High interest rates in microfinance, which often vary between 30% to 70% (Fernando, 2006), draw plenty of criticism for being commercial and exploitative. Since these rates can be justified by high transaction costs and risks associated with microlending, it is often difficult to differentiate between sustainability, profitability and greed. Here are some ways this exploitation can be controlled:
1: Determining Fairness Based on Risk-Adjusted Returns on Investment for Microfinance Providers
High returns on investment in microfinance, sometimes up to 20% to 30% as in Mexico, are a direct function of interest rates and costs of MFIs. It is worth remembering that investors seek returns that compensate the high risk of microlending, which itself is a debatable topic since repayment rates are almost perfect. Nonetheless, the above-mentioned categories (Green, Yellow and Red) can be based on the risk-adjusted returns offered to investors by MFIs and anything beyond, say, average market returns + 10% may be deemed exploitative.
This formula takes into account an MFI’s unique cost structure and the element of financial sustainability into account but may ignore economic downturns in the market.
2: Determining Fairness Based on Interest Rates Margins/Market Rates
The indicator suggested by Professor Yunus is interest rate margin, which is the difference between interest rate charged to your borrowers and the interest rate charged by your funding sources (investors/lenders), i.e. an MFI’s direct profit:
- Pure social orientation of microfinance provider - an interest rate margin of less than or equal to 10% (Green Zone)
- Social as well as financial orientation of microfinance provider - an interest rate margin between 10-15% (Yellow Zone)
- Pure financial objective - an interest rate margin above 15% (Red Zone).
3: Determining Fairness Based on Asset Growth of Borrower and Microfinance Provider
According to Dr S. Santhanam, a three step process is suitable. Excerpted from CGAP’s blog.
Step 1: Before the microfinance program, look at the assets/ wealth of the MFI and their clients.
Step 2: After a reasonable period after introduction of the microfinance program, repeat the exercise.
Step 3(a): If the assets/ wealth of the MFI have grown more than that of its clients’, then it is wrong and needs correction at MFI level.
Step 3(b): If the assets/ wealth of the MFI and that of its clients have moved up in the same proportion, then it is the most ideal situation and it should be allowed to continue.
Step 3(c): If the assets / wealth of MFI have gone lower than that of its clients, then, it needs serious correction at MFI level either by increasing its interest rates/ reducing its cost of operations.
This intuitive formula may account for reasonable explanations for disappointing results, e.g. medical calamity met by the client’s family, or poor utilization of loan.
4: Capping Interest Rates for Microfinance Providers
Bangladesh and Ecuador already have caps on microcredit interest rates of around 30%, and this may encourage microfinance providers to increase loan sizes. These calculations are probably based on an industry-wide study of the average costs and returns of microfinance providers and seeks to prevent excesses. While on the face of it, this seems to be a good way to protect consumers, it may end up harming the sector; you can read the two conflicting points of view here.
These techniques may not fully ensure the social focus of microfinance providers but if used as a starting point, may ensure social orientation is a permanent part of microfinance practice.
References:
Fernando, Nimal A. (2006). Understanding and Dealing with High Interest Rates on Microcredit. Asian Development Bank.
It is interesting to note that in the CGAP blog entry that you referenced, the authors discovered that there were 25 Grameen supported/affiliated MFIs that fell within the “red zone” that Dr. Yunus outlined. Since Grameen Bank was the only institution that fell within the “green zone”, Dr. Yunus’ criteria for achieving “fair” interest rates is either a) unrealistic or b) cannot be replicated by the rest of the microfinance community.
Another way to cut interest rates (although it may be unpopular) would be to cut out nonfinancial-related services. This is probably a subset of #3. Commercial banks don’t offer services such as business training or preventative health services, so why should MFI’s?
I say this tongue-and-cheek because many critics of high MFI interest rates do not take into consideration the social mission of many of these organizations. If MFI’s don’t charge a high enough rate to become self-sustaining, then we start taking away value-added services such as business training that would help the working poor become successful in the marketplace. The poor have no other choice than to go to usurious moneylenders if these institutions are not viable, and isn’t that what we’re trying to prevent in the first place?
Thanks for the comment. I agree that Prof. Yunus’s benchmark isn’t comprehensive enough, and the statistics you mentioned prove this point. In fact, simplistic measures may not be the answer here because the microfinance model is rather complex and varies from country to country in terms of operating costs, taxes, financial costs, etc (which are determinants of interest rates for MFIs). For this reason, I think the ROE (return on equity) formula is better, but that has inherent weaknesses as well. Perhaps the best solution will be to use a combination of these methods because they seem to cover the weaknesses of one another.
You bring up a good point about non-financial services in microfinance. I think it is up to the management to introduce trainings in a way that is efficient enough to contain operating costs, and hence interest rates. One way is to offer it as an opt-in service rather than making it compulsory. Prof. Yunus questions the utility of these trainings for he believes the poor do not need such help to run their businesses; they already have the survival/business skills and only need money to succeed.
Hey Fahmeen!
I was wondering if you’d read anything about the new microfinancing efforts in Haiti, particularly Fonkoze’s collaboration in the new Zafen collaboration to provide interest free microloans and their slick Kiva-esq website. Any thoughts on how much it costs to provide intrest free loans for third-world borrowers? Any thoughts on if this might actually keep some borrowers from repaying their loans? I’m in the midst of Jacqueline Novogratz’s “The Blue Sweater” and she seems to imply that in a lot of occasions if you don’t hold people to business-style accountability, that they tend to want to take advantage of the system.
Do you know of many other ventures where long-term microloans have been provided at no interest or very low interest rates?
Keep up the good work on here!
hi, Danny.
To be honest, I hadn’t heard about the zafen effort before your comment, and I’m glad you did because I now have plans to feature it on my blog. I cannot resist comparing it to Kiva, and I think Zafen wins in terms of giving lenders a better picture of how their money will create a long lasting impact on communities, and not just individuals. A featured project on the website is the reconstruction of a school, where lenders can feel the long term satisfaction of being part of a social uplift of an entire generation or two, or as long as the school is operational. That kind of feeling isn’t present at kiva’s site since they’re not into development work at the moment.
I don’t think offering interest free loans is much of a problem, because Fonkoze will have plenty of other ways to recover their costs, and borrowers can not worry about having to pay mounting interest on loans and focus on their work. The problem of inflation, again, isn’t a problem because the kind of people who lend (individuals looking to make a social impact) won’t be worried about retaining the time value of money. As for encouraging borrowers to pay back on time…well, the loan, in itself, is an obligation. And 12 months is long enough to get the money in order, considering the unpredictability in the money cycle of the poor. However, an added measure could be the creation of risk profiles of the poor, where disciplined borrowers become eligible for larger loans, and this would discourage people from taking advantage of the system (Grameen Bank uses this tool).
I’m not sure about any specific examples, but i know microfinance, practiced according to islamic principles, operates without interest. Unfortunately, there isn’t a lot of documentation in that area.
How is the book coming along? It’s still on my reading list.
Thanks for the compliment. Comments are always appreciated!