Usury Act, 1968 (Act No. 73 of 1968)Report on Costs and Interest Rates in the Small Loans Sector3. Considerations on interest rates and microlending |
| 3.1 | Literature and theoretical review |
The majority of economic literature and schools of thought in economics use the allocative role of the market as point of departure. They argue that any intervention in the market would distort signals in the market and in this way optimal allocation of resources to their best use would not be possible.[9] Thus government refrains from legislating price in most markets because economic theory and experience has shown that a competitive market makes a larger amount of a good available, at a lower price; than any alternative structure.
Four arguments are frequently made to justify the intervention of government in financial markets: (i) monopoIy; (ii) externalities; (iii) imperfect information; and (iv) contract enforcement problems. Monopolies are frequently associated with markets segmented by geography. Introducing more competition into these markets increases the supply of loans beyond the profit maximising level determined by the monopolist Hence government intervention to correct for the under-supply of finance does not necessarily have to imply direct supply by a government lender. The same effect could be achieved indirectly by breaking down barriers to entry and encouraging additional competitors through temporary tax credits or subsidy schemes or increasing access to the segmented area through the expansion of public goods like roads that in turn generate other positive externalities. When the monopolist enjoys increasing returns to scale, governments typically intervene with marginal cost pricing formulas to regulate the monopolists output behaviour and returns.
Externalities are the classic form of market failure. In the realm of financial markets externalities can emerge on the side of borrowers or lenders. On the borrowers’ side, defaulted borrowers increase interest costs to good borrowers as lenders pass on the higher costs of their bad lending experience to the rest of their clientele. Externalities exist on the lender’s side when borrowers have access to more than one source of credit (i.e. obtaining partial funding for a project from more than one lender). This multiple lender scenario creates a potential free rider problem in monitoring since the lenders benefit each other via their monitoring. Another scenario is where a borrower borrows for several projects from different sources of credit. The effort on each project is not separable. The terms and conditions of one lenders contract can affect the effort and payoff for the other lender (Besley, 1992).
Multiple indebtedness, a feature common to microfinance markets where both formal and informal finance intermingles can generate more loans than is socially optimal (i.e. excessive indebtedness). While government interventions to deal with this feature of multiple indebtedness would be desirable, it is not dear what form this intervention could take. Private lenders could undertake denying or reducing the size of loans to those who are already in debt to another source. However, one would need to generate an all embracing credit bureau that shared (or charged for) this universal information base for this to become effective. It is not dear what form government intervention could take to directly address this issue of excessive indebtedness caused by multiple lending unless it undertook to carry out or subsidise this credit bureau clearinghouse role.
Asymmetric or imperfect information is the third and most discussed perspective on market failure. This refers to the uneven, one-sided distribution of information favouring borrowers at the expense of lenders. Adverse selection highlights how interest rates do not dear the market between supply and demand since rising risk premiums only induce risk averse borrowers to leave the loan market while encouraging relatively more risk-prone borrowers with riskier projects to stay in the market The end result is a rise in loan losses for the lender, hence lenders choose not to raise interest rates (beyond some reasonable risk adjusted level) but rather ration the quantity of credit in the market This is considered socially inefficient since even a constrained Pareto optimum has not been reached with under-investment governing the supply of credit (i.e. some credit-worthy borrowers are denied credit since the. lender cannot tell the difference between some good and bad borrowers). This is the classic market failure example used to argue for government intervention in credit markets.
Moral hazard underscores the possibility that individuals with loans will exert less effort to restrain risky behaviour the higher the interest rate. This adverse incentive effort on borrowers behaviour also increases the likelihood of a worsening portfolio for the lender who in turn faces this challenge by rationing credit at lower interest rates. The quantity of loans lent to an individual is restricted for incentive reasons.
Adverse selection and moral hazard jointly generate a socially inefficient supply of finance, i.e. a smaller supply that that which would obtain in a world without asymmetric information problems. where truly creditworthy clients would not be rationed out of lender portfolios. This creates an argument for government intervention to deal with the problem of imperfect information. Creating the argument is one thing. Carrying it out is another thing altogether.
This brings us to the fourth and most important dimension behind market failure, namely, the lack of an effective contract enforcement framework. Practically all the writers in the asymmetric information school assume away this problem. Perhaps this is due to the fact that they all live largely in the United States where contract enforcement is reasonably robust However once one moves to the developing world, especially the world of the disenfranchised within the developing world, one has to face this issue and cannot assume it away. The lack of clearly specified property rights and cost effective and equitable contract enforcement machinery are severe problems for financial markets in these societies. The role of the government here is obvious. Strengthening property rights and streamlining more rigorous contract enforcement procedures and mechanisms are likely the most significant action governments can undertake in developing societies to improve the alleged market failure of financial market.
It is instructive to note that the major breakthrough, substantially reversing financial market failure in the past decade, owes nothing to the traditional recommendations outlined above. This is the breakthrough in lending technologies for the ‘best practice" microenterprise organisations. These organisations directly addressed the core problem of substantially reducing the imperfect information problem, enhancing monitoring, and devising innovative ways around the contract enforcement problem. Direct government intervention in financial market variables played no role in this unique effort except to fund a select number of donors who in turn supported, in an ad hoc manner, consultant and non-profit organisations carrying out these innovations in financial technology.
These breakthroughs emphasise the emulation of a market and incentive based system and appropriate links between property rights and governance in institutions. It further emphasises that the market with no interference from government would find its own way in efficient allocation of resources. However, this is based on the assumption that information can flow unhindered in this market and all the aspects that result in efficient markets are in place. This is not always true in all markets. Markets may be at different levels of maturity and institutions operating in markets may be at less-optimal levels of decision making and allocating resources. In these situations one may find less optimal allocations and opportunities for the formation of cartels, monopolies and exploitation of uninformed clients. Then, what should be done to improve these situations. Mostly theory and experience will tell us that intervention in these markets should be to increase information flows. This is due to the fact that the inefficiency of a market is mostly ascribed to a lack of information and resultant frictions in the market that contributes to inefficient allocation of resources. Thus the problem is basically information and not price. Intervening on price (by setting price ceilings) do not address the original problem, information. Thus the message is that the identified problems should be addressed directly.
It has been argued that, while most consumers can shop effectively for credit, some live and work in areas (and due to historic discrimination) where there is not adequate competition amongst credit providers. That may certainly be true in some instances, especially with respect to cash credit However, the experience is that the imposition of an interest rate ceiling under these circumstances discourages competition that would bring the benefits of multiple alternatives to consumers. Further, most of the credit we are discussing would be classified as consumer credit, thus for the purchase of consumer items. Thus, while a merchant may be prohibited from charging more than an imposed ceiling nothing prohibits the merchant from charging more for a specific consumer item (for example charging R500 for an item selling somewhere else for R250).
Many argue also that interest rate ceilings protect the unsophisticated consumers when they seek credit Once again it can be argued that there is rational for attempting to protect unsophisticated consumers with rate ceilings when they shop for credit, when there is no rational way to protect them when they protect the goods and services that constitute a much larger portion of their total expenditure. It is also argued that it is difficult to believe that the legislator can understand the circumstances of a specific consumer in a specific market better than the consumer herself.
Price determination
Price determination is a standard market function. Demand for more credit puts pressure on prices to move upwards. Competition amongst credit providers puts a downward pressure on prices. A highly competitive market exists where the number of credit providers is sufficiently large or entry by new competitors is so easy that no single credit provider could change the market price through its own decisions on how much to lend.
Another important component of a competitive market is the presence of informed borrowers who are knowledgeable about the availability, pricing and features of alternative credit projects. Creditors respond to increased competition with price cuts only if they fear their customers will defect to a lower price alternative.
In summary, the international theory and practise show that, given the cost structure of microfinance, interest rate restrictions usually undermine and institutions ability to operate efficiently and competitively. Typically, restrictions do not achieve their public policy objectives of protecting the most vulnerable sectors of the population. Instead they drive informal lenders underground, so that poorer borrowers fall to benefit from the intended low-cost financial services. While there is reason to question the appropriateness of interest rate limits in any form, financial institutions that can demonstrate services to the poor at a reasonable cost should receive exemptions in countries where usury laws are in effect.
The US experience of the past 25 years (Staten & Johnson, 1995) has shown that competition in the credit market has dramatically expanded the range of loan products and features available to consumers, facilitated by the relaxation or removal of rate ceilings in most states. They found that the removal of rate ceilings brought more and new competitors to the market with resultant positive impact on the price and availability of consumer credit.
All financial institutions operating in the eight countries that make up the West African Economic and Monetary Union (UEMOA) are subject to a Usury Law provided that the maximum interest rate charged to a borrower should not exceed double the discount rate of the Union’s central bank. In 1996 the Usury Rate fluctuated around 13%. Microfinance institutions, NGOs and donors were active in working with the Central Bank to persuade it to grant an exemption that would enable microfinance institutions to charge high enough rates to reach financial sustainability. Their advocacy efforts were successful and the central bank is in the process of revising the usury law. Two usury rates that would no longer be linked to the discount rates have been enacted: one for commercial banks (18 percent) and one for NBFI and microfinance institutions (27 percent). The flexibility of the central bank demonstrates an understanding of the important role that microfinance institutions are playing in West Africa (Cecile Fruman - Sustainable Banking with the Poor Project). Despite this easing of the interest rate ceilings under the usury act, the Central Bank of the UEMOA stiff maintains rates that are considered to be too low by microfinance practitioners to provide incentives to invest in microfinance. The Central Bank of the UEMOA does not perceive microfinance as a part of the private sector, but as a part of the co-operative and non-governmental sectors, financed with support from donors.
When we study the legislation examples on credit agreements in many countries some examples are interesting in terms of this study.[10]
| ▪ | In Europe the emphasis is on the standardisation of the presentation of the cost of credit through the use of the APR. All creditors and intermediaries must be registered and bodies are established to handle complaints. The EU approach assumes that clear information alone is the most important element for protecting consumers against bad practices from creditors. |
| ▪ | Different EU members states have expanded these rules into national legislation. A case in point is Belgium. One example of the extra arrangement is that the creditor must advise the client on the suitability of the specific credit product for the need of the client. They have a ceiling on interest rates, which are revised every six months. A central database with information on defaulters is maintained by the Central Bank. A lender should only provide a loan after ascertaining that the borrower is in a good position to repay the loan. "Reckless" lending may result in the courts’ punishing creditors by allowing the interest to be reduced or forfeited to compensate the customer. |
| ▪ | In France the Usury Act places the ceiling at 33% above the average lending rate of the banks over the last three months. A free debt rescheduling service (over a four-year period) is now supported by the Central Bank. |
| ▪ | In Spain the consumer credit act was passed in 1995. It follows closely the EU dispensation, focusing on the availability of information to the consumer. The Bank of Spain also runs a complaint service where customer can lodge complaints on unfair practices. They have a Usury Act but the ceiling is to the discretion of a judge on a case by case basis. |
| ▪ | In the USA the Law of consumer credit is embodied in state and federal law. Several states have interest rate ceilings. A state like South Dakota with no ceilings drew all the credit card companies to settle there. Consumer Credit Counselling Services provide debt counselling in all major cities. They are self-financed through a levy system on loans. Bankruptcy procedures are available for all customers on the fresh start principle. You can either file for full bankruptcy or for administration procedures. |
| ▪ | In Australia legislation emphasises full disclosure, provision of regular statements and notices, power for courts to address unjust contracts and scrutinise unfair interest rate changes or levying of fees, protection against unfair contract enforcement and repossession practises, penalties to provides who break these rules, use of a comparison rate. A national strategy is in place to educate the consumers about responsible credit use and to reduce financial over commitment Counselling is provided through 31 agencies financed by the Federal Government emphasis is placed on isolated customers, low-income families and social security recipients. |
| ▪ | Brazil has a consumer protection code. The code provides rules for access to information and public consumer protection agencies are entitled to receive and handle complaints by consumers. |
| ▪ | In Chile creditors are obliged to provide information on the cost of credit The National Consumers Service has the function of studying, evaluating and educating consumers. The service also has authority to bring consumer complaints to the courts. The Consumer Protection Act has created the right to equal and non-discriminatory treatment. |
| ▪ | In India small claims and arbitration procedures have been established which are cheap and informal and consumer courts handle all claims. People have responded positively to this mechanism and many complaints are lodged with most of the judgements in favour of consumers. |
| ▪ | Although there are many specific acts in Malaysia very few are enforced and consumers are not adequately protected. Confusion also exists as to what law would apply in a specific circumstance. |
The conclusion drawn by a recent study on credit legislation [11] is:
| ❑ | that all loans should be regulated, |
| ❑ | that rules on consumer credit practices should be contained in a single act, |
| ❑ | that clear inclusive definitions of consumers and credit should be provided, |
| ❑ | that specific rules on information to consumers should be enacted, |
| ❑ | that the presentation of the cost of credit should be standardised, |
| ❑ | that a cooling or cancellation period should be part of the agreement, |
| ❑ | that ceilings should be carefully considered as they limit access to loans and that different ceiling should apply to different loan categories, |
| ❑ | a minimum down payment should be considered, |
| ❑ | early repayment should be allowed and penalties should be within reasonable limits, |
| ❑ | there should be a limitation on lending periods, in situations where defaults are due to trauma extensions should be considered, |
| ❑ | credit bureaux should be regulated by legislation with specific client rights emphasised in terms of access to personal information, |
| ❑ | national co-ordination of consumer education, provincial consumer desks should be involved, in educational campaigns, debt counselling services to help in over-indebted situations should be created, appropriate mechanisms should be in place where consumers can lodge complaints. |
| ❑ | applicants should be informed of the basis for decisions not to extend credit |
The study found that the international comparison does not provide clear answers to the debate for or against ceilings. It was found in the UK that absence of regulation led to high cost credit In Italy it was found that within the realm of regulated rates illegal lenders flourish while the limitations are respected in other countries where no parallel markets exist In most countries with interest rate limitations the ceiling is not uniform. Different limitations are applied to different types of credit. The study concluded that there is no uniform approach to the imposition of limitations on interest rates and a real possibility that the imposition of ceilings would limit access to credit.
The study was quite comprehensive but did not go into enough detail and sound arguments for the motivation of each proposal. The proposals seem to be merely taking the measures of a range of other countries and applying them for South Africa. However, the study shows clearly that information flows to consumers, consumer education and a system for the lodging and handling of complaints should be the backbone of the government support system to borrowers. The study is not conclusive on interest rate ceilings and lacks a good discussion of the dangers of intervening and distorting market signals.
The microlending industry has shown explosive growth over the last few years. The market development has largely been done by independent organisations and the expected consolidation of activities is now taking place. First independent firms consolidated their activities and now the banking sector is slowly starting to buy up (ABSA buying controlling stake in Unibank) the successful bigger entities or forming strategic alliances with bigger outfits (e.g. Standard Bank and African Bank). The South African situation is a perfect example of the power of legislative changes and the ability of the private sector to react to identified incentives. It is further a good case study of the development of a market and the changes that occur in this process. It started with a few players reaping tremendous profits and now it expanded to numerous players and serious competition in the market. Unfortunately the competition has not necessarily led to much downward pressure on prices, as the market has still not been penetrated to its full potential. it is expected that the prices will stay constant for the foreseeable future but our analysis shows clearly that the cost profile of the sector is under pressure.
The abuse of customers by many formal and informal lenders resulted in serious attention by consumer protection authorities and also in the formation of many alliances that are striving to bring more integrity to the market. Members of these alliances or associations should abide to codes of conduct that are designed to protect the customer. However, the alliances/associations cover not more than the estimated 3500 formal microfinance institutions and the 40 to 70 financiers of enterprise lending. It implies that the majority of the informal and semi-formal organisations are outside the reach of the alliances.
[9] See Stiglitz and Weiss, 1981; Levine, 1993, Mayer, 1992.
[10] Deloitte and Touche study on Credit Legislation
[11] Only salient aspects drawn from the Deloitte and Touche study on Credit Legislation