Many countries in Africa have established interest rate ceilings to protect consumers from high interest rates charged by microlenders. Such ceilings are often the response of governments facing political or cultural pressure to keep interest rates low. The general idea is that interest rate ceilings limit the tendency of some financial service providers to increase their interest yields (all income from loans as a percentage of the lender’s average annual gross loan portfolio) especially in markets with a combination of no transparency, limited disclosure requirements and low levels of financial literacy. Despite good intentions, interest rate ceilings can actually hurt low-income populations by limiting their access to finance and reducing price transparency. If ceilings are set too low, financial service providers find it difficult to recover costs and are likely to grow more slowly, reduce service delivery in rural areas and other more costly markets, become less transparent about the total cost of loan, and even exit the market entirely.
Photo Credit: Pit Buehler
Interest rates coming down…
The paper Microcredit Interest Rates and Their Determinants: 2004–2011 has assembled empirical data that would help frame the question of the reasonableness of microcredit interest rates. The paper shows a decrease of interest rate yield in Africa from 39 percent to 25 percent between 2004 and 2011 despite the increase over the same period of the financial expenses and credit losses. Africa is the region that shows the most substantial continued declines of its interest rate yield (-2.5 percent between 2006 and 2011).
The paper shows that operating expenses are the largest determinant of the rate the borrowers end up paying. In Africa, the operating expense ratio decreased from 28 percent to 19 percent between 2004 and 2011. Despite a decrease of 1.5 percent per annum decrease, the operating expense ratio in Africa remains the highest compared to other regions of the world. There is a need to understand the drivers of operating expenses in Africa and figure out what can be done to reduce them while maintaining financial institution’s efficiency and sustainability.
…but interest rate caps are persisting
In late 2010, a CGAP mapping of countries with interest rate ceilings showed that 17 countries in Sub Saharan Africa had introduced interest rate caps. Some recent events show that this is still an evolving and persistent issue in Africa.
- In January 2013 Bank of Zambia (BOZ) introduced ceilings on the annual effective interest rate of loans charged by non-bank financial institutions (NBFI). In this context, NBFI include companies, building societies, microfinance institutions, development banks, savings and credit institutions, and bureau de change. The ceilings state that: (i) the maximum effective annual lending interest rate for NBFI designated as microfinance service providers by the Bank of Zambia shall not exceed 42% and; (ii) the maximum effective annual lending rate that will be charged by all other non-bank financial institutions will not exceed 30%. The main reasoning for this offered by BOZ is that some NBFI are charging their clients exorbitant interest rates (see table below). The measures taken are supposed to make loans more affordable and equitable to vulnerable borrowers.
- In 2013, the West Africa Economic and Monetary Union, which includes eight francophone African countries, lowered the interest rate ceiling - initially established in 1997 – by three percent. According to the Council of Ministers, the new maximum effective interest rate banks can charge is 15%; MFIs can charge 24%. The Economic and Monetary Community of Central Africa, comprised of 6 countries (Cameroon, the Central African Republic, Chad, the Republic of Congo, Gabon, and Equatorial Guinea), set up an interest rate ceiling in October 2012. The interest rate ceiling specific to the microfinance sector is calculated by applying a margin of 33% to the average effective interest rate charged by microfinance institutions during the previous six months.
There is a strong need for policymakers to understand the interest rate curve, especially when dealing with financial service providers targeting low-income people. Some policymakers do not understand that instituting interest rate ceilings may actually have unintended effects on the overall market.
Alternative measures to protect customers
Despite the trend about capping interest rates highlighted above, some policymakers have taken different approaches. For example, in Kenya, the capping of interest rates was on the table in 2012, but eventually Kenyan authorities abandoned the idea. A similar scenario is unfolding in the Democratic Republic of Congo (DRC), where there is an attempt to impose an interest rate ceiling. However, due to a lack of evidence on how this will help protect clients, the idea is likely to be replaced by a financial consumer protection regulation.
Several initiatives, such as setting up financial consumer protection regulations and enabling an innovative ecosystem of financial service providers, may serve as effective alternatives to interest rate ceilings. These measures can help prevent unscrupulous lending practices while ensuring the development of healthy credit markets for low-income customers.
Although the asymmetry of information between financial service providers and their clients is a reality, it should be noted that commendable efforts are being made by financial institutions for the provision of financial products in a transparent and affordable manner. Along with the efforts towards more transparency, the downward trend of microfinance interest rates worldwide provides another argument against interest rate ceilings. A mindset change is needed since there is no evidence on how an interest rate cap contributes to protecting low-income consumers.
www.mftransparency.org exposed the sad hypocracy of many MFIs which claimed they were helping the poor and let their own investors and donors believe they were doing good, whilst charging rates of 100 - 200% per annum, if not higher. eg. http://www.mftransparency.org/microfinance-pricing/Zambia/ . Previously, mftransparency's data was even more granular, showing which type of institution charged what rates, exposing the myth that NGO based MFIs are more benign. So putting a cap on rates seems the right immediate response from a regulator who has the duty to protect borrowers. That this leads to MFIs lending less, is a direct effect but it does not harm the poor as anybody who has to pay 100% rates of interest is harmed by definition. Setting a cap on rates encourages MFIs to work efficiently and to introduce technology to cut costs. Even in rural areas and making small loans in the range of USD 100 - 200 per client MFIs can efficiently and profitably work with rates of 30 - 40% pa as demonstrated in Asia. The claim that "there is no evidence on how an interest rate cap contributes to protecting low income consumers" is difficult to comprehend as rates of over 50% hurt consumers. Besides, MFI loans are not only targeted at consumers but are in most cases intended to finance productive businesses. To assume that businesses in poor regions in Africa can generate returns that can feed a family, send kids to school and pay interest rates of over 100% is either naive or cynical.
I support the work that mftransparency has been doing, ensuring there is full disclosure of the total cost of borrowing to the borrower, but tend to disagree on its advocating and justification of price cap as a client protection tool. In actual fact this tends to promote the introduction of hidden costs which makes borrowing even more expensive to the poor than intended. Apart from being unsustainable, in normal cases price caps do not consider other factors like the supply side of the funding available to MFIs for on-lending. To assert that caps will force MFIs to be more efficient is an over-assumption. I believe competition and innovation are key to improve efficiency and encourage innovation in the sector than regulations. The case of Zambia is an interesting one worth mentioning, which the proponents of interest caps should analyse and draw important lessons from. Commercial banks had started lowering their interest rate before the cap was introduced, to an extend that private owned MFIs who are funded through debt had started enjoying the slide in interest rates. Soon after the cap, which unfortunately was higher than the average rate the market had smothered to, some banks increased their rates to the maximum cap, to cushion for the possible loss of lending to risky sectors.
MFIs are currently struggling to raise capital as the country risky rating increased due to the control. Social investors who ordinarily would have brought in investments shy away due to perceived risk, and those who come on board increase their ordinarily lower rates. Failure to meet demand will result in the same poor entrepreneurs going to borrow from the streets where the price is more than 50% per month. I therefore do not see any protection with capping prices, neither do I see the benefit on efficiency, other than exposing the poor to loan sharks. Let the market determine the price, let competition drive efficiency and innovation that benefit the MSMEs. The role of the regulator should be creating an enabling environment that promotes transparent pricing, that promotes flow of low cost funding into the country, and that promotes sustainable financial inclusion partnerships with the private sector.
Very good article pointing to some of the issues with interest rate caps and supporting with empirical evidence. I think some have a difficult time understanding high interest rates in a market with the smaller loan sizes, materially higher operating costs, and really ease of payment for the borrower.
Of course some institutions will not be ethical in a profitable/sustainable industry, but should be priced out in the relatively short term a semi-open environment. Opponents of commercial microfinance often have a difficult time conceptualizing the alternatives, assuming it is a binary scenario (paying 75% interest on loans or not paying interest on loans). In reality, when borrowers need these credits, the alternatives become borrowing from moneylenders at higher interest rates (that comes along with other significant risks) or just not having the money to progress (if a seamstress' sewing machine breaks and all of a sudden has no income, there is no doubt a necessity for capital). Ultimately, poorly set interest rate caps will dry up microcredit markets. I think it is difficult to argue that no credit at all is a better alternative to high interest rates.
In general, the article provides a fairly good summary and supports it with a data on a very intricate topic that is difficult to understand without the prior knowledge or understanding. A suggestion for those having difficulty connecting the dots, it would be useful to review examples of microcredit borrowers' household cash flows as well as reviewing the financial statements of microfinance institutions. I think the MFI's charging "unreasonably" high interest rates are the exception rather than the rule.
Quite an elucidating article. What caused the massive drop in Africa's Expense Ratio. If the component is disaggregated, perhaps we can target and work on the outliers to get the ratio further down as the Africa's ratio is still the highest. The paper however papers to say that there is nothing like.excessive interest rate if it being charged by an MFI as against the money Lender. Which I think is a fallacy as pointed out by MF Transparency. Many poor people will take loans only when they are pushed to wall in which case they will venture to pick a loan from the mouth of a lion damn the consequences in a market which is not competitive and transparent enough.
Mid this year, the Kenya Government established interest rate ceilings to protect consumers from high interest rates charged by Banks. This was largely in response to political pressure to keep interest rates low.
As was predicted by CGAP in earlier reports, interest rate ceilings can limit the tendency of some financial service providers to increase their interest yields, especially in markets that have a combination of no transparency, no disclosure requirements and low levels of financial literacy.
Despite good intentions, interest rate ceilings have actually hurt low-income populations by limiting their access to finance and reducing price transparency. In Kenya, ceilings were set too low and financial service providers find it difficult to recover costs. They have reduced lending and service delivery in rural areas and other costly markets, and have become less transparent about the total cost of loans. To mitigate against low interest yields, Kenyan bank have also started to lay off staff and are likely going to start exiting markets in rural settings.
This worrisome behavior by Kenyan banks is likely going to create an opportunity for unregulated MFIs whose main focus is clients located in and rural settings.
By Henry Kiema
Financial Analytics Limited
EFFECTS OF THE REDUCTION OF INTEREST RATES: TOUGHER TIMES TO THE MWANAICHI.
Expect to see more bank staff being laid off, collapse in SME sector and lack of enterprenual initiatives in the shortrun.
Banks are looking for other ways of making profits to break even. Initially it was easy for the banks to give money as they relied on the pool of many customers and interest profit to counter non performing loans but now financial institutions are forced to go back to the drawing board. Banks are now forced to be more aggressive to increase their liabilities book unfortunately this has also been infiltrated by insurance companies, microfinance and real estate investment companies etc...... The playing field has now been chocked by tough competition.
All small banks will now be forced to merge or get acquired vertically by big banks to swallow their losses, Which brings as back to the CBK Requirement of all banks to have a capital of 5 billion. Well I had predicted this trend a year ago when Merali sold part of his banks shares to mwalimu sacco and other trends in the industry.
Looking at it from a broader spectrum, the government is keen on encouraging foreign investment in the country and big companies which will in return have a multiplication effective on boosting the economy, further more, this will make the cost of doing business in Kenya cheap thus, give us a comparative advantage. Well for the normal mwanaichi things will get tougher in the short run. They will be forced to consolidate most of their assets in order to meet the minimum threshold of acquiring investment capital. This are some of the things that our political leaders should step up their game and come up with programmes or development initiatives to educate people of malava. I call it simple wisdom. What we need to ask our aspirants- What kind of environment do they intend to put in malava in order to attract investment both locally and internationally? Dear voters please don't give politicians an easy ride to political power of enormous wealth. If we the voters are naive; then politicians have no choice but to loot the public money. I can't blame them. I blame the voters.