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07/09/2017

Interest Rates In Microfinance

Global differences in microcredit interest rates are dramatic. Small loan sizes are the most commonly cited reason why microcredit rates are higher than normal bank rates. Microcredit is a “high-touch” business, and microfinance institutions (MFIs) have to process thousands of tiny transactions. When asking “how much is too much?” it is important to reserve judgment long enough to examine the conditions that determine international microfinance interest rates.

Interest rate faces three main cost elements, i.e., how big are the loans? What is the maximum loan officer cash load? And finally how much are loan officers paid? But the average loan balances against portfolio yields shows pretty clearly that loan size is only one of the factors that explains the differences between average interest rates.  Where do these considerable differences come from, then? To answer this question, let’s take a look at the main factors that influence MFI interest rates.

The main factors that determine the interest rates in microfinance are as follows:

  • OPERATING COST

Operating costs are the expenses which are related to the operation of a business, or to the operation of a device, component, and piece of equipment or facility. They are the cost of resources used by an organization just to maintain its existence.

Operating costs always have been the main driver of MFIs’ interest rates because microfinance is a labor intensive business. According to major researchers, operating expenses make up close to 50 percent of nominal interest yields in a worldwide comparison. Not surprisingly, the countries with the lowest interest rates tend to have low operating costs.

It’s shown that for MFIs younger than six years old, one additional year in the market is expected to reduce the operating expense ratio between 2-8 percentage points.

  • PUBLIC POLICY

Public Policy represents State objectives relating to the health, morals, and wellbeing of the citizens. In the interest of public policy, legislatures and courts seek to nullify any action, contract, or trust that goes counter to these objectives even if there is no statute that expressly declares it void.

In some countries, there seems to be political motivation to keep microfinance interest rates below a certain level. As far back as 1998, the National Bank of Ethiopia removed all interest rate ceilings in the financial sector, but a majority of MFIs have chosen to maintain a lower interest rate, which has been partly driven by political considerations (Helms and Reille 2004). Independent observers repeatedly report a palpable pressure from the political arena to keep interest rates fairly low.  In Ethiopia and Sri Lanka, most microfinance activities are carried out by public institutions. These institutions often benefit from overt or hidden subsidies: subsidized cost of funds (for Sri Lanka coming from post-tsunami cheap loans) or in-kind subsidies (in Ethiopia, governmental MFIs get some of their staff paid by local government and are allowed to use rent-free public buildings for operating their branches). Unsubsidized private MFIs therefore face very high hurdles to enter these markets. All these factors taken together indicate that MFIs can access a huge and virtually untapped market that is willing to soak up fresh money at almost any price.

  • COMPETITIVE INTENSITY

The intensity of rivalry among competitors in an industry refers to the extent to which firms within an industry put pressure on one another and limit each other’s profit potential. If rivalry is fierce, competitors are trying to steal profit and market share from one another.

So far, there are little reliable data on competition in microfinance markets, which is why we have to rely on anecdotal evidence reported by practitioners in the field. Some argue that maybe competition had reduced, and MFIs’ price-setting strategies became even more unhampered. Despite the large number of microfinance borrowers in Mexico (2.6 million borrowers approximately), competition seems not to have put palpable pressure on MFIs. Anecdotal evidence from Mexico indicates, though, that recently prices have fallen in certain regions where institutions compete for market share.

OUTLOOK

By pursuing financial sustainability and profitability, the Microfinance industry has reached more people permanently without heavy donor dependence. In most countries, since poor people consists the major portion of microcredit, they should be treated as clients rather than recipients of charity.

Many people are surprised to learn that the poor in the developing world lead complex financial lives as they struggle to make their small incomes cover basic needs as well as unusual expenses and opportunities. Poor families are often both savers and borrowers, setting aside money in informal savings ways, and borrowing from relatives, employers, and local grandees as well as professional moneylenders. While not all moneylenders by any means are the evil loan sharks of legend, they do generally charge rates far in excess of those charged by micro lenders.

Client returns to investment are not well documented, but it is known that for short term loans, especially for the kinds of retail and restaurant businesses found in urban microfinance markets, opportunities to leverage an immediate lump sum of cash are often available which many clients find to be an acceptable opportunity cost for equipment or stock that will boost a microenterprise’s earning ability or for consumption needs such as school fees or home improvements. That said, as interest rates come down and loan terms lengthen, microfinance loans become economically attractive to a wider range of businesses, and support longer term investments.

Ultimately, responsible pricing makes good business sense. With the relatively high cost of acquiring new clients in microfinance, financial service providers survive based on long term customer relationships. Setting a price that allows the client’s business to thrive helps to generate more future business for the financial institution.

Image Credit: MAKING IT MAGAZINE (2010)

By Humneet KAUR

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