank determines the price at which it withdraws liquidity from the market. This is the risk-free cost of short-term money, and banks will not lend money to the market below it, because they have a guaranteed buyer of money in the National Bank.

At present, the National Bank buys money at the "base rate minus 1%, which equals 15.5%." For second-tier banks, a 20% ceiling on mortgages creates a price constraint. To the 15.5% price, banks will add at least 2% as the cost of risk, which is the expense they will incur because of bad borrowers. Banks will then add operating costs (including the costs of the MRP-based items), which also come to 1-2%, and whatever remains will be the margin. In the end, the cost price for a bank is 18.5-19.5%. That leaves banks with an additional margin of only 0.5-1.5%, which is very little. Banks will have no incentive to put their scarce short-term resources into such a product when consumer loans are available at higher rates, and those loans also eliminate liquidity risk and interest rate risk.

Another problem is that second-tier banks have no long-term liquidity, because Kazakhstan has neither long-term deposits nor long-term bond programs. Banks will therefore in any case base their cost calculations on the cost of short-term money. Even if we assume that the base rate will decline in the future, banks are very conservative in their decisions and always rely on worst-case scenarios, which means that the base rate may not only fall but also rise. Without long-term fixed-rate liquidity on their balance sheets, banks will not take on interest rate risk on loans.

We can thus see that caps on rates, both on attracting money and on selling it, lead to huge market distortions and create huge imbalances, and other sectors of the economy suffer as a result. That is why it is so important for the country to have market mechanisms in pricing.