Transaction Cost and Interest Rate

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Transaction Cost and Interest Rate

• Amulya
• Centre for Micro Finance

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Agenda

• To understand different types of cost for an MFI
• Factors affecting transaction cost
• Some key findings of CMF case study
• Sustainable interest rate setting and
• Interest rate methods
• Factors affecting interest rates
• Measures of Efficiency
• Exercises

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Transaction Cost???

• Transaction
• Any event that causes a change in an
  organization's status of finances, resulting from
  normal business activity. It is recorded on the
  general ledger by debit or credit tickets.
• A financial transaction involves a change in the
  status of the finances of two or more businesses
  or individuals.
• Cost
• An amount paid or required in payment or an
  expenditure of something, such as time or labor
  ect., necessary for the achievement of a goal

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What are the Incomes and Expenditures in MFIs
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Classification of Cost
Financial expenses / Cost of Fund (Market Driven)
- Interest, fee, commissions on borrowings and
savings
Operating Expenses - Salaries, Travel,
Depreciation, Communication, Printing, Rents,
Utilities, Fees etc.
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Classification of Cost
Loan Loss Provisioning - LLP is the expense shown
to account for the expected future losses and
through this, reserve called Loan Loss Reserve is
created
Non operational expenses - Expenses incurred on
activities which are not core to the MFIs
operations or are not part of its regular
operations
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Understanding Transaction cost
Indirect Transaction Cost
Direct Transaction Cost
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Understanding Transaction Cost
Direct Transaction Cost
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What affects operating cost ???

• Governance and Management (composition of board
  members and efficiency)
• Operating Strategies
• Product and Services
• Management Information System (MIS)
• External Factors
• Some extend the mission and objective of the
  Institution also affect to the Operating Cost
• There is no defined technique to get control over
  the Operating Cost
• the only way is to keep a balance management on
  the aspects affecting to it.

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Factors affecting operational cost

• Governance and management structure
• Operating methodology/model
• Operational area (Geographic profile, client
  density, client needs/demand, existing
  livelihood)
• Scale of operations and expansion strategy
• Focus on financial services
• Staff efficiency (client per credit officer,
  active client per CO, L/O per CO, client per
  branch, L/O per branch etc.)
• Target clients/average loan size
• Product features
• Delinquent Loan (defaulters)
• Infrastructure and use of technology
• Life cycle of group

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Transaction Costs in Group Micro credit in
India

• Savita Shankars Case Study
• (Findings)

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Transaction Cost in Different Lending Models
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Transaction Cost in Different Operational Area
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Transaction Cost in Different Competitive
Environment

• Group formation cost is comparatively less in
  competitive and mature branch due to high
  awareness among the potential clients.
• Direct transaction cost for the first loan 2.1
  and 2.9 for the new branch in competitive and
  non- competitive environment.
• Indirect cost is comparatively much lower in
  mature branch.
• Total transaction cost is 6.3 and 8.9 for the
  new branches in competitive and non competitive
  environment.
• Cost structure is significantly lower in
  competitive environment due to basic awareness.

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Conclusion

• Transaction cost is the major contributor to the
  high interest rates in micro credit loan.
• Key driver of direct transaction loan is field
  staffs compensation and number of group they are
  handling.
• Client density can reduce the transaction cost
  significantly as it reduces the field worker time
  and conveyance time.
• Transaction cost also be reduced by increasing
  staffs productivity.
• Indirect transaction is contributed by number of
  vertical layers in the organization.
• Transaction cost reduces with increase number of
  mature branches.
• The regional variation in the transaction should
  be taken into consideration by policy makers.

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Interest Rate

• MFI must charge interest rates in which it can
  cover all its costs as well as have some margin
  for its growth

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Factors affecting interest rate

• Operating cost of the MFI
• Cost of funds
• Loan loss risk
• Competition
• Desired profitability
• Government / Central Bank Policy
• (the interest rate should be politically and
  socially correct)

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Sustainable rate / Pricing formula

• R Interest rate
• FC Financial cost
• LL Loan loss
• OE Operating expenses
• M Margin for future growth
• I Investment income
• All these figures have to be expressed as
  percentage of average portfolio.

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Interest charging method Flat vs Declining

• Flat Interest Rate
• Calculated on the original face value of the loan
  amount on total loan period.
• Easy to understand, calculate and document.
• No interest charged on overdue within the loan
  period.
• Declining Interest Rate
• Calculated on monthly basis for the total loan
  outstanding.
• Need proper documentation to have monthly
  calculation.
• Comparatively difficult to understand, calculate
  and document.
• Interest rate is charged on the overdue amount.

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Lets Do an Exercise
Mr. XYZ wants to avail a loan of Rs.
12,000/- from the operating MFIs in his village.
There are two MFIs working in his village namely
A and B. After getting approval for his
eligibility to avail loan from both MFIs he
discussed on interest rate and other charges need
to pay. He wants his loan by 1st of January.
MFI A- Interest rate -15 (flat) Registration
fee Rs. 100/- Documentation charge 2 Loan
Period 12 months
MFI B- Interest rate -24 (Declining) Registrat
ion fee Rs. 200/- Documentation charge
3 Loan Period 12 months
Mr. XYZ wants to know that which loan is
costlier for him? Also try to calculate effective
interest rate for both MFIs?
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Repayment schedule (MFI- A)
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Repayment schedule (MFI- B)
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Effective Rate of Interest

• Which method is better declining or flat??
• Any method can be adopted. Choose on convenience,
  it is the effective rate which is important
• Effective interest rates includes both financial
  and transaction cost incurred by the borrower.
  Financial costs include interest, fees, forced
  savings, group fund and other fund contribution.
  Transaction cost transportation and other
  opportunity cost for their time spent.
• Effective rate of interest is helpful in
  determining whether loan is more or less
  expensive for the borrower.
• Appropriate charging of interest rate is vital
  for the sustainability of the organization.

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Effective Rate of Interest
MFI A (1800100240)
12000 17.83 MFI B
(1560200360) 12000
17.67
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Efficiency Ratios

• No. of active clients per staff
• No. of active clients per field staff
• Gross loan outstanding per loan officer
• No. of active clients per branch
• Yield on portfolio
• Operating expense ratio
• Financial operating expense ratio
• Operational self sufficiency (OSS)
• Financial self sufficiency (FSS)
• Return on Asset (RoA)

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Efficiency Ratios
Cash financial revenue from loan
portfolio Yield on gross loan portfolio
-------------------------------------------------
------- Average gross loan portfolio

• Operating expense
• Operating expense ratio -----------------------
  ----------
• Average gross loan portfolio

Operating revenue Operational
self-sufficiency -------------------------------
------------------- (Financial expense
Loan-loss provision expense Operating
expense)
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Efficiency Ratios
(Net operating income Taxes) Return on
assets (ROA) -----------------------------------
------- Average assets
Adjusted operating revenue Financial
self-sufficiency -------------------------------
------------------- (Financial expense
Loan-loss provision expense Operating
expense Expense adjustments)
Total Financial Opt Expenses Financial
Expenses Ratio ---------------------------------
----------------- Average Loan Portfolio
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Lets Do an Exercise

• Stuffs given to you
• Basic Information of MFIs
• Balance Sheet
• Income and Expenditure Statement
• Lets calculate the efficiency ratios???

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• Thank you