The determinants of interest rates in the informal financial sector and its effects on microfinance - a case study of the Ashanti Region of Ghana

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The factors that go into the determination of lending rates in the informal financial sector, is little known. Policy makers base their understanding of informal lending rate determination on basic economic principles. In Ghana, as found in several other developing countries, one vehicle through which economic policies can impact on the informal financial sector is through the price that the 3.6 million people, who comprise that sector, pay for credit. Credit however is the ‘oil of growth’ of business whether large or micro, and its multiplier effect in the reduction of poverty has been documented. The objective of the study was to capture the trend of lending rates in the informal credit market and to establish the determinants of lending rates that operate in the market. The effects that lending rates have on micro-credit in the informal credit market were also studied. As a round up to the study, policy options that would lead to positive effects on micro-credit were recommended. The hypothesis that informal lending rates replicate trends in the formal was set. The research approach adopted for the study included case studies of the various informal lenders, a comparative study carried out amongst the informal lending institutions to bring out the uniqueness in their operations and trend analysis to determine the relationship between informal lending rates and several macro economic variables. The institutions studied were moneylenders, Rotating Savings and Credit Associations (ROSCAs), susu collectors, credit unions, Non Governmental Organisations and Savings and loans companies. The most important factor the institutions seemed to consider in lending rate setting was formal commercial rates. In general, MFIs had lending rates close to the commercial rates. Moneylender’ rates were, however, on the average, thirteen times higher. The only institution that did not follow the trend wan moneylenders, who placed more weight on the risk associated with the borrower. Four critical factors considered by the MFIs were operational costs, commercial rates, risks associated with the borrower and the business philosophy of the organisation. Effective rates deduced for the informal lending institutions studied revealed that some of them (susu collectors and Savings and Loans companies) practice methods that yield effective interest of over 100 percent over their nominal lending rates. The most common methods used for setting the effective rates much higher than the nominal rates without changing the nominal lending rate were the use of the flat rate, commitment / initial fee, up-front payment of interest and compulsory savings. Findings revealed that the general price of consumer goods and exchange rates, were very influential in lending rate setting amongst ROSCAs and credit unions, whereas NGOs and S & L companies reacted more to bank rates and treasury bills rates. The hypothesis that informal lending rates replicate trends in the formal was accepted after analysis of field survey results and literature. Given the above findings, policies recommended are directed at ensuring prudent and credible fiscal and monetary policies particularly with the aim of stabilising the local currency and reducing inflation within the economy, which would also assist in reducing bank rate and Treasury bill rate levels. Other recommendations focus on improving the flow of micro-credit, such as building the capacity of MFIs to manage better, reduce cost of operations and to attain the sustainability in their operations as well as encouraging the institutionalisation of more savings and loans companies and NGOs who characteristically have very large clientele capacity. There is the need to organise moneylenders as well, so that they can act as a channel for on-lending to the informal sector as is being done through the susu collectors association currently. The conscious effort to increase the amount of credit into the system would enhance competition into the informal financial market and lead to a reduction in lending rates as shown by Bell (1990) and explained in the literature review. The increase in the volume of micro-credit and the reduction in lending rates would boost investment and reduce poverty to a large extent in the economy.
A thesis submitted to the Board of Postgraduate Studies, Kwame Nkrumah University of Science and Technology, Kumasi, in partial fulfilment of the requirement for the degree of Master of Science in Development Policy and Planning, 2000