Chapter 5

Estimating Borrower Transaction Costs

Section 1: Introduction
5.1 In the absence of any suitable data available from lending organizations, in this chapter we shall limit ourselves to an attempt to estimate borrower transaction cost across various credit sources. In a perfectly competitive world with full information available at zero cost, homogenous products and instantaneous transactions (i.e., purchase and sale taking place at the same point in time), there is no transaction cost. This means there is no cost involved of the two parties in a transaction beyond what is paid for for sale and purchase of a product /service this means, the seller receives exactly what the buyer pays in exchange for the product/service in question. In other words, neither the seller nor the borrower incurs any additional expenditure while making the transaction. In a real world, however things are not so simple broadly because of three reasons: (i) bounded rationality i.e., human behavior is intentionally rational but limitedly so because of informational lacuna, so that cost is incurred in gathering and processing information, (ii) opportunism or moral hazard, i.e., the parties to a transaction may engage in cheating each other, which means their promises are not necessarily fulfilled in practice, and they need to put special efforts for monitoring and enforcement, and (iii) locking-in effect arising because of unforeseen contingencies, which are beyond the control of the two sides of a transaction. In the context of a credit transaction, these problems arise in boundless manner because credit invariably involves transfer of resources between two sides over a period of time, within which so many things - whether intentional or unintentional -may occur. Moreover, credit being a service with multifarious attributes and conditionalities, invariably makes it prone to adverse selection of one party by the other (reflecting bounded rationality), willful default of loan or induced misappropriation of the collateral by the lender (both implying opportunism), and non-willful default due to unforeseen contingencies, which limits predicted behavior on the part of the borrower or the lender. It is therefore no surprise that both the sides to an act of credit -whether borrower or lender - must invest time, money and

resources to minimize the problems of adverse selection, moral hazard and lockingin effect. Unfortunately, lender side information on transaction cost is not available from any of the lending institutions. So, we shall be focusing on borrower transaction cost alone in this chapter. 5.3 Some of the borrower transaction cost on search and taking precaution

against unforeseen contingencies or against opportunistic behavior from the other side are unobservable and non-quantifiable in simple monetary terms. Only some of these costs are observable and can be expressed in monetary terms. Our intention in this chapter is to lay our fingers on only observable transaction costs, which can be expressed in monetary terms. Obviously, this attempt towards measurement or estimation of borrower transaction cost can at best an imperfect one. 5.4 This chapter is organized as follows. The next section decomposes observed

transaction cost of the borrower in terms of time/wage lost due to search of the right type of lender, and time cost incurred in waiting for the loan to get sanctioned and released on time. It also includes search cost in exploring potential lender for a loan, and expenses incurred on application, documentation and processing fees for getting a loan sanctioned. As a large number of costs are implicit, which cannot be captured through the market logic, our treatment of borrowertransaction cost in this chapter is essentially a partial one. The last section summarizes the findings of this chapter.

Section 2: Some estimates of borrower transaction costs .

5.5 As mentioned earlier, our treatment of borrower transaction costs is far from a comprehensive one, as we are able to lay our fingers on only some of these explicit or implicit costs borne by the borrower, while only some of these can be expressed in monetary terms under appropriate assumptions. The types of borrower transaction costs discussed and estimated in this chapter are: costs incurred by the borrower in undertaking visits to the lender for getting loans (Table 5.1), borrowers search cost in exploring alternative lenders before approaching the final lender (Table5.2), borrowers waiting cost in between application for and sanction of loan, and again between sanction of loan and its disbursement (Table

5.3), and borrowers explicit transaction cost in terms of application, documentation and processing fees (Table 5.4). These costs are added up, when these can be expressed in monetary terms. This is done in Table 5.5. 5.6 As it can be seen from Table 5.1, the borrower has paid the maximum

number of visits to lender (3.95) for loans from commercial banking sources including RRBs. This cost is less but fairly similar for loans from NBFCs (2.54), and lesser for loans from cooperatives and government/NABARD/NGO-promoted SHGs (2.20 and 2.19, respectively). For traditional moneylenders, this figure is only 2.00, and lowest (0.77) for other informal rural money lending agencies. Travelling costs per visit and wage lost per visit, which reflects opportunity cost of time of borrowers from different sources, seem to have broadly a similar pattern it is highest for loans from commercial banks cum RRBs, a bit less for NBFC loans, even less for loans from traditional moneylenders, cooperatives and government/NABARD/NGOpromoted SHGs, and the lowest for other informal rural money lending agencies. It is interesting to note that when we express this component of borrower transaction cost as percentage of the sanctioned loan amount, this figure turns out to be much higher for semi-formal lenders of both types and traditional moneylender (3.03%, 2.85% and 2.39%, respectively) as compared to loans from commercial banks cum RRBs and cooperatives (0.82% and 0.72%, respectively). This figure is once again the least (0.39%) for other informal rural lenders. The transaction cost advantage of the last group of informal rural lenders is well known. However, the lesser transaction cost of formal sector lenders as compared to semi-formal sector lenders can be attributed to the fact that the former provide much larger size loans on average (roughly Rs. 80,000 and 28,000, respectively) as compared to the same for the two semi-formal sector sources (roughly Rs. 4,700 and 11,000, respectively). In other words, while borrower transaction cost on this count may look large for formal sector loans and less for semi-formal sectors, this may be true in absolute terms but not true when expressed in relative percentage terms vis--vis the size of the loan.
Table 5.1: Borrower transaction cost for loans across sources in undertaking visits to the final lender (1) (2) (3) (4) (5) Loan sources # of visits Travelling Wage lost Transaction cost on to final cost per per visit visits to final lender lender visit as % of loan amount Formal-1 (43) 3.95(43) 39.30(43) 126.62(43) 0.82

Formal-2(181) 2.20(181) 17.42(182) 73.02(181) 0.72 Semiformal-1(48) 2.19(48) 14.80(48) 50.68(48) 3.03 Semformal-2(22) 2.54(22) 37.95(22) 87.50(22) 2.85 Informal-1(54) 2.00(54) 23.12(54) 67.03(54) 2.39 Informal-2(124) 0.77(124) 13.70(124) 29.79(123) 0.39 Note: Figures in parentheses represent # of loan cases for arriving at figures in each column. Variation in this number across the same row is due to missing entries on some variables, which the borrower failed to report.

5.7

In the rural context, the borrowers have found to have explored alternative

sources before approaching their final lender. When, the borrower puts more effort in terms of number of alternatives explored and number of days lost therein, it may be looked upon as the importance he attaches to that particular kind of loan, on the one hand, and as the borrowers keenness to avoid the final source of credit, on the other. Columns 2, 3 and 4 in Table 5.2 displays number of alternatives explored, number of days lost in exploring and days lost per alternative explored (columns 2,3 and 4, respectively). In all these threecolumns, formal 1 source usually turned out to be the most costly, followed by informal 1 and formal 2, whereas semi-formal 1 and informal 2 seem to appear on the lower end of the spectrum. If we evaluate borrowers travelling cost and wage cost in the same way, as we have done in columns 3 and 4 of Table 5.1, borrowers search cost as percentage of loan amount turned out be the highest (6.21%) for informal 1, followed by semi-formal 1, semiformal 2, formal 2 and formal 1 (i.e., 5.55%, 5.30%, 1.35% and 1.04%, respectively). Once again, the search cost turns out to be the minimal (0.80%) for informal 2 lenders, thus explaining resilience of this lending group. Table 5.2: Borrower search cost in approaching alternative lenders before visiting final lender classified by final loan source (1) (2) (3) (4) (5) Loan sources # of Days lost Days lost Borrower alternativ in per search cost in es exploring alternative exploring explored alternative explored alternatives to s [(3)/(2)] final lender as % of loan amount Formal-1 (43) 1.88(43) 5.02(43) 2.67 1.04 Formal-2(181) 1.16(181) 1.93(179) 1.66 1.35 Semiformal1(48) 1.08(48) 1.82(47) 1.68 5.55 Semformal2(22) 2.22(22) 2.18(22) 0.98 5.30 Informal-1(54) 1.50(54) 3.20(54) 2.13 6.21 Informal-2(124) 0.52(123) 0.81(123) 1.56 0.80

Note: Figures in parentheses represent # of loan cases for arriving at figures in each column. Variation in this number across the same row is due to missing entries on some variables, which the borrower failed to report.

5.8

In terms of gap between application and approval of loan, on the one hand,

and between sanction of a loan and its disbursement, on the other, formal 1 lenders have the least transaction cost advantages from borrower viewpoint, followed by formal 2, semi-formal 2, informal 1, semi-formal 1 and informal 2 lenders. Naturally, the same pattern holds across the different types of loan sources when one considers the overall gap between application and disbursement of loan (Table 5.3). Table 5.3: Borrower transaction cost in terms of waiting for loan sanction and loan disbursement classified by loan source (1) (2) (3) (4) Loan sources Gap between Gap between Gap between application & sanction & application & approval of loan disbursement disbursement of in days of loan in days loan in days [(2) + (3)] Formal-1 (43) 12.76(43) 10.95(43) 23.71 Formal-2(181) 6.31(182) 6.64(182) 12.95 Semiformal1(48) 3.67(48) 3.33(48) 7.00 Semformal2(22) 5.27(22) 4.95(22) 10.22 Informal-1(54) 4.03(54) 3.83(54) 7.86 Informal2(124) 1.11(123) 3.30(124) 4.41
Note: Figures in parentheses represent # of loan cases for arriving at figures in each column. Variation in this number across the same row is due to missing entries on some variables, which the borrower failed to report.

5.9

Table 5.4 displays borrower expenditure on loan application, documentation

and processing charges, besides showing the average pattern of whether or not loan documentation fee is exempted by the lender (0-1). In terms of application fee the two formal sources are the costliest, followed by the two semi-formal sectors in the intermediate range and the two informal sectors in the lowest range. In terms of documentation fee, semi-formal 2 tops the list followed by formal 1, semi-formal 1, informal 1, formal 2 and informal 2. Informal 2 provides the highest average order of flexibility in exempting the documentation fee, while formal 1 sector has absolutely no flexibility in this regard. Processing fee is the largest for semi-formal 2 and lowest (0) for informal 2sector. In terms of overall transaction cost of this kind

as percentage of loan amount, semi-formal 2 turns out to be the costliest, followed by semi-formal 1, informal 1, formal 2, formal 1 and informal 2.Here again, because the loan size is relatively large for formal sector sources, semi-formal loan turn out to be much costlier as compared to formal sector loans. Informal 2 sector is absolutely free of these costs. 5.10 In Table 5.5, we put together the two types of monetized transaction cost of

Tables 5.15.2, besides adding to it borrowers transaction cost incurred on application fess documentation fees and processing fees. In terms of the first two types of transaction cost, the traditional rural moneylender turns out to be the costliest source (6.21%) followed by loans from semi-formal 1, semi-formal 2, formal 1, formal 2 and informal 2 sources (5.55%, 5.30%, 1.86%, 1.35% and 0.80%, respectively). When we put together all types of borrower transaction costs, which can be expressed in monetary terms under suitable assumptions, semi-formal 2 turns out to be the costliest source of borrowing with 7.28% transaction cost. The traditional rural moneylender with a total transaction cost 6.32% is the second costliest source. Government/NABARD/NGO-promoted SHGs turn out to be having the third highest transaction cost figure of 6.01%. Commercial banks cum RRBs and cooperatives have a much lower figure of 1.91% and 1.43%, respectively. This happens in relative terms when we look upon transaction cost relative to the size of the loan (given in column 2 of Table 5.5). Informal 2 lenders thus continue to have an overall comparative advantage in terms of all transaction costs, which can be expressed in monetary terms.

Table 5.4: Borrower transaction cost in terms of application, documentation and processing fees classified by loan source
(1) Loan sources (2) Expenditu re on loan applicatio n in Rs. (3) Expenditu re on document ation in Rs. (4) Whether exemption from document ation fee allowed (0-1) (4) Processi ng fee in Rs. (5) Total transaction cost on application, documentatio n& processing fees in as % of loan

amount 0.11(43) 0.05 0.11(181) 0.08 7.91(48) 0.46 197.72(22 Semformal-2(22) 8.27(22) 15.45(22) 0.09(22) ) 1.98 Informal-1(54) 1.11(54) 6.48(54) 0.29(54) 0.37(54) 0.11 Informal-2(124) 0(124) 0(124) 0.77(124) 0(124) 0.00 Note: Figures in parentheses represent # of loan cases for arriving at figures in each column. Variation in this number across the same row is due to missing entries on some variables, which the borrower failed to report. Formal-1 (43) Formal-2(181) Semiformal-1(48) 27.12(43) 15.71(182) 5.62(49) 13.83(43) 6.06(182) 8.06(48) 0(39) 0.41(166) 0.13(48)

Table 5.5: Borrower transaction cost in terms of application, documentation and processing fees classified by loan source
(1) Loan sources (2) Average loan amount sanctioned in Rs. (3) Borrower search cost plus transaction cost on visits to final lender as % of loan amount sanctioned 1.86 1.35 5.55 5.30 6.21 0.80 (4) Borrower search cost plus transaction cost on visits to final lender & on payment of various fees as % of loan amount sanctioned 1.91 1.43 6.01 7.28 6.32 0.80

Formal-1 (43) Formal-2(181) Semiformal-1(48) Semformal-2(22) Informal-1(54) Informal-2(124)

79924.88 27634.44 4732.71 11180.46 7209.21 8586.49

Section 3: Summary and conclusion

5.11 In the process of accessing loan from any source, a borrower incurs several types of transaction costs, which can be looked upon as an excess burden on the borrower beyond what he pays to the lender in terms of repayment of the principal with interest. Some of these costs are explicit and some are implicit, and only a few can be expressed in monetary terms to arrive at an overall estimate of borrower transaction cost. Many of the transaction costs, which is rather unobservable, remain outside the orbit of any estimation or analysis. In these circumstances, the present study has attempted to estimate only two types of borrower transaction costs as elaborated below: First, the transaction cost which the borrower incurs in terms waiting for sanction and disbursal of loans, commercial banking sector cum RRBs has the worst record of 23.71 days. Cooperative banks come next, involving 12.95 days of waiting on average. Loans from NBFCs involve 10.22 days of waiting, while the traditional rural moneylender takes about 7.86 days to

sanction and disburse a loan. SHGs promoted by government/NABARD/NGOs take exactly 7 days, while the other informal rural moneylenders like friends, relatives, traders, merchants, shopkeepers, etc.take the minimum amount of time precisely 4.41 days, to release a loan. In terms of monetary transaction cost the borrower incurs in searching for alternatives, approaching the final lender through several trips to him and paying to him in the form of application fees, documentation fees and processing fees, the general presumption is that the informal and semiformal lenders must be having a strong comparative advantage relative to the formal lending organizations. This presumption is belied by the findings of this study, when the borrower transaction costs are expressed as percentage of the loan amount, in view of the fact that much larger size loan is provided by commercial banks cum RRBs and cooperative banks (about Rupees 80,000 and 28,000, respectively) as compared to the loan size of other lenders (varying between Rupees 4.7 thousand to Rupees 11.2 thousand). Thus, borrower transaction costs turn out to be much less in percentage terms for the first two categories of formal sector lenders (namely, 1.91% and 1.43%, respectively) as compared to the two semiformal sources (6.01% and 7.28%, respectively) and the two informal sources (6.32% and 0.08%, respectively). 5.12 In view of the above-stated findings, it is no surprise that the formal lenders,

and especially the commercial banking sector, would not be too keen to provide small loans to a vast number of small borrowers in the country side. The cooperative banks, on the other hand, inspite of their so many off-cited limitations, have been doing this job fairly well i.e., providing bothsmall and large loans at a relatively low transaction cost to the borrower. The traditional rural moneylender has no easy way to scale up his operations and reduce the transaction cost of his borrower. In fact, the traditional rural moneylender, as long as he enjoys a nearmonopoly position in his area of operation, will have little incentive to reduce borrower transaction cost. He can simply pass on this burden to the borrower without inviting a serious loss to his business size. The semi-formal lenders, however, as they are experiencing fierce competition, would be keen to expand their network, besides being keen to provide both small and large loans to minimize

their borrower transaction costs (as well as theirs) through economies of scale and scope. This is where there is a contradiction in our policy while the government talks of financial inclusion through formal financial institution, they are not too keen to make small loans to a large number of borrowers, even though they dont mind moping up all small savings in the form of deposits. The semi-formal sector, which has been expanding at an unprecedented rate over the last one decade or so, is keen to mop up small rural deposits, besides making larger size loans for meeting diversified needs of their borrowers, but they are not being provided the requisite space. The other informal rural lenders, who have strong transaction cost advantages from borrower viewpoint, are making steady progress often unknown to the knowledge of our policy makers. Given scope and policy support to our cooperatives and the semi-formal sectors, these segments could have easily occupied the space currently being captured by informal lenders, given the fact that our commercial banking sector and RRBs have serious limitations in expanding their domain.