APPROVAL. Dr. Nyambane David

Transcription

1 DECLARATION I MUGISHA Epaphura do declare that this dissertation is my original work. It has not been presented for any award in any University, college or other institution of higher Learning. Signed Date i

2 APPROVAL "I confirm that the work reported in this dissertation was carried out by the candidate under my supervision and has been submitted with my approval". Dr. Nyambane David Date ii

3 DEDICATION I dedicate this dissertation to my Dear wife Wibabara Joan and my Daughter Mihigo Blessing and my Son Mihigo Dan for the support and the words of encouragement I dedicate this research work also to my mother Mukarusine Miriyeri for support during my education. iii

4 ACKNOWLEDGEMENT This work would not have been a success without the support and guidance of relatives and friends. Therefore, thanks go to them through guidance that could have been directly or indirectly felt. I am greatly indebted to Dr Nyambane David for undertaking the task of supervising the research leading to this dissertation. I gained a tremendous amount of knowledge under his supervision for expertise, time, care and compassion that have made this work successful and complete. May God bless him. I thank KIU for all work done towards my studies at University. I am very thankful to my fellow students in my group for the wonderful moments and learning experience we shared for the last two years. Not of course forgetting my classmates Kizihira Alphonse, Tumwine Venant, Muhire Modest, Nteziyaremye Jerome. I am very thankful to almighty God for the good health during my studies for the last two years. iv

5 TABLE OF CONTENTS: PAGE Declaration i Approval......ii Dedication.. iii Acknowledgement....iv Table of Contents.....v ListofTables...x List of Abbreviations. xii Abstract....xiii CHAPTER ONE 1.0. Introduction Background Historical Perspective Theoretical Perspective Conceptual Perspective Contextual Perspective Statement of the problem Purpose...11 v

6 1.4. Objectives of study Research questions Scope of study Significance of the study CHAPTER TWO 2.0 Literature Review Introduction The structure of Micro Finance interests Key institutional issues The roles of government and the central bank Rational for high MF interest rates Affordability of MF interest rates by the poor Who are the clients of microfinance institution Credit Credit analysis Factors to consider in credit analysis The lending process Check on collateral and preparation of loan agreement Default loans Causes of default loans 35 vi

7 2.7.5 Indicators of default loans Management and control of potential loan losses Prevention of problem loans and loss Handling default loans Conclusion CHAPTER THREE 3.0 Methodology Introduction Research design Target Population Sampling Strategies Data collection methods Data collection instruments Data quality control Administrative Procedure Data analysis Limitations of the study CHAPTER FOUR vii

8 4. 0 Data presentation, analysis and interpretation Introduction MFI interest rate charges in Rwanda The importance of unit cost of lending Limited sources of funds for on-lending The importance of risk The roles of government and the central bank Data interpretation Primary data Questionnaire Secondary data Interview Conclusion..69 CHAPTER FIVE 5. 0 Summary, conclusion and recommendations Summary of findings Conclusion Recommendations Prospects for future research...76 viii

9 5.5 References Appendices...81 ix

10 LIST OF TABLES Table Table 1.1 Dates when some Micro Finance Institutions in Rwanda were established..2 Table 1.2 present savings and loans for the period Table 1.3 Consolidated Financial Statement of Micro Finance Institutions on December 31 st Table 2.1 Comparative interest rates in 6 Asian economies Table2.2 A hypothetical Cost structure of a Commercial bank and Micro Finance Institution Table 4.1 Interest rates of Micro Finance Institutions in Rwanda 50 Table 4.2 Comparative interest rates in Rwanda Table 4.3 Interest rates for Agriculture Projects in Rwanda Table 4.4 Inflation rate Rwanda Table 4.5 Trends of deposits and credits of one Micro Finance Institution in Rwanda Table 4.6 Education level analysis Table 4.7 Analysis of clients with credits Table 4.8 Analysis of credit management literacy...61 Table 4.9 Analysis of economic activities of clients Table 4.10 Analysis of credit repayment period x

11 Table 4.11 Analysis of interest rate per month Table 4.12 Problems encountered during credit repayment period Table 4.13 Presents doubtful debts for the period Table 4.14 Bad debts written off Table 4.15 Recovery of loans written off xi

12 List of Abbreviations MFIs: MF: Rwf: CSS: MDGs: ICT: BNR: BK: BCR: BCDI: BRD: COGEBANK: COOPEC: VFC: MINECOFIN: NGO: UBPR : CGAP: SACCO: Micro Finance Institutions Micro Finance Rwandan Francs Credit and Savings Society Millenium Development Goals Information Communication Technology National Bank of Rwanda Bank of Kigali Commercial Bank of Rwanda Bank of Commerce, Development and Industry Rwanda Development Bank Insurance Bank Savings and credit Cooperatives Vision Finance Company Ministry of Finance and Economic Planning Non Governmental Organization Popular Bank of Rwanda Consultative Group to Assist the Poor Savings, Credit and Cooperative Schemes CEFE SA-AGASEKE: Financial Enterprise Centre Company- AGASEKE UOMB: Urwego opportunity Bank xii

13 ABSTRACT This research aimed at finding out why the Poor People still borrow in Rwanda despite the wide range of high interest rates charged by Vision Finance Company. The problem statement of this research based on several reports of 2008, 2009 and 2010 from Vision Finance Company. The objectives of the research were to determine whether Interest rates in Vision Finance Company are high, to determine whether people continue to borrow from Vision Finance in Rwanda Company and to determine the influence of government policy on interest rates and loan repayment. While carrying out the study, data collection methods were used both primary and secondary sources of data, the methods used were documentation, interviews, questionnaire and direct observation. The study revealed that Poor People still borrow in Rwanda despite the wide range of high interest rates charged by Vision Finance Company. The research found out that, economically active poor are able and willing to pay the high interest rates when right opportunities offer themselves for borrowing and they prefer to pay high interest rates to not getting where to borrow at all. VFC which operate savings are able to reduce their cost of funds which enables them to charge lower interest rates than those which do not have deposits; The cost of funds to the VFC is still high especially because availability of sources of funds for on-lending are limited and the financial sector is neither developed nor well integrated; Although in Rwanda there is no indication at the moment of influencing interest rates xiii

14 by putting in place interest rate ceilings, government should avoid this temptation because as a policy, its negative effects ultimately outweigh its positive effects. It creates distortion which lead to eventual collapse or chronic subsidy which is never sustainable because the MFIs would have to use up its capital to support the subsidy, or get into permanent subsidy support. xiv

15 CHAPTER ONE 1.0 INTRODUCTION 1.1. Background Historical Perspective Micro Finance Institutions are organizations that provide banking services such as savings, credit and money transfers to poorer people who cannot access ordinary mainstream banking services. In 1974, famine struck Bangladesh at the time, Dr Muhammad Yunus was a professor of economics at the University of Chittagong. Disillusioned by the elegant theories of economics that could not explain the thousands of poor people dying of starvation on the streets; he was determined to find a practical way to help the poor. During a visit to the nearby village of Jorba, he was astounded to find that a sum of $27 could radically change the lives of 42 people in the village. This was the sum of money they collectively needed to buy bamboo to make the stools they sold to make a living. He took $27 from his pocket and made 42 loans to the stool makers in this tiny village. They were able to pay him back with interest and take a step towards lifting themselves out of poverty. And now the world Bank estimates that more than 16 million people are served by some 7,000 micro finances all over the world. Consultative Group to Assist the Poor experts mean that about 500 million families benefits from these small loans making new business possible. 1

16 THE CLIENT MARKET POTENTIAL STILL UNSATISFIED Table 1.1: Dates when some MFIs in Rwanda were established Name of MFI Year of establishment RWANDA POPULAR BANK 1975 ZIGAMA-CSS 1997 URWEGO OPPORTUNITY BANK 1997 SAVINGS AND CREDIT COOPERATIVES 1999 VISION FINANCE COMPANY 1999 AGASEKE 2003 UBAKA 2003 INKINGI 2004 UMUTANGUHA 2005 UNGUKA 2005 AMASEZERANO 2006 Source: Capmer.org/new/docs/les conditions de credit au Rwanda. PDF; Table 1.1 shows that out of five MFIs visited by the researcher, apart from the UBPR which started in 1975, four others started between 1997 and 2006; a life span of less 10 years. All the above five MFIs which were visited show characteristics of a young MF industry. Table 1.2: Present savings and loans for the period expressed in million of Rwandan francs Indicators 31/12/ /12/ /12/ /12/2010 Total savings Gross loans Loans as 62% 70% 28% 21% proportional to savings Source: Secondary data 2

17 With reference from the above table, savings for the period were , , and million of Rwandan francs respectively. In calculating the proportion of loans to savings, the results were 62%,70%,28% and 21% respectively. The savings were not stable because it reduced in 2008 increased in 2009, but loans increased from 62% to 70% because microfinance was encouraging the poor to start small business regardless of what someone deposited. The microfinance continued its lending limits because their lending capacity over deposits should not be more than 70%. This is good because over lending is considered as one of the major causes of credit non recovery. East African countries also found it viable to implement MFIs as tool of poverty reduction therefore they signed in 2008 MFIs Capacity Building initiative in East African Countries (Kenya, Uganda, Tanzania, Ethiopia, Rwanda and Burundi) where the strengths and weaknesses of 35 MFIs shall be analyzed, benchmarks, set and measures for the improvement of institutional difficulties implemented. After the completion of these activities, some 12 MFIs are then expected to be rated by an official rating agency as Tier 2.This improved status, thanks to the advancement of their structures and capacities, would allow them to fulfill the basic criteria for accessing commercial financial and this project will end in 2012.For Rwanda perspective the first micro finance began to exist since 1975 with the establishment of the first Popular Bank at NKAMBA (former KABARONDO district). After the 1994 genocide in Rwanda, the micro finance sector has known a dramatic progress through the support of relevant international and Non Governmental Organizations especially humanitarians. According to BNR 2008 report status that significant increased activity in the micro finance sector between December 31 st,2007 and on December 31 st, 2009, outstanding deposits of all MFIs amounted to rwf, and the gross outstanding loans of 50.1billions rwf. The number of beneficiaries of the MFIs was people by June These figures are still heavily influenced by those of Zigama CSS( Credit and Savings society) 3

18 which alone amounted to approximately half of the outstanding deposits and loans of all cooperatives and savings and credit Unions. Table 1.3: Consolidated Financial Statement of MFIs as at December 31 st Description (Million in rfw) 31 st December st December 2009 Variation Total Assets 60, , Total Deposits 38, , Gross outstanding loans 42, , Non-performing loans 2, , Provisions 1, , Source: ( BNR, 2009) By the end of September 2009, there were 100 MFIs and one micro finance bank that were divided as follows: 87 Savings and credit Cooperatives (COOPEC) 11 Limited companies One Micro finance bank ( Urwego opportunity Bank) About Vision Finance Company S.A Rwanda Established in 1999, Vision Finance company(vfc) is an affiliate of World Vision International. Since its founding, VFC has been committed to alleviating poverty in Rwanda by ensuring that poor people have access to credit to support business initiatives that will improve their life circumstances. VFC s mission is to promote economic empowerment and improve the standards of living of the Rwandan population through the provision of financial services to the working poor with an emphasis on women living in rural areas. 4

19 1.1.2 Theoretical Perspective MFIs are expected to recover all the costs and on top earn a profit return to finance their own growth. If all the costs are not accurately and comprehensively computed and recovered by the interest rates when funds are lent out, it will inevitably lead to a distorted interest rate. This will further lead lenders resorting to practices such as hiding costs into other charges to clients or dodging the poor to lend a few well to do rich clients whose costs of lending is lower and matches a lower interest rate(robinson, Marguerite,: 2001 pp142). This simply explains that all costs must be reliably estimated with minimum distortions and it does not matter whether the clients use the funds obtained to finance fixed assets or working capital. The price that reflects all the cost elements comprise the interest rate and how high these costs are, determines how high the interest rate will be and therefore, how easy will be for borrowers to pay lenders the principal amount and interest thereon. Although interest rates depend largely on the cost elements outlined above, it also depends on the following factors; individual institutional competencies and their respective managements, the age and size of the MFI which largely determines the level of efficiency, the nature of products and services offered to clients and the nature of client target market(ledger wood, Joanna,:2000 pp11). Other factors that influence interest rate include the broader macroeconomic environment and the level of social economic infrastructural development that supports the economic activities. Furthermore other factors that influence MFI interest rates include political policies in as far as they influence financial outcomes and psychological factors especially building trust and confidence in the financial intermediation process and managing expectations. There are other non- economic social pressures and groups which may influence interest rate. Rosenberg, Richard, 1996 Ledger wood, Joanna, (2000), pp150, offers a model, outlined below, on approximation of sustainable interest rates. The other method which was suggested is less straight forward because it relies on the internal rate of return which can prove difficult for practitioners of micro enterprises to compute, although it gives a more accurate estimation of interest rate. To manage 5

20 interest rate payments, MFIs can then easily manipulate, differently, the computation of interest rate to be charged. MFIs could achieve this either by ensuring the following: all interest charged is recovered at the beginning; a commission is charged on the total loan amount and recovered at the beginning; payments for interest and principal are paid in weekly installments; that the interest is applied flat on the whole loan throughout the period; a flat interest amount is received upfront; the flat rate and upfront interest in combined with a fee; compulsory savings are retained by the MFI to guarantee the loan, normally subtracted from the loan; it could be a combination of flat, upfront interest rate, fee and compulsory saving all combined. All the above techniques result into different annualized interest rate implications for the client and give different Net Present values. This research has adopted the basic model shown below because it is the one adopted by most MFIs in Rwanda which were visited. The annualized interest rate, R=AE+LL+CF+K/II LL Source; Ledger wood, Joanna, (2000),pp149 Where; R is the annualized rate of interest, CF is the proportion of the cost of funds using the Weighted average cost of capital (WACC- will be defined below), AE is the proportion of total administrative expenses incurred by the MFI, LL is the proportion of loan loss provision, K is the proportion of capitalization and opportunity cost II is the proportion of investment income earned each of the above cost or income elements is expressed as a percentage of the average loan portfolio. In the formula above, the numerator is the sum of the proportion of the costs that go into the interest rate as a cost of financing, while the denominator is the proportion of the loans that are good. In other words, the total financing cost is distributed only over the recoverable loans. The behavior of the numerator is such that as the costs decrease, interest rate 6

21 should decrease, while the denominator is such that as the loan loss decreases (as the good loans increase), the denominator increases and approaches one, consequently making the interest rate to decrease. The Average Weighed Cost of Funds or Capital, WACC(Gitman, J. Lawrence, 2006 pp505), denoted by ka is given Ka=(wi*k1)+(wp*kp)+(ws*kr or n) Source: Gitman, J.Lawrence (2006).pp505 Wi+wp+ws=1 In the formula, Wi=proportion of long term debt in capital structure, Wp= proportion of preferred stock in capital structure, Ws=proportion of common stock equity in capital structure Conceptual Perspective The dependent variable in the study is loan repayment. Loan repayment defined from Wikipedia, the free encyclopedia as A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower. In a loan, the borrower initially receives or borrows an amount of money, called the principal, from the lender, and is obligated to pay back or repay an equal amount of money to the lender at a later time. Typically, the money is paid back in regular installments, or partial repayments; in an annuity, each installment is the same amount. The loan is generally provided at a cost, referred to as interest on the debt, which provides an incentive for the lender to engage in the loan. In a legal loan, each of these obligations and restrictions is enforced by contract, which can also place the borrower under additional restrictions known as loan covenants. Although this article focuses on monetary loans, in practice any material object might be lent. 7

22 Acting as a provider of loans is one of the principal tasks for financial institutions. For other institutions, issuing of debt contracts such as bonds is a typical source of funding. The independent variable which is interest rates defined by Investopedia explains 'Interest Rate' as Interest is charged by lenders as compensation for the loss of the asset's use. In the case of lending money, the lender could have invested the funds instead of lending them out. With lending a large asset, the lender may have been able to generate income from the asset should they have decided to use it themselves. Using the simple interest formula: Simple Interest = P (principal) x I (annual interest rate) x N (years) Borrowing $1,000 at a 6% annual interest rate for 8 months means that you would owe $40 in interest (1000 x 6% x 8/12). Using the compound interest formula: Compound Interest = P (principal) x [ ( 1 + I(interest rate) N (months) - 1 ] Borrowing $1,000 at a 6% annual interest rate for 8 months means that you would owe $ The interest owed when compounding is taken into consideration is higher, because interest has been charged monthly on the principal + accrued interest from the previous months. For shorter time frames, the calculation of interest will be similar for both methods. As the lending time increases, though, the disparity between the two types of interest calculations grows. An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for deferring the use of funds and instead lending it to the borrower. Interest rates are normally expressed as a percentage of the principal for a period of one year Interest rates targets are also a vital tool of monetary policy and are taken into account when dealing with variables like investment, inflation, and unemployment 8

23 From Wikipedia, the free encyclopedia Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds. When money is borrowed, interest is typically paid to the lender as a percentage of the principal, the amount owed to the lender. The percentage of the principal that is paid as a fee over a certain period of time (typically one month or year) is called the interest rate. A bank deposit will earn interest because the bank is paying for the use of the deposited funds. Assets that are sometimes lent with interest include money, shares, consumer goods through hire purchase, major assets such as aircraft, and even entire factories in finance lease arrangements. The interest is calculated upon the value of the assets in the same manner as upon money. Interest is compensation to the lender, for a) risk of principal loss, called credit risk; and b) Forgoing other investments that could have been made with the loaned asset. These forgone investments are known as the opportunity cost. Instead of the lender using the assets directly, they are advanced to the borrower. The borrower then enjoys the benefit of using the assets ahead of the effort required to pay for them, while the lender enjoys the benefit of the fee paid by the borrower for the privilege. In economics, interest is considered the price of credit. Interest is often compounded, which means that interest is earned on prior interest in addition to the principal. The total amount of debt grows exponentially, and its mathematical study led to the discovery of the number 9

24 1.1.4 Contextual Perspective VISION FINANCE COMPANY SA Profile Mission: Our mission is to provide financial and non-financial services to the economically productive Rwandan poor, especially women, through the development of sustainable and small micro-enterprises Background and Main Challenges: "Vision Finance Co. SA (VFC) was started in 1997 as a Microfinance Department under World Vision Rwanda and later registered as a separate program called Amizero (Hope) Microfinance in It was then incorporated as a limited Liability company (Societe Anonyme) in October 2003 and licensed as a regulated Microfinance Institution by the Central Bank in September VFC is a wholly-owned microfinance subsidiary of World Vision International represented by its program in Rwanda, World Vision Rwanda. World Vision is a Christian humanitarian organization dedicated to working with children, families and their communities worldwide to reach their full potential by tackling the causes of poverty and injustice. World Vision strives to impact poor communities through its remarkable model of utilizing the five arms of development, namely Health, Education, Food, Water and Economic Enterprise. VFC hence fulfills the fifth arm of developing sustainable economic enterprises in Rwanda through targeted and meaningful penetration of Rwandan communities using the most effective and proven methodologies to lift communities out of poverty. VFC currently serves over 22,000 credit and savings clients in eight branches and 20 Site Offices (a total of 28 locations) in all of the administrative provinces of Rwanda, with a loan portfolio of about 10

25 RwF 1.8bn as of end of VFC intends to reach over 40,000 savings and credit clients by 31 December 2012 with a loan portfolio of over RwF 5bn, through its three key lending methodologies of Community Banks, Solidarity Groups and Individual Loans. About 70% of all VFC clients are women. VFC s typical client is usually a mother aged over 45, often widowed, looking after an average family size of seven (some of them orphans) and owns a small business, usually a stall in the market, or a small shop/kiosk by the roadside. VFC targets women because its believed that empowering the women of Rwanda will ultimately lift the nation out of poverty. 1.2 Statement of the problem: Poor People still borrow in Rwanda despite the wide range of high interest rates charged by Vision Finance Company. Many people have accessed credit through Vision Finance Company. A lot of funds have been expensed in the institutionalization of Vision Finance Company for purposes of making it credit intermediary of the poor. Impact created by Vision Finance Company to reduce interest rates assault is less significant as many people have continued to borrow at high interest rates. Information Micro on continuity borrowing from Vision Finance Company is available. The best practices of successful Vision Finance Company have not been well documented. The big proportion of revenue of this country is derived from credit operations and most of the activities are facilitated by credit, despite the failure of the loan to generate income to repay the principal and interest. 1.3 Purpose of the study The main purpose of this research was to establish the reasons why poor people continue to borrow despite the high interest rates charged by MFIs. 11

26 1.4 Objectives of study: i. To determine whether Interest rates in Vision Finance Company are high. ii. To determine why people continue to borrow from Vision Finance in Rwanda Company. iii. To determine the influence of government policy on interest rates and loan repayment. 1.5 Research questions include: i. Are interest rates charged by Vision Finance company high? ii. Do people continue to borrow from Vision Finance company in Rwanda? iii. Does government policy influence interest rates and loan repayment? 1.6 Scope of the study: This study will be carried out in VFC at Head Office based in Kigali and the period under consideration is 2007 to The study will focus on assessing interest rates and loan repayments. 1.7 The significance of the study: The study will provide information concerning why people still borrow in Rwanda despite the wide range of high interest rates charged by Vision Finance Company in addition to existing information. The study will also provide information for policy makers and all those people doing further studies as far as interest rates and loan repayments in Microfinance institutions is concerned. 12

27 CHAPTER TWO 2.0. LITERATURE REVIEW: 2.1. INTRODUCTION According to Ledger wood, Joanna, (2000:pp1), MF has evolved as an economic development approach intended to benefit the poor. In the 1970s, government agencies were the predominant method of providing credit to clients with no credit history. Latter in the 1980s, the subsidized, targeted credit model was the object of steady criticism, because most programs accumulated large loan losses and required frequent recapitalization to continue operating. As a result changes in approach occurred with emphasis shifting from the subsidized approach to building up formal financial institutions based on financial systems (Robinson, Marguerite, 2001 pp52). Varying models have evolved from Grameen Bank model initiated by Dr. Mohammed Yunus of Bangladesh which supports community based lending, to ACCION International of Latin America which supports solidarity groups and other NGOs that emerged later such as K Rep of Kenya, which support individual lending ( Otero, Maria, & Rhyne, Elisabeth, 1994 pp ). According to the World Bank s Development Report 1999/2000: Some 80% of the world s billions living in low and lower middle income economies do not have access to a formal sector offering financial services ( Robinson, Marguerite, 2001 pp 10 ). Again according to Ledger wood, Joanna, (2000), since the 1980s, the field of MF has grown substantially. During the , research on inventory revealed 1,000 institutions with outstanding loans of over USD 7 billion and over USD 19 billion in deposits serving over 500 million people (Robinson, Marguerite,:2001 pp26 ).MF in the 1990s (Robinson, Marguerite,:2001 pp22) was marked by a major debate between two lending views: the financial systems approach, sometimes called the minimalist approach, emphasizes institutional self sufficiency as the only possible means to meet wide spread client demand for convenient and appropriate financial services (Versluysen, Eugene,: 1999 pp58). The poverty lending approach sometimes referred to as the integrated or maximalist approach focuses on reducing poverty through credit, often provided together with complementary services such as skills training, literacy, numeracy, health, nutrition, 13

28 family planning, and other social programs (Versluysen, Eugene,: 1999 pp59). This latter approach provides financial intermediation services below market interest rates. MFIs by definition offer financial intermediation (Versluysen, Eugene,: 1999 pp55), although they often also offer social intermediation. On one hand, financial intermediation includes loan products, savings products, insurance products and payments services. On the other hand, social intermediation is defined as the process of building the human and social capital required for sustainable financial intermediation. They include enterprise development, training, organizational development and skills development. Interest rate is defined as the amount charged for a loan, usually expressed as a percentage of the sum borrowed, conversely, the amount paid by a bank, building society, etc., to a depositor on funds deposited, again expressed as a percentage of the sum deposited(dictionary of Finance and Banking,:1997 pp180). In this study, focus will be on the definition, although in the case of MFIs, deposits affect loans since the cost of funds which is one of the major variables that determine interest rates on loans is influenced by the level and cost of deposits. Economically, interest rate is a required rate of return on money borrowed. According to Rhyne, Elisabeth, (1995) Robinson, Maguerite,(2001)pp24 MF can be sustainable at every level of clientele with even the poor being able to pay the full cost of lending. The advantages with the financial systems approach are obvious; they grow and expand outreach systematically by leveraging additional capital and also escape chronic donor and government dependence and influence. The way MF services will be offered is influenced by the overall political and economic environment. This includes; different macroeconomic country level policies, the level of development of the sector including the suppliers of MF financial intermediation and country contextual factors such as regulation, supervision; and the organization of MF clients. There are five well known ways to deliver MF intermediation (Ledger wood, Joanna, 14

29 2000 pp 82-86). The first approach is the individual lending mainly practiced in urban and production based clients and also rural farmers who may possess some collateral. The second approach is the Solidarity group lending as practiced by the Grameen Bank but also practiced in many other parts of Asia, Africa and Latin America. In this case, the clients are organized into groups whereby group members mutually guarantee each others credit and are legally held responsible for other members loans. No collateral is required and appraisal is jointly performed by group members together with credit officers. The third approach is the Village banking which is a credit and savings associations which offer MF intermediation especially in the rural areas. Membership is on voluntary basis and financing is from members contributions as well as from the MFIs. The fourth approach is the Savings and Loans Associations which offer financial intermediation to members only. The fifth approach is the Latin America Solidarity Group lending mainly tailored to serve small scale market vendors who need small short term working capital loans. MF interest rates pose a very important concern because the target markets served by MFIs are poor people and interest rate being the price of funds charged to this category; it is sometimes assumed that it should be and seen to be fair and trusted by clients. For MFIs to operate on a sustainable basis, however, they need to ensure cost recovery. When interest rates are fixed under market forces, this ensures efficient resource allocation and offers a better and reliable opportunity to grow and to reach poor clients as possible. 2.2 THE STRUCTURE OF MF INTEREST RATES As indicated earlier, the objective of a MFI is to offer financial services for which it must charge an interest rate that covers all costs in order for the institution to be sustainable (The CGAP Occasional Paper No.1:1996). An important factor to consider is to ensure that the borrowers are also able to earn adequate return on their profits and be able to meet both their business commitments and in addition meet the lenders commitments. Funds can only be accessed at a cost for which a price must be charged not only covering the cost of funds (cost of funds includes the risk element, the inflation factor 15

30 plus the opportunity cost of the funds which explain the capitalization rate) for on lending, but also to cover administration expenses such as salaries, staff benefits, rent, utilities, depreciation expenses, training, and other operating expenses which form the largest costs of MFIs. Another cost that enters into the computation of MFI interest rate is the loan loss, which also has to be included since not all loans to clients are recovered. 2.3 KEY INSTITUTIONAL ISSUES The structure of an annualized interest rate as shown above reveals that the major factor which largely influences MF interest rate is the cost of financing. In analyzing the factors that influence the variables indicated above, there are two broad categories of major influences on MF interest rates: On one hand, there are factors internal to the MFIs which can be influenced by their Boards of Directors and Management, while on the other hand there are factors that are environmental and external to the MFIs. These internal factors can be sub categorized as strategic or operational, whereby strategic factors are considered as those determined by the respective Boards of Directors including setting Goals, Mission and Vision of the MFIs. According to Campion, Anita & Frankiewicz, Cheryl,(1999 Occasional Paper No. 3 pp17 30), board decisions are very important because they determine not only the nature of the MFI but also its general orientation and focus. Ledger wood, Joanna, (2000 pp111) states that governance and ownership are critical in directing MFIs visionary whether to adopt business like approach or not, which drives the motivation of management. According to Candace, Nelson, (1996 pp35) such decisions extend to organization structural issues like whether an MFI will be a Limited Company, Non Governmental Organization (NGO), or a Cooperative, and this will imply the extent to which profit will be a major focus or not. Governance will also determine how wide or narrow the organization structure will be, which will also have a direct bearing on how heavy administrative expenses will be. Strategic factors are meant to set strict guidelines within which management must operate which will largely determine the efficiency of the MFI and influence the determination of the interest rate. 16

31 Operational factors include outcomes of management decision making, specifically, issues relating to the variables indicated in the formula of the annualized interest rate above (Campion, Anita & Frankiewicz, Cheryl,:pp31-36). There are examples of tools which have been developed to improve the operational efficiency of the MFIs. One such tool outlined (Ledger wood, Joanna,:2000 pp ) is the operational review tool which assesses 7 readiness indicators, the indicators include: corporate governance; markets and clients; credit methodology; distribution; human resource management; computerization and financial management. A close analysis of these indicators by management of MFIs helps in functional management focus and improves operational efficiency. Another example of a useful tool is the Activity Based Costing (ABC) developed by Cooper, Robin, & Kaplan, S. Robert, (n.d, Second Edition, pp ). This tool goes into detail to identify cost drivers when allocating costs to a product, appropriate interest rate can be better apportioned to specific products to which it relates, or possibly make an average of the total costs for the whole business from a point of knowledge of profitable and less profitable products. The management of MFIs could even take the hard decision to abandon some of the existing un profitable products. Cost apportionment is based on cost drivers such as staff time, offices space, equipment time, transport, security and other overheads. Efficient management is judged by how much they are able to push down these operational costs without affecting negatively the bottom line of the MFI. External environmental factors that influence MF interest rates include macroeconomic factors (Ledger wood, Joanna,:2000 pp11) Such as market supply and demand arising from the general behavior of the economy as a whole, behavior of competitors, inflation and exchange rates which determine the stability of the currency especially when foreign sources of financing are involved. Competitive factors would lead to questions such as whether or not MFIs should compete on interest rate charged, type of products offered, markets where MFIs are operating or through promotion and advertising. It would also raise the question of the quality of services offered to clients and the nature of the uniqueness of the market. 17

32 2.4 THE ROLES OF GOVERNMENT AND THE CENTRAL BANK One of the most important issues facing MF today is regulation and supervision (Robinson, Maguerite,:2001 pp20-30). Regulation is intended to lead to efficiency of markets in allocating resources towards the most productive sectors which will harness economic growth (Churchill, Craig,:1997, Occasional paper No 2). Furthermore, they are intended to minimize moral hazard by opportunistic behavior of some managers, which would otherwise endanger client funds (Mankiw, N.Gregory,:1997 pp581). These two aspects are performed by the Central Bank. Many NGOs providing financial intermediation are not regulated. According to Chavez, Gonzalez Vega(n.d) Otero, Maria,& Rhyne, Elisabeth, (1994), pp55-74, Regulation refers to a body of principles, rules, standards, and compliance procedures that apply to financial institutions. Financial supervision involves the examination and monitoring of organizations for compliance with financial regulations. Prudential regulation and supervision are designed to avoid a banking crisis and maintain the integrity of the payment system, protect depositors and encourage financial sector. Competition and efficiency. Case studies edited by Churchill, Craig,:1997 (Occasional Paper No 2), on regulation and supervision in Indonesia, Bangladesh, Philippines, Bolivia, Colombia, Peru, Kenya, West Africa, and South Africa, offer rich and wide experiences on advantages and disadvantages of regulation. The impact of the legal environment on interest rates need not over emphasized. The role of the government is to put in place policies that promote the MF sector, and to make social and economic development plans on how the sector will contribute to its social and economic goals. Interest rates affect investment as well as consumption decisions on a day to day basis. Government has keen interest on how interest rates are determined because of the broader macroeconomic stability of the economy as influenced by interest rates. The challenge of government is: Creating an enabling environment by offering tax and financial incentives, Establishing social and economic infrastructure, Attracting educated labor force 18

33 Availing technological potential Legislating a conducive legal environment including flexible environmental codes and attractive employment contracts, Establishing a favorable security environment, Ensuring low entry and exit costs and putting in place conducive investment laws plus ensuring political stability. Improving the country risk to attract foreign sources of finance, Encouraging inflow of different financial and human resources relevant to the MF Industry. And, through the Central Bank and other economic institutions, government may influence fiscal policy through taxes which will impact on the MFIs also.the above conditions are intended to create a favorable and attractive environment from both the perspective of the MFIs and the borrowers and are in particular enablers to the establishment of MFIs, improving their performance and efficiency and therefore the interest rates they charge. In Rwanda in particular, effective 2005, all regulated MFIs have a tax relief for 5 years after being licensed. Relief on tax improves the profit position of MFIs which implies that they can afford lower interest rates during the establishment period of the MFI when the start- up costs are high. Interest rate is a basic concern of Central Banks in general because it is one of the primary tools of monetary policy. Interest rates charged by MFIs are of particular concern because the poor who comprise their clients are vulnerable which, to the Central Bank, makes it more vital concern. In executing the monetary policy, the Central Bank (Schiller,R. Bradley, 1994 pp ), performs different roles which impact on interest rates: It ensures a stable and progressive economic environment which enables borrowers to invest and spend and lenders to have trust and confidence in the financial intermediation process. Economic activity is essential in determining supply and demand for funds and therefore, impacts on interest rates; 19

34 The Central bank controls inflation in order to ensure that those lending do so with confidence that they will not lose value of their assets over time because of inflation. Furthermore, the central bank maintains a stable exchange rate regime and manages a foreign exchange reserve which facilitates stabilization of the currency, which also directly influences interest rate determination; The Central bank also regulates money supply through open market operations by controlling liquidity in the economy which directly impacts on supply and demand for money in circulation, and thus on interest rates as well; To set and review the monetary policy as a tool to stimulate and stabilize the economy. The Central Bank institutes prudential regulation especially to protect depositor s funds. The respective roles of the government and the central bank in influencing the environment that affects the determination of interest rate are expected, especially given the fact that the central bank acts also as an advisor to the government on financial and monetary issues including interest rates. This does not necessarily mean that they interfere with the market forces which would inevitably lead to interest rate distortions. Instead, they endeavor to build the necessary physical, social and economic infrastructure that creates an enabling environment within which different economic entities can safely and freely operate to their advantage. The BNR policy in Rwanda on MFIs and the monetary policy stipulate a number of guidelines that include the following: MINECOFIN,(2006) pp8-11 Putting in place incentives that promote Investment opportunities through favorable legislation and tax incentives to MFIs that meet specified minimum eligibility criteria; Promoting professional, transparent and a participatory approach in the management and operations of the MFIs; Promoting professional training, capacity building and standards of practice; Promoting sustainability policies and principles of MFIs by promoting a free market environment and eliminating any market distortions where they exist; Encouraging long 20

35 term finances and partnership focusing on MFIs. For example, through the Central bank, MFIs can access guarantee funds established by government. These guarantee funds are meant to bring the risk of borrowing down and therefore the cost of lending and consequently, the interest rates; Promoting gender dimensions of MFIs by encouraging development of special services and promoting other alternative appropriate approaches to cater for other vulnerable groups. This is done through offering economic and other incentives to cooperatives and other organizations willing, and ready to serve un privileged populations without compromising the sustainability principles; Ensuring a stable and progressive economic environment conducive to borrowing and investment, and for lenders to have trust and confidence that lending is profitable. One important thing BNR has done to improve stability, is to establish insurance deposit funds to protect MFIs during risky and uncertain periods. Economic activity is essential in determining supply and demand for funds and therefore, to influence interest rates; Ensuring stability and predictability of the currency within a flexible exchange rate system that responds to market forces in allocation of economic resources. It has so far maintained a stable exchange rate regime and manages foreign exchanges reserves. This role facilitates stabilization and therefore demand for the currency which influences interest rates; Ensuring that MFIs lend with confidence that they will not lose value of their assets over time. That is the reason why inflation targets are integrated in the cost of funds. The BNR targets inflation not to exceed 10% which it hopes to achieve by close supervision and monitoring of monetary and fiscal policies; Encouraging MFIs to face challenges of continuous quality improvement of service delivery. For example it has increased the minimum initial capital requirements of MFIs registered as private companies from 100 million francs to 300 million francs. It has also regulated delinquency should not exceed 10% of the loan portfolio and portfolio at risk should not exceed 5%. The biggest MFI in 21

36 Rwanda, UBPR is in the process of being transformed into a Commercial bank in order to offer a wider range of products so as to improve its profitability; Encouraging and stimulating MFIs to take initiatives that promote product development, and in fine-tuning improvement of access to financial systems through a well developed action plan to be approved by the BNR Board of Directors soon. The main aim is to integrate the MFI sector in the financial and monetary system. 2.5 RATIONAL FOR HIGH MF INTEREST RATES MFIs serve the poor and may be expected to charge low interest rates compared to commercial banks which lend the relatively richer clients. On the contrary, interest rates charged by MFIs are generally higher than those charged by Commercial Banks. The high interest rates charged by MFIs generally attract not only criticism but also concern. However it should be understood from economic logic that interest rate is nothing but a cost of financing which must be carefully and comprehensively analyzed in order for it to be recovered. Table 2.1: Comparative interest rates in 6 Asian economies. Country Commercial Bank MFIs APR Informal sources (eg money APR lenders) Indonesia 18% 28-63% % Cambodia 18% 45% % Nepal 11.5%(priority sectors) 18-24% % 15-18(other sectors) India 12-15% 20-40% % Philippines 24-29% 60-80% 120+% Bangladesh 10-13% 20-35% % Key: APR- Annual interest Percentage Rate. Source: Helms, Brigit(2004) 22

37 Table 2.1 confirms that in Asia like elsewhere, MFI interest rates are higher than those charged by Commercial banks. However, it is also evident that the MFI rates are much lower compared to those of the informal sector. The interest rates charged by MFIs can be as high as double those charged by commercial banks while those charged by the informal sector can be as high as over 10 times those of the MFIs and 20 times those of Commercial banks. According to Rutherford, Stuart, (2003 pp76), the presence of the informal sector teaches three important lessons. First, that some poor people enjoy financial services not available universally, and are able and willing to pay for them highly; second, that the informal sector is tailored to specific client needs in terms of the variety they offer; third, that the informal sector offers their services at a price (Rutherford, Stuart:2003 pp76). This explains the fact that borrowers are underserved and are ready to pay a high price as long as they are happy with the product. In other words, they would avoid the informal lenders if they had enough MFIs that would offer cheaper funds. Research done in India where the operating costs have been brought down to about $ 0.25 per interaction with a customer indicate that MFI interest rates have been steadily falling as a consequence. Administrative costs associated with the high number of interactions per borrower continue to be the main determining factor to push MFI interest rates high (Helms, Brigit,: 2004, Occasional Paper No. 9). The challenge is to strive to stimulate innovations that improve the productivity of MFIs, but even then, interest rates charged by MFIs are likely to remain proportionally higher. The point is that the unit cost of lending by MFIs is higher than that of commercial banks because operating costs of MFIs per unit are higher; which is largely attributed to the small sized loans they give, the remoteness of areas where they operate and the unique characteristics of the target markets which they serve as compared to Commercial banks (Robinson, Maguerite,:2001 pp30). The above point can be illustrated by comparing two hypothetical lenders, a big commercial bank which is to lend one big client, and an MFI lending the same amount to 1000 borrowers; 23