Why Banks Charge What They Do and How to Get Cheaper Credit – Advice by a Banking Economist

The core mission of commercial banks is to mobilize deposits from economic actors (governments, MSMEs, and households) with excess cash in exchange for a savings interest rate, and to issue loans to economic actors with a shortage of funds in exchange for a lending interest rate. Economists give three motives to explain why households, businesses, or governments seek to hold money: the transactionary, speculative, and precautionary motives.

Loan credit repayment failure risks emanate from two information asymmetries. The first, adverse selection problem, occurs before the borrower signs the loan agreement, as the bank cannot perfectly distinguish between high-risk borrowers (bitter lemons) and low-risk borrowers (sweet oranges). When banks choose to raise interest rates to compensate for the lack of this information, they unintentionally push away low-risk borrowers while attracting high-risk borrowers.

The second, moral hazard problem, occurs after the borrower signs the loan agreement, as they change their behavior and take actions that increase the probability of failing to repay the loan by diverting funds to other purposes, since they know the bank bears most of the downside risk, having already benefited.

Measures and Tools Banks Use to Reduce Information Gaps, Reduce Borrower Costs, and Avoid Rationing Credit

The banks protect themselves from adverse selection and moral hazard information gaps problems through credit rationing, i.e., the banks restrict the amount of credit they issue or raise interest rates prohibitively high, resulting in creditworthy individuals and MSMES being denied loans because they lack collateral security, transparent or transparent record keeping.

Credit Reference Bureaus (CRBs) such as TransUnion, CreditInfo, and Metropol facilitate credit information sharing. Banks insist that borrowers provide collateral for loans to motivate them to behave responsibly.

Also Read: How to Grow Your Small Savings into Big Money Using Mobile Banking in Kenya

Banks also impose strict restrictive conditions (covenants) to harshly penalize moral hazard misbehavior after they get the loan, e.g., limiting additional loans, asset sales, risky investments, and giving or guaranteeing loans.

Violations attract higher interest rates, freezing disbursements or demanding immediate full repayment.

The Components of the Bank Lending Interest Rate – Why Banks Charge What They Do

Banks in Kenya use the Risk-Based Credit Pricing Model (RBCPM) interest rate formula to price their loans depending on the economic sector or credit non-repayment risk of the business or individual. Table 1 below shows the maximum total credit interest costs for three banks.

The first component of the Risk-Based Credit Pricing Model is the base lending rate, with Kenyans using either the stable and predictable Central Bank Rate (CRB) currently at 8.75% preferred by banks and their customers or the Kenya Shilling Overnight Interbank Average (KESONIA at 8.7516 on 17^th June 2026 ), which changes every interbank trading day, subject to a maximum 75% above or below the CBR.

The CBR is normally above inflation to respect the principle of time value of money, which says a shilling today is worth more than a shilling in the future due to the erosion of the value of goods and services the shilling can buy by inflation. The CBR is also normally above the 91-day Treasury Bill rate, which is the lowest risk-free asset banks can buy instead of lending to the more risky MSMEs and households, and thus covers the commercial bank’s cost of funds (the average interest rate banks pay for deposits and borrowed funds).

The second component is the commercial bank-calculated Risk Premium (“K”). This includes the borrower’s unique credit profile/score/rating plus the bank’s operating expenses (staff costs, loan loss provision, depreciation of property and equipment, amortization charges, rent, director fees, and other operational costs), and markup for shareholder returns.

The third component is any legitimate and transparent administrative fees and charges associated with the loan. This includes the Loan Application and Credit Evaluation (LACE) fee, which ranges between 2.5% to 5% of the borrowed amount.

Also Read: How Young Kenyans Can Access Business Loans Without Collateral – Useful Tips by a Banking Economist

Excise duty is set at 20% of LACE. A credit life insurance policy is usually around 1% or less of the borrowed amount.

11 Tips on How To Get Cheaper Credit

1. Compare the minimum and maximum lending rates at the Total Cost of Credit (TCC) website and Annual Percentage Rates (APRs) by banks or 3^rd parties to select the cheapest bank, and then confirm with the bank other fees and charges for LACE, 20% LACE excise tax, and a credit life insurance policy.
2. Compare and negotiate with several law firms or valuers to reduce such costs.

• Choose a reducing balance loan, which charges interest only on the remaining unpaid principal, meaning your interest costs shrink over time as opposed to a fixed-rate loan, which keeps the same interest rate and repayment amount for the entire life of the loan.

1. Have a high, clean credit score or an MSME credit rating to get the lowest risk-based pricing.
2. Loans secured by collateral or guarantors are cheaper than unsecured loans.
3. Build your credit profile by making prompt bill payments and starting with small loans from lenders that share credit information with CRBs to establish an on-time repayment track record.

• Start and deepen your Strength of Relationship (SOR) by routing your salary or business payments through your bank account to build a banking history.
• MSMEs can seek to become payment agents and merchants of banks to access cheaper loans.

1. MSMEs get cheaper cash flow-based supplier loans if they are part of an ecosystem value chain whose loans are guaranteed by an anchor corporate.
2. Banks that have credit risk guarantee schemes offer lower lending rates.
3. Individuals and MSMEs trained by banks on financial literacy and entrepreneurship education enjoy lower lending rates.

Frequently Asked Questions (FAQs)

1. Who offers lower lending rates between banks and fintech lenders? Commercial banks are cheaper for long-term, large-amount loans because of lower, regulated interest rates, while fintechs charge higher daily or monthly percentages for quick personal loans, salary advances, and SME microloans, which, when converted to Annual Percentage Rates (APRs), make for one-to-one comparison.
2. How does a borrower’s Strength of Relationship (SOR) with a bank lead to a lower lending rate? It’s an evaluation that measures the depth (number of products consumed), width (share of wallet), and age (history and duration) of a customer’s connection to the bank, which shows loyalty, offers benefits like waived fees, lower preferential interest rates on loans, and easy access to loans or negotiations.

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