Reducing the Cost of finance and Enhancing Financial Inclusion in Africa: Policy Options

May 18, 2015
On average, lending spreads are higher in Africa than in other developing countries. Several government have reacted by establishing lending rate caps, yet these administrative measures can be counterproductive because interest rate ceilings do not ensure lower long-term lending rates and can adversely affect financial inclusion. In fact, lending institutions can react by simply increasing other service costs to recoup lost income. Moreover, lenders can stop servicing riskier segments of the market (such as MSMEs) if the cap does not adequately compensate operating and other costs. In a recent paper "The Cost of Financing in Africa: Policies to Reduce Cost and Enhance Financial Inclusion", we analyse the main components of spreads and explore a wide set of reforms that can help lower the cost of finance and ultimately increase financial inclusion while avoiding the negative effects of interest rate controls. In a nutshell, we found that operating costs and mainly personnel costs tend have the lion's share of spreads in African countries (akin to other developing countries). This may be the result of combination of typical features of African financial systems such as concentrated banking systems, high lending risk premia, and higher upfront investment requirements to expand outreach. We also found that investment patterns have a significant effect on lending spreads. African banks tend to invest relatively more in government securities, perhaps reflecting higher profitability compared to lending operations that inherently incur much larger expenses and carry more risks, particularly in some African countries. Therefore, lending interest rates can be driven upwards to compensate for the opportunity cost of investing in securities. We argued that policy makers have a wide set of policy reforms at their disposal to lower the cost of finance (and increase financial inclusion) while avoiding the negative effects of interest rates controls. In the paper, we group these policies into seven categories: (I) production/operating costs, (II) regulatory costs; (III) credit risk; (IV) alternative banking business; (V) profitability and return on capital; (VI) macroeconomic stability and country risk; and (VII) enhancing financial inclusion. The list of reforms presented in the paper (and related country examples) is not exhaustive, but it is intended to illustrate the wide array of options available when seeking to lower the cost of finance. Policy makers aiming to reduce financing costs should prioritize reforms that promise the biggest impact based on country circumstances. Policies related to operating costs and profits could potentially have a big impact given their large share in the interest rate spreads. Accordingly, the following measures are crucial: improving the business environment to reduce transaction costs, such as: improving insolvency/creditor rights and suitable collateral frameworks; promoting agency and mobile banking to reduce costs associated with increased access in rural and scarcely populated area; reducing the cost of borrower information (e.g. through effective credit information systems). Reducing infrastructure costs and insecurity are also key measures to reducing operating costs in Africa. And, increasingly relevant, promoting non-bank financial institution growth enhances competition and contestability within the banking sector while directly increasing financial inclusion of underserved segments (for a more complete list please see paper). This blogpost is based on the paper
"The Cost of Financing in Africa: Policies to Reduce Cost and Enhance Financial Inclusion", prepared by
Paola Granata,
Katie Kibuuka, and
Yira Mascaró
from the
World Bank.

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