ECONOMICS MADE SIMPLE : Economic foundations of bank lending interest rates in Tanzania
What you need to know:
These financial institutions include traditional banking and non-banking ones. The former include commercial and development banks, while the latter include non-banking micro-financial institutions. The lending rates may be as high as over 20 per cent in some banks while deposit interest rates are as low as 2 per cent. This makes a wide spread (difference between lending and deposit rates) of about 18 per cent.
Now and then there have been calls for banks to reduce lending interest rates. The calls have been mainly coming from politicians. This is based on the fact that lending interest rates in the country’s financial institutions are rather high in absolute terms and in relation to deposit interest rates.
These financial institutions include traditional banking and non-banking ones. The former include commercial and development banks, while the latter include non-banking micro-financial institutions. The lending rates may be as high as over 20 per cent in some banks while deposit interest rates are as low as 2 per cent. This makes a wide spread (difference between lending and deposit rates) of about 18 per cent.
One wonders why the lending rates are that high in this seemingly competitive industry with over 40 banks and a multitude of non-banking financial institutions. Some possible economic foundations and causes of high lending rates need to be known before calling for a reduction of the same. This article outlines reasons for high lending rates in the Tanzanian type of economy.
It is to be understood that an interest rate is the price that financial institutions charge for their core business, which is lending money. As it is for other businesses, it costs to conduct a banking business. All factors of production have to properly be paid for. Therefore, financial institutions have to charge ‘adequate’ price (interest rates) to be able to cover their costs. These costs typically include, but are not limited to staff costs mainly salaries. They also include banking infrastructure costs broadly speaking: insurance, security, various taxes and fees, including rental fees for business premises.
Banks have to make profit
Financial institutions, including banks, are profit making entities, especially private-owned ones. They are normally neither charity organisations nor are they non-profit making. As rational actors in the economy, they aim at making and maximising profit. They, therefore, have to charge a price in the name of interest rates to cover their costs and make a ‘reasonable’ profit margin.
Inflation is the base
A banking business revolves around taking deposits from the public and lending the same to make profit. The concept of time value for money is critical in banking. Inflation, therefore, is among the core and most fundamental drivers of high interest rates. This is mainly so in an inflation-ridden economies like that of Tanzania.
This government has seen double digit inflation rates and has to tame it below double digit. In order to protect value of the money they lend, lending institutions have to charge inflation-adjusted interest rates. Therefore, the higher the inflation (actual or potential) the higher the interest rate ceteris paribus (other factors remaining constant). One wishes that this was the same for depositing interest rates.
Demand side economics perspectives
Another possible explanation for a rather high borrowing interest rate is high demand for loans. Economic theory predicts higher prices (in this case higher borrowing interest rates) if there is high demand for the good or service being sold. This reason is questionable as a real driver for high interest rates in Tanzania. This is because it is said that banks are sitting with idle money that is seeking borrowers. Of late, it has been banks that are seeking for borrowers than in the recent past, when some people had to bribe to get loans.
With over 40 banks and many non-banking financial institutions in Tanzania today, it seems that the supply side of loans is bigger than the demand side for the same. That is exactly why one would expect lower interest rates as it has been the case of mobile phone tariffs. This paradox indicates that the ceteris paribus conditions in the economic law of supply of and demand for loan does not hold.
Consumers ignorance
Some consumers of some bank products are ignorant and lack awareness of alternative cheaper loan products. This in turn forces them to consume high interest loans. This is likely to be the case for some consumers of commercial banks, who do not know that there are lower rates elsewhere. For example, development banks have lower borrowing rates than commercial ones. This is because compared to the former, the latter are long-term and developmental in nature and at times are subsidised by the government. Therefore, by and large it is ignorance and lack of awareness (information asymmetry) that will make a rational economic actor in the market to borrow at higher rates. Therefore, if there were ‘enough’ development banks and consumers become aware of this, commercial banks could be forced to reduce their lending rates to lure borrowers. Unfortunately, for borrowers and, fortunately, for commercial banks, this is not foreseen in the near future.
Impacts of high rates
It would be to the national economy interest if lending rates were lower and affordable to the majority of Tanzanians. This is because high interest rates are not good for borrowers. They increase the costs of borrowing, the cost of doing business using borrowed money and by extension it fuels inflation and holds economic growth back.
High rates hinder access to finance and by extension poverty alleviation efforts, especially for lower income groups. It is unfortunate that lower interest rates depend on sustainable radical and fundamental changes in most of the causes for high interest rates. Although a tall order and concerted efforts to make such radical and fundamental changes are necessary.
