ahmed - effective costs of loans bangladesh

8/7/2019 Ahmed - Effective Costs of Loans Bangladesh

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World Development, Vol. 17. No. 3, pp. 357-363, 1989. 0305-750x189 $3.00 + 0.00Printed in Great Britain. 0 1989 Pergamon Press plc

Effective Costs of Rural Loans in BangladeshZIA U . AHME D*The Ohio State University, Columbus, Ohio

Summary. -The paper compares transaction costs of borrowing from both formal and informalsources in rural Bangladesh and finds that transaction costs of loans from formal lenders arehigher than those of loans from informal lenders. Transaction costs per taka of loan decrease withloan size, but much faster for formal than for informal loans. The effective costs of loans arecalculated to show that for small loans, the effective costs of formal loans were higher than thoseof informal loans, while for large loans the formal loans were cheaper than informal loans. Thuslarge borrowers benefit from the subsidy in the formal credit market.

1. INTRODUCTIONIn the last two decades, substantial funds havebeen channelled into rural financial markets inlow incomes countries (LICs) to strengthen theformal financial markets and increase the ruralpopulations access to them. Yet, in most ofthese countries, the formal financial institutionsare still a long way from being self-sustaining anda large segment of the population is still depen-dent on informal financial markets (Von Pischkeand Adams, 1980).Two explanations have frequently been of-fered for the limited use of formal rural credit inLICs: one focuses on lenders costs and the otheron borrowers costs. Gonzalez-Vega (1976) de-veloped a model that shows how concessionaryinterest rates on loans discourage formal lendersfrom lending to the rural poor, especially whenlenders incur relatively high transaction costs oflending in rural areas.2 Adams and Nehman(1979) show that excessive total costs of borrow-ing from formal institutions due to high bor-

rowers transaction costs discourage many ruralborrowers in the LICs from using formal sourcesof credit.3 Ladman (1984) added to this by devel-oping a model to show that borrower transactioncosts result chiefly from the rationing mechanismemployed by formal lenders, who face hightransaction costs of lending but are unable tocover these costs due to limitations set by thefinancial authorities in the form of fixed, conces-sionary lending rates.With controlled interest rates, lenders engagein implicit price setting that involves differentialtreatment of loan applicants in terms of loanallocation, disbursement_ monitoring and super-

vision. This implicit price setting procedure en-ables the lenders to exclude or ration unwantedclients. The activities involved in the screeningmechanism lead to increased transaction costsfor both borrowers and lenders. In addition, theintermediary also transfers as much of the burdenof his own transaction costs as possible to theborrowers, further raising the total costs of bor-rowing. Cuevas (1984) builds a model to showthat the spread between the total borrowing costand the explicit interest cost reflects the value ofthe implicit charges. He then estimates a bor-rowers transaction cost function to show thetrade-off between the controlled (explicit) in-terest rate and transaction costs arising from therationing activities of the lenders.This paper builds on this earlier work andcompares the transaction costs of borrowing fromformal and informal sources in Bangladesh toshow that borrowers transaction costs are higherin the formal market than in the informal market.It will also be shown that a relevant measure ofthe costs of credit to borrowers is the effectivecost of amount borrowed.4 It will then be shownthat the effective cost of formal credit is higherthan that of informal loans. Data from a 1981survey of rural households in 12 villages inBangladesh are used to estimate transaction costsof borrowing and the resulting effective costs of

I am grateful to Professors Dale Adams and RichardMeyer of the Ohio State University for their guidanceand helpful comments. I also received helpfil advicefrom Messrs. J. D. Von Pischke, John Strauss andForrest Cookson. All errors and omissions, however,are my responsibility.

357


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3.58 WORLD DEVELOPMENT

loans from both formal and informal lenders(Ahmed, 1982).

2. THE MODELBorrower costs of credit (BC) include not onlynominal interest costs (NI) but also borrowertransaction costs (TC). Adams and Nehman(1979) defined the borrowers price of credit interms of real net costs of the loan by including thechanges in purchasing power (AP) over the loanperiod as:

BC=NI+TC-AP. (1)In a regime of fixed, concessionary lending rates,the share of transaction costs in total borrowingcosts has been found to be very high in the formalmarket (Shahjahan, 1968; Nehman, 1973; Alam,1981; Ahmed, 1982; Cuevas, 1984).An important feature of borrowers trans-action costs is that they are invariably incurredprior to and at the time of obtaining the loan.Therefore, instead of a simple linear addition tothe interest cost of funds as used by Adams andNehman (1979), Alam (1981), Cuevas (1984),and others, these transaction costs should bediscounted from the loan amount (L) to get thenet value of the incremental funds received bythe borrower. The difference between the totalrepayment that is due at maturity and the netaddition of funds from the loan proceeds will givea more accurate measure of the total absolutecosts of borrowing a given amount of net usablefunds. This incremental payment, expressed as apercentage of the net loan received, can bedefined as the annualized effective cost of theloan. This effective rate of interest (E) per unit oftime can be calculated as:E = (1 + r) S/Lf(L-TC) - I (2)where: r is the explicit interest rate, n is the loanterm in years.5 For borrowers with positivetransaction costs, the effective rate will, there-fore, be higher than the explicit interest rate ofthe loan. However, for a given loan size andtransaction cost, the effective rate decreases withincreasing loan term n and, in the limit,approaches the explicit interest rate (Ahmed,1982). Also, it can be shown that for a given loansize and fixed interest rate, the effective costincreases with the transaction costs of borrowing.Differentiating equation (2) partially with respectto TC gives:dE/aTC = [(l + r)ln] -C/U(L-TC)+ > 0 (3)Thus borrowers incurring high transaction costs

of borrowing will bear high effective rates ofinterest on their loans.

3. EFFECTIVE COSTS OF LOANSIN BANGLADESHCosts of credit were calculated from dataobtained from a survey of a rural credit marketin Bangladesh. The survey area was RaipuraUpazilla (similar to a county) in the old DhakaDistrict (now in Narsingdhi District). A stratifiedtwo-stage sampling method was designed for thesurvey (Cochran, 1977; Deming, 1950). Fourunions (similar to precincts) were selected in thefirst stage with a probability equal to the numberof households in the villages. The householdswere then divided into two strata - those thatborrowed from the institutional lender, theBangladesh Krishi Bank (BKB), and those thatdid not borrow from the BKB - drawing fromeach stratum an equal number of households atrandom. The sample of households that bor-rowed from the BKB, Raipura Branch wasobtained from the list of BKB borrowers. Theremaining households in each primary unitformed the population for the sample of house-holds that did not borrow from the BKB. A totalof 122 heads of households were interviewed forthe study, divided equally between those whoborrowed from the BKB and those who did not.In order to reduce the likelihood of inaccuraterecall by the interviewees, questions were re-stricted to activities in the current year only andto infrequent events that were expected to beeasier to remember.6 Most information regardingloans from the BKB was confirmed by informa-tion provided by the bank. Since the chances offorgetting transaction costs are minimal and theinformation on the loans was accurate, it wasassumed that other information provided wasalso reasonably accurate. Loans from the infor-mal sources, however, were difficult to doublecheck. As these loans had very few transactioncosts, the need for checking was minimized.To avoid questions about amounts spentdirectly on bribes or gratuities, which manyborrowers might not like to disclose, borrowerswere asked to report total cash expenditure netof interest payment. Hence the total cash compo-nent of transaction costs includes such diverseitems as travel expenses, food and entertainmentexpenses, bribes, and losses incurred when bor-rowers sold in-kind credit (generally fertilizer) toauthorized dealers in exchange for cash. Infor-mation on the opportunity cost of time associated

with processing and obtaining the loan wasdetermined by estimating the value of the time


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COSTS OF RURAL LOANS 359the borrower spent away from his work. Carewas taken to exclude visits to town not associatedwith the loan. The cost of each workday wascalculated from the prevailing market wage ratefor male workers in the borrowers profession inthat village. In the case of in-kind loans frominformal sources, the market value of the com-modity at the time of the loan transaction wasused to determine the market value of the loan;similarly, if the repayment was in-kind, then themarket value of the commodity (or service) at thetime of repayment was used. In case the loan hadnot yet matured, the market value of therepayment was calculated in terms of marketprices prevailing during the interview period.Of the 61 households that did not borrow fromthe BKB, Raipura Branch, 36 (59%) obtainedfunds from informal sources (including friendsand relatives) - some of them obtaining multipleloans. However, 25 (42%) did not borrow anyfunds at all. During the period of study (1980-81). the interest rate on most formal agriculturalloans was set at a 12% nominal rate (a -3% realrate) by the Bangladesh Bank. Ignoring trans-action costs, there should be a great demand forfunds at negative interest rates because of theassociated income transfer. It is likely that the

effect of this low interest rate ceiling on institu-tional credit was to increase noninterest means ofcredit rationing by the formal lending institu-tions. At the same time. interest rates in theinformal markets were free to clear the marketand lenders were not forced to depend on anoninterest rationing mechanism. Nominal inter-est rates on informal loans for the sample aver-aged 42% (a 23% real rate) with some small,short-term loans carrying rates as high as 120%annually.Table 1 shows the frequency distribution oftotal transaction costs of borrowing from theBKB by major components: cash costs, and costof workdays lost. The bottom part of the tableshows the frequency distribution of transactioncosts of borrowing from informal sources. It canbe seen that the majority of borrowers from theBKB incurred costs much above the averagetransaction costs in the informal market. About60% of BKB borrowers incurred cash costs overtaka 50, and in terms of the opportunity cost oflost work time, about 70% incurred costs overtaka 50. Only 3.4% of borrowers from informallenders had cash costs over taka 50 and, consider-ing their opportunity cost of time, only 7%incurred costs over taka 50.

Table 1. Disrribufion of loans by transactions COSISof borrowingBorrowers

From the Bangladesh Krishi Bank:Amount in Travel & misc. cost Opportunity costi Total transaction costtakas* number of number of number ofcases W) cases (%) cases W)O- 5 0 2451-100 14101-200 15201-300 3 (;:;

Above 300 5 (8)Total 61 (100)From the informal lenders+

C-SO 40 (98)51-100 -101-200 1 2,201-300 - -Above 300 - -Total 41 (1W

18161510261 (100) 61

38 (93)2 I:;

3;1 1- - 1- - -

41 (loo) 41lUS$ 1 = Bangladesh taka 16.69 in 1980-81.topportunity cost of workdays lost was calculated as: Cost = D x Y; where Dis the number of days (or parts thereof) actually spent away from work inconnection with the loan, and Y is the estimated daily income foregone by thefarmer during that period.$Due to some multiple loans there are a total of 41 loans for 36 borrowers.


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360 WORLD DEVELOPMENTTable 2. Average transactions costs and annualized effectiv e costs

BorrowersFrom the Bangladesh Krishi Bank:Size of No. Average travel Opportunity Average transaction Ratio of TC Averageloans of & misc. costs costs costs (TC) to loan effective(takas) cases (takas) (takas) (takas) (%) cost (%)

l-500 5 52501-1,000 25 941,001-3,000 26 147Above 3,000 5 370Sample 61 141From the informal lendersl-500 25 2500-l,ooo : 3l,ool-3,000 2Above 3,000 7 19Sample 41 5

58 110 29 146126 220 28 169129 276 18 59161 531 7 16132 272 22 108

2 7 3 5720 23 3 8657 58 4 6316 35 1 2116 21 2 54

Table 2 shows the average loan transactioncosts by the component costs for various loan sizegroups. Although total transaction costs are highfor large loan sizes, the cost per unit of moneyborrowed decreases with loan size. Average cashtransaction costs increase from taka 52 for thesmall loans of taka 500 or less to taka 370 for thelarge loans of over taka 3,000. The average forthe sample is taka 141. Similarly, average cost ofworkdays lost increases with loan size from taka58 for small loans to taka 161 for large loans. Theaverage for the sample is taka 132. The averagetransaction costs for BKB borrowers range fromtaka 110 for the small borrowers to taka 531 forthe large borrowers, while the average for thesample is taka 272. However, as expected,transaction costs as a percentage of loan valuedecreased with loan size from 29% for the smallloans to 7% for the large loans, with an averageof 22% for the sample. Except for the large loansover taka 3,000, the transaction costs per taka ofloan are higher than the interest costs of 12%.The declining ratio of transaction costs to loansize shows that large borrowers are not asaffected by transaction costs as the small bor-rowers. Thus the rationing mechanism imposesadditional costs mostly on the small borrowerswho are most likely to be poor and for whom theconcessionary interest rates were designed.In the case of the sample of informal bor-rowers, the average transaction costs from in-formal sources are not only low, they are arelatively insignificant proportion of the loansize. In the informal market, average cash trans-

action costs increase with loan size but the rangeis not as wide in absolute value as in the formalmarket. The sample average is taka 5, which isonly 4% of the cost in the formal market. Again,the sample average opportunity cost of time istaka 16, which is only 12% of the cost in the BKBsample. Average transaction costs are taka 7 forsmall loans and rise to taka 35 for the large loansover taka 3,000, while the sample average is 21taka.12 Consequently, the ratio of transactioncosts of loan size is much lower than for the BKBloan sample. The ratio of transaction costs toloan size shows that the credit disbursementmechanism and the loan screening process do notimpose significant additional costs on the bor-rowers. Perhaps, transaction costs incurred bylenders in the loan screening process are internal-ized in the explicit interest rate charged.The last column in Table 2 shows the nominalannualized effective costs of credit for differentloan sizes in the two markets. As expected, theeffective rates are higher for the small loans thanfor large loans. Comparing the effective rates inthe two markets, we find that for loans of taka1,000 or less the annualized effective cost of169% is highest in the formal market, while forloans above taka 3,000 the effective rate of 16%is lowest in the formal market. In fact, for loansover taka 1,000, the effective costs in the formalmarket are lower than in the informal market.However, for loans of taka 1,000 or less, theeffective costs in the formal market are muchhigher than in the informal market. The averageeffective cost for the sample is about 108% in the


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COSTS OF RURAL LOANS 361formal market, which is twice the average effec-tive cost of 54% in the informal market. Onewould assume that those BKB clients who bor-rowed at these prohibitive costs were looking atthe early costs as sunk costs, or investmentfor future loans, or were planning to stretch outthe loan beyond maturity or not repay at all(Ahmed, 1982). This comparison suggests thatsmall borrowers would patronize the relativelyless expensive informal market, while the largeborrowers would prefer to seek the cheaperformal credit.Table 3 shows the results of T-tests comparing

to rural formal credit in all low income countries.The results. nonetheless, are suggestive and helpto clarify the impact of transaction costs on creditdemand. as stressed by Adams and Nehman(1979). The results of the sample survey alsolend support to the views and explanations ofGonzalez-Vega (1976). The noninterest rationingmechanisms of the formal lenders have resultedin the small. poor borrowers being excluded fromthe formal market. This allows the large, richborrowers, who incur relatively small transactioncosts, to take advantage of the low, subsidizedinterest rates. The income transfers via the

Table 3. Hypothesis restingVariable Borrower Mean Standard T-valuet DF Remark

sample errorTransaction BKB 272.0 36.67 Rejectcost 6.74 64.34 Ho(total) non BKB 20.5 7.02Transaction cost BKB 21.7 2.29 Rejectas percentage of 8.01 79.83 Holoan (%) non BKB 2.4 0.74Effective BKB 107.7 18.57 Rejectcost (%) 2.55 87.89 Ho(nominal) non BKB 54.2 9.81

*T-tests comparing cases of samples of BKB and non BKB borrowers.? Testing thehypothesis (Ho) that the population means of the two samples are same for therespective variables. (Monetary values denominated in takas.)TBecause of separate variances in the two samples, the T-values are approximatevalues.

transaction costs and the annualized effectivecosts of borrowing in the formal and informalmarkets in the sample survey. The hypothesisthat the transaction costs and the annualizedeffective costs are same in both markets is tested.The T-scores for the different variables testedshowed that the samples are from differentpopulations, i.e., transaction costs and the effec-tive rates are significantly different in the twopopulations, and that they are higher in theformal {bank) market than in the informalmarket.

4. CONCLUSIONThe data used in this study are from a small

sample in only one country. This limits our abilityto draw generalizations about problems of access

negative real interest rates, therefore, accruemainly to these large borrowers. On the otherhand, the informal sources provide a muchneeded alternative to the small borrowers.By measuring costs in terms of the effectiveborrowing costs, one can more clearly identifythe reasons for the limited use of formal credit inthe rural sector, particularly by the small, poorborrowers. The demand for credit, defined as afunction of the marginal borrowing costs, followsthe normal downward slope with respect to theeffective borrowing costs. Thus a major policyconclusion evolving from this study is to encour-age financial innovations and policies that wouldlower the effective borrowing costs to nonpre-ferred borrowers. Innovations should be aimedat reducing the transaction costs incurred in ruralfinancial transactions, and policies should bedirected at liberalization of the market mechan-isms that determine the equilibrium interest rate.


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362 WORLD DEVELOPMENT

NOTES1. Formal financial institutions include banks.

cocperatives and other nonbank financial organizationsthat are formally recognized by the financial authorityto operate as financial institutions.

2. Transaction costs of lending include expensesincurred by the lender to service the loans, and costsrelated to the default risks.

3. Total borrowing costs include the interest costs aswell as noninterest transaction costs incurred by theborrower in connection with the loans net of anytransfer income due to inflation (Adams and Nehman,1979). Transaction costs of borrowing can be brieflyclassified into two categories: (a) explicit cash costs thatinclude expenditure on travel, entertainment, bribesand gratuities, forced purchase of other lender servicesand/or products, and other expenses connected withrequirements imposed by the lender; and (b) implicit oropportunity costs of time spent applying for andobtaining the loan. i.e., the opportunity cost of lostwork time (Ahmed, 1982).

4. The effective cost is the annualized incrementalpayment measured as a percentage of the actualadditional funds borrowed.

5. If the interest rate r is defined as the nominalinterest rate, then E is the nominal effective rate. Thiscan be converted into real terms by calculating the realinterest rate on the loan: rr = (r-p)l(l+p), and using itin place of r in the equation to get the real effectiverate; where p is the yearly inflation rate.

6. Problems of recall are mostly associated withconsumption expenditures. Records of such expendi-tures are rarely kept. So with the length of recall,memory decay of expenditure estimates is fairly com-mon in LDCs (Lynch, 1980). However, one is morelikely to remember unusual expenses on such items asbribes and entertainment to get a loan.

7. The only reliable control information is thatprovided by other surveys. The data on informalmarkets in this survey are consistent with those of

REFERAdams, Dale W., and G. I. Nehman, Borrowing costsand the demand for rural credit, Ioournal for

Development Studies, Vol. 15, No. 2 (1979). pp. 165-176.Ahmed, Zia U., Transactions Costs in Rural FinancialMarkets in Bangladesh: A Study of A Rural CreditMarket, Unpublished PhD dissertation (Charlottes-ville. VA: University of Virginia, 1982).

Alam, Mohammed Ferdous, Cost of &edit frominstitutional sources in Bangladesh, BangladeshJournal of Agricult ural Economics, Vol. 4, No. 2(1981). pp. 51-60.

several other studies such as Shahjahan (1965).Quasem et al . (1978). and Chaudhury and Gafoor(1981).

8. Most bank loans in the survey were taken be-tween October and December of 1980, and some weretaken as late as March 1981. The period betweenAugust and November is usually the harvest period.The jute harvest is usually in August-September, andthat for Aman paddy rice is usually November-December. Normally the wage rate during this period ishigher than that during other periods. The interviewswere conducted during the weeding and post-sowingperiod. Real wages of agricultural labor in Bangladesh.in fact, have been following a decreasing trend since1968-69 (Khan, 1972). So after accounting for theeffect of inflation, it can be reasonably assumed thatthe nominal wage rate prevailing in the area during theinterview period would not be very different from thenominal rate prevailing at the time of taking the loan.

9. The inflation rate was 15% during 198s-81, andthe exchange rate for US$ 1 was taka 16.61 during theperiod (Bangladesh Bank, 1981).10. There was one case of an informal interest bearingloan where the estimate for the opportunity cost of timeseems unusually high compared to rest of the sample.Sample averages without this case are reported below.11. In most cases, the amount of the loan approved isproportional to the value of the collateral provided.Therefore, it is appropriate to assume that small bor-rowers are poorer than the large borrowers.12. If we exclude the case of the informal borrowerwith an unusually high cost of lost work time, then thesample average cost of workdays lost becomes taka I I,while the sample average transaction cost decreases totaka 16. As a result, the sample average ratio oftransactions costs to loan size falls to 2%.13. The T-statistics reported are approximate valuesfor samples with unequal variances.

ENCESBangladesh Bank, Economic Trends, Vol. 6, No. 2

(1981).Chaudhury, R. H., and A. Gafoor, Rural credit inBangladesh, Paper presented at the Fifth AnnualConference of the Bangladesh Economics Associa-tion (Dhaka, Bangladesh: April 30-May 3, 1981).Cochran. W. G.. Sam&g Technigues, 3rd edition(New York: John Wiley-and Sons, 1977).

Cuevas, Carlos E., fnrermediarion Costs and SculeEconomies of Banking Under Financial Regulationsin Honduras, PhD dissertation (Columbus, OH: TheOhio State University, 1984).


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COSTS OF RURAL LOANS 363Deming, W. E., Some Theory_ of Sam pling (New York: surveys: A case from Sierra Leone, Working PaperJohn Wiley and Sons, 1920). No. 10 (East Lansing, MI: Department of Agricultu-Gonzalez-Vega, C., On the Iron Law of Interest Rate ral Economics, Michigan State University, 1980).

Restrictions: A gricultural Credit Policies in Costa Nehman, G. I.. Sm all Farmer Credit Use in a DepressedRica and in Ot her Less Developed Countries. Unpub- Communit y in Sao Paulo, Bra:il, Unpublished PhDlished PhD dissertation (Palo Alto, CA: Stanford dissertation (Columbus, OH: The Ohio State Uni-University, 1976). versity, 1973).

Khan, A. R., The Economy of Bangladesh (London: Quasem, M. A., M. Alam, and J. C. Shaha, RuralMacmillan Press, Ltd., 1972). credit in Bangladesh: A case study at Patuakhali,Ladman, J. R., Loan transactions costs, credit ration- Farm Economy, Vol. 1, No. 1 (1978) pp. 63-92.ing, and market structure: The case of Bolivia, in Shahjahan, M., Agricultural Finance in East PakistanD. W. Adams, D. H. Graham, and J. D. Von (Dhaka, Bangladesh: The Asiatic Press, 1968).Pischke (Eds.), Undermining Rural Development Von Pischke, J. D., and D. W. Adams, Fungibilityw ith Cheap Credit (Boulder, CO: Westview Press, and the design and evaluation of agricultural creditInc., 1984). projects, Am erican Journal of Agricult ural Eco-Lynch, S. G., An analysis of interview frequency and nomics, Vol. 62, No. 4 (1980).reference period in rural consumption expenditure

APPENDIXDerivation of equation (2): Maturity = n yearsExplicit loan value =L Therefore, total repayment = (1 + E). (L-TC) (ii)Explicit interest rate = r % Equating (i) and (ii), we get:Maturity = n years (1 + E). (L-TC) = (1 + r). LTherefore, total repayment = (1 + r). L . . . . . . . . . . . . (i) (1 + E) = (1 + r). (L/L-TC)Transaction costs =TCNet incremental loan value = L-TC (1 + E) =(1 + r) +5i?ZAnnualized effective cost =E % E =(1 + r) C/UL-TC -1.

ahmed - effective costs of loans bangladesh

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