Globalized Populism and Interest Rates
What irony! Globalization gives everybody an edge, even populists, do-gooders, and social-justice activists. These groups now announce the “failure of the capitalist system worldwide.”
The market hasn’t failed. What has failed is the political system that is supposed to establish an effective system of checks and balances. But that’s the topic of a separate
Today, not even the United States has been saved from the wave of populism. With White House backing, the U.S. Congress recently approved a bill that, among other things, will regulate the interest rates some banks charge (although the Senate voted down a more radical version of this proposal).
One of the do-gooders’ constant obsessions is interest rates. The typical populist argument —which in Mexico has many proponents— says that we should protect consumers from abusive bankers —and there is some truth to this— but we should act with great caution.
The problem with fixing an arbitrary ceiling on interest rates is that we run the risk of leaving those who most need access to formal credit out of the game: people at the Bottom of the Pyramid (BOP).
The point is that giving credit is a costly process because, regardless of the amount, it requires investigation, documentation, monitoring, management, and collections, besides shouldering the losses incurred by people who don’t pay their loans.
Given these fixed costs, it’s only profitable for most banks in the world to issue large loans.
The BOP needs a different kind of credit than traditional banks are willing to offer: to begin with, people in this strata need much smaller amounts, a payment plan that coincides with their weekly incomes, as well as predetermined rates, time limits and payments. In short, they need prices and conditions of certainty that few traditional banks can guarantee.
Populist Euphoria Only Favors Loan Sharks
Let’s suppose that, in a fit of populist euphoria, Mexico’s Congress set rates at 30%, that the opportunity cost of money (that is, the cost of attracting it, inflation, etc.) is 10% a year, and that, given the risk, the profit rate has to be 10% a year for investors. Let’s also suppose that the fixed cost of the whole lending process is Mex$1,000 a year for each loan.
For a million-peso loan, Mex$1,000 comes to 0.1%. So the rate that should be charged is 20.1% (10% + 10% + 0.1%). We can see that million-peso loans are not affected by the legal limit.
But things are very different for a Mex$2,000 loan: the fixed cost comes to 50% a year, and the rate that has to be charged in this case (10% + 10% + 50% = 70%) is prohibited by law.
So, such a law would effectively prevent loans for Mex$2,000 or less. In fact, any loan for under Mex$10,000 would be “prohibited” because Mex$10,000 is the lowest amount that could be lent at 30% under these conditions.
Thanks but No Thanks
The bottom of the pyramid is not helped by the whims of the do-gooders —they certainly do feel good “helping”! The BOP needs loans more than any other segment of the population, often as a matter of survival.
However, rate ceiling simply send consumers to the black market, to loan sharks, at much higher rates. The rate ceilings are a blessing for loan sharks and a calamity for the BOP that is suddenly expelled from formal market.
“You Can’t Fool All the People All the Time” (Abraham Lincoln)
Banco Azteca has nine million loan customers, and its rate is frequently over 30%. Are its clients fools? Of course not. They could ask for loans anywhere else, and they will if the terms are better. Today, those conditions do not exist, and that’s why nine million families have opted for our bank.
At Banco Azteca, we ensure that the conditions of our loans are the best available for that market segment and that there is no risk to the consumer: we don’t raise the rate; we don’t advance payment deadlines; and the consumer takes on a fixed weekly payment. It’s that simple. At this bank, we take all the risks that of our product.
It’s a way of doing business that is much more sensitive to the needs of the BOP. The credit crisis that exploded last year was the result of banks transferring a large part of the risk directly to the consumer: increasing rates, suddenly stopping their lines of credit, and revising other conditions. Today we are seeing the results of that way of doing business.
Competition, Not Regulation
Regulatory ceilings on prices in any market only foster the growth of a black market and the resulting defenselessness of the most vulnerable consumers. Humanity has experienced this on innumerable occasions throughout history, but populist politicians just don’t learn —or don’t want to.
The only solution for reducing interest rates is more competition, which fosters creativity and the technology advances that reduce the fixed costs of offering loans. And this is not achieved by decree.
Interview with Ricardo B. Salinas on CNBC (May 18, 2009)
Full Transcription of the Interview