Interest Rate Debate in Microfinance: reflections on regulated caps
The setting of interest rates in the field of microfinance (MF) has been hotly debated for years. On the one hand, it is claimed that high interest rates are justified because of the elevated operating and processing costs of serving very small loans without collateral.
On the other hand, it is argued that high interest rates occur either because the microfinance institution (MFI) is making too much money or is simply inefficient. For whatever reasons, high interest rates are passed along to those who can least afford them — poor, people. Thus, MF more than before, is faced with an ethical question: should MFIs be mission driven or profit seeking? And, what is the “just” balance?
In the last few years, the commercialization of MF following the downscaling of commercial banks (currently more than 80 commercial banks worldwide operate in MF) and equity investor involvement has caused the MF sector to grow to approximately US$60 billion, with more than 200 million micro-borrowers. At the same time, to minimize the potential exploitation of micro-borrowers, more than forty countries have introduced ceilings or caps on MF interest rates.
Many MFIs use the Grameen Bank model, setting rates around +15% above the cost of funds. The original vision of Professor Yunus, the author of this model, was that interest rates would decline with time, thus allowing MFIs to pass along savings to micro-borrowers while competing and serving their social mission. Unfortunately, 30 years later this vision has not been realized and the debate about interest rates remains a sore point in many countries where micro loans can range from 30% to 70% plus cost of funds.
Although intended to protect micro-borrowers, interest rates caps have produced market challenges and disruptions in a number of countries. Recent examples include:
Ecuador: The government regulated market caps on MF interest rates in 2007, and by 2010 further reduced the cap for retail micro-lenders to 30.5% from 33.9% and for all other lenders to 27.5%. This forced small MFIs to go up-market or to sell their portfolio to larger MFIs; it also left clients needing small loans without formal MF.
Nicaragua: According to Alfredo Alañiz, President of the Association of Nicaraguan Microfinance Institutions, member institutions’ portfolio growth fell from 30% per year to less than 2% when Parliament introduced an interest rate ceiling in 2001.
Bolivia: Considered the worldwide role-model of MF, Bolivia had already seen market competition reduce interest rates from over 100% a decade ago to currently 18%. However, this year, the government introduced an 11% interest rate cap on 60% of loan portfolios of all regulated financial institutions; the other 40% remain uncapped. [Note: Bolivian MFIs will have five-years to comply with this regulation.] Several MFIs believe that the 11% cap was not determined by cost alone, but by political considerations and are fearful that such rates will eliminate many small MFIs or force them to sell or go up-market (as has happened in Ecuador). They also state that those MFIs which provide not only loans, but also healthcare and education services to the poor will be significantly affected. Further, local MFI practitioners state that it is difficult for institutions to remain solvent making loans averaging US$500 to US$1,000 and interest rates of 11%, without subsidy from NGOs or the government. The Global Microscope Report by the Center for Financial Inclusion scores MF countries as a way of benchmarking their progress toward a financially inclusive environment for the bottom of the pyramid. Bolivia for the last few years had achieved first and second place: this year (2014) with the new interest rate cap regulation, it fell to ninth place worldwide.
Colombia: According to Beth Rhyne, Managing Director, Center for Financial Inclusion, Columbia has had MFI interest caps for years, which fluctuate annually set by government officials. These are set at levels which presumably prevent MF players from over-charging micro-borrowers.
India: In 2011 India launched a cap on MF interest rates of 26% for loans up to 50,000 rupees (US$1,124) and at that rate stagnation and reduced borrowing followed. To offset this, in April 2014, the Reserve Bank of India introduced a more flexible rate: cost of funds (at market rates) plus 10% for existing MFIs and cost of funds plus 12% for new MFIs. These manipulations of interest rates caps, together with other MF government regulations and the political fallout of the Andhra Pradesh scandals, left more than 400 million people in poverty without the option of obtaining a micro-loan, and microfinance capital shrank by 40%. Many are now forced into the informal money markets where rates can be exorbitant, despite India’s strong anti-usury laws.
While several MF practitioners have felt that these rates have allowed reasonable margins, others have reported that these new restrictions on margins and interest rates are too stringent, will limit product innovation and competition, and act as an incentive for MFIs to up-scale at a faster rate.
A recent study by CGAP (Consultative Group to Assist the Poor) analyzed interest rates in over 866 MFIs between 2004 and 2011, finding that most African countries have instituted interest rate caps to protect consumers, in some cases due to political and cultural pressures. The study reported that overall interest rates in Africa declined as a result of market competition from 37% to 25%, despite increasing financial expenses, credit losses and inflation. Other research reports, however, have stated that the African region is the highest of any region in the world where loans sore to above 50%. Notwithstanding, the CGAP report points out that: “Despite good intentions, interest rate ceilings can actually hurt low-income populations by limiting their access to MF, reducing price transparency and shying away equity impact investors”.
An increased awareness of interest rates applied to micro-loans was illustrated at the 17th Microcredit Summit held in Mexico in September 2014, when Chuck Waterfield, CEO of the research center, Microfinance Transparency, asked the Summit participants: “How much (profit) is too much?”. Waterfield has tracked interest rates in 30 countries, with the numbers revealing some startlingly high rates in certain developing countries. For example, in Mexico interest rates on microloans range between 95% and 154%. He noted that the “industry position right now is that there are no upper limits on how much profit an MFI can make.” To control high interest rates, Waterfield called for “obligatory, external governmental regulations” along the lines of those enacted by India and Bolivia.
The recent 20 year-long World Bank research report on the effectiveness of poverty reduction in Bangladesh shows that the benefits microfinance brings to families in poverty are tangible, particularly to the next generation in supporting education, health, higher standards of living and women empowerment. In Bangladesh, MF regulators have capped interest rates at 27%. Given the very active Bangladesh microfinance market, the cost structures and the fact that the high population density allows for a much greater case load per loan officer than any other country, the 27% rate cap is reasonable according to BRAC practitioners.
The debate on interest rate caps will undoubtedly continue in the next years as mobile technology and mobile money play an increasingly significant role in the field, hopefully reducing operating costs and improving transparency. Vikram Akula, former CEO of SKS Microfinance in a recent book emphasizes the importance of client education by MFIs, and how new technology will certainly help toward this end.
One potential aspect of regulation to which all MFIs have responded positively is the creation of local “credit bureaus” with mandatory membership for local MFIs. Appraising a client’s credit-worthiness is expensive, timely, and often inaccurate. According to David Roodman local credit bureaus could act as a “transparency” tool for reviewing indebtedness and repayment history.
As the sector develops, regulators will want to continue to address the interest rate cap issue highlighted here, along with other important issues including implementation of sector lending priorities, diversification of funding, and channeling of public deposits toward MF. As the industry moves forward, regulators will undoubtedly find the optimal balance to ensure that MFIs’ objectives and operations are ultimately aimed at serving and benefiting the micro-customer.
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Historically, efficiency and competition are viewed as the main reasons why most MF interest rates have declined in the last decade along with the fact that micro loan sizes worldwide have gradually increased as well (i.e. fewer MFIs offering the $200 loans). At the same time, several newer politically-driven laws, enacted for the protection of people in poverty, ironically, may be limiting the flow of funding.
Finding the optimal regulatory balance will continue to be challenging, involving considerations related to protecting depositors and borrowers, loan sizes, keeping down the costs of MFIs and its supervision, and preventing regulations from restricting innovation and competition.
MF does not need more regulation, it needs smarter regulation, to ensure that MF interest rates are fair, transparent and provide reasonable protection to MF customers, while also allowing viable MF business operations and market development. By: Laura Giadorou Koch