Transaction Costs in Mexico's Preferential Credit

Transaction Costs inMexico’s Preferential Credit

Mariano Rojas and Luis Alejandro Rojas*

In recent years the Mexican economy has undergone a process of financialliberalisation. Interest-rate controls have been abandoned and their determinationis left to the market.1 However, some preferential credit programmes forspecially targeted activities, with the financial support of the nationaldevelopment banks, continue to provide credit at subsidised interest rates.Preferential credit is provided mainly by the major development bank,NacionalFinanciera, with the objective of promoting activities considered sociallyimportant, according to non-market criteria, such as micro and small enterprises,labour-intensive activities, exporting activities, and programmes for industrialmodernisation. A fundamental assumption implicit in any preferential-creditprogramme is that the use of subsidised interest rates will reduce the cost of thefinancial resources to the benefiting firms.

The approach used in this article maintains that the interest rate is not theonly cost of credit. There are also costs related to the process of applying forand obtaining the financial resources. These are known astransaction costsandare unavoidable, and there are reasons to believe that in the case of preferentialcredit they tend to be large. Hence, to evaluate the efficiency of apreferential-credit programme it is necessary to go beyond its purely financialcost — the interest rate.

The article aims to evaluate the true cost of the financial resources in apreferential-credit programme, taking into consideration both sets of costs.2 Theinvestigation covers a preferential-credit programme financed byNacionalFinanciera, drawing on data from 125 credit applications collected from the

* Professor of Economics, Universidad de las Américas-Puebla, Mexico, and officer of theSecretariat of Foreign Trade and Finance (SECOFI), Mexico, respectively. The opinionsexpressed in this document are not necessarily shared by SECOFI.

1. Policies such as the elimination of credit ceilings by activity, the removal of quantitativerestrictions on the banking sector, and the elimination of minimum reserve requirements werefollowed. See Aspe (1993).

2. It is not the purpose of the article to discuss the advantages and disadvantages of providingsupport for some activities on the basis of non-market criteria. The article confines itself toevaluating the efficiency of cheap credit programmes in reducing the cost of credit andfostering specially targeted activities.

Development Policy ReviewVol. 15 (1997), 23–46

© Overseas Development Institute 1997. Published by Blackwell Publishers, 108 Cowley Road,Oxford OX4 1JF, UK, and 238 Main Street, Cambridge, MA 02142, USA.

24 Development Policy Review

archives of four credit unions and a medium-sized commercial bank in the stateof Puebla. The transaction costs are identified and classified according to thekind of requirement by which they are generated. Then, using a methodologybased on the internal rate of return, these costs are expressed in terms of apercentage rate comparable to the interest rate.

The investigation distinguishes betweeneffective transaction costsandtheoretical transaction costs. The latter concept assumes that all therequirements of the credit contract are satisfied, while the former recognises thediscretionary power of the financial intermediaries to add or waive requirementsand calculates the transaction costs only on the basis of those requirements thathave been effectively fulfilled. This distinction permits the study of the use oftransaction costs as a credit-rationing mechanism on two bases: a credit contractwith a specific schedule of transaction costs, and the discretionary adjustmentof the contract requirements for specific clients.

In addition, information was collected from each application about certainqualitative and quantitative variables, such as firm size, amount of credit, kindof financial intermediary involved, etc., and used to study the relationshipbetween transaction costs and institutional aspects of the preferential-creditprogramme. It was found that transaction costs are relatively large and that thereis a bias against micro and small enterprises. Paradoxically, these are preciselythe kinds of firms that the preferential-credit programme is aimed at assisting.

Providing preferential credit

The mechanism

Mexican development banks grant loans at preferential interest rates by meansof a scheme which incorporates private financial intermediaries (commercialbanks and credit unions). The development banks provide the intermediarieswith the resources to finance preferential-credit programmes. The schemeconstrains the intermediaries in respect of the maximum interest rates they cancharge and the kinds of activity to which the resources can be allocated. Theintermediaries are bound by these restrictions; however, they have room toinfluence the credit conditions by imposing additional requirements in theapplication process.

Hence the provision of preferential credit is implemented through arediscount mechanism, the objective being to ‘foster the development ofstrategic sectors, . . . share the credit risk and simplify the application’(Nacional Financiera, 1994). This rediscount mechanism emerged as analternative to the direct provision of credit by the development banks. Inprinciple, the efficiency of the programme is expected to increase by the use ofthe infrastructure and technology of the intermediaries. From the latter’s

Rojas and Rojas,Transaction Costs in Mexico’s Preferential Credit 25

perspective, the restrictions imposed by the development banks on the interestrate are exogenous, while the application requirements (transaction costs) areendogenous. Borrowers face both costs when applying for preferential credit.Thus, the development bank does not lend directly to firms; instead, theexpertise and infrastructure of the financial intermediaries are used to mobilisethe resources.

The participating agents

Nacional Financiera is the largest development bank in Mexico.3 In 1989 itcompletely reorganised its role in order to provide greater support to the privatesector of the economy.4 This investigation examines one of its preferential-creditprogrammes, PROMYP (Programme of Support to Micro and Small Industries),in which it acts as a second-tier bank, rediscounting loans made by the financialintermediaries under the conditions of the preferential-credit programme.

Financial intermediaries Both commercial banks and credit unions play anintermediation role in the programme. They obtain the financial resources fromNacional Financieraat subsidised interest rates and allocate these resources tofirms under the conditions imposed byNacional Financiera. Their profits comefrom the mark-up in the interest rate, which must also cover the cost of theintermediation and the risk involved.

Once a completed application for credit is received, the intermediaries usetheir expertise to evaluate the application and supervise the appropriate use ofthe loan. These activities increase their operating costs and tend to reduce theirprofits. They therefore have an incentive to enhance their profits by excludingthose clients that represent high operational costs and high credit risks. Becausethe interest rate is exogenously fixed, the intermediaries have to use theapplication requirements (transaction costs) as an automatic selection mechanismto exclude these unwanted clients.

As a rule, commercial banks focus on large and medium-sized firms and onestablishing long-term relationships with their clients, in the hope of reducing

3. The other main development banks are:Banco Nacional de Comercio Exterior(BANCOMEXT) (National Bank of Foreign Trade);Banco Nacional de Obras y Servicios(BANOBRAS) (National Bank of Infrastructure and Services);Banco Nacional de ComercioInterior (BNCI) (National Bank of Domestic Trade); andBanco Nacional de Crédito Rural(BANRURAL) (National Bank of Rural Credit).

4. According to its own figures (Nacional Financiera, 1994),Nacional Financieraallocated94% of its resources to the public sector and only 6% to the private sector in 1987. However,in 1991 the situation was reversed and 94% of the resources went to the private sector.


costs by taking advantage of economies of scale.5 Credit unions specialise inproviding credit to small firms, which may find it difficult to gain access tocommercial banks. Their business is at the local or regional level, and they lookto reduce their costs by their thorough knowledge of their clients and the targetmarket.6 Clients outside their target market are, in principle, of no interest to thefinancial intermediaries. It is common for credit unions to ask their clients tobecome union members by contributing to the union’s capital and purchasingits shares. This mechanism complements the supervisory and credit-evaluationactivities and the requirement of collateral. Banks generally ask their clients tohold a bank balance with them.

Credit beneficiaries Firms are generally classified according to their size:

a. Micro and small firms: Micro-enterprises employ no more than 15 workersand have sales of less than N$900,000 Mexican pesos. Small firms employ nomore than 100 workers and have sales of less than N$9 million Mexican pesos.Micro-enterprises are basically family firms, with an informal organisationalstructure and poor accounting and financial systems.b. Medium-sized and large firms: These have more than 100 employees andsales above N$9 million Mexican pesos. They are well structured, with theirown accounting, legal, and financial departments; and they generally havealternative sources for obtaining financial resources.

Characteristics of preferential-credit contracts

Every credit contract calls for the satisfaction of a number of requirements,including:

a. Technical requirements, related to the provision of information about thefirm’s economic situation. This is needed to evaluate the success of thecompany, and includes economic information about the firm, as well as incomestatements and balance sheets.b. Legal requirements, related to the provision of information about the principalshareholders or owners of the firm. Documents such as certificates of birth,marriage, and residence are required, as well as certificates of ownership,

5. Commercial banks in Mexico generally work with credits of more than N$100,000 Mexicanpesos.

6. There are four types of credit unions in the Mexican financial system: agricultural,industrial, commercial, and mixed credit unions, which finance two or more of the agricultural,industrial, and commercial activities. Mixed credit unions are the ones considered in thisinvestigation.


mortgages, recent tax declarations, and related information. To satisfy theserequirements the borrower becomes involved in the payment of fees to legal andgovernment agencies.c. Accounting and financial requirements, including financial studies, cash flowstatements, and forecasts evaluating the project’s likelihood of success.Borrowers have to pay fees to accounting and financial firms to satisfy theserequirements.d. Field information, corresponding to the requirements used to monitor thecorrect use of the financial resources, such as photographs of collateral,valuation of collateral, purchasing receipts, and related information.

The financial intermediaries have ample flexibility to manipulate thesecontract requirements. They can thus use the transaction costs to designself-selection mechanisms to attract only suitable clients.7

Transaction-costs literature

According to Adams (1994: 2) transaction costs are: ‘explicit and implicitspending made by the participants in financial transactions, excluding thepayments for interest rate, the cost of resources, and cost of potential creditlosses’.

González-Vega (1986, 1992), Adams (1993, 1994), and Adams et al. (1987)have studied the structure of transaction costs as an alternative credit-rationingmechanism used by financial intermediaries when the interest rate isexogenously fixed. From their findings the structure emerges as the result ofexogenously imposed restrictions on the use of the interest rate and also ofinformation problems such as adverse selection (see Akerlof, 1970; Laffont,1989) and moral hazard (see Besley, 1994; Laffont, 1989), which are commonin the banking business. Under the loanable-funds approach the interest rate isseen as the price of loans, and as co-ordinating intertemporal decisions onsaving and investment. However, according to Stiglitz and Weiss (1981) if theinterest rate is fixed below its market equilibrium value, and the pricemechanism cannot clear the resulting excess of demand, lenders have to findalternative mechanisms, such as transaction costs, to ration credit.

The implementation of transaction costs is carried out unilaterally by thefinancial intermediaries, and their structure cannot be controlled ‘even bygovernment decrees’ (González-Vega, 1992: 25), as in the case of preferentialinterest rates. Thus, financial intermediaries can easily add requirements to thecredit contracts and use the transaction costs to implement self-selectionschemes (see Laffont and Tirole, 1995), looking to deter those clients who are

7. See Laffont and Tirole (1995) for an explanation of self-selection mechanisms and thetheory of incentives.


considered highly risky or undesirable. The existence of transaction coststherefore means that cheap credit, provided at low interest rates, ends up beingvery expensive for some firms, with the total cost of borrowing from thepreferential-credit programme including both the financial cost (interest rate) andthe transaction costs.

Transaction costs vary according to the characteristics of the borrowers,indicating the financial intermediaries’ preferences for specific kinds of clients.For example, they may consider new clients to be more risky; thus, an inverserelationship can be expected between transaction costs and the time-span of therelationship between the lender and the borrower. An inverse relationship is alsoexpected between transaction costs and the amount of credit, justified in part bythe preference of financial intermediaries for formally established large andmedium-sized firms.

Methodology

The total cost of obtaining preferential credit is given in equation (1):8

(1)

A detailed study of the terms of a preferential-credit contract was undertakento detect all the potential sources of transaction costs. Once these sources wereidentified and classified, the next step was to calculate the cost of satisfyingeach one of the requirements imposed by the financial intermediaries.

Theoretical and effective transaction costs

Theoretical transaction costs A theoretical appraisal of transaction costsassumes that the borrowers satisfy all the requirements in the contract of credit.The requirements are therefore listed and the cost of satisfying each of them iscalculated. The costs arrived at by this method are calledtheoretical transactioncosts, and they assume that there is no discrimination in the requirementsdemanded of any borrower. However, even if all borrowers are treated equallyin respect of the fulfilment of the requirements of the contract, the financialintermediaries can design the contract in such a way that the transaction-costsschedule discriminates against particular groups of clients and creates aself-selection mechanism to ration the credit. Thus, the theoretical transaction

8. To use this equation it is necessary to express transaction costs in terms of a percentage ratecomparable to the interest rate. The pertinent methodology is discussed below.


costs can be associated with the application by the financial intermediaries ofa second-degree price-discrimination strategy to dissuade particular groups ofpotential clients (see Tirole, 1989; Laffont and Tirole, 1995).

Effective transaction costsIt is common for the financial intermediaries towaive some of the requirements in the contract for specific firms. Thus, not allfirms are asked to fulfil all the requirements. There can also be cases wheresome firms are asked to satisfy additional requirements not mentioned in thecontract. This discretionary power of the financial intermediaries with regard tothe requirements demanded can be associated with the implementation of athird-degree price-discrimination strategy, the objective being to encouragecertain clients and, implicitly, to discourage others from borrowing from theintermediary.9

Hence, the appraisal of the theoretical transaction costs does not provide acomplete picture of the transaction costs faced by preferential-credit borrowers.It is necessary to undertake an empirical analysis of the requirements fulfilledby each credit application. The transaction costs arrived at by this method arecalled effective transaction costsand, when compared with the theoreticaltransaction costs, they permit an evaluation of the extent and nature of thethird-degree price-discrimination strategy implemented by the intermediaries.

Calculation of the transaction costs

Identifying the transaction costs58 kinds of requirements directly related topreferential-credit applications were identified from the contracts, and wereclassified into a number of groups.10 It is important to note that the transactioncosts included in this analysis are only those directly related to the applicationfor a preferential credit. They can be considered specific to the fulfilment of therequirements of the credit application under consideration, and from theapplication perspective they must be considered as variable costs.11

9. In the case of a third-degree price-discrimination strategy the financial intermediary has thediscretionary power to discriminate across fims, while in the case of a second-degreeprice-discrimination strategy the financial intermediary simply designs a price scheme andleaves it to the firms, in a self-selection process, to choose their best option. See Tirole (1989)and Laffont and Tirole (1995).

10. A detailed list of the requirements, their description, and their imputed costs is availablefrom the authors.

11. This is because every time a firm applies for a credit it is forced to fulfil the requirementsover again. The financial intermediaries generally ask for original certificates anddocumentation, and because this documentation is not returned to the clients after theapplication is processed the applicants are forced to face the transaction costs every time they


Some firms also incurred costs that were not specific to the application underconsideration, but which were needed to normalise their legal situation and toqualify them to apply for a credit. From the application perspective these mustbe considered as fixed costs, because the firm would not be forced to incurthem again when applying for a new credit. The fixed costs were calculated, butare not included in the analysis. In consequence, the transaction costs studiedin this investigation are those specific to the application for a preferential credit.

Gathering the information A list of the requirements demanded in the creditcontract was needed to calculate the theoretical transaction costs. This wasstraightforward. However, to calculate the effective transaction costs it wasnecessary to have access to the archives of the intermediaries to determinewhich requirements were effectively fulfilled. The majority of the intermediarieswere reluctant to allow access to their archives; however, four credit unions anda medium-sized commercial bank in the state of Puebla were willing tocollaborate so long as complete confidentiality was ensured in the use of theinformation. The five financial institutions can be considered as representativeof the industry. To incorporate a wide variety of firms, a random and stratifiedsample was taken from the archives of the intermediaries. The final samplecomprised 75 firms from the archives of the credit unions and 50 firms from thecommercial bank.

From the files of the applicants it was possible to identify which of the listedrequirements were satisfied by the clients. Other information not directlyrequired by the credit contract but asked for by the financial intermediaries,such as photocopies of school certificates and professional diplomas, was alsoconsidered. In addition, the following information was collected from theclients’ files: kind of firm, activity of firm, kind of financial intermediary,time-span of intermediary–firm relationship, interest rate charged, and whetheror not there was also a recommendation. Most of these variables are qualitativeand some categories were defined to study their relationship with the transactioncosts.

Calculation and classification of the transaction costsThe market cost ofsatisfying every requirement was calculated. In many cases a simulation of theprocess needed to satisfy the requirement was undertaken. In other cases theinformation came from experts in the area. Many public institutions, legal andaccounting firms, insurance companies, and other organisations were visited togather the information.

It was assumed that the prices and fees for this were uniform across clients.Thus, any variation in transaction costs across borrowers could be taken as

apply for a credit. In any case, most of the firms studied did not make a great number ofcredit applications.


resulting from differences in the requirements and not in the market prices that

Table 1Classification of the transaction costs

Category Description Expenditure

1. Transportation Costs incurred by borrowers in visiting thefinancial intermediaries

Explicit

2. Legal Legal fees paid to law firms, attorneys, andpublic offices

Explicit

3. Governmental Payments to obtain certificates from publicoffices, and credit-related taxes

Explicit

4. Accounting Payments to accounting offices to obtaincertified statements of account and financialanalyses

Explicit

5. Reciprocity Cost of reciprocity to a Credit Union,including the cost of purchasing its shares.Cost of keeping a minimum balance in bankingaccounts

Explicit

6. Paperwork Cost of completing all the forms required bythe intermediary, including photocopies ofdocuments, pictures, elaboration of personaldocuments, and others

Explicit

7. Opportunity cost Cost of not obtaining the credit immediately,and of the time needed to gather all theinformation required by the intermediary

Implicit

8. Other costs Cost of obtaining documents such ascommercial references, and investment andspending receipts

Explicit

I. Transaction cost(1–8 combined)

Cost of fulfilling the requirements to obtaina preferential credit

Explicit andimplicit

the borrowers faced. In those cases where price divergence did exist, the lowestprice was used to calculate the transaction costs;12 hence, the real transactioncosts could be even greater than those calculated. In cases involving publicinstitutions and public services, the official fees were used.

12. Price-discrimination and client-building practices could imply differences in the prices andfees paid by the economic agents to complete the requirements.


The exercise was undertaken during the final months of 1994 andconsequently the calculations are at prices current at that time.13 The transactioncosts were classified into 8 categories and also as explicit or implicit accordingto the kind of expenditure needed to satisfy the requirement (see Table 1).

Measuring the transaction costs

The transaction costs can be expressed in relative terms (as a percentage of theamount of credit) or as a percentage rate comparable to the interest rate. Thelatter approach enables us to interpret them as a mark-up over the interest ratecharged, and thus as capable of being manipulated by the financialintermediaries to ration the credit in their best interests. Consequently, thismethod is preferred, and the methodology used to obtain this expression isexplained below.

Calculation of amortisation The information obtained from the clients’ filesincluded the specifications of the credit contract: term, amount, and interest ratecharged. Using the formula for linear payments with interest payments overremaining balances, this information was used to calculate the amortisation foreach of the credits. This type of amortisation assumes that the capital is paid infixed monthly instalments, dividing the credit amount by the number of monthsthat the contract lasts:

(2)

whereKt = monthly capital payment instalment, which remains constant for thewhole period (K1=K2= . . . =Kn=K), C = amount of credit, andn = number ofmonths or term of the contract.

Interest payments are made on the capital balance that remains unpaid at theprevious period (n–1), according to the rate agreed in the contract. With thiskind of scheme the payments decrease over time, because the balance on whichinterest is paid diminishes.

The general formula for the calculation of linear amortisation is:

(3)

13. The exchange rate during the study period (1994) was approximately N$3.4 Mexican pesosper US$1.


where At = amortisation for periodt, t = time (1, 2, . . . , n), r = monthlyinterest rate, (Kt*( t–1)) = payments made over capital up to periodt–1, and{ C–Kt*( t–1))} = debt’s remnant at the beginning of periodt.

Calculation of the percentage rate of transaction costsThe investigation usedan internal-rate-of-return methodology, equalising the present value of theamortisation to the net amount of credit after the subtraction of the transactioncosts. If the transaction costs are positive the borrower must spend resources toobtain the credit; in consequence, the net amount of resources obtained is lessthan the contracted amount.

(4)

Equation (5) then shows the use of the internal-rate-of-return methodology tocalculate the total cost of credit (TCC), expressed as a percentage rate:

(5)

From equation (5) it is possible to work out theTCC. If the transaction costswere nil, then theTCC would be equal to the contracted interest rate (r). If thenet amount of credit decreases because of positive transaction costs, then theTCC is greater thanr, implying the existence of a transaction-costs mark-up.Therefore, theTCC includes the financial cost of credit (r) plus the impact ofthe transaction costs (T), with all concepts expressed in terms of percentagerates. Solving forT is therefore:

(6)

Separation of the transaction costsIt is useful to separate the transaction costs(T) according to the defined categories (Tjs) to discover the impact of eachcategory on the total cost of credit. The relative participation of each categoryin the total amount of transaction costs was therefore calculated.

(7)


whereCj = participation of categoryj in total amount of transaction costs,j = 1,2, . . . , 8.

Equation (8) shows how to obtain the impact of each category, expressed interms of a percentage rate.

(8)

where Tj = transaction cost that corresponds to categoryj, expressed as apercentage rate (specific cost),j = 1, 2, . . . , 8, andT = total transaction costs,expressed as a percentage rate.

Hence, it is possible to know what kinds of requirements increase transactioncosts and to study their relationship with some explanatory variables.

Main results

Importance of effective transaction costs

The effective transaction costs measure the cost of fulfilling all the requirementsdemanded by the financial intermediary (which are not necessarily the same asthe requirements asked for in the credit contract). A weighted average of thesecosts was calculated for the aggregate of the applications and for four ranges ofthe amount of credit,14 the objective being to calculate the average transactioncosts per unit of preferential credit. Table 2 shows the importance of theeffective transaction costs in the total cost of the credit.

For the aggregate of applications the average interest rate is 19.3%. Theeffective transaction costs imply a mark-up of 4.2 percentage points (or 18%)over the interest rate, increasing the total cost of credit to 23.5%.

The cost is greater for small amounts of credit. For example, for credits ofless than N$40,000 pesos, the effective transaction costs imply a mark-up of 70percentage points, raising the total cost of credit to almost 90%. For creditsbetween N$40,000 and N$129,000 pesos, the effective transaction costs imply,on average, a mark-up of 25 percentage points. This goes down to only 6.3percentage points for credits between N$129,000 and N$258,000 pesos, andfurther decreases to only 1.3 percentage points for large amounts (more thanN$258,000 pesos).

Table 3 shows the effective transaction costs specific to each category andfor different ranges of the amount of credit, the objective being to identify thoserequirements that effectively increase the total cost of a preferential credit. For

14. Four ranges were defined seeking to include approximately one quarter of the creditapplications in each range.


the aggregate of applications, the requirements associated with the reciprocity

Table 2Effective transaction costs per unit of credit:

annual percentage points by ranges of credit amount

Amount (pesos) Term(months)

Effective trans.costs (T)

Interestrate (r)

Total cost ofcredit (T+r)

0–40,000 38.3 70.08 19.17 89.2540,000–129,000 40.5 25.20 19.47 44.67129,000–258,000 39.1 6.25 19.92 26.17258,000–3,000,000 62.9 1.32 19.12 20.44

Total 56.9 4.20 19.27 23.47

Note: The ranges of credit do not include the upper limit.

Table 3Effective transaction costs:

annual percentage points by categories and ranges of credit amount

Concept Total 0–40,000

40,000–129,000

129,000–258,000

258,000–3,000,000

1. Opportunity cost 0.54 13.01 3.18 0.81 0.262. Legal cost 0.68 7.98 2.54 0.92 0.403. Accounting cost 0.14 0.89 0.85 0.23 0.134. Paperwork cost 0.00 0.30 0.21 0.12 0.005. Reciprocity cost 2.17 41.10 16.52 3.35 0.266. Governmental cost 0.27 0.89 0.42 0.23 0.267. Transportation cost 0.14 1.48 0.42 0.12 0.008. Other costs 0.27 4.44 1.06 0.46 0.00

9. Total 4.20 70.08 25.20 6.24 1.32

Note: Some very small values, when rounded, become null values.

cost represent more than 50% of the effective transaction costs, increasing theaverage cost of credit by 2.17 percentage points. As already noted, thereciprocity costs associated with the requirement to buy shares from a creditunion or to hold a bank balance, are under the direct control of the financial


intermediaries. Hence, the high value of the reciprocity cost reflects theexistence of adverse selection and moral hazard problems, as well as the desireof the financial intermediaries to take precautions. It can be noted that therelative importance of the reciprocity cost tends to decrease for large amountsof credit, indicating that the requirements related to this cost are used byfinancial intermediaries as a credit-rationing mechanism against micro and smallfirms.Following the reciprocity cost, in order of importance, are the legal andopportunity costs which increase the cost of credit by 0.68 and 0.54 percentagepoints, respectively. For small amounts of credit (less than N$40,000 pesos), thereciprocity cost is the most important cost, increasing the total cost of credit by41 percentage points. This is followed by the opportunity cost, which reacheslevels of 13 percentage points, and the legal cost, at almost 8 percentage points.For credits larger than N$258,000 pesos the legal cost is most important.

It is evident that transaction costs introduce a bias in the allocation ofpreferential credit for micro and small enterprises. Credit given at cheap interestrates ends up becoming very expensive, once transaction costs are taken intoaccount.

Theoretical transaction costs

The effective transaction costs facing applicants for preferential credit arise fromtwo factors: the requirements asked for in the contract of credit, and thediscretionary waiving or addition of requirements for some clients. Thissubsection studies the first explanatory factor; thus, the transaction costs werecalculated on the assumption that all the credit requirements were fulfilled.

A weighted average of the theoretical costs was calculated for all 125applications under study, and for different ranges of the amount of credit. Table4 presents the calculated theoretical transaction costs per unit of preferentialcredit, i.e. the costs prevailing if the financial intermediaries made noexemptions for certain customers in the fulfilment of the contract requirements.Thus, Table 4 displays the kind of transaction-costs scheme implicit in thecontract.

Two main conclusions can be derived from the results shown in Table 4.First, these transaction costs are significant; the fulfilment of all requirementswould increase the cost of preferential credit by 12.7 percentage points onaverage. Second, the contract is designed in such a way that there is a biasagainst small amounts of credit.15 The theoretical transaction costs tend to

15. This kind of discrimination is associated with a second-degree price discrimination. Allclients face the same price schedule; thus, the financial intermediary is not openlydiscriminating against any client. However, the schedule is designed so as to discourage thoseclients considered as undesirable by the financial intermediary. See Tirole (1989).


decline with the amount of credit; for amounts greater than N$258,000 pesos

Table 4Theoretical transaction costs:



40,000–129,000

129,000–258,000

258,000–3,000,000

1. Opportunity cost 2.16 2.16 2.88 2.04 1.802. Legal cost 1.68 3.96 2.64 2.40 1.323. Accounting cost 0.96 11.40 3.00 1.68 0.364. Paperwork cost 0.00 0.36 0.12 0.00 0.005. Reciprocity cost 3.48 20.28 10.44 8.16 0.726. Governmental cost 2.64 2.88 3.60 3.84 2.287. Transportation cost 0.12 0.84 0.24 0.12 0.008. Other costs 1.68 19.20 4.92 2.76 0.60

9. Total 12.72 61.08 27.84 21.12 7.08


they represent 7 percentage points, while for credits of less than N$40,000 pesosthey represent 61 percentage points. Thus preferential credit becomes moreexpensive for small amounts of credit, indicating that a credit-rationing policyagainst micro and small enterprises is implicit in the contract.

A detailed examination shows the importance of the requirements associatedwith the reciprocity cost. In effect, for all ranges of amount, with the exceptionof those above N$258,000 pesos, the reciprocity cost is considerable. Hence, therequirement to buy a credit union’s stock or to hold a bank balance creates agreat burden for the users of preferential credit. The requirements associatedwith other costs and the accounting cost are also significant for small amountsof credit, while the requirements related to the governmental cost becomeimportant in the case of large amounts of credit.

Discrimination in requirements

Financial intermediaries can use their discretionary power to add or waiverequirements in order to ration preferential credit according to their owninterests. The concept of requirements’ overprice — defined as the differencebetween the effective and the theoretical transaction costs — is introduced tostudy this third-degree price-discrimination schedule. Table 5 shows the


overprice from waiving or adding requirements expressed in percentage points

Table 5Overprice from requirements:



40,000–129,000

129,000–258,000

258,000–3,000,000

1. Opportunity cost –1.62 10.85 0.30 –1.23 –1.542. Legal cost –1.00 4.02 –0.10 –1.48 –0.923. Accounting cost –0.82 –10.51 –2.15 –1.45 –0.234. Paperwork cost 0.00 –0.06 0.09 0.12 0.005. Reciprocity cost –1.31 20.82 6.08 –4.81 –0.466. Governmental cost –2.37 –1.99 –3.18 –3.61 –2.027. Transportation cost 0.02 0.64 0.18 0.00 0.008. Other costs –1.41 –14.76 –3.86 –2.30 –0.60

9. Total –8.52 9.00 –2.64 –14.88 –5.76


(comparable to the interest rate) and shown by categories of transaction costsand ranges of credit amount. A positive value of the overprice indicates that thefinancial intermediaries are adding requirements to the contract to make thecredit more expensive to some clients, while a negative value indicates thewaiving of some requirements to reduce the transaction costs to some clients.To give an idea of the relative importance of the two the overprice was alsocalculated as a percentage of the theoretical transaction costs, as shown inTable 6.

It can be observed from Table 5 that for the aggregate of applications thewaiving of requirements reduces the theoretical transaction costs by 8.5percentage points per unit of credit lent. The most important discounts comefrom waiving requirements associated with governmental, opportunity and othercosts. Table 6 shows that, for the aggregate of applications, the discounts fromthe waiving of requirements are significant, representing 67% of the theoreticaltransaction costs and, in consequence, implying a huge discount in the effectivetransaction costs. In relative terms the waiving is greater in those requirementsassociated with governmental, accounting and other costs. The only conceptshowing the existence of an overprice is the transportation cost; however, thisoverprice is both absolutely and relatively small. Hence, the general practice ofthe financial intermediaries is to design a contract with an excess ofrequirements and to use their discretionary power to reduce transaction costsaccording to their interests.


However, a study of the behaviour of the overprice by ranges of amount of

Table 6Overprice in requirements by categories as a percentage of theoretical

transaction costs by ranges of credit amount


40,000–129,000

129,000–258,000

258,000–3,000,000

1. Opportunity cost –75.0 502.3 10.4 –60.3 –85.62. Legal cost –59.5 101.5 –3.8 –61.7 –69.73. Accounting cost –85.4 –92.2 –71.7 –86.3 –63.94. Paperwork cost *** –16.7 75.0 *** ***5. Reciprocity cost –37.6 102.7 58.2 –58.9 –63.96. Governmental cost –89.8 –69.1 –88.3 –94.0 –88.67. Transportation cost 16.7 76.2 75.0 0.0 ***8. Other costs –83.9 –76.9 –78.5 –83.3 –100.0

9. Total –67.0 14.7 –9.5 –70.5 –81.4

Note: A negative value shows the existence of a discount. A (***) sign indicates apercentage that could not be calculated because of a null value in the denominator.

credit shows a more interesting story. It can be observed that for credits of lessthan N$40,000 pesos there is a total overprice of 9 percentage points,representing almost 15% of the theoretical transaction costs. Thus, for smallamounts of credit the financial intermediaries tend to increase the requirementsbeyond those demanded by the credit contract. This practice indicates a desireon their part to use their discretionary power to discriminate against applicationsfor small amounts of credit.

The scheme of this third-degree price-discrimination schedule is peculiar;while there are important overprices in some requirements, there are importantdiscounts in others. In absolute terms there are overprices (additionalrequirements) in concepts associated with the reciprocity cost (20.8 percentagepoints), the opportunity cost (10.8 percentage points), and the legal costs (4percentage points), and discounts (waiving of requirements) in conceptsassociated with other costs (14.8 percentage points), accounting costs (10.5percentage points), and governmental costs (2 percentage points). Table 6 showsthat these overprices and discounts are relatively significant with respect to thetheoretical transaction costs — a finding which indicates the immensediscretionary power of the financial intermediaries.

For credits larger than N$40,000 pesos the financial intermediaries show atendency to waive requirements, offering preferential credit on better terms. For


credits between N$40,000 and N$129,000 pesos this implies a discount of 2.6percentage points, equivalent to 9.5% of the theoretical transaction costs. Forthis range of amounts there are significant waivings associated withgovernmental, accounting, and other costs, while there are additionalrequirements in the area related to reciprocity costs. For credits betweenN$129,000 and N$258,000 pesos the waiving of some requirements implies adiscount in effective transaction costs of 14.9 percentage points (70.5% oftheoretical transaction costs). In this case there are important exonerations inrequirements associated with reciprocity, governmental, and other costs. Forcredits over N$258,000 pesos clients are exempted from fulfilling manyrequirements. This represents a reduction of 5.8 percentage points in theeffective transaction costs (81.4% of the theoretical transaction costs). The mainexonerations are in those requirements related to the governmental and theopportunity costs.

In consequence, the financial intermediaries have great discretionary powerto ask their clients to fulfil more or fewer requirements in the contract of credit,and the use of this power implies important differences between the theoreticaland the effective transaction costs. Moreover, the power is used in such a wayas to imply discrimination against borrowers of small amounts.

Relationship between effective transaction costs and amount of credit

The existence of an indirect relationship between the effective transaction costsand the amount of credit is one of the main hypotheses of the transaction-costsliterature. It states that micro and small firms face, on average, highertransaction costs as compared with medium-sized and large firms. Thus,preferential-credit programmes, mainly designed to encourage micro and smallenterprises, do not completely meet their objectives. The cheap-credit subsidyis basically given to large firms. The results shown in the previous subsectionsas well as those in Table 7 support this hypothesis.

To explore the hypothesis further a linear single-variable regression analysiswas run,16 with transaction costs as the dependent variable and the amount ofcredit the independent variable. Except in the cases of governmental, accounting,and other costs, a significant indirect relationship between the transaction costsand the amount of credit was found. Table 7 summarises the results of theeconometric exercise.

The t-test shows the existence of this indirect relationship for the totaltransaction costs and for almost every individual category. Because micro andsmall firms generally borrow small amounts of credit, these results confirm

16. Other specifications were used; however, they showed no improvement or variation in thekind of relationship estimated.


previous findings about the existence of a bias against such enterprises in the

Table 7Regression analysis

Dependent variable Sign of the relationship Significance level

1. Opportunity cost neg. *2. Legal cost neg. **3. Accounting cost neg. n.s.4. Paperwork cost neg. **5. Reciprocity costs neg. **6. Governmental cost neg. n.s.7. Transportation cost neg. **8. Other costs neg. n.s.

9. Effective transaction costs neg. **

Notes: Independent variable: amount of credit, dependent variable: effective transactioncosts. neg. stands for an inverse relationship. Significance level measured with at-test.n.s. stands for non-significant relationship, ** indicates that the relationship is significantat 95%, while * that it is significant at 90%. The values of the coefficient of fitness (R2)are less than 0.1 in all regressions.

lending of preferential credit. The low values of the fitness coefficient suggestthe existence of other explanatory variables, probably related to the prevailinginstitutional framework. The following subsection explores further the impactof some qualitative variables associated with the institutional framework.

Relationship between effective transaction costs and categorical variables

Information, obtained from clients’ files, about the firms, the financialintermediaries, and the contracts of credit was used to construct some qualitativeor categorical variables and to study their relationship with the effectivetransaction costs.17 An ANOVA analysis was carried out and theχi2 statistics(Chi-square) was used to study the statistical significance of the relationshipamong the density functions of two or more categorical series. The rejection ofthe null hypothesis implies that the variable has an impact (makes a difference)in the transaction costs. The non-rejection of the null hypothesis means that the

17. For the quantitative variables the ranges were defined in such a way as to include an equalproportion of observations in each range.


transaction costs are the same for all categories of the variable.18 Table 8

Table 8Results of the categorical analysis

Independent variable Kind ofintermediary

Size offirm

Kind ofactivity

Status ofrecommendation

Years ofrelationship

Opportunity cost ** n.s. n.s. * *Legal cost ** * n.s. ** n.s.Accounting cost * n.s. ** n.s. n.s.Paperwork cost ** n.s. n.s. n.s. n.s.Governmental cost n.s. n.s. n.s. n.s. n.s.Transportation cost ** n.s. ** n.s. **Reciprocity cost ** ** ** ** **Other costs n.s. n.s. n.s. * n.s.

Effective transaction costs ** * * ** **

Notes: H0: transaction costs are similar for all ranges of the categorical variable. **: H0

rejected at significance level of 5%. *: H0 rejected at significance level of 10%. n.s.: H0

not rejected at significance level of 10%.

presents the main results of the analysis, indicating whether the ranges ofqualitative variables make a difference in the total and specific effectivetransaction costs. The following are some comments on the main findings.

a.Kind of financial intermediary : In most cases the effective transaction costsdiffer according to the kind of intermediary. They tend to be higher whenborrowing from credit unions.

Many factors explain this difference in transaction costs. First, the clients ofcredit unions face higher transportation costs, because they tend to be locatedrelatively far from the financial institution. They also need to make more tripsto complete their application (four on average) compared with the banks’ clients.

Second, the reciprocity cost is greater because most of their clients do nothave a credit history and, in principle, imply higher adverse-selection andmoral-hazard risks. The requirement to buy shares is strictly enforced by thecredit unions, while the requirement to hold balances in the banks is not alwaysenforced.

18. For an explanation of the ANOVA technique see Green (1978).


Third, banks generally work with large firms, which have more borrowingexperience and can take advantage of economies of scale in the fulfilment of therequirements. Relatively new and inexperienced micro and small firms usuallyborrow from credit unions.

b. Size of firm: There is some evidence to show that larger firms face, onaverage, lower effective transaction costs. This is explained basically bydifferences in the reciprocity cost. Micro and small firms lack reputation andcredit history, and they borrow mainly from credit unions. Consequently, theyare forced to buy shares from the credit unions or to hold balances with thebanks to get access to credit.

c. Activity of the firm : There is evidence suggesting that the effectivetransaction costs differ by activity. The difference originates in the concepts ofaccounting, transportation and reciprocity costs. Firms in the industrial andservices sectors tend to face lower transaction costs, while those in theagricultural and commercial sectors tend to be in the higher-cost ranges.Generally, firms in the latter two sectors tend to be located in the rural areas,far from the urban and financial centres, so they face higher transportation costs.In addition, they are relatively smaller and have little credit history, whichexplains why the financial intermediaries tend to ration the credit to these firmsby increasing their reciprocity costs.

d. Recommendation status: Some credit applications were accompanied by arecommendation from a director or a senior officer of the financial institution.19

The applications were therefore classified into two groups according to thisfactor. The findings show that a recommendation significantly reduces theeffective transaction costs. This confirms that the financial institutions can usetheir discretion to reduce or eliminate some of the requirements of the creditcontract. It also shows that many of the requirements play a credit-rationingrole, in view of the fact that the interest rate is exogenously fixed.

The cost is much lower for recommended applications in respect ofopportunity, legal, reciprocity and other costs. This implies that borrowers witha recommendation get the credit faster and more easily, and are not required tobuy as many shares or to hold as much money in their bank accounts asborrowers without a recommendation.

19. The recommended firms received support from a director of the financial institution or aperson of influence in the community. The information comes directly from the clients’ files.The objective of the recommendation was to speed up and facilitate the approval of credit forthe firm. It is important to note that the firm’s possession of a recommendation could indicatea previous satisfactory relationship with the intermediary or could reflect the use of somenon-credit-related influence.


e. Years of relationship: The applications were classified into three groupsaccording to the time-span of the client–intermediary relationship. It was foundthat the effective transaction costs are much lower for those clients who havemaintained a long-run relationship with the intermediary. This is to be expectedbecause the existence of a long-run permanent relationship improves the qualityand quantity of the intermediary’s information about the client. Morespecifically, transaction costs are much lower in respect of opportunity,transportation and reciprocity costs. This shows that long-run clients obtain thecredit faster, with fewer visits to the financial intermediary, and with smallerbalance-holding or share-purchasing requirements.

f. Interest rate: The distribution of the transaction costs was not found to varyaccording to the interest rate charged. The effective transaction costs are nottherefore correlated with the financial (interest-rate) costs of the credit.

Conclusion

The empirical results confirm the importance of taking transaction costs intoaccount in the study of preferential-credit policies. It is common fordevelopment banks to focus their preferential-credit programmes on theprovision of credit at relatively low interest rates. However, this investigationdemonstrates that the transaction costs in these programmes can be very high,and that they are used to ration the credit according to the interests of thefinancial intermediaries.

The credit-rationing process in the case of preferential-credit programmeswhich fix the interest rate is found to be based on two factors: the design of acredit contract that deters some kinds of firms from borrowing, and thediscretionary power of the financial intermediaries to add or waive requirementsto the contract. The findings of the investigation indicate that this discretionarypower is considerable. The credit contract is designed in such a way thattransaction costs are, in principle, very high, especially for micro and smallfirms. The intermediaries can also reduce the transaction costs for specific typesof clients by waiving some requirements. In some cases they even add newrequirements to the contract for very small loans. It was also found that therequirements associated with reciprocity costs were used intensively as acredit-rationing mechanism.

Thus, if the objective of the development banks is to foster certain activitiesby providing cheap credit, it would be better if they focused their attention onreducing the transaction costs by means of a modification of the requirementsof the credit contract, rather than on reducing and fixing the financial cost of thecredit. The original objectives of the credit programmes supported by thedevelopment banks could even be distorted by the use of transaction costs as a


credit-rationing mechanism. Credit provided at cheap interest rates for specialprojects or activities can become very expensive once transaction costs are takeninto account.

In the particular case investigated, the largest development bank in Mexico(Nacional Financiera) supported a preferential-credit programme and fixed theinterest rate at which the financial intermediaries were to provide the credit.However, these intermediaries made use of transaction costs to ration the creditto suit their own interests, creating a structure of effective transaction costs thatdeterred specific kinds of clients from applying for preferential credit. Forexample, an inverse relationship was found between transaction costs and theamount of credit, implying that the cost of credit is much higher for newenterprises and for micro and small firms, which generally borrow smallamounts, than for medium-sized and large ones. Although the interest rate isrelatively similar, once transaction costs are taken into account the total cost ofa credit below N$40,000 pesos is, on average, at least four times higher thanthat of a credit above N$258,000 pesos.

Another finding shows that the reciprocity, legal and opportunity costs are theconcepts that have a stronger influence on transaction costs. A study of theconcepts making up the transaction costs indicates where future efforts to reducethe cost of credit should be concentrated. It was also observed that transactioncosts vary in relation to the type of intermediary, the size of the borrowing firm,its business activity, the time-span of the firm–intermediary relationship, andwhether the firm’s application has been recommended.

The following final suggestions can be put forward.First, the use of transaction costs as a credit-rationing mechanism forces

many firms to allocate economic resources to the fulfilment of theserequirements, and in many cases this can be considered as a directlyunproductive use of resources. This scheme of credit rationing therefore impliesa waste of economic resources. Schemes using the interest rate to ration creditcould be a preferred mechanism, if only because they do not force economicagents to become involved in directly unproductive activities.

Second, the objectives of preferential-credit programmes that fix the interestrate at lower levels are not satisfactorily met. Even with a fixed interest rate,financial intermediaries have complete flexibility to use transaction costs toallocate the financial resources according to their own interests. In the Mexicancase investigated, medium-sized firms were the main beneficiaries of the cheapcredit programme, not only because they borrowed larger amounts of credit, butalso because they faced lower transaction costs in comparison with micro andsmall firms. This finding contradicts the professed objective of thepreferential-credit programme to promote micro and small firms.

Third, it is important to study the alternatives that micro and small firms havefor obtaining financial resources. In principle, they could use the financialsystem to obtain credit at market interest rates; however, transaction costs are


also expected to be high for such firms in the non-preferential creditprogrammes. A study of the transaction costs in these non-preferential creditprogrammes should therefore be on the agenda for future research.

References

Adams, Dale W. (1993)A Critique of Loan Targeting and What to do AfterOvercoming the Habit. Studies in Rural Finance Occasional Paper No. 2087.Columbus, OH: Ohio State University.

Adams, Dale W. (1994)Transaction Costs in Decentralized Rural FinancialMarkets. Studies in Rural Finance Occasional Paper No. 2039. Columbus, OH:Ohio State University.

Adams, Dale W., González-Vega, Claudio and von Pischke, J.D. (1987)CréditoAgrícola y Desarrollo Rural: La Nueva Visión. Columbus, OH: Ohio StateUniversity.

Akerlof, George A. (1970) ‘The Markets for Lemons: Quality Uncertainty and theMarket Mechanism’,Quarterly Journal of Economics8: 488–500.

Aspe, Pedro (1993)El Camino Mexicano de la Transformación Económica. MexicoCity: Fondo de Cultura Económica.

Besley, Timothy (1994) ‘How Do Market Failures Justify Interventions in RuralCredit Markets?’,World Bank Research Observer9(1): 22–47.

González-Vega, Claudio (1986)Mercados Financieros Rurales en América Latina.Dominican Republic: CEMYB.

González-Vega, Claudio (1992)República Dominicana: Mercados FinancierosRurales y Movilización de Depósitos. Columbus, OH: Ohio State UniversityPress.

Green, Paul E. (1978)Analyzing Multivariate Data. Orlando, FL: The Dryden Press,Harcourt Brace Jovanovich.

Laffont, J.J. (1989)The Economics of Uncertainty and Information. Boston, MA:MIT Press.

Laffont, J.J. and Tirole, J. (1995)A Theory of Market Incentives in Regulation andProcurement. Boston, MA: MIT Press.

Nacional Financiera(1994) Informe de Labores. Mexico City.Stiglitz, Joseph E. and Weiss, Andrew (1981) ‘Credit Rationing in Markets with

Imperfect Information’,The American Economic Review: 393–409.Tirole, Jean (1989)The Theory of Industrial Organization. Boston, MA: MIT Press.

Transaction Costs in Mexico's Preferential Credit

Documents

Transcript of Transaction Costs in Mexico's Preferential Credit