The microfinance industry has come under criticism for the high cost of loans or interest rates Microfinance Institutions (MFIs) charge on their loans to the target clients - who mainly are the poor and low-income earners. The criticism is somehow fair since it is logically trying to connect the objective of microfinance - which involves the reduction of poverty by empowering the poor, especially women - to the high interest rates charged on the loans meant for this purpose.
These critics conclude that considering the high interest rate charged by MFIs, poor clients after taking microfinance loans are in most cases pushed further below the poverty-line, and this worsens their already sorry state. This, they say, is mainly because the economic opportunities available to the productive poor cannot guarantee adequate returns or profit on their investment to enable them to repay the very expensive loans that they contract from the MFIs.
The reasons supporting some of these claims are linked to the stories that purport to indicate that some clients of microfinance committed suicide after being harassed by the officers of MFIs for defaulting on the repayment of their loans. In Ghana, such stories are not widespread but some of such incidents have been reported in parts of Asia. The microfinance critics again associate the causes of the suicides to high interest rates that lead to high default rates by some microfinance clients.
This and other reasons has prompted a proposal to introduce interest rate control or a ceiling for MFIs to help ensure that microfinance clients do not pay too much for the loans they borrow, and also to introduce uniformity in the pricing of microfinance loans. The achievement of this directive is expected to support the theoretical reasoning that cheap or affordable loans can increase uptake of loans by the poor and low-income earners, and will further improve the rate of loan repayment.
In an attempt to protect microfinance clients from the high interest rates charged, some countries have passed regulations as to the acceptable interest rate or interest rate margins MFIs in those countries can charge.
In the wake of the debate on high interest rates charged by MFIs, some people or governments have stepped in to propose the capping of interest rates. This according to proponents will prevent over-indebtedness and further prevent poor people from becoming poorer. There are current examples of some countries that have bought into the interest rate control debate and have moved to enact such regulations. For example, the Andhra Pradesh (AP) Region in Indian has enacted regulations to protect microfinance clients. Among the key regulatory issues is the introduction of an interest rate ceiling or interest rates capping for all MFIs.
The big question, however, that keeps coming up in the interest rate debate is: “is capping interest rates the way to go for the microfinance industry?”
Are micro loans too expensive relative to their operations?
The claim that interest rates for micro loans are high may only be true when looking at the interest rates as a figure without taking a critical look at the operative mechanisms of the microfinance institutions.
Most MFIs operate in economies that have serious developmental challenges characterised by low levels of infrastructure development that do not easily and effectively support their operations. The environments in which these MFIs operate are largely undeveloped, requiring very innovative but expensive means of improving access to financial services for the target-clients.
In order to improve access to financial services, MFIs must strategise to send their services to their target-clients, who mostly live in the least developed part of the countries where microfinance is helping to fight poverty. These strategies may include hiring mobile staff which may have to use motorbikes or other means to get to the clients for loan disbursement, collections, withdrawals and deposits mobilisation (if allowed by the country’s law). All these constitute high operating cost for MFIs.
In view of this, it is only normal for MFIs to adopt appropriate pricing of their services to ensure that it covers cost and leaves them with a margin or profit to satisfy their shareholders (that is, if it is a commercial MFI). It is important to state that the objective of commercial MFIs, like any other business, is to become sustainable by making profits from their operations. Sustainability is not only important for the MFIs but the entire objective of fighting poverty, since it is the only ingredient that will guarantee the existence of the MFIs to continue to assist the productive poor to participate in the process of wealth-creation.
The making of loans in small or micro amounts to clients is another important factor that adds to the operating cost of MFIs. Making and recovering small loans is costly on a per unit basis. Making micro loans is more expensive compared with advancing traditional loans. In microfinance, loan-recovery is largely executed by staff visits to clients (whether individual or group), and this is also a source of cost for the MFIs. These challenges are not the case with traditional banking, since the majority of their clients either walk to the bank to honour their loan payments or have standing orders for them.
The other issue that leads to high costs for MFIs is the cost of on-lending funds. In Ghana, for example, most of the MFIs finance their activities by loans from commercial banks or private investors. Ghanaian MFIs in most cases are only able to secure the funds they need at commercial rates from the universal banks. The truth is that MFIs in Ghana do not receive any special rate from the traditional banks.
They are treated just like any bank customer - irrespective of the fact that they on-lend the funds they contract from the traditional banks. In the case of MFIs raising funds from interested private investors, the decision to put their funds into these MFIs is only based on rates that are above what other banks will pay if they invest the same amount.
The lack of adequate funding with considerate rates and terms is one of the several challenges facing the microfinance industry in Ghana. In the absence of grants and aid that characterised the industry some decades ago, MFIs are sourcing commercial funds to meet their loan demands. In instances where MFI funds are largely from commercial loans, the MFI is obligated to repay the loans and its interest to improve their credibility. The cost of the funds is in this case passed on to the clients.
It is important to point out that the majority of MFIs in Ghana are yet to be successful in accessing funds from microfinance investment vehicles (MIVs) due to reasons which include the absence of clear legal regulations supporting their operations (susu companies), and lack of a clear and acceptable governance structure.
There are several additional reasons that make microfinance programmes expensive. For instance, the training and capacity-building performed by MFIs for their clients is economically expensive. This is one thing that most traditional banks do not invest in, since the majority of their clients are illiterates. Another reason is that granting loans to the poor and the low-income earners is known to be associated with high risk, and therefore MFIs - in order to safeguard their investment - mostly compensate for the high risk by ensuring that the price of their loan safeguards their investments.
From these and other reasons, it is evidently clear that the cost of loans from MFIs will be naturally expensive. In view of that, those people who think that programmes meant for poverty alleviation should be free or below the rates of the traditional banks should reconsider their position: rather, they should call for the education of microfinance clients to enable them take independent decisions that will enable them to shop for the best offers on the market before contracting any loan from competing MFIs.
Why capping or controlling interest rates is not the way out
Literature on interest rate control seems to express the fact that capping interest rates will pose a negative challenge to the microfinance sector as it did for the traditional banking sector some years ago. Such a regulation can also affect the ability of using credit to reduce the effect of poverty.
MFIs as lenders will incur losses if a ceiling-rate is set at a level less than what is required for cost-recovery. Implementing interest rate controls can reduce an MFI's willingness and ability to expand operations, and would further discourage potential investors from supporting the industry.
Furthermore, capping interest rates would reduce the creditworthiness of MFIs, thereby reducing their ability to borrow from the market to finance their operations. The long-term effect of this on the industry is that it would prompt a decline in the supply of credit, contrary to expectations of policymakers or governments who seek such a policy.
Adequate pricing of micro loans will partly ensure the sustainability of the microfinance industry and thereby sustain the various efforts in improving access to financial services for the poor to aid the fight against poverty.
Supporters of interest rate controls for the microfinance industry should support the industry to rather innovate in systems that will reduce the cost of their operations and further lobby governments to provide the needed environment for setting up more microfinance organisations that will inject competition into the industry, since competition can naturally help force interest rates down.
THE WRITER IS A MICROFINANCE OFFICER, ARB APEX BANK LIMITED
roayeh@gmail.com
