# ANNEX 7: SUBSIDY DEPENDENCE INDEX FOR RURAL FINANCE INSTITUTIONS<sup>5 4</sup>

Two main problems face the analyst who must rely on conventional accounting data to measure the financial performance of rural finance institutions (RFIs): the difference between the expense and income (including reimbursement of specific expenses by state or donor) captured and reflected in the RFI income statement and those expenses and incomes not recorded in the RFI income statement, and the lack of a design in conventional accounting practices to reflect and appropriately report on all types of subsidies received by an RFI.

Conventional accounting practice measures the cost of funds priced at their actual cost. The opportunity cost of an RFI's borrowed funds - that is, the cost the RFI would have to pay for its funds if access to concessional funds were eliminated - is not taken into account. The SDI calculation assumes that the volume of the RFI's outstanding loan portfolio remains unchanged. Hence, the change is caused by substituting concessional borrowed funds with voluntary savings, obtained at a market deposit interest rate. Thus. if the central bank loans to an RFI at 2 percent, conventional accounting practices list the cost of the loan at 2 percent p.a. However, if the cost of alternative non-concessional funds is 12 percent p.a., then the SDI considers the 10 percent difference in interest rates on those funds and identifies this subsidy received by the RFI. The rationale is that if the subsidized RFI paid only 2 percent p.a. on central bank rediscounting facilities instead of the prevailing market deposit rate of 12 percent p.a., the accounting profit and the financial ratios measuring the RFI's profitability would not convey that such ratios were only obtained due to the significant subsidy embodied in the cheap central bank rediscounting facilities. Providing an RFI with concessional funds is the most common method of subsidization, yet calculating the value of the subsidy implicit in the RFI's concessionally borrowed funds requires information not included in the RF's financial statements. The same is true for the RFI's equity.

In contrast to the profit maximizer, who does not differentiate between profit that is subsidydependent as long as continued subsidization is ensured and profit that is fully subsidyindependent, subsidy dependence is crucial to RFI's performance assessment. The social cost of RFI operations, of which subsidies constitute a significant share, is essential in determining the social justification for their existence and continued operations, because rural RFIs are often public or quasi-public institutions. To illustrate the futility of the current financial reporting system, one may ask, for example, what is the meaning of an RFI's return on equity of 20 percent when 50 percent of the RF's financial obligations constitute concessional borrowed funds from the central bank (rediscounting facilities), carrying an interest rate significantly below market deposit interest rates, and one-third of its payroll cost, 80 percent of its loan losses and all training expenses are assumed by the government.

> _54_ The Subsidy Dependency Index was introduced in Yaron. 1992b. This annex is excerpted from: M. Gurand,

> G. Pederson. J. Yaron. 1994. _Outreach and Sustainability of Six Rural Finance Institutions in Sub-Saharan Africa._ World Bank Discussion Paper No. 248. Washington. DC: Agriculture and Natural Resources Department. World Bank, pp. 72 - 75.

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