C Setting interest rates at market levels

arguments against subsidized interest rates also are powerful:

(i) They usually mean low real deposit rates, which weaken savings mobilization, unless they are offset by significant subsidies, which generate their own problems.

(ii) They erode the capital base of the financial institution, progressively diminishing its capacity to serve its clientele.

(iii) They encourage lending for low-return activities, weakening the possibilities for the credit program to generate increases in sector income.

(iv) Since low real interest rates cannot be used to screen applicants or projects, rationing of credit tends to be carried out on the basis of non-economic criteria.

(v) Small-scale loans entail higher administrative costs per unit lent, and higher interest rates are needed to cover those costs.

(vi) Agricultural loans are risky on average, and for the sake of the sustainability of the viability of the financial institution a risk premium should be built into the interest rate for institutions oriented toward agricultural lending.

Forced savings programs in which credit clients are required to 'deposit' a certain percentage of the loan received with the lending institution have been common among microfinance programs for several years and have, in many cases, improved the clients' ability to save regularly. Evidence strongly suggests that if appropriate services are available, the poor will voluntarily save in large proportions. Voluntary savings programs are critical for two reasons: as potentially the largest and most immediately available source of finance for microcredit programs and as a much needed and demanded financial service for the poor ( from Rachel Rock, 'Introduction', in R. Rock and M. Otero (Eds), From Margin to Mainstream: The Regulation and Supervision of Microfinance, Monograph Series No. 11, Accion International, Somerville, Massachusetts January 1997, p. 7).

50. The advantages of savings mobilization in this context are seen primarily for rural financial institutions and the rural sector. In the aggregate, the quantitative evidence on the response of private savings to interest rates in developing is unclear. However, that may be due to the fact that only recently have most developing countries moved toward financial liberalization. For a summary and discussion of this evidence, see P. R. Masson, T. Bayoumi and H. Samiei, 'International evidence on the determinants of private saving', The World Bank Economic Review, 12(3), September 1998, pp. 483-501.

With reference to rural financial institutions oriented toward the small-scale borrowers, a CGAP note has said:

Experience around the world has shown that microentrepreneurs do not need subsidies and that microlenders cannot afford to subsidize borrowers. Low income entrepreneurs want rapid and continued access to financial services, rather than subsidies. Most microenterprise clients see the 'market interest rate' as the rate charged by the money lender or curb market, which is often double the interest rate charged by microlending institutions. Subsidies often send the signal to borrowers that the money comes from government or donors who regard the poor as objects of charity, and borrowers see this as a signal not to repay. Few low income entrepreneurs end up benefitting from subsidized programs, because these programs fail before they reach significant numbers. Efficient financial intermediaries need to charge high rates to cover the costs of making small loans (from Nancy Barry, 'The Missing Links: Financial Systems That Work for the Majority', Focus, Note No. 3, The Consultative Group to Assist the Poorest, Washington, DC, USA, October 1995, p. 3).

Dale Adams, one of the early advocates of using market interest rates for agricultural lending, summarized the arguments against subsidized interest rates in the following words:

Interest rates are critical in determining the performance of financial markets, and cheap-credit policies are a major reason for the poor performance of rural financial markets in low-income countries. They destroy the incentives for rural households to save in financial form and seriously distort the way lenders allocate loans.51

(d) Sound governance. Institutional autonomy is a basic requirement. In its absence, strong pressures often are applied to make loans on political criteria. An analysis of the the loan portfolio of the Honduran Government-owned agricultural development bank, BANADESA, revealed that the largest loans, commonly referred to by the bank's staff as 'political loans', had lower repayment rates than smaller loans.52 This pattern has been experienced in other countries as well.53 Sound governance also means adequate institutional arrangements to avoid conflicts of interest in making loan decisions and to ensure accountability. To satisfy governance norms, both appropriate institutional structures and training are needed.

(e) Capable management. Selecting the management well and training the managers and staff of a rural financial institution are keys to its effectiveness and to its viability as well. Training can be expensive but its benefits justify the costs. An evaluation of the Grameen Bank, for example, commented: 'Staff training includes an intensive 6 months of mostly fieldwork, with some time spent in the classroom. Training is also provided for borrowers and center chiefs. Grameen Bank's success is at least partially due to its intensive training

Keeping administrative costs low is one of the determinants of the sustainability of a financial institution, and proper training

51. Dale W. Adams, 'Are the Arguments for Cheap Agricultural Credit Sound?', in D. W. Adams, D. H. Graham and J. D. Von Pischke (Eds), 1984, p. 75.

52. Secretaría de Recursos Naturales, Grupo Técnico de Trabajo sobre el Sector Financiero Agrícola, Las Políticas y la Estructura del Sector Financiero Agrícola, Tegucigalpa, Honduras, 1990.

53. A similar experience in Costa Rica is recounted in Robert C. Vogel, 'The Effect of Subsidized Agricultural Credit on Income Distribution in Costa Rica', in D. W. Adams, D. H. Graham and J. D. Von Pischke (Eds), 1984, Chapter 11.

helps guide staff in that direction. The approach to managing the institution and its loan portfolio also must be appropriate to the rural milieu. Very different approaches are required for small-scale rural borrowers than for large industrial borrowers. This topic is addressed in Section 7.6 below. (f) A market orientation in designing its financial services.55 Most of the innovative work applied to rural institutions in recent years has concerned policies for lending and techniques of savings mobilization, largely for microfinance institutions. In both areas, new approaches consistent with rural markets have been tested on a large scale and, while there are no formulas that can be applied in all contexts, there are guidelines that are generally applicable and approaches that may be adapted to different circumstances. For example, 'In the early 1980s in Indonesia, BRI staff asked villagers why they did not make use of.. . the national savings program administered by Bank Indonesia, the central bank.. . . The replies were nearly unanimous. People from one end of the country to the other responded that [it] permitted withdrawals only twice a month, and that the restriction on withdrawals was unaccept-able'.56 It is now recognized that the creation of savings instruments and other financial services in developing countries must be based on a careful assessment of clients' preferences.

In a study of four financial NGOs in the Gambia it was concluded that institutional sus-tainability of a financial program depends on its ability to mobilize deposits through offering attractive interest rates, covering operating costs without subsidies, diversifying portfolios to reduce risks that arise from covariance of borrowers' incomes, relying on local loan approval committees, developing effective substitutes for physical collateral, and maintaining high rates of loan recovery.57

The viability of a financial institution is not entirely in its own hands, even with the best institutional strategies. Both its operating policies and its balance sheet are affected by national policies which influence the profitability of agricultural production and the conditions of operation for financial institutions. The two main policy determinants of the viability of rural financial institutions are the following:

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