Scope of Maximum Interest Rate Regulations (Report of Workshops (1))
Kazutoshi Sugimura *, Masaru Itatani, Masaki Bessho (Bank of Japan)
Research LAB No.17-E-1, March 8, 2017
Keywords: Maximum interest rate regulations; Deemed Interest; Arrangement fees
JEL Classification: D03, D18, E21, G02, K12, K22, K23
Contact: firstname.lastname@example.org (Masaru Itatani)
- Currently the Ministry of Finance.
Statutory provisions regulating maximum interest rates (referred to generally hereafter as "maximum interest rate regulations") employ words that are interpreted to include various payments to creditors such as "fees" in addition to "interest in substance" (i.e. "compensation for the use of principal").
Although this is considered effective in preventing evasion of regulation, it may have the effect of including payments made by parties to financial transactions without any intention to evade these regulations. The Report of the Workshops on "Contemporary Financial Transactions and Their Regulatory Treatment" (2016) (the "Report") explores this issue with regard to the interpretation of relevant laws and legislative actions. The Report refers to economics discourses related to maximum interest rate regulations and clarifies the intent and purpose of such regulations.
In Japan, limits on interest rates are regulated by the Interest Rate Restriction Act (Act No. 100 of 1954) (the "IRRA"), the Act Regulating the Receipt of Contributions, Receipt of Deposits and Interest Rates (Act No. 195 of 1954) (the "Contributions Regulation Act"), and the Money Lending Business Act (Act No. 32 of 1983).
In terms of scope, these laws regulate a broad range of items and do not only cover payments to which parties agree to refer as "interest." In order to prevent any evasion, these laws set out the concept of "deemed interest." For example, Article 3 of the IRRA provides that "any monies other than principal, whether referred to as a reward, discount charge, commission charge, inspection fee, or any other name, which the creditor receives with regard to the lending of money, shall be deemed to be interest; provided, however, that this shall not apply to expenses for concluding the contract and for the performance of obligations."
Furthermore, Article 5-4 (4) of the Contributions Regulation Act provides that except for the types of money listed under each item in said article, "money that the person lending money receives in connection with the loan, whether it is termed an honorarium, fee, or inspection fee or referred to by any other name, is deemed to be interest."
Statutory provisions regarding maximum interest rate regulations indicate that various items (such as a variety of fees) are considered as "deemed interest," in addition to the so-called "interest in substance" (i.e. money and other substitutes paid in proportion to the loan value and the loan period as compensation for the use of principal). Although these provisions are considered effective in preventing evasion, they can be interpreted too broadly and include any money given and received by parties to financial transactions who do not intend to evade maximum interest rate regulations.
It should be noted that violation of the Contributions Regulation Act may result in criminal penalties, the harshest form of legal remedy. Uncertainty over the interpretation of the relevant legislation may have substantial chilling effects on the development of innovative financial transactions. For example, there have been discussions about the legal uncertainty regarding whether fees received prior to loan execution, such as arrangement fees in syndicated loan transactions, are subject to maximum interest rate regulations.
Arrangement fees in syndicated loan transactions are understood as compensation for arrangement services. When an enterprise or investment project is in need of funds, an arrangement service connects such enterprise or project with lenders using various financial arrangements and/or involves the credit evaluation of such enterprise or project.
The legal relationship between a fund borrower and an arranger is understood as a type of Quasi-Mandate (Jun-Inin) contract intended to form a loan syndicate.
As arrangement fees are paid as compensation for arrangement services, which typically consist of operations that can be separated and are substantially different in nature from providing loans, it has been suggested in some literature that there is no risk of defeating the legislative intent of maximum interest rate regulations.
Based on such an analysis, some recent studies have proposed an interpretation which limits the scope of such regulations to "interest in substance" i.e. "compensation for the use of principal" only, and results in maximum interest rate regulations not applying to arrangement fees.
The purpose of maximum interest rate regulations
What is the purpose of maximum interest rate regulations? According to the theory of consumption in neoclassical economics (the life-cycle hypothesis and the permanent-income hypothesis), consumers borrow money to maintain a stable level of current and future consumption, while taking into account of current and future income levels. On such analysis, any regulation that limits a consumer's access to credit may diminish efficiency.
However, behavioral economics may offer a different explanation. In behavioral economics theory, some consumers may borrow excessively based on their preference of "choosing myopic smaller profits over future larger profits (known as hyperbolic discounting)" or based on their irrationality.
In addition, lenders may try to increase their profits by taking advantage of such preference or irrational behavior. The welfare of such consumers/borrowers may be diminished as a result of their own spontaneous decision-making, and they may regret such decisions later. Maximum interest rate regulations may be justified as a form of paternalistic intervention. In other words, maximum interest rate regulations may exclude from the market some high-risk consumers who are unable to borrow at the maximum interest rate or below. Accordingly, as long as social welfare is improved by excluding such high-risk consumers, maximum interest rate regulations may be justified.
Although this theory suggests that maximum interest rate regulations are mainly for the protection of a certain subgroup of borrowers, the maximum interest rate regulations in place are broadly applied regardless of borrowers' attributes (whether or not borrowers may harm their own welfare).
Scope of Regulations
Recently, some studies on the interpretation of maximum interest rate regulations particularly focus on whether certain payments should be categorized as "interest in substance" (i.e. "compensation for the use of principal"). However, in light of the purpose of maximum interest rate regulations as discussed, the scope of such regulations may not necessarily be determined pursuant to the characteristics of "compensation." Rather, based on the understanding that maximum interest rate regulations are aimed at excluding some high-risk consumers from the market, the purpose of such regulations will be more efficiently served when their scope is interpreted as including whatever compensation creditors may receive, regardless of their characteristics.
However, if the scope of maximum interest rate regulations is broader than necessary to achieve this aim, it should be reconsidered. Legislation that excludes some types of transactions for which there is little regulatory need may be a more desirable solution. Such legislation can remove chilling effects on the development of innovative financial transactions.
One possible approach is to exempt transactions in which the borrower belongs to a certain type of business entity, or transactions that exceed a certain value. Some jurisdictions have implemented such legislation. In Japan, the Act on Specified Commitment Line Contracts (Act No. 4 of 1999) offers a good example of this.
It may be difficult to draw a clear line between regulated and unregulated transactions. For example, in the state of New York, when corporate loans became exempt from maximum interest rate regulations, murky practices prevailed where borrower-individuals were forced to incorporate to evade regulations applicable to loans for individuals.
Another approach is to enumerate transaction types which are exempt from regulations. For example, the Act on Specified Commitment Line Contracts provides the exemption for some commitment line contracts with a certain type of borrowers (defined as "specified commitment line contracts"). If clear categories are properly defined, legislation can be used to exempt transactions by enumerating those that are excluded.
This approach cannot completely eliminate all uncertainty as there are unforeseen potential innovative transactions in the future. In addition, even when providing exemptions for transaction types that already exist, legal uncertainty over whether or not a transaction should be regulated may not be entirely dispelled if the legislator fails to clearly define transaction types in the statutory instrument.
Statutory provisions governing maximum interest rates could apply to a variety of fees, leading to legal uncertainty. If the scope of regulations is too broad, legislation can be used to create exemptions for some types of transactions which do not frustrate the intent and purpose of the relevant regulations.
- Report of Workshops on "Contemporary Financial Transactions and Their Regulatory Treatment" (2016), to be included in Kin'yu Kenkyu (Monetary and Economic Studies), Institute for Monetary and Economic Studies, Bank of Japan (forthcoming 2017) (in Japanese).
The views expressed herein are those of the authors and do not necessarily reflect those of the Bank of Japan.