In DepthThe QuestionShould goverments limit microfinance interest rates?


Posted on Friday, 26 November 2010 17:58

Should goverments limit microfinance interest rates?

By Arvind Ashta

Amidst a crisis in the Indian microfinance industry, legislators and bankers are asking if an interest rate ceiling in necessary to protect consumers and strengthen the performance of nonviable institutions. There is no global consensus on how and when to limit interest rates, but Professor Arvind Ashta analyses the many sides of the argument

The debate on whether microfinance should have interest rate caps is an old one. Different countries, including France, have imposed interest rate ceilings at different periods and on different kinds of loans. Some states in the US impose ceilings, and some do not. There are no interest rate caps in the UK except for some building societies. Thus, there is no global consensus, and the consensus in any one place changes over time.

In the microfinance industry, it is common knowledge that low transaction amounts lead to high transaction costs as a percentage of the amount loaned. Average interest rates were estimated at 28% worldwide in 2006, down from 35% in 2003.

How micro is micro?

Most people think that the average microfinance loan is $100. They are not aware that the EU considers any loan less than €25,000 to be microloan. The average loan for the average microfinance institution (MFI) that reports on the Microfinance Information Exchange was about $1,400 in 2009. This amount is skewed upwards by a few outlier institutions that lend huge amounts.

If we take the total loan portfolio of the 1,040 institutions for which data is available and divide it by the total number of borrowers, the average loan size comes to $700. This is close to what the median institution provides as credit – about $500. What is surprising is that 33% of the borrowers are in India and Bangladesh, where the average loan size from large institutions is $100-$150.

The largest institutions in terms of size are found in Bangladesh. These claim an interest rate of 15-20% per year. The next largest are in India. On average, they charge interest rates of 24-30% per annum.

Nothing to be scared about

If institutions lending small amounts can survive with interest rates of 15% to 30%, why should they be scared of interest rate caps at 30% or 40%? In November, Bangladesh decided to cap its microfinance interest rates at 27%. A month earlier, the Andhra Pradesh government in India placed a cap so that interest rates will not exceed the loan's principal. Those believing in absolutely free markets would not normally be in favour of interest rate caps because they keep supply from meeting demand. Or would they? Is it possible that behind the business loans provided by MFIs, credit card companies and consumer credit divisions of banks are eyeing the idea of reaching out to low-income consumers?

Follow the money

If institutions that hand out small loans can be content with interest rates of 15-30%, it seems logical that all the institutions giving larger loans should also be able to manage at such high interest rates. So, there seems to be no a priori reason for interest rates to be more than 30%. In the Union Economique et Monétaire Ouest-Africaine, a ceiling gives an effective interest rate cap of 27% for MFIs and 18% for banks. Here, the average loan size is much larger, and there is no reason why 27% should not be adequate in Bangladesh.

Except of course, if the economies of scale do not come down to loan size but to the number of borrowers – and there is some evidence of this. In that case, the largest microfinance institutions would be happy to have interest rate ceilings to block new entrants that have higher costs because they have fewer customers. Large entrants, like banks, would not be deterred: interest rate ceilings would become a source of monopoly power or oligarchy. In fact, to clean up the market of hundreds of small and often uneconomic institutions, an interest rate ceiling could be helpful to mainstream players. It also eases the choice for consumers who would no longer have to choose between 100 MFIs but between perhaps 10 or 20.

Mind the gap

Inflation is also a factor. Different countries have different amounts of it, and some countries could accordingly have higher rates. An MFI should be allowed some maximum spread between the rate of interest it gives for microsavings, which should also protect against inflation, and the rate it charges for microcredit. There are points on both sides of the argument, for and against interest rate caps.

The question to be answered is who should decide if there should be interest rate caps or not and, if so, at what level? Should the microfinance industry self-regulate or should the task be left to the legislators? Perhaps the legislator is the best judge and should decide whether to impose caps, and if so, at what level.

Arvind Ashta is finance professor and microfinance chair at the Burgundy School of Business

Last Updated on Friday, 26 November 2010 18:30

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