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Printed in Great Britain. 0 1989 Pergamon Press plc
ZIA U. AHMED*
The Ohio State University, Columbus, Ohio
Summary. -The paper compares transaction costs of borrowing from both formal and informal
sources in rural Bangladesh and finds that transaction costs of loans from formal lenders are
higher than those of loans from informal lenders. Transaction costs per taka of loan decrease with
loan size, but much faster for formal than for informal loans. The effective costs of loans are
calculated to show that for small loans, the effective costs of formal loans were higher than those
of informal loans, while for large loans the formal loans were cheaper than informal loans. Thus
large borrowers benefit from the subsidy in the formal credit market.
357
3.58 WORLD DEVELOPMENT
loans from both formal and informal lenders of borrowing will bear high effective rates of
(Ahmed, 1982). interest on their loans.
the borrower spent away from his work. Care effect of this low interest rate ceiling on institu-
was taken to exclude visits to town not associated tional credit was to increase noninterest means of
with the loan. The cost of each workday was credit rationing by the formal lending institu-
calculated from the prevailing market wage rate tions. At the same time. interest rates in the
for male workers in the borrower’s profession in informal markets were free to clear the market
that village.’ In the case of in-kind loans from and lenders were not forced to depend on a
informal sources, the market value of the com- noninterest rationing mechanism. Nominal inter-
modity at the time of the loan transaction was est rates on informal loans for the sample aver-
used to determine the market value of the loan; aged 42% (a 23% real rate) with some small,
similarly, if the repayment was in-kind, then the short-term loans carrying rates as high as 120%
market value of the commodity (or service) at the annually.
time of repayment was used. In case the loan had Table 1 shows the frequency distribution of
not yet matured, the market value of the total transaction costs of borrowing from the
repayment was calculated in terms of market BKB by major components: cash costs, and cost
prices prevailing during the interview period. of workdays lost. The bottom part of the table
Of the 61 households that did not borrow from shows the frequency distribution of transaction
the BKB, Raipura Branch, 36 (59%) obtained costs of borrowing from informal sources. It can
funds from informal sources (including friends be seen that the majority of borrowers from the
and relatives) - some of them obtaining multiple BKB incurred costs much above the average
loans. However, 25 (42%) did not borrow any transaction costs in the informal market. About
funds at all. During the period of study (1980- 60% of BKB borrowers incurred cash costs over
81). the interest rate on most formal agricultural taka 50, and in terms of the opportunity cost of
loans was set at a 12% nominal rate (a -3% real lost work time, about 70% incurred costs over
rate) by the Bangladesh Bank.’ Ignoring trans- taka 50. Only 3.4% of borrowers from informal
action costs, there should be a great demand for lenders had cash costs over taka 50 and, consider-
funds at negative interest rates because of the ing their opportunity cost of time, only 7%
associated income transfer. It is likely that the incurred costs over taka 50.”
Borrowers
O-50 24 18
51-100 14 16
101-200 15 15
201-300 3 (;:; 10
Above 300 5 (8) 2
Total 61 (100) 61 (100) 61
Borrowers
Table 2 shows the average loan transaction action costs increase with loan size but the range
costs by the component costs for various loan size is not as wide in absolute value as in the formal
groups. Although total transaction costs are high market. The sample average is taka 5, which is
for large loan sizes, the cost per unit of money only 4% of the cost in the formal market. Again,
borrowed decreases with loan size. Average cash the sample average opportunity cost of time is
transaction costs increase from taka 52 for the taka 16, which is only 12% of the cost in the BKB
small loans of taka 500 or less to taka 370 for the sample. Average transaction costs are taka 7 for
large loans of over taka 3,000. The average for small loans and rise to taka 35 for the large loans
the sample is taka 141. Similarly, average cost of over taka 3,000, while the sample average is 21
workdays lost increases with loan size from taka taka.12 Consequently, the ratio of transaction
58 for small loans to taka 161 for large loans. The costs of loan size is much lower than for the BKB
average for the sample is taka 132. The average loan sample. The ratio of transaction costs to
transaction costs for BKB borrowers range from loan size shows that the credit disbursement
taka 110 for the small borrowers to taka 531 for mechanism and the loan screening process do not
the large borrowers, while the average for the impose significant additional costs on the bor-
sample is taka 272. However, as expected, rowers. Perhaps, transaction costs incurred by
transaction costs as a percentage of loan value lenders in the loan screening process are internal-
decreased with loan size from 29% for the small ized in the explicit interest rate charged.
loans to 7% for the large loans, with an average The last column in Table 2 shows the nominal
of 22% for the sample. Except for the large loans annualized effective costs of credit for different
over taka 3,000, the transaction costs per taka of loan sizes in the two markets. As expected, the
loan are higher than the interest costs of 12%. effective rates are higher for the small loans than
The declining ratio of transaction costs to loan for large loans. Comparing the effective rates in
size shows that large borrowers are not as the two markets, we find that for loans of taka
affected by transaction costs as the small bor- 1,000 or less the annualized effective cost of
rowers. Thus the rationing mechanism imposes 169% is highest in the formal market, while for
additional costs mostly on the small borrowers loans above taka 3,000 the effective rate of 16%
who are most likely to be poor and for whom the is lowest in the formal market. In fact, for loans
concessionary interest rates were designed.” over taka 1,000, the effective costs in the formal
In the case of the sample of informal bor- market are lower than in the informal market.
rowers, the average transaction costs from in- However, for loans of taka 1,000 or less, the
formal sources are not only low, they are a effective costs in the formal market are much
relatively insignificant proportion of the loan higher than in the informal market. The average
size. In the informal market, average cash trans- effective cost for the sample is about 108% in the
COSTS OF RURAL LOANS 361
formal market, which is twice the average effec- to rural formal credit in all low income countries.
tive cost of 54% in the informal market. One The results. nonetheless, are suggestive and help
would assume that those BKB clients who bor- to clarify the impact of transaction costs on credit
rowed at these prohibitive costs were looking at demand. as stressed by Adams and Nehman
the early costs as “sunk costs,” or “investment” (1979). The results of the sample survey also
for future loans, or were planning to stretch out lend support to the views and explanations of
the loan beyond maturity or not repay at all Gonzalez-Vega (1976). The noninterest rationing
(Ahmed, 1982). This comparison suggests that mechanisms of the formal lenders have resulted
small borrowers would patronize the relatively in the small. poor borrowers being excluded from
less expensive informal market, while the large the formal market. This allows the large, rich
borrowers would prefer to seek the cheaper borrowers, who incur relatively small transaction
formal credit. costs, to take advantage of the low, subsidized
Table 3 shows the results of T-tests comparing interest rates. The income transfers via the
*T-tests comparing cases of samples of BKB and non BKB borrowers.? Testing the
hypothesis (Ho) that the population means of the two samples are same for the
respective variables. (Monetary values denominated in takas.)
TBecause of separate variances in the two samples, the T-values are approximate
values.
transaction costs and the annualized effective negative real interest rates, therefore, accrue
costs of borrowing in the formal and informal mainly to these large borrowers. On the other
markets in the sample survey. The hypothesis hand, the informal sources provide a much
that the transaction costs and the annualized needed alternative to the small borrowers.
effective costs are same in both markets is tested. By measuring costs in terms of the effective
The T-scores for the different variables tested borrowing costs, one can more clearly identify
showed that the samples are from different the reasons for the limited use of formal credit in
populations, i.e., transaction costs and the effec- the rural sector, particularly by the small, poor
tive rates are significantly different in the two borrowers. The demand for credit, defined as a
populations, and that they are higher in the function of the marginal borrowing costs, follows
formal {bank) market than in the informal the normal downward slope with respect to the
market.’ effective borrowing costs. Thus a major policy
conclusion evolving from this study is to encour-
age financial innovations and policies that would
lower the effective borrowing costs to nonpre-
4. CONCLUSION ferred borrowers. Innovations should be aimed
at reducing the transaction costs incurred in rural
The data used in this study are from a small financial transactions, and policies should be
sample in only one country. This limits our ability directed at liberalization of the market mechan-
to draw generalizations about problems of access isms that determine the equilibrium interest rate.
362 WORLD DEVELOPMENT
NOTES
1. Formal financial institutions include banks. several other studies such as Shahjahan (1965).
cocperatives and other nonbank financial organizations Quasem et al. (1978). and Chaudhury and Gafoor
that are formally recognized by the financial authority (1981).
to operate as financial institutions.
8. Most bank loans in the survey were taken be-
2. Transaction costs of lending include expenses tween October and December of 1980, and some were
incurred by the lender to service the loans, and costs taken as late as March 1981. The period between
related to the default risks. August and November is usually the harvest period.
The jute harvest is usually in August-September, and
3. Total borrowing costs include the interest costs as that for Aman paddy rice is usually November-
well as noninterest transaction costs incurred by the December. Normally the wage rate during this period is
borrower in connection with the loans net of any higher than that during other periods. The interviews
transfer income due to inflation (Adams and Nehman, were conducted during the weeding and post-sowing
1979). Transaction costs of borrowing can be briefly period. Real wages of agricultural labor in Bangladesh.
classified into two categories: (a) explicit cash costs that in fact, have been following a decreasing trend since
include expenditure on travel, entertainment, bribes 1968-69 (Khan, 1972). So after accounting for the
and gratuities, forced purchase of other lender services effect of inflation, it can be reasonably assumed that
and/or products, and other expenses connected with the nominal wage rate prevailing in the area during the
requirements imposed by the lender; and (b) implicit or interview period would not be very different from the
opportunity costs of time spent applying for and nominal rate prevailing at the time of taking the loan.
obtaining the loan. i.e., the opportunity cost of lost
work time (Ahmed, 1982). 9. The inflation rate was 15% during 198s-81, and
the exchange rate for US$ 1 was taka 16.61 during the
4. The effective cost is the annualized incremental period (Bangladesh Bank, 1981).
payment measured as a percentage of the actual
additional funds borrowed. 10. There was one case of an informal interest bearing
loan where the estimate for the opportunity cost of time
5. If the interest rate r is defined as the nominal seems unusually high compared to rest of the sample.
interest rate, then E is the nominal effective rate. This Sample averages without this case are reported below.
can be converted into real terms by calculating the real
interest rate on the loan: rr = (r-p)l(l+p), and using it 11. In most cases, the amount of the loan approved is
in place of r in the equation to get the real effective proportional to the value of the collateral provided.
rate; where p is the yearly inflation rate. Therefore, it is appropriate to assume that small bor-
rowers are poorer than the large borrowers.
6. Problems of recall are mostly associated with
consumption expenditures. Records of such expendi- 12. If we exclude the case of the informal borrower
tures are rarely kept. So with the length of recall, with an unusually high cost of lost work time, then the
memory decay of expenditure estimates is fairly com- sample average cost of workdays lost becomes taka I I,
mon in LDCs (Lynch, 1980). However, one is more while the sample average transaction cost decreases to
likely to remember unusual expenses on such items as taka 16. As a result, the sample average ratio of
bribes and entertainment to get a loan. transactions costs to loan size falls to 2%.
7. The only reliable control information is that 13. The T-statistics reported are approximate values
provided by other surveys. The data on informal for samples with unequal variances.
markets in this survey are consistent with those of
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APPENDIX