Interest Rates and Defaults

Bit of an ITK post here. No one has asked me to do it but I saw something online this morning where Aliko Dangote was complaining about high interest rates being a nuisance to doing business in Nigeria. 

This is of course true as interest rates at 30% or more automatically mean that loads of businesses cant be funded i.e. any kind of business that requires a large upfront investment followed by returns in later years. In short, beyond the quick buying and selling, there’s very little you can do with borrowed funds at such rates.

So what makes interest rates very high? There are several things. One of such is the level of savings in a country. The Chinese as a whole have a savings rate of an astonishing 40% of income i.e. the average Chinese man saves 40% of whatever he earns on a monthly basis. Since everyone is saving in this manner, it means that banks can afford to pay them very low interest rates as there’s unlikely to be any competition for such funds – it’s a take it or leave it market. As you might have heard, bankers operate on the 3-6-3 formula – they take your deposits and pay you 3% interest on it. They then lend your money to someone else and charge him 6% on it. Once all this is done, they make sure they are at the golf course by 3pm. Job done. 

I digress. There’s also something else that affects interest rates – defaults. In short, looking at the interest rates in a market can tell you something about the rate at which borrowers default – borrow money and just walk away without repaying, perhaps mistaking it for a gift. 

Let’s use very simplistic numbers to try to work this out. Imagine you are a lender and you start off with N1m as funds you want to lend to borrowers for a profit. Now let’s even assume your number one priority is to ensure that you do not lose a single kobo of your initial investment, never mind making a profit.

Now let’s imagine you lend N100,000 each to 10 different borrowers. One borrower’s mother dies ‘suddenly’ at the age of 98 so instead of buying the palm oil he trades to resell, he diverts the money to pay for the caterer at her burial party. Naturally he stops repaying the loan. Another borrower simply disappeared. When you went to look for him at the address he gave, you discover he never lived there and everyone in the neighbourhood claims not to have seen him in weeks. 

So you are left with 8 borrowers who thankfully continue to repay their loan. Now if they make all their repayments, at the end of the loan repayment period, you will get back N800,000 (ignore the profit you need to make for now). So you are N200,000 down from where you started.

This is where interest rates come in – how much do you need to charge the 8 ‘good’ guys to get back to N1m? A simple way to calculate this is by dividing the N200,000 shortfall equally across the 8 guys which gives each person N25,000. In other words, you need to charge each borrower a 25% interest rate (N25k/N100k) just to get back to the N1m you started with. 

Now you might say this is all a bit unfair – why should you, the good guy, be made to pay for the sins of the runner? Such is life and there are no easy answers to this question. But bear in mind that you are the business man in this and your number one priority is to ensure you dont lose any money. 

What if a 3rd borrower also runs away? You are staring at a loss of N300k so you then need to charge the remaining 7 guys something in the region of 43%! just to break even. Perish the thought if more people run away. 

This relationship between defaults and interest rates, as simplistic as the above example is, explains a few things to us. One of such is why poor people get charged a higher interest rate than other people. This is one of the ironies of finance because charging a poor person a high interest rate automatically increases their chances of default. But then, poor people are more likely to default anyway given the pressure on their finances. 

It also explains the two competing points of view in a borrower lender relationship – the borrower simply looks at the lender and wonders why one earth he is being charged a punishing rate of interest. The lender on the other hand looks at his ‘loan book’ i.e. all the borrowers he is exposed to and is primarily concered with how to ensure that the whole book doesnt lose money. If the lender sees a loss in one side of the loan book, he has to find a way to plug it elsewhere. 

We can have an endless debate about the fairness or not of doing things this way but its worth bearing in mind that if the lender ends up with N800,000 to lend, that simply means there is N200,000 less to lend to the economy. In other words, someone who might need the funds probably wont get it in future. 

What to do? We definitely need to do whatever we can to reduce the rate at which people default when they borrow money. Protecting someone you know who’s borrowed money but not paid doesnt really help anyone. The banks also need to be far more rigorous in their checks before lending money to anyone. Being slack just ends up punishing the good guys unnecesarily.

This is why it is so frustrating that the credit bureaus that were supposed to help people build a credit profile havent really got off the ground for like 4 years and counting now. It didnt help that, in his usual manner, Governor Sanusi decided to regulate the sector in his own image even before they got off the ground. The licencing requirements can be found here. You need N500m as ‘minimum capital requirement’ to start one. Why on earth this is required for what is effectively a glorified Baba Alajo business is beyond me. What this means is that if a group of young smart guys come up with a useful computer based system of running a credit bureau, they are unlikely to be able to operate one as they need to come up with more than $3m and find the ‘experience’ required. 

Finally, the way our ‘big men’ borrow money and just buy a nice boat with the money is a big problem for the rest of society. I generally dont have a problem with rich people as I think that the best way to look at them is how much do they cost society by being rich? Most rich people dont buy stuff that ordinary folk buy so they are unlikely to cause inflation for the rest of society in that regard. For example imagine that it suddenly became a fad among rich people to buy Kia Picantos to use as go karts and destroy them afterwards. Kia Picanto dealers will soon notice the increased demand and raise the prices thereby putting an inflationary cost on the working guy who wants to buy the car so as to get to and from work everyday. But thankfully rich people buy Range Rovers and Porsches instead. Rich people also pay taxes used to fund education but then send their kids to private school i.e. a net benefit to society as they are paying twice for the same thing.

But when rich people borrow and refuse to pay, kai, this is a problem. And we get a lot of this in Nigeria. Society ends up paying for this reckless behaviour either through bailing out AMCON to the tune of $21bn or just higher interest rates for everyone else as the banks seek to claw back some of the money they have lost.  

 

So if you are reading this and you want to help in your own little way to bring down interest rates, my advice to you is to save more and consume less :). And if after you have done such a noble thing, if you know anyone in your family who has borrowed money and refused to pay, tell them that’s not a very nice thing to do and persuade them to pay back what they owe.

I promise you, I have not been paid by any bank to write this. Honestly

 

FF

 

 

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2 thoughts on “Interest Rates and Defaults

  1. You see why many of us young blood have financial problems, we wont read things like this. We would rather go after softsells and those BN things.Interest rate is so crazy and MFBs are below standard. I recommend people to start SHARE groups , you can read his article on it http://www.thisismoney.co.uk/money/markets/article-1509958/A-shared-experience.html
    That way, people can get interest free loans and do joint investments which actually helps to reduce risk . Good for people that are risk-averted and help to promote saving culture

    Good write up!

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