Richard Rosenberg, Adrian Gonzalez, and Sushma Narain, CGAP’s co-authors, provide an in-depth look to address the question of whether microcredit borrowers are being exploited by unreasonably high interest rates. CGAP is an independent policy and research center that provides market intelligence and is dedicated to advancing financial access for the world’s poor. The organization is housed at the World Bank and is supported by over 30 development agencies and private foundations. This paper explores the components of microcredit interest rates in order to provide a framework for borrowers and other microfinance practitioners to determine whether “excessive” MFI lending rates are more than occasional exceptions.
The 28 page report provides the following three conclusions: There is no evidence to suggest any widespread pattern of abusive MFI interest rate through borrower exploitation. Rosenberg, Gonzalez, and Narain do find empirical evidence that operating costs are much higher for smaller microloans that regular bank loans; thus, suggesting that sustainable interest rates for microloans have to be (but not necessarily) significantly higher. Lastly, the analysis has illustrated that in recent years there has been a rapid decline in interest rates, operating costs and profits. The report expects this trend to continue in the medium-term future.
In order to understand the reports conclusion, one must understand the four main components that are reflected in an MFI’s interest rates: cost of funds, loan loss expenses, operating expenses, and profits. The report explores the fours components utilizing available data on 555 sustainable MFIs reporting to the Microfinance Information Exchange (MIX) through 2006, updated as of April 2008. MIX data for 2007 became available in October 2008; thus, too late for inclusion in this paper. A simplified version of the relevant formula is:
Income from Loans = Cost of funds + Loan Loss expense + Operating expense + Profit
The report states that the median interest rate for sustainable MFIs was roughly 26 percent in 2006. While the report noted that Mexican MFI Compartamos’s annualized interest rate (that drew so much public attention) on loans of 85 percent was high (excluding the 15 percent tax paid by clients), that was an exception. In addition, MFI interest rates have been declining by 2.3 percentage points a year since 2003. When comparing other rates paid by low-income borrowers, MFI interest rates are significantly lower than consumer credit rates in 36 countries for which the co-authors had reported.
When comparing MFI rates to credit union rates in only 10 countries, the average MFI rate was typically higher. MFI interest rates tended to be the same where credit unions offered a specialized microcredit product. However, Rosenberg, Gonzalez, and Narain conclude that while these MFI rates are higher than credit unions, it is not clear what to make of this data since the sample size is very small and there is limited information regarding the comparability of customers and products.
Cost of Funds
MFI’s interest expense as a percentage of their liabilities shows that their borrowings have been relatively expensive, averaging 5.1 percent vs 3 percent for commercial banks in the same countries in 2006. No additional detail is provided. The report also suggests that MFI managers on a “medium term” basis, usually do not have much control over these cost. While it may be difficult for MFIs to meet the hurdles for depository licensing, the co-authors believe that increasing reliance on deposit funding will lower costs over the longer term (as regulators authorize more MFIs to take savings).
Loan Losses
The co-authors believe that interest rates are neither increasing nor influenced by loan losses. Default rates due to borrower default were relatively low, at 1.9 percent in 2006. The global and regional loan losses as a percentage of GLP, average for 2006 are as follows: World (2.3 percent), Africa (4.9 percent), East Asian Pacific (EAP) (1 percent), Eastern Europe and Central Asia (ECA) (1.5 percent), Latin American and Caribbean (LAC) (3 percent), Middle East and North Africa (MENA) (1.2 percent) and South Asia (1.5 percent). According to the report, loan losses above 5 percent tend to become unsustainable for MFIs; however, the high average loan loss rate for Africa is driven by a few outliers.
Operating/Administrative Expenses
The report states that the only reliable way to determine whether MFI’s operating costs are appropriate is to conduct a study of each MFIs individual operation. Nevertheless, the co-authors believe that there are other factors that can provide insight to operating costs. Regression analysis provides evidence that there is a strong inverse relationship between loan size and operating expenses. Thus, tiny loans require higher administrative expenses that are not substantially offset by economies of scale.
Administrative costs have been declining by 1 percentage point per year since 2003 (from 15.6 percent in 2003 to 12.7 percent in 2006). This pattern holds true for all regions except South America. The analysis on the trend of operating costs was derived from a set of 175 sustainable MFIs that reported to the MIX for 2003 and 2006. The report suggests that as an MFI ages the learning curve should produces substantial reduction in terms of efficiency.
Regression analysis provides evidence that an age of an MFI is strongly associated with lower operating costs (in addition to excluding the effects of loan size and scale). In addition, operating costs (as a percentage of loan portfolio) tends to drop by 2 to 8 percentage points for each of the years 1 through 6, 1 to 2 percentage points for years 7 through 11, and less than 1 percentage point each year thereafter.
Profits
The report continues to provide a comparison of MFI profitability vs. bank profitability (measure by both return on asses and return on equity). The average return on MFI owner’s equity in 2006 was 12.3 percent (moderate according to the co-authors) vs. 17.7 percent for banks. Profits of sustainable MFIs (measured as a percentage of loan portfolio) have been dropping by one-tenth (0.6 percentage points) per years since 2003.
In addition, the most profitable 10 percent of worldwide portfolios (provided by the MIX) produced a return on equity above 35 percent in 2006. Rosenberg, Gonzalez, and Narain state “that over two-thirds of MFIs with these high returns were non-profit organizations, captured by NGOs and never reaching the private pocket.” The returns remain in the respective organization for further expansion of financial services. Interestingly enough, the report (analyzes 555 sustainable MIX MFIs, weighted by loan portfolio) concludes that completely eliminating all profit would reduce the median MFI’s interest rate by only about one-sixth.
Competition
While Rosenberg, Gonzalez, and Narain believe that competition amongst MFIs do not necessarily always lower interest rate, it appears to have decreased in markets where microcredit has become competitive. This evidence applies to all regions analyzed with the exception of Bangladesh. It is unclear to the co-authors why this is the case. However, the report concludes that interest rates, profits and administrative costs have continued in a downward trend from 2003-2006.
By Zoran Stanisljevic
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