Usury Act, 1968 (Act No. 73 of 1968) Report on Costs and Interest Rates in the Small Loans Sector 1. Introduction

 

Microlending provides access to credit to individuals who need relatively small amounts of credit at a time. By definition, these individuals represent the poorer elements in society who do not have access to formal bank loans, to credit cards or other automatic debit facilities. The development of a semi-formal or formal microlending industry in most countries is seen as a positive element in the development of a financial system that is expanding its outreach into lesser-serviced segments of the economy. This results in financial system with deeper outreach, overall.

 

In most developing countries, there exists a very small formal sector that provides financial services to the poor or to small borrowers. In West Africa, the recent development of the savings and credit unions that have achieved significant scale has created sustainable institutions that are providing both consumer and productive finance. In East Africa, the co-operative savings systems have been very good at collecting savings (which is an important financial service for the poor), but have not been able to complement it with successfully providing small loans. In Central Africa, there are virtually no formal or semi-formal financial systems that are servicing the bottom end of the market.

 

South Africa is a unique case in Africa and its microlending sector is not exception. Most of its nine million salaried employees have bank accounts, representing a large segment of the population that is linked to the formal banking system. However, most of these individuals do not benefit from access to other financial services, including credit There has been a very heavy reliance on the informal sector to meet both short and long-term savings needs (e.g. stokvels and burial societies). For credit, the populations who cannot access formal bank finance go to informal, township-based moneylenders (mashonisas) or pawnbrokers for emergency and short term finance.

 

In 1992, the issuance of the Exemption to the Usury Act removed loans under R6,000 from the interest rate ceiling. This was designed to open up the market for servicing small borrowers. This created the incentive for the development of a new industry to provide credit to the large number of salaried employees with bank accounts, but who could not obtain credit From an informal credit system carried on in the backs of shops or shebeens, a new officially sanctioned microlending industry has grown to achieve proportions that are unparalleled in the rest of Africa. With an estimated annual turnover of between 20 and 30 billion Rand, microlenders now provide a wide variety of credit products to millions of South African consumers for a wide range of uses. This has been an extremely dynamic, demand driven industry.

 

But with the development of any dynamic, new industry, there are individuals and companies that abuse the system or use socially unacceptable means of doing business. This provides a need and an opportunity for government to introduce rules and regulations to govern the industry and to provide a framework for the sound growth of a socially responsible industry. This regulatory framework needs to consider how to foster the continued growth of the industry and link it to the rest of the formal financial sector without creating distortions in the market to address specific social issues. As with any other demand driven industry, the regulatory environment must be careful to not cause disinvestment in the sector, or lead to an exodus of the formal lenders towards the informal and unregulated parts of the economy where they cannot be monitored and controlled.

 

The Department of Trade and Industry (DTI) commissioned this study to examine the costs associated with lending and the interest rates for the small loans sector in South Africa. This study will provide the background information to the DTI to assist it to develop criteria for setting further regulations for governing the microlending industry.

 

 

The government has put in place a set of rules and regulations to govern the microlending industry, while trying to draw large semi-formal segments of the microlending industry into the formally regulated sector. The Exemption to the Usury Act, described in Annexe "A" to Government Notice 713 of 1 June 1999 lays out these rules and regulations. It successfully sets the conditions for better control and monitoring. It addresses many of the concerns about the social acceptability of the methods and practices being used by microlenders to guarantee their repayment, as well as on "acceptable" interest rates. Paragraph 3.3 of this Annexe set the maximum rate of interest[2] on microloans at ten times the prime rate of interest from the Reserve Bank of South Africa.

 

These rules affected the operating methods, practices and profitability of an important segment of industry stakeholders, the short-term cash lenders. These rules were not well received, and a number of them filed suit against the DTI. Their key practical issues were with:

 

 

On November 11, 1999, Judge Mynhardt ruled to set aside paragraph 3.3, governing the maximum interest rate, from the Annexe, but upheld all other elements in the Annexe. He determined that the Minister of Trade and Industry did not adequately study the issue of interest rate ceilings and their impact on the industry before arriving at the formula for a maximum interest rate. However, he ruled that none of the other key elements being contested by the applicants would be set aside.

 

Upholding paragraph 5.1 of the annexe, which interdicted the use of personal information such as pin codes and bank cards as security arrangements, will have an important structural impact on the industry. As the pin card has been the main source of security for the short-term cash microlenders, they maintain that this will have an important negative impact on their cost of doing business and their rate of bad debt The removal of the bank card and pin will force the industry to invest in other risk control tools, which will take a while to develop, test, and put into application.

 

1.1.1 Issues leading to this study

 

Key concerns for the DTI

 

DTI is concerned with many issues relating to interest rates and the microlending sector and practices. The first is related to the exploitation of the client by the lender, either real or perceived. Money lending has long been a controversial issue. It is often cited to be the oldest profession in the world, subject to many abuses especially when servicing people who do not have much choice. Over the years, socially acceptable norms for interest rates have arisen, and if an interest rate is perceived as being too high, it brings many negative perceptions with it. The public perception of a 30 percent per month interest rate is that it is very high. However this does not necessarily reflect the perception of the borrower who may not look at the interest rate as the qualifier, but on the affordability of the loan (ability to repay) and the benefit that s/he will derive from the use of the loan.

 

The second main concern is the impact of the interest rate on the borrower. The "debt spiral" refers to individuals who owe so much on their loans that they are caught in a trap where they must continue to borrow in order to pay off past loans. It can be demonstrated that high interest rates can more easily lead borrowers into a debt trap, from which they cannot escape. Critical questions that need to be investigated are how does it start, who is responsible (the lender or the borrower), and what exacerbates it? Clearly high interest rates can exacerbate a debt spiral.

 

A third concern for DTI related to interest rates, but which has less to do with consumer protection, is how to increase the investment in SMME lending. Interest rate ceilings

contribute directly to creating disincentives from investing in new technologies to make loans that are perceived to be riskier. Higher interest rates can provide the necessary

incentive to invest in developing those new tools and technologies, as has happened with the microlenders.

 

Issues surrounding determining the cost of making small loans to set interest rates

 

This study has been a long time coming. It was to have been one of the early endeavours of the Microfinance Regulatory Council (MFRC) that has been delegated the role of regulating the microlending industry in 1999. The DTI considered doing the study before issuing the Exemption Notice in June of 1999, but did not As they testified in the court case, "the microlending industry contained so many diverse operations and products that research aimed at establishing objectively an appropriate interest rate for each lending product would not be feasible. This level of sophistication is only achieved in a few developed countries and the industry and its regulation has not yet developed to such a level of sophistication."

 

On the surface, setting interest rates appears to be quite a simple concept: identify the costs associated with providing credit services to different kinds of clients, add a "fair profit margin, and set the interest rate cap. But in reality it is not so simple. As has been identified during this study, there are myriads of different elements that must be taken into consideration. In terms of costs, some of the issues that must be addressed include questions like what costs should be added into the calculation? Does one consider only mature companies, or also those companies that are in the start-up and investment phases?

 

When addressing the issue of "fair profit margin" some of the questions are; fair to whom? Is it adequate to ensure continued investment in the industry? In terms of the effects of capping interest rates, will it restrict the entry of new lenders into the market, especially in the harder to reach (and therefore more costly) small, rural, isolated markets? Will capping interest rates lead to a restriction in the supply of credit to the poorest members of the community? How will the setting of interest rates affect the overall levels of competition in the industry?

 

1.1.2 The Microfinance sector within the South African Economy

 

How big is the microfinance sector in aggregate economic terms? The microfinance sector is still quite small in comparison with the formal banking sector, but growing much more rapidly. Its contribution to the national economy is probably not accurately reflected in the national data because of the informal sector nature of many of the industry members, resulting in an under-estimate of size and contribution to GDP. The finance, insurance, real estate and business services sector is a significant contributor to the South African economy, providing approximately 15% of total GDP in real terms in 1998. The total assets of the banking sector at the end of 1998 were R654 billion, with advances totalling R545 billion. Although the size of the microfinance industry is estimated at RIO to R15 billion with advances at R10 billion (Econometrix, 1999), we would argue that this is a gross under estimate. However, it is dependent on the definition of the sector and Econometrix focused only on the microlending component Crude estimates of the total microfinance industry would be at least R2Obn, based on an assessment of current supply of microfinance.

 

1.2 Methodology and key issues in the examination of the subject

 

1.2.1 Data gathering design and implementation

 

The time frame and scope of this study necessitated innovative approaches to data gathering and analysis. It was decided that the emphasis would be on secondary data and surveys would only be used to confirm and enrich secondary sources. In this regard the following secondary and primary sources were identified and exploited.

 

Information from the MFRC database

 

The complete database of applications lodged with the MFRC was the starting point of our analysis. After studying the applications’ data, we focused on those applications that were successful since the MFRC captured more detailed information on these institutions, than those that were not approved. We then chose approximately 90 institutions for which we obtained the financial statements submitted by these institutions to the MFRC, to analyse their data. We captured this information from the files, since the MFRC has not yet started capturing of the content of the financial statements into a database. We chose these institutions based on a random sample of firms from within each legal category, stratified by size. Thus, we tried to obtain a spread relative to certain key variables (e.g: annual turnover, branches, clients, and term of loans) to ensure that our cost calculations covered a diagonal cross section of different microfinance institutional formats. We then interviewed a number of these institutions on the basis of a carefully structured questionnaire (Annex 8) to confirm the MFRC data and to obtain more information on risk and other product characteristics.

 

Submissions to DTI

 

The DTI supplied us with a range of submissions provided by institutions in the sector during the period before the announcement of the regulatory changes.

 

The November 1999 court case

 

A copy of the November court case was studied in detail and is discussed above, in Section 1.1.

 

Survey of clients of informal lenders

 

The University of Pretoria launched a survey amongst dents of informal lenders. The results from this survey are analysed and presented in Section 4.4.2.

 

Government Personnel Salary System (PERSAL)

 

The DTI arranged access to the PERSAL database. The Department of State Expenditure (DSE) assisted in drawing snapshot information for two time periods (July 1999 and February 2000). Although the number of variables are quite limited on the PERSAL system analysis of their data did give us a good overview of the indebtedness, profile, and geographical spread of debtors. This is discussed in Section 4.4.3.

 

lnterviews with stakeholders

 

It was decided in the beginning of the study period that the budget and time allotted to this study do not allow for a comprehensive survey of the sector. Thus, we mostly made use of secondary data as was argued earlier. However, we felt that interviews with stakeholders in the form of associations and groupings of different institutions would add tremendously to our assessment of trends and possible future happenings. This proved to be extremely worthwhile. A list of people and institutions interviewed is supplied in Annex 3. We interviewed more than 40 institutions covering several hundred branches, many of which made very comprehensive presentations to us.

 

1.2.2 Discussion of profitability calculations

 

We have already seen that there is demand for microcredit; be it from a legally registered commercial bank, a Section 21 enterprise development lender, a "cash loan" microlender, a pawnbroker, or a mashonisa. If one is to try to put a ceiling on interest rates, the issue that arises is "what is a fair profit margin?" As noted in the earlier sections on the different types of lenders, each serves a discrete market that is not being serviced by other lenders, either because of risk, lack of resources, or other factors. The costs associated with the lending will vary greatly (see below) depending on the market; the type of lender, the technologies being used, the cost of money, etc. The return to the lender from the lending operation may also be a function of the other activities in which the lender is active.

 

While the return to the lender may vary greatly in terms of a percentage of the amount loaned, the actual Rand return to the lender will also vary greatly based on the overall amount loaned. Is it proper to compare an individual lending 4,000 Rand of his/her own money during the month with a bank that is lending billions of Rand? The first must consider the labour and risk that the lending engenders and earns net revenue of RI ,000 a month (R12,000 a year for an annualised 300% return on equity), while the latter earns net revenue of R50 million a year on an equity base of R250 million (a mere 20% return on equity). When one takes into consideration that the bank will never lend to the clients that the small lender will due to the risks, different perspectives arise. Clearly there needs to be different mechanisms and approaches for estimating a reasonable return to investment, be it based on time or money, for different kinds of lenders.

 

Return to Labour

 

Some of the research that has been carried out on microenterprise development can be very helpful in sorting through this issue. Microenterprises, by their very nature, earn very small amounts of money in absolute terms given their small scale. A microenterprise might gross R100 in a day based on R50 in inventory that it sells, for net earnings of R50. This represents a 100% return on the investment in a single day, but the actual return to the individual remains small for a full day’s labour (his only equity).

 

To resolve this issue, leading practitioners in microenterprise development advocate using a calculation based on the return to a day’s labour for the small enterprises. This allows for a more rational and realistic comparison for the microlenders on the best ways for them to earn a living wage and where their financial incentives lie.[3]

 

Return on Equity (ROE)

 

ROE is the standard performance measure for any investor in deciding where to invest. The long-term survival of businesses requires that they earn a satisfactory and sustainable return on shareholders investment If a business does not provide a competitive return on equity, it will lose the investment as the owners of the funds will move them to other investment opportunities that yield a higher return.

 

Table 1: Overall ROE and capital ratio of the major commercial banks in 1998 compared to Theta Group in 1999

 

 

These returns on equity, illustrated in table 1, must be compared to the returns on equity from other corporations in South Africa to allow investors to determine those areas with the best potential return on investment.

 

Return on Assets (ROA)

 

ROA falls between ROE and Return to Labour in terms of measuring profitability. Where a large commercial bank can take relatively inexpensive deposits which it will on-lend, a smaller private company is lending only its own limited funds from equity or funds that it has borrowed at a significantly higher rate. The cost of the assets is significantly different. Therefore, ft is best to compare like institutions with like institutions, because a microlending institution may have assets (cash to lend from borrowing) that have cost ft significantly more to acquire than a commercial bank (cash to lend from deposits).

 

Where does the profit come from?

 

While all revenue for microlenders officially comes from charges to clients quoted as interest rates, not all profit in the commercial banking sector comes from interest revenue. Commercial banks are currently regulated under the Usury Act, which sets a ceiling on the interest rates that they can charge. This interest rate does not include the cost of the transaction and other charges by the banks for their services. Yet, the commercial banks earn a significant amount of their revenue from fees and the charges for these and other transactions. At the same time, micro-lending institutions are required to include all of their transactions charges in their interest rates. This can create a sizeable distortion between the rates quoted by the formal banking sector and the micro-lenders. It also has a great impact on the sources of profitability for the institution. The Banking Council submission notes that the margins in serving the lower end market are low. [4]

 

Table 2: Proportion of transaction and other charges to total income: South Africa’s major banks

 

 

Conclusion on methods for determining profitability as a measure of capping interest rates.

 

It is virtually impossible to find one common measure against which to compare the profitability of different types of financial institutions in order to determine a "fair" profit margin for that kind of institution. Return to equity is one important way for publicly traded companies to compare their potential as investment opportunities. Return to assets is not appropriate when comparing banking institutions with microlenders.

 

Return to labour is the key consideration for a small lender who would prefer to earn a higher daily wage than a huge percentage on a small amount He lives on the surplus created by his activities after costs are subtracted.

 

One of the concerns about using the profit margin as a way of setting appropriate interest rate ceilings is that It engenders inefficient operation When the ideal should be to promote more efficient operations through attaining higher profit margins, an institution that is at the margin of passing the ceiling will simply increase its costs to avoid going over the profit ceiling. More efficient operations will lead to decreasing charges to the consumers through increasing competition.

 

1.2.3 Interest rate calculations[5]

 

There are several ways to calculate interest on a loan, of which two methods are most common: the declining balance method and the fiat (face-value) method. Interest is generally paid over the term of the loan, although it is sometimes paid up front These methods are discussed in detail in Annex 4.

 

The declining balance method

 

This method calculates interest as a percentage of the amount outstanding over the loan term. Interest calculated on the declining balance means that interest is charged only on the amount that the borrower still owes. The principal amount of a one-year loan, repaid weekly through payments of principal and interest, reduces or declines every week by the amount of principal that has been repaid. This means that borrowers have use of less and less of the original loan each week, until at the end of one year when they have no principal remaining and have repaid the whole loan (assuming 100 percent repayment).

 

 

The flat rate method

 

This method calculates interest as a percentage of the initial loan amount rather than the amount outstanding (declining) during the loan term. Using the flat rate method means that interest is always calculated on the total amount of the loan initially disbursed, even though periodic payments may cause the outstanding principal to decline. Often, but not always, a flat rate will be stated for the term of the loan rather than as a periodic (monthly or annual) rate. If the loan term is less than 12 months, it is possible to annualise the rate by multiplying it by the number of months or weeks in the loan term, divided by 12 or 52 respectively.

 

If a flat interest payment (fixed rate) is charged on a loan which is repaid with regular principal payments, the effective rate of interest is significantly higher than the nominal rate.

 

MFI's calculating interest using the on a declining balance would have to increase their nominal interest rate substantially to earn the same revenue as an MFI calculating interest on a flat basis.

 

How do Fees or Service Charges Affect the Borrower and the MFI?

 

In addition to charging interest, many MFI’s also charge a fee or service charge when disbursing loans. Fees or service charges increase the financial costs of the loan for the borrower and revenue to the MFI. Fees are often charged as a means of increasing the yield to the tender instead of charging nominal higher interest rates.

 

Fees are generally charged as a percentage of the initial loan amount and are collected up front rather than over the term of the loan. Because fees are not calculated on the declining balance, the effect of an increase in fees is greater than a similar increase in the nominal interest rate (if interest is calculated on the declining balance).

 

Calculating Effective Rates

 

MFls often speak about the "effective interest rate" on their loans. However, there are many ways in which effective rates are calculated, making it very difficult to compare institutions’ rates. The effective rate of interest is a concept useful for determining whether the conditions of a loan make it more or less expensive for the borrower than another loan and whether changes in. pricing policies have any effect. Because of the different loan variables and different interpretations of effective rates, a standard method of calculating the effective rate on a loan (considering all variables) is necessary to determine the true cost of borrowing for clients and the potential revenue (yield) earned by the MFI.

 

The effective rate of interest refers to the inclusion of all direct financial costs of a loan in one interest rate. Effective interest rates differ from nominal rates of interest by incorporating interest, fees, the interest calculation method, and other loan requirements into the financial cost of the loan. The effective rate should also include the cost of forced savings or group fund contributions by the borrower, because these are financial costs. We do not consider transaction costs (the financial and non-financial costs incurred by the borrower to access the loan, such as opening a bank account, transportation, child-care costs, or opportunity costs) in the calculation of the effective rate, because these can vary significantly depending on the specific market. However, it is important to design the delivery of credit and savings products in a way that minimises transaction costs for both the client and the MFI.

 

1.2.4 Factors affecting the cost of tending

 

We equate the cost of lending to those components that contribute to the calculation of the interest rate. We assume that we are mostly working with organisations, or sections or divisions of organisations that are entirely dedicated to microlending. This is a heroic assumption, as we know that some of the institutions are active in many markets (e.g. pawnbrokers are active in the financial market and in the second hand furniture market). Whenever we doubt the correct allocation of costs to a specific activity this will be highlighted. In our approach to calculate the cost components of the microlenders, we assume that the profit margin is also a contributor to the level of interest rate. In addition we study the administrative cost component, the risk cost component and the cost of capital component.

 

This approach was decided on for several reasons. In essence the DTI wants to know whether the interest rates charged by microlenders are realistic rates and that no exploitation of clients is taking place. One approach to ascertain this is to calculate the interest rates of the different products offered by the microlender and to take a view on the level of the interest rate. In this approach Several problematic areas can be identified. It can be argued that we are not comparing institutions on the same basis. Some institutions provide only 30-day cash loans. Is it fair to directly equate the cost structure of such a lender with the cost structure of a lender providing only 36-month loans for housing? What about the fact that the 30-day cash lender can reuse his capital 12 times per year? On the other hand the 30-day lender has a cost of lending that is roughly multiplied by twelve, while the 36-month lender's cost structure is totally different Some institutions set up retail networks, while others work through existing networks (like employers).

 

Further, only a few institutions gave us adequate information with which to do interest rate calculations. Thus, the calculations we do make are for illustrative purposes. We still emphasise the complete cost structure based on the activities of a year, rather than merely looking at interest rates. Another important consideration is that the cost components approach, include fee and other income charged to clients. The interest calculations exclude these costs to clients.

 

Cost of capital

 

We define the cost of Capital as all those costs that have to do with obtaining capital. In essence it starts with interest rate costs. We add to that the payment of dividends (or withdrawals) to owners as that compensates the owners for the use of equity. We consider any cost incurred to mobilise and compensate capital used in allocation to borrowers part of the cost of capital. Changes in interest rates and risk perceptions of the sector by investors would all impact on the cost of capital. Investors in the sector would probably favour short-term investments, as it is not clear what will happen with the interest rate ceiling in the sector and that directly impact on the profitability of the investment. Bank charges will clearly form part of the cost of capital.

 

Administration (concept of transaction cost)

 

All cost incurred in running the organisation are included in the administration cost component This includes product design and marketing costs. As the level of competition increases in the sector institutions spend more on innovative product design and marketing of these products. One of the first signs of an emphasis on marketing after ABSA took the controlling share in Unibank was the erection of massive advertising boards on key routes in the Gauteng area.

Administration (including stationery, telephone, postage, equipment rental) and office expenses (including office rental, maintenance an cleaning, depreciation, water and lights), salaries and staff benefits (including uniforms, training, entertainment, subsistence and travel, motor vehicles, pension), information technology hardware and software, consultants, accounting and audit lees are most of the costs contributing to the administrative cost component

 

Risk

 

Although the risk component is argued on the basis of organisational and systemic risk it is quite difficult to price. We studied the expenses of microlenders and included fines, collection fees, legal costs, security costs, bad debts provision, insurance and first aid costs as the risk component We included only realised costs. No adjustments to the risk costing were made due to interest rate increases embodying systemic risk.

 

Required return (profit margin)

 

It is difficult to ascertain what would be the "acceptable" rate of return for a microlender to determine whether they are earning more or less. Therefore, we took the difference between annual income and expenditure (before tax) as the surplus component of the total (cost) structure of the microfinance business, reported simply as "surplus".

 

Although the four components listed above provide a comprehensive list of issues, there are numerous issues that impact on the levels of the different components. The provision of financial services in a rural setting increase the administrative cost component as well as the risk component Increasing the risk component would also impact on the cost of capital component (increased costs due to higher perceived risks) while all of this would decrease the surplus component.

 

Providing services to entrepreneurs, whose repayment is based on cash flow, would also increase the risk compared to providing service to salaried or wage earning customers.

There are therefore numerous impacts on these components.

 

For example, offering financial services to small farmers in a remote rural arid area would impact on all aspects of cost very often the cost would be so high that no transactions would be made, implying that no market would exist in which financial services would be offered to small farmers. The other extreme is offering financial services to the urban employed backed by collateral in the form of a provident fund. In this scenario thousands of transactions take place and a competitive and innovative market exists that is efficient and offers the clients choice and good services.

 

The environment and the broader influences within which financial services are offered also play a major role. Here we refer to the legal and regulatory framework, property rights and the enforcement of contracts. Where services are provided in situations with loosely defined property rights and inadequate enforcement of contracts services will be very expensive, transaction costs will thus be high and the market will be extremely inefficient.

 

1.2.5 Factors affecting the risk associated with lending

 

The size and complexity of the South African financial environment and in particular the speed of its recent expansion (on several institutional levels) pose a challenge to the ability of the system to handle the larger risks involved. Three sources of risk should be highlighted: credit risk, market risk, and operational risk.

The World Bank (1999) indicates that there has been an increase in the non-performing loans to total loans ratio. In the general banking sector it went from a low of 32 percent in 1996 to 4.7 percent in 1999. In one bank this ratio is over6 percent. This increase in non-performing bans signals an increased credit risk. Mortgage and instalment loans posing this risk, in particular. As the banks in South Africa bear very small components of interest rate risk1 they pile most of it on their customers. Rate increases are then almost comprehensively for the account of the customer and many customers then find it difficult to service these loans, and as a consequence the default rate rises. Credit risks also stem from transactions between banks. The interbank market is a limited resource for funding and it increased in importance as a reaction to a decline in deposit funding. Deposits dropped from 79.3 percent of total assets in 1996 to 74 percent of total assets in 1999. The interbank loan transactions financed 3.6 percent of total assets in 1996 and 5.4 percent in 1999. This increases the covariant risk in the banking sector.

 

In terms of market risk the World Bank mission (1999) argues that it is not the level but the ability of banks to assess the market risk that may be a problem. Thus, the banks do not have a clear view of the size of potential losses and this increase operational risk - in that the banks have no idea whether they have adequate resources to continue operations and honour all obligations.

 

In this study we are not analysing the risk of commercial banks in general. We are more interested in the risk of the microlending sector, which we would like to assess in terms of risk originating in the organisation and risk originating in the system (systemic risk). Firstly, the same origins of risk apply in the microlending sector. Credit risk especially is an important consideration as (overtly) microfinanciers finance most of their activities with credit (rather than relying on deposits). Several of the bigger commercial banks are now investing in the larger term lending microfinanciers. In this way, the risk from the banks’ side comes to the microfinance sector and risk from the microfinance sector is now mixed with the bank’s risk This increases the systemic risk as microfinanciers are not subject to the same stringent control as the rest of the banking sector.

 

In organisations (thus organisational risk) in the microfinance sector, risk originates from several sources. These are primarily client-originated risk and organisational originated risk. Client-originated risk is embodied in the provisions for bad debts and bad debt write-offs. It is essence a function of the repayment ability of the client This ranges in terms of the sources of loan repayment of the client Where loan repayment is based on consistent income streams and the availability of collateral the risk is Inherently the risk of loosing a job, or becoming unemployed. Where repayment ability is a function of an inconsistent income stream, risk is in essence higher and unfortunately, mostly not covered with any collateral security.

 

While microfinance institutions and commercial banks are vulnerable to liquidity problems brought on by a mismatch of maturities and term structure, the risk features of microfinance institutions, servicing the small loan market, differ significantly from institutions serving the more affluent like most commercial banks. This is primarily due to the microfinance Institutions’ client base and context within which they operate. The client base is normally comprised of the low-income clients, without assets, requiring small short-term loans. It also is due to the lending models (small, mostly unsecured loans) and ownership structure. In South Africa the diverse number of microfinance institutions serving the sector also differ in terms of risk exposure.

 

The organisation originated risk has to do with the capitalisation of the organisation, the assessment techniques of the organisation and it internal financial management and control. Many institutions lack sophisticated systems and lack internal expertise. In a recent survey of microlenders the demand for very basic training in financial management and especially asset management was identified as very important.

 

Risks in the microfinance industry related to institutions serving microentrepreneurs are different than those servicing the employed.

 

 

Most of the problems of MFls have to do with clarity of goals-does the organisation provide services to lighten the burdens of poverty, or to encourage economic growth, or does it target a specific group, like the handicapped. However, quite often the goal and the structure of the institution in terms of ownership, capitalisation, governance and management are not matched.

 

It is clear that institutions with different client profiles have different risk profiles. Table 3 illustrates the South African situation specific to the microfinance sector.

 

Table 3: South African situation specific to the microfinance sector.

 

 

 

[2] Said rate of interest to include all transactions costs associated with making the loan, except insurance.

 

[3] Haggblade and Gamser, A Field Manual for Subsector Practitioners. November 1991, p.33

 

[4] Banking Council Submission, p.3.

 

[5] several texts exist that cover interest rate calculations. In this report we use a standard text as base and to ensure that we do not compare different methods The text used is Ledgerwood, Joanna. (1999). Microfinance Handbook: An Institutional and a financial perspective. Published by Sustainable Banking with the Poor Project, The World Bank, Washington DC.