High interest rates have caused a stir in the microfinance community, where microfinance institutions justify the figures and the media criticizes them. The recent microfinance crisis in India saw a twist in the story that led everyone to wonder if these justifications were valid – the five largest microfinance institutions in India simultaneously slashed their interest rates to 24%, amid harsh criticism from the government and media.
One of the reasons attributed to interest rates in microfinance is the high cost of funds – among other sources, microfinance providers may obtain loans from commercial banks, who lend to MFIs at market rates. After this, microfinance institutions need to add a premium to cover their own costs and risks, which means the interest rates paid by micro-entrepreneurs can go pretty high.
This makes business sense because commercial banks charge a premium over ‘their’ cost of funds (public deposits in the form of micro-savings accounts, equity capital, and borrowings from the central bank, if necessary).
Naturally, if interest rates are to be reduced, microfinance institutions must have two options:
- Reduce the premium (also referred to as the ‘spread’) – this is dependent on transport costs, administrative costs, profit, salary expense, risk, etc., which means it can only be reduced if operations become more efficient,
- Reduce the cost of funds – this can be reduced by obtaining subsidized loans (through development agencies), non-interest loans (e.g. through Kiva), and public deposits.
One of the reasons cited by Vikram Akula for the SKS IPO was the inability to access low-cost funds in the form of public deposits, owing to regulatory restrictions. This is indeed a problem for the entire microfinance sector in India, as mentioned by the recent article in Hindustan Times:
“As MFIs, we have always stated that the growth of the base (of customers) will be critical to the reduction of costs. In addition, we can reduce costs if cheaper source of funds are made available to us,” Vijay Mahajan said (President, Microfinance Institutions Network).
