Understand interest rates in microfinance
In Luxembourg, negative interest rates are increasingly common. In fact, this is a problem which we face when it comes to managing the Fund’s liquidity position. Given the low interest rates which we are used to, it can be very difficult to understand why the interest rates charged to micro-entrepreneurs may be so high. The portfolio yield averages 26%- this can be considered as average interest rates on all loans, stripping out the effect of interest rates in each individual country.
There are two perspectives on this:
MFIs are social businesses and strive to operate in a financially sustainable manner. This implies that interest rate on microloans must cover MFIs’ costs of providing the loans, refinancing the portfolio, and providing for bad loans. In addition, the pricing should include a reasonable profit margin to finance future growth.
This had previously been a challenge for LMDF’s partner MFIs and when we conducted research into the microfinance interest rates back in 2014, despite the relatively high interest rates charged by MFIs, the average yield margin was -0.5%, suggesting that our MFIs were, on average, making small losses after taking operating costs, risk costs and financing costs into account. When the same research was conducted in 2019, MFIs now have a small profit margin (1%), permitting them to better finance future growth.
Yet what is causing a partner MFI to go from an average interest rate of 25.9% (notably lower than the 29.6% in 2014) to this relatively weak profitability? The main expense is operations which accounts for 60% of the total rate.
There are several reasons why MFIs have such comparatively high operating costs. Business models for MFIs are based on proximity to their clients who operate mostly in the informal economy. Clients are often visited on a weekly basis. Second, MFIs of limited size need to amortise necessary fixed costs such as IT systems, management, or branches over many very small transactions. Yet we are seeing that these costs are reducing. Technology is supporting efficiencies and economies of scale are supporting these trends across many MFIs.
The other expenses include the financing costs. This has stayed remarkably stable for LMDF’s partner MFIs over the years at just over 7%. Risk costs and provisions, i.e. the cost of losses on underlying loans which MFIs have had to write off as unrecoverable, have also stayed relatively stable at just over 2%.
When analysing the cost structure of an MFI, it is important to keep two questions in mind.
- What is a reasonable profit margin for an MFI, or when does it exploit clients for its own interests?
- Does an MFI operate as efficiently as it should if costs are borne by the end clients through the interest rate charged?
We are confident that the answer to these questions, in the case of LMDF, is that MFIs do not generate excessive profits on the back of the poor and that operational efficiency is on average very good, as evidenced by the work we shall see from our MFIs in the rest of the report.
Pricing in microfinance is complex and it is insufficient to look at the supply side only. This second perspective looks at what we know about the demand side, i.e. how micro-entrepreneurs use microfinance, why they accept to pay what appears to us to as high interest rates and what alternatives are available to them.
Answers can be found in three fundamental needs that drive the financial activities of the poor.
First, poor people with limited access to formal financial providers crucially need a diversity of financial services and providers. Diverse services, formal (MFIs, banks, etc.) and informal (family, friends, colleagues, money lenders, etc.), help match irregular, unpredictable and low incomes with daily needs (food, shelter, education, health, etc.).
The continued existence of money lenders, even in environments where there is ample access to microfinance, illustrates the importance of a diversity of providers. Money lenders are probably much more expensive than microfinance in terms of interest charged but they are accessible and do not require lengthy forms and loan documentation to be filled out. They are also likely to be located just around the corner and hence complement the offering of an MFI, which may be located further away and may only be accessible through periodic visits from loan officers.
Second, poor households are most vulnerable if faced with emergencies. If the household wants to avoid making enormous sacrifices such the fire-sale of assets, poor people need flexible financial products to cope with their exposure to risks. Here, savings and insurance services are particularly important.
Third, poor people need reliable financial services. Within the countless uncertainties and exclusions which characterize poverty, access to reliable and fair financial services is very important and matters much more than the price.
Beyond these three fundamental needs, we should not forget the nature of the informal economy in which microentrepreneurs operate. The fact that even after paying back a microloan with a relatively “high” interest rate poor people are still able to make some money should imply that the rate of return on the cash they invested in their businesses is remarkably high. One often overlooked fact is that for most of these activities, the principal input is the time and skills of the micro-entrepreneur him/herself.