Are Microcredit Interest 47955 Rates Excessive? Over the past two decades, institutions that make microloans to low-income borrowers in developing and transition economies have focused increasingly on making their operations financially sustainable by charging interest rates that are high enough to cover all their costs. They argue that doing so will best ensure the permanence and expansion BRIEF 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. The problem is that administrative costs are Nevertheless, accepting the importance of inevitably higher for tiny microlending than financial sustainability does not end the discussion for normal bank lending. For instance, lending of interest rates. An interest charge represents $100,000 in 1,000 loans of $100 each will money taken out of clients' pockets, and it is obviously require a lot more in staff salaries than unreasonable if it not only covers the costs of making a single loan of $100,000. Consequently, lending but also deposits "excessive" profits interest rates in sustainable microfinance into the pockets of an MFI's private owners. institutions (MFIs) have to be higher than the Even an interest rate that only covers costs and rates charged on normal bank loans. includes no profit can still be unreasonable if the costs are excessively high because of avoidable As a result, MFIs that claim to be helping poor inefficiencies. people nevertheless charge them interest rates that are substantially higher than the rates richer High microloan interest rates have been criticized borrowers pay at banks. No wonder this seems since the beginning of the modern microfinance wrong to observers who do not understand, movement in the late 1970s. But the criticism or do not agree with, the argument that has intensified in the past few years, and MFIs can usually serve their poor customers legislated interest rate caps are being discussed best by operating sustainably, rather than by in a growing number of countries. Part of the generating losses that require constant infusions reason for the increased concern about rates is of subsidies. simply that microfinance is drawing ever more public attention, including political attention. In today's microfinance industry, there is still Another factor is that quite a few MFIs are now some debate about whether and when long- being transformed into private commercial term subsidies might be justified in order to corporations. reach particularly challenging groups of clients. But there is now widespread agreement, within In the early years most MFIs were ownerless the industry at least, that in most situations MFIs not-for-profit associations, often referred to as ought to pursue financial sustainability by being nongovernmental organizations (NGOs). If an as efficient as they can and by charging interest NGO generates a profit, the money normally rates and fees high enough to cover the costs of stays in the institution and is used to fund their lending and other services. additional services and benefits for clients. But February 2009 2 many NGO MFIs have eventually wanted to circumstances of individual MFIs around the add deposit-taking to their activities, because world, but also because there is no agreed they see savings services as valuable for their standard for what is abusive. There is an intense clients, and because capturing deposits allows dispute about how high interest rates and profits them to fund expansion of their microlending. would have to be to qualify as "excessive," and When NGOs approach a government banking indeed about whether terms like this have any authority for a license to take deposits, they are useful meaning, at least in the arena of for- usually required to reorganize their businesses profit microfinance. In a recent CGAP study, into for-profit shareholder-owned corporations. we did not propose any theoretical framework Once this happens, profits can wind up in the or benchmark against which to measure what pockets of private shareholders, inevitably is excessive or not. We presented available raising the specter of such owners making data, and then formed our own admittedly extreme returns on their investment by charging intuitive judgment about the reasonableness of abusive interest rates to poor borrowers who the general picture appearing in that data. Of have little bargaining power because their other course, readers will apply their own criteria or credit options are limited. intuition to the data in judging whether rates or profits strike them as "abusive," "exploitative," A firestorm of controversy erupted in April 2007 "excessive," "unreasonable," etc. when shareholders of Compartamos, a Mexican MFI with a banking license, sold a part of their CGAP analyzed the level and trend of microcredit shares in a public offering at an astonishingly rates, and compared these rates with other high price, which made some of the individual rates that low-income borrowers pay. Then we sellers instant millionaires. One important "decomposed" MFI interest income, looking at reason for the high price was that Compartamos the levels of its four main components: cost of was charging its clients very high interest rates funds, loan loss expense, administrative cost, and making very high profits. The annualized and profit. Finally, we briefly considered whether interest rate on loans was above 85 percent emerging competition can be expected to lower (not including a 15 percent tax paid by clients), rates in the future. producing an annual return of 55 percent on shareholders' equity. Interest rate levels In fact, most MFIs charge interest rates well below · Based on the best data available, the median those that provoked controversy in the case of interest rate for sustainable (i.e., profitable) Compartamos. But the story tapped into a deep MFIs was about 26 percent in 2006. The 85 well of concern about high microcredit interest percent interest rates that drew so much rates and the trend toward commercialization attentiontotheMexicanMFICompartamosare of microfinance. truly exceptional, rather than representative of the industry. Less than 1 percent of borrowers Are microcredit rates abusively high? Obviously pay rates that high. there can be no one-size-fits-all answer to this · MFI interest rates declined by 2.3 percentage question, not only because there are huge points a year between 2003 and 2006, much variations in the interest rates and related faster than bank rates. 3 Comparison with other rates Administrative expenses paid by low-income borrowers · Tiny loans do require higher administrative · MFI rates were significantly lower than expenses, which are not substantially offset by consumer and credit card rates in most of economies of scale. On the other hand, the the 36 countries for which we could find rate learning curve of MFIs as they age produces indications, and significantly higher than those substantial reductions. rates in only a fifth of the countries. · Administrative costs, at about 11 percent of · Based on 34 reports from 21 countries, MFI loan portfolio in 2006, are the largest single rates were almost always lower--usually contributor to interest rates, but they have vastly lower--than rates charged by informal been declining by 1 percentage point per lenders. year since 2003. This decline appears to be a · MFI rates were typically higher than credit true improvement in the cost of serving each union rates in the 10 countries for which borrower, not just the result of expanding data were found. But in the cases where the loan sizes. credit unions offered a specialized microcredit · We have no statistical way to quantify how product, their interest charges tended to be much avoidable fat remains to be trimmed the same as, or higher than, prevailing MFI from MFI operating costs. Given the finding rates. However, it is hard to make much of this about the learning curve--i.e., that the level information, not only because the sample size of these costs is strongly related to the age is so small, but also because we know little of the MFI--it would be unrealistic not to about the comparability of customers and expect substantial inefficiency at a time products. when most MFIs are relatively young, and when most national microfinance markets Cost of funds are immature and noncompetitive. We are unaware of any evidence to suggest that · MFIs have to pay more than banks pay when MFIs in general are out of line with the they leverage their equity with liabilities, and normal evolution of efficiency for businesses their cost of funds as a percentage of loan in such markets. portfolio (about 8 percent) showed no sign of dropping in 2003­2006. But it is hard to Profits criticize MFI managers for their funding costs, because they don't usually have much control · MFIs on average have higher returns on assets over these costs, in the medium term at than commercial banks do, but MFIs produce least. lower returns on equity for their owners. The median return on MFI owners' equity in Loan losses 2006 was moderate--12.3 percent, roughly 4 percent lower than the return for banks. The · MFI interest rates are not being inflated by very high profits that have drawn so much unreasonable loan losses. In fact, default rates attention to Compartamos are outliers, not at are very low--about 1.9 percent in 2006. all typical of the industry. February 2009 · At the same time, the most profitable universal the lower-interest-rates-through- 10 percent of the worldwide microcredit competition scenario will be. portfolio produced returns on equity All CGAP publications above 34 percent in 2006, a level that is no How all this information is put together is up are available on the doubt high enough to raise concerns about to each reader. We approach the issue from CGAP Web site at www.cgap.org. appropriateness for some observers. Much a development perspective, where the main of this profit is captured by NGOs and never concern is not financial results but rather client CGAP reaches private pockets. But some of it does benefit--including, of course, those future 1818 H Street, NW MSN P3-300 go to private investors. A judgment about clients who will get access to financial services Washington, DC whether such profits are "abusive" would as new investment expands the outreach of 20433 USA depend, not only on the observer's standard MFIs. A few MFIs have charged their borrowers Tel: 202-473-9594 for what is a reasonable profit, but also on interest rates that seem considerably higher than Fax: 202-522-3744 investigation of individual MFI circumstances, what would make sense from this perspective. including the risk levels faced by investors Indeed, it would be astonishing if this were not Email: cgap@worldbank.org when they committed their funds. the case, given the diversity of the industry and · Profits of sustainable MFIs, measured as the scarcity of competitive markets yet. © CGAP, 2009 a percentage of loan portfolio, have been dropping by about one-tenth (0.6 percentage The real question is whether unreasonable points) per year since 2003. MFI lending rates are more than occasional · Profits are not a predominant driver of interest exceptions. We do not find evidence suggesting rates. For the median MFI, the extreme and any widespread pattern of borrower exploitation unrealistic scenario of complete elimination by abusive MFI interest rates. We do find of all profit would cause its interest rate to strong empirical support for the proposition drop by only about one-seventh. Such an that operating costs are much higher for tiny interest reduction would not be insignificant, microloans than for normal bank loans, so but it would still leave microcredit rates at sustainable interest rates for microloans have to levels that might look abusive to politicians be significantly higher than normal bank interest and the public, neither of whom usually rates. We find a general pattern of moderate understand the high costs that tiny lending profits for MFI owners. Finally, we find that inevitably entails. interest rates, operating costs, and profits have been declining quite rapidly in recent years, Competition and we would expect this trend to continue in the medium-term future. · One cannot assume that competition will always lower interest rates. Interest rates do This Brief is a summary of "The New appear to have dropped in the markets where Moneylenders: Are the Poor Being Exploited microcredit has already become competitive, by High Microcredit Interest Rates," by Richard except in Bangladesh. But it is still too early Rosenberg, Adrian Gonzalez, and Sushma to make any robust prediction about how Narain (Washington, D.C.: CGAP, 2009). AUTHORS Richard Rosenberg, Adrian Gonzalez, and Sushma Narain