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KDI FOCUS Korea’s Maximum Interest Rates: How to Embrace Vulnerable Borrowers during Interest Rate Hikes July 26, 2022

KDI FOCUS

Korea’s Maximum Interest Rates: How to Embrace Vulnerable Borrowers during Interest Rate Hikes

July 26, 2022
  • 프로필
    KIM, Meeroo
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Recently, the benchmark interest rate has continued to rise, and the procurement interest rate of financial institutions has also been rising. However, the legal maximum interest rate is fixed at 20%, raising concerns that those who took out high-interest loans will be pushed into non-institutional finance. Shall we take a closer look?

 Author: Kim Mi-roo, Fellow at KDI  

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#Rate Increase #Legal Highest Rate #Basic Rate #Procurement Rate #CreditLoan
|   Script   |
As the base rate is accelerating, the funding interest rate in the financial sector is rising rapidly.

The funding interest rates refer to the interest paid by financial institutions for their lending to households and businesses.

High-interest lenders, like credit card and capital companies, have increased their funding rate to more than double the base rate.

This increase has raised concerns that households receiving high-interest credit loans near the legal ceiling may be pushed out of the loan market, as many of these borrowers are from vulnerable households.

The legal maximum interest rate was originally introduced to protect them and has since been reduced from 66% to 20%.

And, there are ongoing discussions to further reduce the interest burden on the underprivileged.

Suppose a further decrease in the legal maximum rate.

The scenario shows that a 2% reduction in the statutory rate would benefit 774,000 high-interest credit loan borrowers.

But, banks may become reluctant to grant loans as they will no longer be able to generate profits from these high-interest rate borrowers.

Approximately 659,000 individuals who have borrowed from non-banking financial firms may be driven to seek non-institutional financing, including private lenders.
The size of unsecured loans is estimated to be about 6 trillion won.

And, if you factor in other loans these borrowers already have, there's a possibility of up to 33 trillion won in defaults.

Now, suppose the funding interest rate increases while the statutory maximum rate remains fixed at 20%,

Again, vulnerable households were forced from the loan market.
However, unlike the positive effects of a lowered statutory ceiling in the previous scenario, the increased funding rate did not bring any benefits, such as reduced interest rates for some households

A 2% increase in funding rate may deny access to credit loan for 690,000 households from non-banking financial companies.

This translates to 6 trillion won in credit loans, with total household loan delinquency potentially reaching 35 trillion won when considering all loans held by household

It seems inevitable that an increase in the base rate will result in a rise in the funding rate.
In this situation, a fixed statutory ceiling is likely to bar vulnerable households from obtaining loans.

To avoid these negative impacts, we looked into the possibility of a variable legal maximum interest rate, which would adjust its statutory ceiling rate based on the market interest rate.

By introducing a variable legal ceiling during a 2% increase in the funding rate, nearly 98.6% of previously excluded borrowers would be able to re-enter the loan market.

From the perspective of consumer utility, with a fixed legal maximum interest rate, a rise in the funding rate would lead to a decrease in consumer surplus by about 50,000 won per person per month. But if we switch to a variable legal ceiling, that decrease would only be about 3,000 won.

So, it seems that a variable legal maximum interest rate system would benefit consumers by improving their overall utility.

High-interest rate borrowers are mainly from the vulnerable class and many are multiple debtors, making it difficult to track in real time if they are being excluded from the market since the funding interest rates are highly volatile.

Solving the negative impacts of rising funding rates with policy finance alone has its limits.
With that in mind, it's important to link the statutory maximum interest rate to the market interest rate so that vulnerable borrowers can easily renew their loans, even during interest rate hikes.

Additionally, the government should also continuously support particularly the vulnerable through low-interest policy finance, especially those who have difficulty affording essential goods.


 

※ The provided materials below have been translated into English using computer-assisted translation.

The rapidly rising policy rate is driving up the costs of funds in the non-banking financial sector. Under the fixed legal ceiling of interest rates, higher funding costs may force households who have taken out loans near the statutory limit into private or non-institutional lenders. 

Since vulnerable borrowers with heavy debts from multiple lenders have borrowing rates close to the lawful upper limit of interest rates, the legal cap should be linked to the market rate to protect the vulnerable and facilitate the rollover of their debts. In addition, the government should sustain its efforts to provide financial support for the underprivileged, including low-interest policy financing for those identified as suffering from excessive indebtedness.


I. Issues

Inflation is rampaging the globe, well above the 2% target of central banks in major countries and Korea. In response, the monetary authorities in these countries are aggressively raising interest rates or planning to make a similar move.

Central banks in major countries are accelerating their interest rate hikes in response to rampant inflation. 

Inflation is rampaging the globe, well above the 2% target of central banks in major countries and Korea. In response, the monetary authorities in these countries are aggressively raising interest rates or planning to make a similar move.

Higher policy rates lead to higher funding costs for financial institutions to finance their lending to households and businesses, hence higher interest rates for consumer credit products. In particular, funding costs for high-interest lenders (credit card and capital companies and savings banks) that offer loans with interest rates as high as the legal cap climbs faster than the base rate. As of the end of June 2022, while Korea's base rate rose by 1.25%p (0.5%→1.75%) year on year, the interest rates on credit card bonds and other financial bonds (AA+, 3yr) more than doubled, up by 2.65%p (1.8%→4.45%) over the same period (Figure 1). 

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Of those using high-interest (18-20%) credit loans, 84.8% are vulnerable households, and 48.6% are heavy debtors with multiple creditors. Accordingly, overdue loan payments can ripple through other financial sectors when their rollover is limited.

In other words, the cost of funds, or the interest rate paid by financial institutions to fund their lending, fluctuates as a function of market rates. However, Korea has fixed the legal maximum for interest rates on loans at 20%. Put differently, as the funding rate rises, the spread between the statutory ceiling and funding costs narrows, thus possibly forcing high-interest borrowers out of the loan market. 

The most worrying aspect of this situation is that ‘high-interest (close to the legal ceiling rate) loan users’ are mostly low-income households. [Figure 2] displays the shares of vulnerable households and heavy debtors in different interest rate ranges (as of June 2022). The analysis defines vulnerable families as ‘those in first and second income deciles’ or ‘with poor credit scores (less than 700, bottom 20%)’ and heavy debtors as ‘those with credit loans from three or more institutions. Of households with low-interest loans (not exceeding 4%), vulnerable families and heavy debtors account for 8.9% and 10.8%, respectively, while among those with high-interest (18~20%) credit loans, the respective shares are 84.8% and 48.6%. The higher the interest rate, the higher the percentage of risky borrowers. 

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Accordingly, increasing funding rates will likely displace vulnerable households with low incomes or poor credit scores to private or non-institutional lending sources. Also, given nearly half of them are heavy debtors, limited rollovers can make their late or missing loan payments ripple through other financial sectors. 

Since credit loans from banks have funding rates far below the statutory cap, a lower cap does not bring forth substantial changes. However, this may not be the case for some non-banking financial companies, especially high-interest lenders, such as credit card and capital companies and savings banks, that have charged as high as the statutory ceiling. In line with such observations, this study focuses on high-interest lenders to analyze the impact of lower statutory caps and higher costs of funds under the fixed maximum interest rate system. Based on the analysis findings, it also recommends adopting maximum variable interest rates linked to market rates. 


II. Maximum Interest Rates: Background and Milestones

The statutory rate ceiling is the highest rate of interest legally permitted to charge on loans. Per this single blanket cap, loan contracts with interest rates higher than the maximum interest rate are void, and a creditor cannot claim the amount exceeding the cap. In Korea, maximum lending rates are primarily regulated by the Act on Registration of Credit Business and Protection of Finance Users (Private Lending Act) and the Interest Limitation Act. The former applies to banking and credit businesses, which have been authorized, approved, and registered, and the latter to loan transactions between persons.

The  interest rate ceiling intends to prevent market power abuse by financial institutions and protect low-income earners in the credit market. Frequent market entry and exit by banking institutions may lead to customer mistrust about getting their money back, increasing the likelihood of a massive bank run. In response, the Korean government pursues systemic stability by allowing these institutions a limited level of market dominance based on its power to approve and authorize. Still, there remains a possibility of abusing the dominant position to charge unreasonably high-interest rates on loans, especially to those with weak bargaining power, and maximum interest rates aim at preventing such misconduct. 

Also contributed to adopting the legal cap is, if disregarding the possibility of default, a characteristic of loan markets that lower-income households pay more for the same loan than their higher-income counterparts. Since the probability of default stands higher among those with a lower and unstable income, financial institutions tend to charge higher interest rates on loans to vulnerable households with lower incomes. The maximum interest rate caps the interest rate for the poor and underprivileged. 

In the background of legislating statutory interest rate ceilings, many countries, including Korea, have similar rationales as aforementioned. Korea enacted the Private Lending Act in October 2002 with a legal ceiling rate of 66% under its Enforcement Decree. After seven amendments, the statutory maximum now stands at 20% (Figure 3) after the latest revision on July 7, 2021, from 24%, and further cuts are currently under discussion. 

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The Private Lending Act and the Interest Limitation Act regulate the statutory maximum interest rate for registered banking and credit businesses and loan transactions between persons, respectively. While allowing some market dominance of financial institutions with its control over authorization and approval, the Korean government has adopted the statutory maximum rate to prevent the misuse of their market power and protect low-income persons in the credit market. 

 

III. Impact of Maximum Rate Cuts

Lowering the highest possible rate of interest a lender can charge a borrower brings about mixed consequences for households. On the positive front, some households may benefit from lower rates, especially those paying close to the upper limit. Since they are more likely to be lower-income and financially vulnerable, the rate cut will leave them with more disposable income. 

Since enacting the Private Lending Act in October 2002, the statutory maximum was lowered from the initial 66% to the current 20% after seven revisions of its Enforcement Decree.

On the negative side, lenders charging higher rates will be scaling down the supply of loans, rejecting households that are no longer profitable, especially those with high default risk. Since low-income families are more likely to fail to meet financial obligations in general, the odds of their exclusion from the credit market are high.

Slashing the legal maximum rate has mixed effects, as it can lower the interest rates for some households but exclude other households with low income from the market. 

As a result, the rate cut would create a wide rift between consumer surplus gains of the positively affected and losses of the negatively affected. To further elaborate, credit loans with an interest rate near the ceiling are generally smaller in volume than other loan types like home mortgages. It means the growing burden of monthly repayment due to the higher rate is limited, but, on the contrary, excluded borrowers will see an extensive loss in their consumer surplus. All in all, cutting down the legal ceiling rate leads to a loss in overall consumer surplus. 

Still, overall consumer welfare diminishes since the loss from the disadvantages of the rate cut eclipses the gain from its advantages. 

Against the backdrop, this study examines what happens when the current statutory ceiling of 20% goes further down. Suppose a 2%p cut (20%→18%). As of the end of 2021, about 774,000 persons to whom credit card and capital companies have extended credit will have a lower interest rate, as opposed to about 659,000 borrowers crowded out of the non-banking and pushed into private lending or non-institutional financial sector (left panel, Figure 4). It is because borrowers who could finance with the earlier maximum rate are denied under the new lower cap as they are no longer economically viable for those lenders. 

차트 샘플

Lowering the legal ceiling to 18% would result in about 659.000 borrowers, or the total credit amount of roughly 5.9 trillion won, to informal financing. Without their smooth rollover, overdue loans can amount to 33.2 trillion won, and this tendency worsens as the cap goes further down. 

 In the 2%p cut scenario, the total credit amount of the borrowers forced out to seek private or non-institutional financing is about 5.9 trillion won (left panel, Figure 5). However, accounting for their home mortgages and other loans, the total cost incurred comes to 33.2 trillion won. In other words, the mix of a lower ceiling, the restricted rollover of vulnerable borrowers, and the failure to find alternative financing in the informal sector may lead to overdue loans of 33.2 trillion won (right panel, Figure 5).

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The larger the rate cut is, the faster the number of denied borrowers grows. Suppose a 4%p reduction (20%→16%). Roughly 1.084 million borrowers will have to turn to private or non-institutional financing (left panel, Figure 4). Credit loans held by those borrowers are around 10.8 trillion won, and when including home mortgages and other loans, the total is approximately 55.3 trillion won (Figure 5).

When converting the consumer surplus change caused by a 2%p cut into monetary values, the loss is about 50,000 won per month for each borrower (left panel, Figure 6). The decrease in consumer surplus among the excluded far exceeds the increase among the positively affected borrowers with a reduced payment burden. Furthermore, the greater the legal ceiling rate cut, the greater the loss in consumer welfare. 

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IV. Fixed and Variable Maximum Interest Rates: Impact of Higher Funding Costs

As the maximum interest rate is fixed at a certain level, higher funding costs alone can be enough to exacerbate the exclusion of vulnerable borrowers from the credit market. A rise in funding rates translates into higher costs for financial institutions to acquire funds for lending, driving up the interest rate, which is the price of getting loans. However, borrowers who have already loaned close to the ceiling cannot be charged any higher. Hence, if the lending rate increases beyond a certain point, lenders stop financing some borrowers as it becomes unprofitable, driving them out of the market. 

This section looks further into the exclusion of vulnerable borrowers due to rising funding rates in the non-banking financial sector. The base year for costs of funds is the end of 2021 (2.37%; 3yr credit card bond, AA+), and, as of June 2022, the funding rate has risen by about 2%p since the reference year. The analysis finds that a 2%p rise crowded out about 692,000 borrowers who were once eligible for credit loans through non-bank financing in late 2021 (left panel, Figure 7). Accordingly, the credit loans held by those pushed out of the informal sector stand at about 6.3 trillion won (left panel, Figure 8), and the sum of all loans taken out by those excluded borrowers amounts to 35.3 trillion won (right panel, Figure 8). If they fail to renew their loans through policy financing, private lending, or non-institutional financial entities, overdue loans may amount to 35.3 trillion won. 

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While the maximum interest rate is locked in, even when the cost of funds rises above the set rate, lenders cannot raise rates on borrowers who already have loans close to the cap and thus discontinue their loans due to unprofitability. 

This tendency intensifies as funding costs increase. Another 1%p rise in keeping with base rate hikes will likely force about 970,000 borrowers out of the non-banking sector, for which they were once eligible in the base year, and shove them into private or non-institutional financings. Their credit loans are about 9.4 trillion won, while the sum of all their loans is approximately 49.6 trillion won (Figure 8).

About 2%p increase in costs of funds since the end of 2021 would drive away nearly 692,000 borrowers (6.3 trillion won) into the non-institutional financial sector. If these borrowers fail to roll over their loans smoothly, the total amount of overdue loans may be up to 35.3 trillion won, which may worsen as the base interest rate climbs higher. Variable statutory ceilings can greatly reduce the exclusion of vulnerable borrowers caused by rising costs of funds.

Nevertheless, variable maximum interest rates can markedly reduce the exclusion of the financially vulnerable triggered by higher funding costs. Assuming the statutory ceiling is set as high as the lending rate, most of the vulnerable borrowers to whom lenders would have denied loans because of the rising cost of funds can still access credit services. The variable ceiling can resolve the price rigidity of loans near the absolute legal limit.

Meanwhile, some borrowers have to pay more under the variable statutory ceiling. It is because of instances where the same interest rate level near the absolute legal maximum remains available even after the lending rate goes up. Nevertheless, under the flexible ceiling, their ex-ante loan approval rate increases, improving their average ex-ante consumer surplus at the application stage. Yet, their ex-post consumer surplus, which considers only the surplus after loan approval, decreases slightly. Still, the gain in consumer welfare of the borrowers that the absolute gap would have driven out but retained under the floating cap overwhelms the loss. Hence, adopting the variable ceiling system enhances both the ex-ante and ex-post surplus of all consumers by large margins. 

This study examines a hypothetical adoption of the variable statutory ceiling, given the funding cost had actually increased 2%p since the base year at the end of 2021. Per the analysis, out of 692,000 borrowers that the fixed ceiling would have excluded from the market, 682,000 borrowers, or 98.6%, are given access to the loan market under the variable ceiling system. Also, about 754,000 borrowers see an average increase of1.38%p in loan interest rates, equivalent to about 10,000 won per month, considering that their credit loans in the non-banking financial sector are 9.116 million won on average. 

차트 샘플

The consumer surplus gain for borrowers who acquire market access under the variable ceiling translates to about 309,000 won per month per borrower. On the contrary, the increase in the monthly payment for negatively affected borrowers by the variable cap does not exceed 10,000 won. 

The results show that variable statutory ceilings can immensely improve consumer welfare. As opposed to decreased consumer surplus by roughly 52,000 won per month per borrower when the funding cost falls 2%p under the fixed gap, it is only 3,000 won under the variable cap. That is, switching to floating ceilings boosts consumer welfare by about 49,000 won per month per borrower. Such improvements become more evident as the funding rate increases further. When it rises by 1%p to a 3%p gain from the base year, the increase in consumer surplus driven by the adoption of the variable statutory maximum is estimated at 630,000 won per month per borrower (left panel, Figure 9).



V. Conclusion and Policy Suggestions

The fallout of COVID-19 has hit the vulnerable harder, and many of them have not fully recovered from the economic distress. Despite ongoing struggles, rate hikes are unavoidable due to soaring inflation expectations and the depreciating Korean won triggered by monetary tightening in major countries. The state of affairs may increase lending rates in the non-banking financial sector even higher. Consequently, crowding-out vulnerable households may worsen without tying the statutory gap to the market rate.

Fortunately, the follow-up measures announced by the Korean government, together with lowering its statutory ceiling in 2021, can partially offset the adverse effects of higher lending rates. These measures include expanding policy financing for low-income earners, slashing the upper limit of loan brokerage fees, and reorganizing the mid-range interest-rate loans (Financial Services Commission, Ministry of Justice, and Financial Supervisory Service, Mar. 30, 2021). Among them, policies like lowering the interest rates on Sunshine Loan 17 and a temporary provision of refinancing programs for high-interest (over 20%) loan users may partly alleviate the exclusion of vulnerable families from the loan market due to rising borrowing costs. 

However, since borrowing rates are easily affected by market conditions, it is not easy to monitor the exclusion of borrowers as the lending rate fluctuates. That is to say, policy financing alone cannot address the negative impacts of higher lending rates. For this reason, the statutory ceiling needs to be floating in tandem with the benchmark rate, e.i., the variable maximum interest rate. 

Paying special attention to the fact that high-interest loan borrowers are mostly the underprivileged with low-income or poor credit scores, the government should link the maximum interest rate with the market rate and facilitate the rollover of their debt during rate hikes. Moreover, the government should keep the scope of households eligible for loans constant by maintaining a steady spread between the legal ceiling and the interbank rate and protect those crowded out of the loan market through policy financing or fiscal programs. 

Crowding vulnerable households out of the loan market may exacerbate as the policy rate rises. 

Major countries have adopted maximum interest rates floating with market rates. France classifies loans into 12 groups and calculates quarterly annual percentage rates (APR) for each. Afterward, its central bank announces average market interest rates by group and sets the upper limit with a formula of ‘average market interest ratex1.3.’ This way, the statutory maximum in France is linked to the interbank rate and differs from group to group. Germany and Italy similarly set their average market rates. Germany selects the lower value between ‘average market interest rate×2’ and ‘average market interest rate+12%p.’ Italy follows a formula of ‘average market interest rate ×1.5.’ 

Meanwhile, Brazil employs an equation of ‘base rate (SELIC rate)×2’ in line with its central bank policy (Maimbo and Gallegos, 2014; Ferrari et al., 2018). Also, India reformed its interest rate system in 2014, switching from an absolute cap to a relative cap based on market rates to improve the operational flexibility of non-banking financial companies (NFBC) and microfinance institutions (MFIs) (Ferrari et al., 2018). These countries opt for a flexible approach by adjusting the legal ceiling quarterly based on changing market conditions. 

Because borrowing rates are highly volatile, policy financing alone cannot fully address the negative effects of higher borrowing costs. Hence, it is necessary to help vulnerable borrowers swiftly roll over their loans during interest rate hikes by adopting the variable ceiling system. 

As for Korea, the interest rates of monetary stabilization bonds (1yr) or government bonds (2yr), which have a similar maturity period to general credit loans, can be used as the reference rate for the variable statutory ceiling. While the policy rate as the benchmark is also conceivable, it would be inappropriate because the scale of fluctuations is substantially different from that of the lending rate in the non-banking financial sector. The cost of funding in the non-banking financial sector is also not desirable, considering that financial institutions could directly affect the rate by controlling the demand for funds. 

Korea should consider maximum interest rates linked to monetary stabilization bonds (1yr) or government bonds (2yr), which have a similar maturity period to general credit loans. Fiscal support should be maintained, including policy financing for selected underprivileged households without essential living items or in economic hardship due to growing debt repayment pressure during interest rate hikes. 

As already pointed out, some borrowers will have to pay higher rates if the maximum ceiling changes from fixed to variable, but the principal of their credit loans is relatively small (9.116 million won on average) compared to their home mortgages. Accordingly, subsequent higher rates for getting loans will result in a somewhat limited increase in their monthly repayment (about 10,000won). Despite the small amount, such an increase still burdens struggling households, and appropriate safeguards should be in place. 

There should be continued discussions on the appropriate level of statutory ceiling, and preemptive actions are required using routine analyses of the size of excluded households from the loan market. 

Safeguard measures cover easing the monthly repayment burden by extending loan maturity, policy financing, and fiscal subsidies. For example, Hong Kong and Italy have provided loans with varying maturities for vulnerable households to reduce their monthly payment burden during interest rate hikes, which is worth considering for Korea. At the same time, the government should maintain policy support for those financially underprivileged. Such efforts should include policy financing for selected households with limited capacity to buy essential items or undergoing economic hardship due to growing repayment pressure in times of interest rate hikes. 

Aside from adopting the variable statutory ceiling, there should be continued discussions on its proper maximum level, which come down to deciding the spread between the benchmark rate and the variable legal maximum rate. Narrowing the spread will inevitably lead to curtailing vulnerable households’ access to financial products in the institutional sector. In this regard, it is necessary to analyze the size of excluded vulnerable families under different statutory ceilings and use the findings to determine the preliminary budget for microfinance programs so that proper support will promptly reach susceptible households.
 

CONTENTS
  • Ⅰ. Issues

  • Ⅱ. Maximum Interest Rates: Background and Milestones
  •  
  • Ⅲ. Impact of Maximum Rate Cuts
  •  
  • Ⅳ. Fixed and Variable Maximum Interest Rates: Impact of Higher Funding Costs
  •  
  • V. Conclusion and Policy Suggestions
 
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