The Interest Rate Debate in Microfinance

Introduction:

Over the past two decades Microfinance Institutions (MFIs) and NGOs have made use of a range of designed features, i.e they have focused on reaching the poor by keeping the loan sizes small, targeting women, adopting group based lending systems, mobilizing small and frequent savings deposits and have tended to set interest rates at higher levels than in the past. The issue of high interest on micro-loan has been criticized since the beginning of the modern microfinance movement in the late 1970s, but it intensified in the last few years as it is drawing more public and political attention. These institutions which give micro-loans to low-income borrowers in developing and transition economies are charging higher interest rates and fees high enough to cover their costs and thus making their operations financially sustainable. They have repeatedly argued that doing so will best ensure the permanence and expansion of the services they provide. Sustainable (i.e., profitable) microfinance providers can continue to serve their clients without needing ongoing infusions of subsidies, and can fund exponential growth of services for new clients by tapping commercial sources, including deposits from the public. On the other hand, a group of observers who do not agree with this argument say that MFIs that claim to be helping poor people nevertheless charge interest rates that are considerably above the rates richer borrowers pay at banks. No wonder this seems wrong to these observers who do not understand, or do not agree with, the argument that MFIs can usually serve their poor customers best by operating sustain-ably, rather than by generating losses that require constant infusions of undependable subsidies.

2. The Debate

To start with the debate that, ‘are the interest rates charged by the MFIs excessively high’? we know that there is no perfect answer to this question as there are huge variations in interest rates charged by the MFIs around the world. Also another matter of concern is that how high interest rates and profits would be qualified as “excessive”. Before continuing with this discussion it is important to understand what an interest rate is.

In simple terms, the interest rate is the price of money. As a price it is made up of a number of components as far as a lender is concerned. It is the means through which the lender:

• pays for the cost of the funds that are being lent (cost of capital); if these are from savers then the savers are likely to expect a return which will at least cover inflation and so maintain the value of the savings;
• recovers the cost of providing the services (costs of administration); the costs of the staff employed to given and recover loans, and costs of the offices, vehicles and stationery that are necessary to provide that service;
• covers losses as a result of those who default on their loans (costs of default).

Now-a-days, the MFIs have accepted the need to charge interest rates which cover inflation and make a contribution to costs. This means interest rates which are positive in real terms and are comparable to those charged by formal-sector banks (sometimes termed as market interest rate). This differs from earlier practices in the sense that when the provision of credit from NGOs, MFIs and State Banks were actually at subsidized rates. This cheap credit was attractive to borrowers outside the target group, and was diverted away from its intended purposes; and loans were often not repaid. The combination of cheap credit and widespread default resulted in rapid erosion of loan funds. Thus it’s very important to charge a rate of interest that covers the cost of inflation, administration, and default so that the loan fund is able to revolve and maintain its value.

On the other hand an interest charge represents money taken out of clients’ pockets, and in this case the clients are poor. Moreover, the MFIs claim to be helping the poor, because that is their ultimate motive and the interest rates charged by these MFIs are much higher than what the rich borrowers pay at bank. Again the costs become high due to some avoidable inefficiencies which the poor people who are generally the client’s of these MFIs have to bear in the form of higher interest rates. So, charging higher rates of interest by these MFIs would not only be unreasonable but also inhuman.

Now there’s another intense dispute about how high interest rates and profits should be to qualify as “excessive”. According to CGAP expert Rich Rosenberg, “There are huge variations in the interest rates and related circumstances of individual MFIs around the world.” So CGAP did a study on 500 MFIs around the globe to shed some light on this issue. The study found that the median interest rate for sustainable (i.e., profitable) MFIs was about 26 percent in 2006. The 85 percent interest rates charged by Compartamos (a Mexican MFI ) was truly exceptional. Less than 1 percent of borrowers pay rates that high. MFI interest rates also declined by 2.3 percentage points a year between 2003 and 2006, much faster than bank rates.

We will look at the factors that affect the interest rates in microfinance:

Higher cost of funds – We know that MFIs have to pay more than banks for the borrowed money and MFI managers don’t have much to do to control the costs.

Low default rates - While the cost of funds is necessarily reflected in MFI interest rates, rates are not being inflated by unreasonable loan losses. Default rates are very low—about 1.9 percent in 2006. Higher administrative expenses - Tiny loans certainly require higher administrative expenses, which are not substantially offset by economies of scale. The good news is that the learning curve of MFIs as they age produces substantial cost reductions. While we cannot quantify how much avoidable fat remains to be trimmed from MFI operating costs, one must expect substantial inefficiency when most MFIs are relatively young, and when few national microfinance markets are competitive. We know of no evidence to suggest that MFIs are out of line with the normal evolution of efficiency for businesses in such markets, and administrative costs have been declining by about a tenth per year since 2003.

Competition – Its not fact that competition will always lower interest rates. But interest rates do appear to have dropped in the markets where micro-credit has already become competitive, except for Bangladesh.

Profits - The study found that profits are not a predominant driver of interest rates. For the median MFI, the imprudent scenario of complete elimination of all profit would cause its interest rate to drop by only about one-sixth. And MFI owners earn less on their investment than commercial bank owners in the first place. The median return on MFI equity in 2006 was moderate—12.3 percent, compared to 17.7 percent for banks. Profits of sustainable MFIs, measured as a percentage of loan portfolio, have in fact been dropping by about one-tenth (0.6 percentage points) per year since 2003. Contradictory to this, the most profitable tenth of the worldwide micro-credit portfolio produced returns on equity above 34 percent in 2006—high enough to raise concerns about appropriateness for some observers. Much of this profit is captured by NGOs and never reaches private pockets. But some of it does go to private investors. Now the question is whether such profits are “exploitative” or not will depend, not only on the observer’s standard for what a reasonable profit is, but also on individual MFIs’ circumstances, including the risk levels faced by investors when they committed their funds.

In his study Rosenberg argues that, “How all this information is put together is up to each individual….. The real question is whether unreasonable rates are more than occasional exceptions. We don’t find evidence suggesting any widespread pattern of borrower exploitation by abusive MFI interest rates. We do find strong empirical evidence that operating costs are much higher for tiny microloans than for normal bank loans, so sustainable interest rates for microloans have to be significantly higher than normal bank interest rates. We also find that interest rates, operating costs, and profits have been declining quite rapidly in recent years, and we would expect this trend to continue in the medium-term future.”

3. Conclusion

Our ultimate goal or motive behind this debate is to search the answer for the question that “what should be the ideal or optimum rate of interest?” This is what that has been bothering the majority of the people in most of the countries. The ideal situation would be that the interest rate should be enough to cover the cost of operation and would also allow some profit for capitalization but it should not be so high that it appears exploitative. What I feel is that the ability to cover all the administrative costs through the interest charged to borrowers is only likely to develop over a period of time, as the system of lending becomes more efficient, and the number of borrowers receiving loans increases. Attempting to recover costs in the early stages of the scheme is likely to result in interest rates which are excessively high.

When comparing interest rates with those of formal-sector banks it is also important to recognize the hidden costs that poor borrowers face when they approach banks. They may be charged loan fees, heave to organize ‘gifts’ for bank staffs, and incur transport costs to get there. Worse they may be treated with disdain and even contempt – not a monetary cost, but a cost all the same. The actual price that a borrower is paying for loans from these sources is therefore higher than the interest rate alone; and the attitude of bank staff can make the transaction even more burdensome. This is why loans which carry interest rates comparable to the formal sector are still likely to be positively regarded by clients.

There is also an ongoing campaign for capping the rate of interest to protect the poor from the exploitation of greedy MFIs, who on some ground or other charge higher rates either to enjoy their luxury or to bear the costs of their inefficient high operational costs. But, for the sake of competitiveness and provision of quality services, it is better not to have capping but to form a consensus on a range of interest rates that will ensure a win-win situation for both the lenders and the borrowers. This may be possible with the government/central bank/regulatory body playing a leading role.

The rate of interest of MFIs should not, however, be compared with the rate of money lenders, but it may be compared with the commercial rate to show how cost-effectively MFIs operate. MFIs provide small loans to hundreds of borrowers at a rate of interest, which in many cases is not much higher than the commercial rate. As Muhammad Yunus suggests, it should not ever be more than 10 percent higher than the market rate.

Thus we can reach our objective (i.e an optimum interest rate or the ideal situation) by creating an environment where all the parties involved in the society ( practitioners, governments, donors, banks, corporations, NGOs, foundations, wholesale funds, networks, civil society and others) join hands and come together and work effectively and efficiently to eradicate poverty.