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Matsvimbo Dida:  Financial Inclusion Matters

“If you pick up a starving dog and make him prosperous, he will not bite you. This is the principal difference between a dog and a man” – Mark Twain, US author Many microfinance institutions believe in that saying by Mark Twain. They believe that they are doing a great job of providing microcredit to the rest of the population shunned by banks and yet the same people after being helped complain about high interest rates. Researches have however proved that finance charges (interest rates and commissions) charged to the poor are by far greater than the non-poor.

This is mainly because of the risk factor attached to their segment and also the difficulties of administering loans to this lower segment of the market due to the high numbers involved. They also do not enjoy longer tenure borrowing facilities as those enjoyed by their counterparts due to their lack of capacity. Yet they remain a critical segment attractive to developmental financiers and forward looking financial institutions. Some financiers are uncertain how long the poor can go paying them. On the other hand, the poor normally lack collateral for supporting their loans.

What determines interest rates

The level of interest rate charged on a borrowing is a determinant factor on whether one borrows from the same source in future or even considers borrowing at all. Microfinance Information Exchange (MIX) and some experts have argued that high interest rates mostly affect the poor. Researches have proved that the world over, formal financial services sector borrowing rates are comparatively lower than those in quasi-formal and informal markets. Poor people borrow from the quasi-formal and informal markets which are characterised by high interest rates. Conversely, the non-interest charges (fees and commissions) are lower in the latter two markets than in the formal markets. Formal markets have lower interest rates but higher fees & commissions.

There are four components of interest rates which help explain what makes interest rates and why interest rates may be high.

The poor are shunned by banks for fear of high risk of default and also that their demand comprise of small amounts of borrowing among the very numerous borrowers thereby raising administration costs. This affects the overhead costs due to high labour intensity requirement. In the same vein, where debts are not effectively followed up, the number of NPLs (non-performing loans) rises. The challenges in collection may also be reflected in high provision for NPLs on the rates, a component which exists when determining level of interest rate as per table above. The NPLs quadrant covers issues to do with client risk profile which also incorporates issues like collateral. The interest rate charged to a borrower should be sufficient to cover cost of funds, overheads, the risk of non-performing loans/bad debts, as well as meet profit objectives of the financial institution.

Financial institutions play an intermediation role between depositors and borrowers. They get money from depositors which they onward lend to borrowers. They will need to pay interest to the depositors and this means they need to charge the borrowers sufficient interest so that they can pay the depositors. The cost of funds is generally the amount of money the financial institution has to pay the depositors and any statutory obligations relative to securing the deposits. The interest rate should also factor-in the overhead expenses of the financial institution which may range from salaries/wages of staff, loan application processing costs, premises, and other outreach costs incurred by the financial institution. The overheads vary from lender to lender.

Experts have stated that it is the processing costs which are the causes of price differentials between larger loans from banks and smaller loans issued by MFIs (microfinance institutions). Quiet apparently, the rate of interest should also accommodate bad loans which may from time to time be written-off. This also calls for effective credit screening processes. Low ratios of bad loans leads to lower interest rates while high ratios would be detrimental to the survival of the lender. Lastly, the lending institution should meet its profit objectives from the interest rate it charges the borrowers. The appetite for profit differs from lender to lender. However, banks, MFIs and other private entities are under more pressure for profit than NGOs and Not-For-Profit MFIs.

The impact of limits of interest rates to financial inclusion

Limits on the rates of interest, referred to as ‘interest rates caps’ in the banking sector, are used by governments for a range of political and economic reasons, mainly to support a specific industry or area of the economy. Interest rates caps are maximum limits beyond which rates must not be charged. Examples are where the government specifies interest rates for financing the agricultural sector. In Zambia, interest rates were used to support credit constrained SMEs sector. It is the role of government to protect vulnerable groups of the society and in this regard, a government is sometimes seen using interest rate caps to protect consumers from usury interest rates and predatory practices by some lenders. In Zimbabwe, the agricultural sector enjoys lower interest rates than other sectors. However, researches have indicated that access of pure agricultural loans in Zimbabwe has long turned difficult for many farmers due to a variety of reasons.

The use of interest rate caps by the regulatory authorities have an adverse effect that it distorts market and pulls out lending services from the lower segment of the market. This is in light of cost of credit vs access to credit for the lower market segment. In addition, studies show that MFIs have historically funded expansion outreach rapidly from profits. This implies that existing customers fund or subsidise outreach to new areas. The caping of interest rates hinder such expansion and financial institutions would prefer to remain profitable in their existing markets than risk expanding.

In extreme legislation, government action may result if financial institutions retracting from certain areas thereby hindering outreach and financial inclusion. For instance, in Nicaragua the government through Microfinance Association LAW (2001) capped interest rates to the average of interest rates charged by banks and also legislated widespread ‘debt forgiveness’. This resulted in a number of MFIs and commercial banks withdrawing from certain areas of the markets, much to the detriment of the poor. There is evidence pointing to the fact that capping of interest rates incentivises lenders to stay outside the regulatory system, eg in Bolivia. In Zimbabwe, the regulatory authorities until recently, have not actively pursued capping of interests and this saw growth of registered MFIs reaching 163 microfinance institutions as of end of March 2016 as microfinance is considered profitable business. There are however still a good number of unregistered Money Lenders/Microfinance Institutions which are staying out of registration due to a number of reasons some of which include lack of proper structures and documentation. In the circumstances, the decision to cap or not to cap interest rates has always been a dilemma for regulatory authorities in many countries. In liquidity-strained economies, letting the market forces to take their course result is usurious interest rates while on the other hand capping the interest rates may result in adverse effect on the development of outreach programmes by MFIs. It requires a balancing act and regulatory authorities need to know “which bridges to cross and which ones to burn”.

Please note that this article was written in private capacity of the writer and the views have nothing to do with any institution which the writer may be associated with. The writer is contactable on – [email protected]