Korea sees growing calls for reform in maximum legal interest rate

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There are growing voices that South Korea should introduce a sweeping reform in the country’s system that limits the maximum legal interest rate to 20 percent, which was set two years ago.

There were concerns at the time of the cut on July 7 2021 about market distortions as the statutory maximum interest rate was lowered to a level that was in line with the lending rates of institutionalized lenders and the disruption has continued across the financial sector.

The negative effects have become evident across the financial sector, especially during periods of significant increases in market interest rates.

Critics argue that the current method of determining the maximum legal interest rate, which is susceptible to political influence, needs a complete overhaul.

Recent policies on private mid-rate loans announced by the Financial Services Commission highlight the adverse impact of the detached maximum legal interest rate.

According to the regulator, interest requirements for private mid-rate loans in the second half of this year are set at an annual rate of 10.5 percent for mutual financial institutions and 17.5 percent for savings banks.

The policy aims to increase lending to individuals with moderate credit standing. Loans meeting the specified requirements receive incentives through relaxed regulations, and interest requirements are adjusted semi annually based on market borrowing rates.

However, the interest requirements remain unchanged for mutual financial institutions and savings banks, despite their substantial increase in borrowing costs.

Considering the steep rise in banks’ borrowing costs, mid-rate loan interest rates should rise, potentially exceeding the maximum legal interest rate. But current limitations prevent such adjustments.

Authorities find themselves unable to increase the limit on mid-rate loan interest rates due to the fixed maximum legal interest rate of 20 percent.

The controversy surrounding illegal private lending is a significant consequence of the existing maximum legal interest rate.

As borrowing costs rise, private lenders and savings banks, which require interest rates higher than 20 percent to generate profits, are compelled to halt lending due to the statutory maximum interest rate.

A report by the Korea Institute of Finance released in February titled, “Analysis of Changes in Loan Users after the Reduction in Maximum Interest Rates in 2021,” estimated that between 18,000 and 38,000 people were excluded from the institutionalized loan market and resorted to illegal private finance in the year following the end of June 2021.

As market distortions persist, many argue that the method of determining the maximum legal interest rate, which has only seen reductions without any increases over the past two decades, requires comprehensive reform.

During the period of interest rate increases in 2010 and 2011, when the maximum legal interest rate was around 40 percent, further reductions posed no significant burden.

However, in the current period of rate hikes, interest rates for institutionalized lending institutions approach the maximum legal interest rate in the late 10 percent range. At the time of the reduction in the maximum legal interest rate in 2021, the policy rate stood at 0.5 percent, but it has since risen to 3.5 percent.

The borrowing costs for private lenders and savings banks have also surged.

Despite these developments, interest rates for loans to the public remain tied to the 20 percent limit, resulting in significant profit margin decreases and cases of discontinued lending operations.

The problem lies within the political realm.

While financially vulnerable individuals fall victim to illegal private lending, lawmakers, fearing public backlash, continue to introduce bills calling for a reduction in the maximum legal interest rate.

Even proposals for indexation, where the statutory maximum rate adjusts with changes in the base rate, have been hindered by political considerations.

“The government should introduce a system whereby the statutory maximum interest rate can be adjusted to prioritize economic conditions,” said Lee Soo-jin, a senior research fellow at the Korea Institute of Finance.