What Makes Up the Interest Rate on a Loan

Interest Rates

Financial literacy should probably be taught from school onward. I read a lot of comments complaining that loan rates in Kazakhstan are high. I will try to explain in plain language what an interest rate is made of.

A bank's interest rate consists of:

1. The cost of funds;
2. The cost of risk;
3. The bank's margin.

1. The cost of funds is what the bank pays to raise money in the market. As a rule, this means interest paid to depositors and the related expenses, interest paid to bondholders, and payments to other creditors. I will not go into how the cost of funds depends on the maturity of the funding, as that would complicate the matter. The funding rate is very closely correlated with the base rate of the National Bank of Kazakhstan (NBK), because a great many financial instruments are tied to it. If the NBK rate rises, the cost of funding rises too.

The base rate depends on inflation in the country, because under inflation targeting the base rate is one of the tools for containing inflation. The higher inflation is, the higher the rate must be to hold it down. Therefore, to reduce the cost of funding, inflation must be reduced.

The base rate is currently 9.5%.

2. The cost of risk depends on the amount of loans that borrowers fail to repay. In other words, it is the amount of losses the bank incurs from loan defaults. Both risk appetite and the cost of risk vary with the type of loan.

For example, the cost of risk is lower on secured loans and depends on how quickly collateral can be seized and sold, and how fully it covers losses. In unsecured consumer lending, the entire amount of defaults is passed on to good borrowers through the interest rate. That is why the gap between secured and unsecured loans is so large. For example, if 10 out of every 100 units of credit issued are not repaid, the cost of risk is 10%.

To reduce the cost of risk, three things are needed: good, high-quality scoring to identify reliable borrowers, an effective collection process, and a sound institutional environment that shortens collection times. Quality scoring depends on the availability of data. The collection process depends on the bank, and the institutional environment depends on the state.

3. The bank's margin must cover all of the bank's operating costs and provide a return to shareholders. The approximate benchmark in Kazakhstan is currently 4%. To bring the margin down, banks need to cut their costs and competition in the financial sector needs to increase.

Accordingly, at zero risk, the minimum loan rate would be around 13.5%. To that we add the cost of risk. In secured lending it is currently 1.5–3%; in unsecured lending it is higher, from 3% to 15%, depending on risk appetite.

As a result, retail lending rates range roughly from 15% to 28.5%.

To lower retail rates, all three of the components above must be reduced. To reduce inflation, we need to stop subsidies from distorting the work of the base rate, fight gray imports, increase exports, improve the institutional environment so that it can attract investment, increase competition, and expand supply in the market.

To reduce the cost of risk, we need to improve data availability to raise the quality of scoring, and to improve the institutional framework for recovering problem debt (courts, private bailiffs, notaries, the mortgage law, procedures for recovering collateral, and so on).

To reduce banks' margins, we need to increase competition in the industry and push digitalization further, since on our small market cost savings from economies of scale do not fully work. Competition grows through the steady entry of new players, and that is possible only with a favorable institutional environment.

I do not know of any other ways to reduce interest rates.