Usury Report > Annex VI: Scenarios for Interest Rate Reduction

The three scenarios below were developed to help in the decision making process for the Department of Trade and Industry in their regulation of the microlending sector. These scenarios are not all encompassing , but help to provide a little more structure to the debate around interest rate ceilings. In this analysis, the following characteristics will be kept in consideration:

➢	microlending is a service for which there is demand and will continue to be demand in the future. When people really need money, they will look for it, and will find it, at any cost.

➢	the microlending industry in South Africa is a commercially driven sector, that responds to profit incentives;

➢	the microlending industry in South Africa has many vested interests that will seek to modify their behavior if the incentives are correct;

➢	if the industry becomes "overregulated" then it will either disappear (lenders will stop lending) or will go underground (lenders will not be registered and will lend illegally);

➢	it is in the best interest of the DTI and South African population to keep the microlenders formally registered and recognised by the government;

➢	It is in the best interest of the government and the South African population to keep the microlending industry alive to provide financial services to the poorer segments of the economy; and

➢	incentives should be provided to lenders to change their behavior in the direction desired by the DTI, while keeping them in the formal sector.

The predominant current effective market rate of interest is 30 percent. This reflects a price that corresponds to what borrowers are willing to pay for funds and the rate where lenders are willing to supply funds. Most of the short-term money lending industry in South Africa has been developed around this price.

Current Trends in the Short Term Cash Lending Industry.

Structure of the industry. Current trends in the industry have been towards consolidation of smaller lending shops into larger lending shops, or the acquisition of independent lenders by larger, corporately structured, lenders. This has already led to a reduction in the number of shops, which is predicted to continue through this year.

These larger cash lenders view this as an industry in which they earn corporate profits and will continue to invest in the industry as long as they see a reasonable return on investment. They will also determine where to open branches based on the profitability of those branches. As with the formal banking sector, which is closing many of its branches in less profitable areas, hence depriving the population there of financial services, the large, formal cash lenders will close theft formally registered branches in less populated areas.

The industry is becoming more competitive, as the larger money lending institutions increase their outreach and seek market share. They are trying different techniques to gain market share, hence increase their overall profitability. This trend is very positive for leading to reductions in the cost of lending and introducing new technologies, over time.

Price sensitivity. In urban areas with a more concentrated market, it is likely that there will be more competition. Some of the larger lenders have tested different pricing strategies and found that customers are price sensitive and will switch to a lender that has a cheaper product over time. But price sensitivity is also related to the borrower’s ability to repay. Calculations are not made based on interest rates, but on the amount of the repayment, the availability of the funds, and the service provided by the lender.

The more structured lenders have also done detailed analysis to determine their minimum cost structure, below which they will lose money. This is discussed more fully below under the profitability secton.

Repayment techniques/technology. The elimination of the use of the bank card and pin has led the sector to seek other ways of reducing the risk of lending. Where default rates ran between 2.5% and 5%, per month, with the use of the bank card, the best indications are that these are increasing by several percentage points per month. Few of the cash lenders have succeeded in actually switching away from using the bank card and pin. Therefore at the very time when pressure is being applied to reduce interest rates, the lenders costs are rising due to increased risk.

There are new technologies being used by the lenders; including greater use of credit references and tests of new software products to allow for the direct deduction of loan repayments from the individual’s bank account. However, these have not been refined yet and are still being tested.

Profitability. Profitability of lenders varies by the size of the business, the location of the business (rural vs. urban), and the use of systems to minimize risk and manage their business. It was estimated in the study that the average 30 day cash lender earns a surplus of about 17 percent, over the course of the year.

Based on analysis carried out on the sample of 143 microlenders and taking into consideration administrative expenses and risk for bad debt, a lender with an outstanding book of R120,000 and charging 30 percent will just break even over the course of the year (after including salary to the owner). This figure will vary based on the size of the microlender, his outstanding portfolio, his bad debt and his administrative expenses. Assuming that there is no change in the cost structures, as one drops the interest rate to 25%, a book of more than R200,000 is required to just break even. At an interest rate of 20%, it will take an outstanding book of R400,000 to break even. If one is to add some profit incentive to the activities, these amounts will increase.

New product development. There has been little new product development surrounding the 30 day cash loan. One trend, in some lending companies, has been for the lenders to seek to shift theft better and more reliable clients over to longer-term loans.

Scenario 1.

➢	Set the maximum monthly effective interest rate at 30%

➢	To be reduced within 6 or 12 months to 25%

➢	To be farther reduced within another 6 or 12 months to 20%

The logic behind a progressive reduction in the allowable rate of interest is sound. In theory, setting gradually lower interest rate ceilings in the future will give current lenders the time to develop new techniques to lower their costs, primarily through reducing their risk or refining their administrative structures. Alternatively, smaller lenders, who cannot achieve economies of scale, need to have sufficient time to sell their businesses to larger lenders. If the time is sufficient, it will allow for a smooth transfer of assets from small operations to larger operations.

The eventual interest rate ceiling of 20 percent is still higher than the effective rate of interest for most of the large, payroll deduction based term lenders, so there will be no impact on them or their practices. Therefore, the impact will be on the cash lenders who are making thirty-day loans.

The current trends. Following this progression will provide for a relatively smooth transition in the industry, allowing it to continue its current process of rationalisation. With a clear deadline for the drop in interest rate ceilings, microlenders will have the time to make a decision on whether to try to compete and stay in business by reducing their costs and improving their repayment methodologies or whether to sell out to other, larger microlenders.

Six months is most likely too rapid a period to allow for the rationalisation of businesses by reducing their costs or to effect the sale and transfer of a business to a new larger company.

Twelve months should provide sufficient time to reduce their costs by five percent and to stay in business. This timeframe will also allow for the MFRC to monitor the effect of this consolidation on changes in the structure and supply of financial services, in particular in the smaller towns where there is less competition. Providing another 12 months to reduce the interest rate to 20 percent will allow for a smooth transition to complete the rationalisation of the industry.

The size of the industry. The overall size of this segment of the industry in the formal, registered sector will probably gradually decline a little bit. This may be brought on by greater selectiveness on the part of the lenders to counteract the increased risk associated with the loss of the use of the bank card, as well as the closing of some of the smaller registered lenders.

The players. The players in the industry will change from a multitude of small, independent lenders to a more concentrated group of lenders controlling larger numbers of branches.

These lenders will be better financed, will use better systems to manage risk and to control costs. They will also be more competitive and will focus on traditional corporate approaches to earning higher returns, including gaining market share.

The product. The fundamental product would not change. It would remain a thirty day loan for which there are easy controls to estimate the ability of the borrower to repay. The repayment mechanisms will gradually change as banking technology changes. There may be more investment in working with the commercial banks which hold the majority of the deposit accounts from which loans are repaid.

The client. The effect on the client, in terms of access to finance, will be minimal. Over time, the clients will get access to lower cost money.

Scenario 2

➢	Set the initial rate at 22.5%

➢	Reduce the effective interest rate ceiling to 20% after 12 months

This interest rate ceiling is higher than the effective rate of interest for most of the large, payroll deduction based term lenders, so there will be no impact on them or their practices. The impact will be on the cash lenders who are making thirty day loans.

Trends in the industry. Setting the maximum monthly effective interest rate at 22.5 percent will effectively exclude most of the smaller lenders from earning a profit and will force them to either close, go underground, or find some way to get around the legislation. The larger corporate lenders will stay in business, at least for the short term, but they will very likely reduce their investment in the industry because they will see a reduced return on investment that will not make it financially viable for them to continue investing in the sector. The sudden reduction in interest rates might also lead the larger cash lenders to close out their shops in the more disadvantaged areas.

The size of the industry. Initially the size of the industry will drop quite a bit in the formal registered sector. However, as registered supply drops, many of the borrowers will simply shift over to the informal sector to get needed loans, where they have less protection from the regulatory agencies.

The players. There will be a gradual, but significant change in the different players in the industry. Dropping the effective interest rate by 7.5 percent, will cause many of the smaller lenders to decide to close their businesses immediately or to go underground, leaving only the larger lenders in operation.

The product. As above, there will be very limited change in the product.

The clients. The impact on the clients under this scenario will be to immediately reduce the access to formally registered financial services by those people resident in less "profitable", more isolated areas. Since they will need to borrow the money somewhere, they will most likely be forced to borrow it from unregistered lenders who will be charging higher rates of interest.

Scenario 3: Keeping the Interest rate ceiling at the current amount of 10 x prime (average of the four major banks).

Based on the analysis carried out in this study, it is clear that the most significant costs facing the cash lenders come from administrative costs and risk, not from the cost of capital. In addition, very few of the short term cash lenders have access to funds from the formal financial sector based on the prime rate of interest. Hence, changes in the prime rate of interest therefore have very limited impact on the short term lenders’ cost structures. In addition, since a one point variance in the prime rate would lead to a 10 point variance of the effective interest rate, there is disproportionate weight placed on this single variable, which accounts for such a small portion of their cost of lending.

Setting the effective interest rate at ten times prime entails setting the interest rate at below the break even point for almost all of the cash lenders who were analysed. Therefore, choosing this rate will effectively force the closing of a large number of the existing cash lenders in the formally registered sector to either cease their activities, to take them underground, or to develop new ways to get around the legislation.

The players. There will be very visible drop in the number of formally registered microlenders. The immediate impact would most likely be to eliminate lenders who are operating in the rural areas and the lower income peri-urban areas.

The product. The 30 day cash loan will probably all but disappear from the formal registered market. Only cash lenders with proven clients will still remain in business, offering longer term loans.

Usury Act, 1968 (Act No. 73 of 1968)