I would like us to discuss an introduction to Banking and other financial services. First of all, what is a bank and what is microfinance?
A bank is a financial institution that accepts deposits from the public and creates credit. Lending activities can be performed either directly or indirectly through capital markets. Due to their importance in the financial stability of a country, banks are highly regulated in most countries. Microfinance is a source of financial services for entrepreneurs and small businesses lacking access to banking and related services (Wikipedia).
Difference between Banks and MFIs
For the purpose of today’s lessons, I would like us to categorise financial institutions into two: Banks and Microfinance Institutions (MFIs). Microfinance institutions could further be divided into two: profit-making MFIs and Social-mission MFIs. Profit-making MFIs are mostly limited liability companies while the social-mission MFIs are mostly NGOs, faith-based organisations which identified some needs and would like to satisfy them. There are also banks that are wholly dedicated to microfinance in certain countries. The differences here are mostly based on the regulations of certain jurisdictions.
Banks are allowed to take deposits from the public while at the same time providing loan services, letters of credit, forex transactions and other allied financial services. The majority of MFIs are credit-only institutions except in some semi-banks like savings and loans companies. Savings and loans companies could be described as second-tier banks. They are not allowed to offer foreign/forex operations in certain countries.
What is an Interest Rate?
Many of us would normally get services from banks and microfinance organisations. There is one distinct difference in their costs to the customer. This is called the interest rate. Others will say service charge, management fees or floating rates in case of Islamic Banking. At the end of the day, interest rate or whatever it is called is the return to the lender which is paid by the customer who accepted a loan from the lender over a certain period. It is a holding cost plus risks of not paying it back. It could also be described as the return of lending after factoring the risks to the lender.
Factors affecting the Interest rates
Interest rates are normally higher in the profit-making MFIs than the banks. This is due to the fact that the banks have a cheaper source of funding their loan books: deposits from the public.
MFIs incur a lot of costs in their outreach programs, serving clients who otherwise would not have qualified in the parlance of the banks. Profit-making MFIs borrow from wholesale lenders and some banks in order to lend to their customers. In most cases, they have to add a good margin on their borrowed funds making their interest rates higher.
MFIs also lend with little or no credit history of their clients thereby making them vulnerable to high defaults which may later cripple the MFIs. They, therefore, try to cover their costs by high-interest rates.
When the risk of paying back is low, then interest rates are generally low. If the chances of clients not paying back are high, then interest rates are also high.
Not only the above-mentioned reasons, inflation and general economic conditions also influence the rates.
Why do you care about interest rates at all?
The fact is that you need to know where to go in case you need financial assistance from institutions rather than family and friends.
Consider admiring a beautiful lady and you wanted to have her for good! The first step is to strike acquaintanceship, followed by friendship before you can go ahead and propose love to her. You are likely to succeed if you followed these steps rather jumping straight into love proposal on your first day. If you need her quickly, then you better visit the prostitute line. They would not just charge you high but you are likely to contract STD.
Banks base their business on a relationship. You must first open an account and run it for some time. They would like to know your credit history before the banks could lend money to you. With this, you are most likely to get a very good interest rate and favourable terms of repayments.
Without this, you could also approach the MFIs depending on your circumstances. You are most likely to pay exorbitant fees, interests and charges but you shall surely get a quick service. Does this sound like the lady analogy above?
Methods of Interest Rates
In many countries, interest rates are regulated by their Central Banks. The MFIs and banks are required to charge reducing balance method of interest rates. Most MFIs in West Africa still charge flat rate (straight line) interest because the interest rates are not regulated. If you work their fees, charges and minimum deposits or collateral requirements into what is called Effective Interest Rate (EIR), you really are paying more for their services.
Next time you are going to borrow, ask your relationship/loan officer if the interest rate s/he mentioned to you is a reducing balance or a flat one. Also, check the mission and vision statement of the organisation to see what they are about.
Then you will know in case you default, they will not come for your children as slaves till you get the money to pay back!
In the next article, we shall look at the development banks and wholesale lending institutions. And we shall look at the capital requirements and the mode of operations of these institutions. Stay tuned!