The principal elements that drive SME loan interest rates

From the beginning of SME banking, its most controversial dimension has been the interest rates charged by banks. These rates are higher (often much higher), than corporate and commercial banking rates, mainly because it inevitably costs more to lend and collect a given amount through thousands of small loans than to lend and collect the same amount in a few large loans.


Higher administrative costs have to be covered by higher interest rates. But how much higher?

Many entrepreneurs say that SME banks are taking advantage of small businesses by charging excessive interest rates, based on the fact that they have little negotiating power.

In this article we will review the components of the loan interest rates that are the main factors that determine the level (high or low) of these rates.

Banks use their interest income to cover costs, and the difference between income and costs is profit (or loss).

A simplified version of the relevant formula is the following:

Income from loans = Cost of funds + Loan loss expense + Operating Expense + Profit

(A fuller formula is
Income from loans + Other income = Cost of funds + Loan loss expense + Operating expense + Tax + Profit)


Obviously, interest income (i.e. the amount of loan charges that SME banks collect from their customers) moves up or down only if one or more of the components on the right side of the equation moves up or down.

Let’s look at these components individually:

Cost of funds

Banks fund their loans with some combination of equity (shareholders money) and debt (money borrowed from depositors, other banks or other lenders). The equity is not free (as shareholders demand dividends) while borrowed funds entail a cost in the form of interest expense.

Loan loss expense

Most SME banks are backed by no collateral, or by collateral that is unlikely to fully cover a defaulted loan amount. As a result, turmoil of late payments or defaults is especially dangerous for a bank.

When a borrower falls several payments behind on a loan, or something else happens that puts eventual collection of the loan in doubt, the accounting practice is to book a “loan loss provision expense” that reflects the loan’s loss in value. This practice recognizes probable loan losses promptly rather than waiting for the full term of the loan to expire and collection efforts to fail before booking the loss. If the bank books a provision expense for a loan, but the loan is later recovered in full, then the provision expense is simply reversed at that point.

Operating expenses

Operating expenses include the costs of implementing the loan activities i.e. personnel compensation, supplies, travel, depreciation of fixed assets, etc. Operating expenses consume the majority of the income of most SME bankers’ loan portfolios, so this component is the largest determinant of the rate the borrowers end up paying.

Profit

Profit is a residual: the difference between income and expense. In banks, net profit is often measured as a percentage of assets employed or as a percentage of the shareholder’s equity investment.

Generally, SME bank profits are so controversial that it can be easy to overestimate how much they affect the interest rates that small businesses pay (no doubt, SME loan interest rates would still be very high even without them).

Finally, from a borrower point of view, a typical way to state interest rates is to calculate an annual percentage rate (APR) on a particular loan product.

APR takes into account the amount and timing of all the cash flows associated with the loan, including not only things that are explicitly designated as “interest” and “principal,” but also any other expected fees or charges (as well as compulsory deposits that are a condition of the loan). This APR indicator is a good representation of the effective cost of a loan for borrowers who pay as agreed. APR can be substantially different from (usually higher than) the stated interest rate in the loan contract.


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