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

 

Background

 

The microlending industry in South Africa has veritably exploded over the past eight years since the Exemption to the Usury Act in 1992 removed interest rate ceilings on small loans under R6,000. It has been an excellent example of how a virtually non-existent financial industry can develop given the right incentives. It has been fuelled by private capital and is currently seeing large amounts of investment from the formal financial sector. The sector has seen so much growth that in June 1999, the Minister of the Department of Trade and Industry (DTI) issued a new exemption to the Usury Act which created a regulatory institution (the Micro Finance Regulatory Council - MFRC) to manage the sector, added new regulations to govern the way that microloans could be given and repayments collected, and set a ceiling on the interest rates that could be charged under the exemption.

 

In a law suit concluded on November 11, 1999, the Judge upheld most of the new notice for the Exemption, but struck down the interest rate ceiling, which had been set at ten times the prime rate. The DTI is concerned by a number of issues related to interest rates - the potential exploitation of borrowers by lenders, the impact of high interest rates on borrowers and potential debt spiral, and the shortage of micro-enterprise finance. It therefore commissioned this study to examine the cost of making small loans to help it to establish a new interest rate policy that would address those problems.

 

The study was carried out by a three person team over a ten week period from February 16 to April 25, 2000. The findings and recommendations below are the result of interviews with many of the key stakeholders in the industry, interviews with dozens of microlending institutions, review of literature on interest policy from around the world, in-depth examination of data collected by the MFRC, and analysis of data provided from the government payroll system (Persal).

 

Key findings

 

The microlending industry has entered a very dynamic stage of its growth since the creation of the MFRC. The industry has seen unprecedented investment by formal financial institutions in the sector and is being integrated into the overall financial system of South Africa. It has a very dynamic formal side, parts of which are undergoing much change, and a very large informal side, which has not changed at all.

 

The formal side of the industry is highly diverse. With more than 850 registered institutions comprising more than 3,500 branches, it is comprised of a range of different firms with different legal statuses (from natural persons to publicly traded commercial banks), a tremendous variation in size and outreach (from lenders with 100 clients and R50,000 in the portfolio to lenders with over a million clients and more than three billion Rand in the outstanding portfolio), and important differences in targeted term of loan (from five days to three years). Interest rates from microlenders vary greatly from effective rates of 60 percent for long term loans (up to three years) to rates that can surpass 1,000 percent for very short term loans of less than a week. But interest rates are not the main concern to the borrower, especially on the very short term loans. The borrowers main concern is getting access to the credit and on the usefulness of the money for the period that s/he has it.

 

The overall size of the formal industry is growing. According to the MFRC statistics, the average outstanding balance at any point in time is about R5.3 billion for about 2.5 million clients. The registered smaller, cash lenders specialising in 30 day loans account for over 400,000 clients with a current book of nearly 0.5 billion Rand. This contrasts with the 1.35 million outstanding term loans worth over 3.4 billion Rand.

 

On an annualised basis, however, the estimate of the turnover from the registered firms places it at about R10 billion, accounting for more than 7.6 million loans. In contrast to the snapshot view of the industry where the term lenders dominate, on an annualised basis, the short term lenders, (less than six months) account for nearly 80 percent of the loans made and 64 percent of the total value of loans made in the course of the year.

 

The informal side of the microlending market is comprised of traditional sources of short term money for South Africans. These include the mashonisas (or township lenders) who provide thirty day money at rates of 30-50 percent per month, the stokvels (including burial societies) that provide rotating credit and informal savings operations to their members, and pawnbrokers that function under the second hand goods act.

 

It is estimated that the total size of the industry between formal and informal lenders, on an annualised turnover basis, is in the range of R25 billion.

 

There is an increasing problem with over-indebtedness in South Africa. The data from PERSAL is quite clear that over the past eight months, there has been an increase in the number of borrowers in the government system and a substantial increase in the loan volume and number of loans per borrower. Nearly half of the clients on the PERSAL system now have loans and 15% of those are trapped in a debt spiral [1]. This was also reflected by a rural survey carried out in the Northern Province, which showed that 25 percent of the borrowers borrowed to make payments on another loan.

 

However, the major debt problem appears to be stemming from the term tenders, who are taking salary deductions at the source, before the employee even sees his/her paycheck.

Some term lenders often write irresponsible loans to salaried employees, leaving them with unacceptable net take-home portions of the salaries that are then forcing the clients to take short term debt at even higher interest rates. This is a greater cause of long term indebtedness than short-term loans from the 30 day cash lenders.

 

Conclusions

 

We therefore conclude that merely fixing an interest rate at a specific level is a naive approach to regulating this sector. This sector is far more complex Fixing an interest rate ceiling will not address the indebtedness of the people already trapped. It will not increase competition to the extent of driving down prices. It has not worked in other countries and it will not work in South Africa. People already in debt will suffer more, since ceilings will drive many of their providers underground, out of public scrutiny. Even if a ceiling is fixed, no amount of resources will ensure a complete monitoring of the sector. Instead, we suggest a more pragmatic approach should be pursued, based on the reality of the sector and the assumption that we do not want to stifle the sector with legislation. We also do not support unlimited freedom to microlenders as we believe in transparency and the strong vested interest that the larger lenders have In developing this into a sound, sustainable market.

 

The main problems fall into two arenas. First the borrower is ultimately responsible for his/her own actions. Second, but the lending institutions also play a critical role in the problems of the sector. Therefore the solution must address both of these constituents. In addition, shortages of capital for microenterprise lending are a function of the perceptions of high risk in the sector, poorly adapted lending technologies, and lack of incentives to invest in new product development in the sector.

 

The Problems and Broad Solutions

 

At the root of this study are three main concerns for the DTI:

 

The base cause for this condition is due to two major factors: aggressive lenders and uninformed or naive clients. The high interest rates being charged to the clients are not the cause of the over indebtedness, but do exacerbate the problem.

 

Exploitation can be seen either as lending a borrower more than s/he needs or wants or charging them a higher rate than they thought that they would be paying by adding on extra charges. The base cause for this condition is due to aggressive lenders, uninformed clients, and poor information flow between clients about alternative options. Exploitation can take the form of overselling the borrower on credit (i.e. lending him/her more than s/he needs), not providing accurate information to the borrower about the implications of the cost of lending and the borrower not being aware of other options.

 

While consumption credit is spreading like wildfire (based on payroll deductions), small and microenterprise finance (where repayment is based on cashflow not on guaranteed salary deductions, is not growing very rapidly). The commercial banking sector provides very little enterprise finance under R50,000 (its "glass floor) and the microlenders provide very little above R10,000. The fact that it is cashflow based means that the perceived risk is higher than payroll based lending.

 

For the first two sets of problems, there are four major categories of solutions that are appropriate to address the cause:

 

For enterprise finance, the two main causes for the insufficient supply of small enterprise finance:

 

The Recommendations

 

Based on the analysis above and the overall shared vision of the potential of the microlending sector in the future, we propose the following recommendations:

 

 

The analysis demonstrated that the size of the branch has a big impact on the surplus that the branch earns, but so does the age and maturity of the lending institution, the location of the business and nature of the clientele. Setting interest rate ceilings will restrict the flow of credit into the system. This, in turn, will have the greatest impact on those who have the greatest need for short-term emergency credit, the poor. This would likely force them to go to the informal lenders who are even more expensive. Our analysis demonstrated that rural and peri-urban lenders, serving the poorest members of the community, require the highest interest rate to make a profit.

 

However, if the DTI decides that setting interest rates is an imperative, they should not be set based on the cost of money, but rather on the administrative costs of making the loans. In order to promote the greatest amount of transparency in the industry (in order to promote and stimulate investment in new products), while still maintaining the level of service provision, the DTI should set the interest rate ceiling as high as possible and set it as a fixed rate. Having a fixed rate of interest will allow investors to do their calculations and determine where they wish to invest their money.

 

The ceiling should be based on the price that has been set by the current short term market forces. This will cause the least distortion in the market and will not penalise the rural poor. Therefore, our recommendations would be to place two ceilings, one for short term cash lenders and one for term lenders, since there are significant structural differences between the two.

 

The effective interest rate ceiling for the cash lenders should be set at 30 percent per month. A gradual lowering of this ceiling could be planned over time, providing a sufficient delay between the reductions to allow the industry to incorporate the changes needed to bring its cost structure down. The timing and amount of the reduction should be published to allow the industry to prepare.

 

The effective interest rate ceiling for the term lenders should set a 10 percent per month, initially, with a gradual reduction planned over time.

 

 

 

Clearly, there is limited flow of information about borrowers at present, even though there are three credit bureaux that are concentrating on clients of the short term cash lenders. Therefore, the DTI should promote:

 

 

Both of these can be easily bypassed by the borrower. However by making them aware of and promoting industry standards and guidelines as a form of consumer protection, this may act as a catalyst for borrowers to consider the implications of the loan.

 

Stimulating investment in SMME finance remains a serious challenge. The recommendations are:

Increase the ceiling on the exemption from SMME loans beyond R10,000 to R25,000.

 

 

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[1] A debt spiral is when a borrower is forced to borrow to help pay back his loans, hence driving him deeper into debt