Wall Street Journal
August 11, 2015
In recent years, microfinance—distributing small loans to the poor—has been at the center of an intense debate about the ethics of charging low-income customers high interest rates and then making a profit from them.
Chuck Waterfield created a microfinance institution in Haiti in 1985 followed by one in Bolivia and has since worked with microfinance providers including in Peru and Mexico. In 2008, he founded Micro-Finance Transparency, a U.S.-based nonprofit that analyzes interest rates, fees and regulatory issues involving microfinancing institutions around the world.
The 57-year-old American, one of the judges for The Wall Street Journal’s Financial Inclusion Challenge, spoke to the Journal about some of the common misconceptions about microfinance interest rates, how microloan prices are set, and the ethics of making profit from the poor. Edited excerpts from the interview:
Why are microfinance interest rates usually higher than commercial bank rates?
Microfinance uses a labor-intensive method of disbursing loans, with loan officers going out and visiting clients face to face in rural areas, villages or slums on a regular basis. This is far more expensive than customers going to bank branches. Lenders have worked at improving efficiencies, such as grouping clients together for visits and reducing the amount of training that is bundled with the loan. But even so, operational costs are relatively higher than for conventional loans.
To give an example, if the lender spends $100 to manage a $1000 loan for a year, that 10% operating cost ratio needs to be built into the price—which includes the interest rate plus any fees. If the loans are smaller and you spend $100 to manage a $200 loan, then you’re at 50%.
How can a poor borrower pay back a microloan with a 30% interest rate, much less a 100% one? Isn’t this extortion that’s not much better than going to a loan shark?
Borrowers can and do pay back because a high price on a small loan is within their means. If the total debt of the client doesn’t get too high, they can pay it off, but there are serious doubts about the client being better off after paying all that interest. In borrowing for their microbusiness, clients potentially can invest that $200, make a quick return to cover the cost of the loan, and be better off.
However, the higher the price and the longer they are paying that price, the harder it is to come out ahead. Microfinance prices are high, but rarely are they as high as loan-shark prices. In addition, loan sharks tend to have higher penalties and charge interest-on-unpaid-interest, so clients get into a deeper and deeper hole. For the most part, microfinance refrains from this.
Photo credit: Chuck Waterfield
Given the higher operational costs of microfinance, what is a reasonable margin of return for a microfinance institution?
As we see, prices must necessarily be higher for the poor, just to cover costs. To add a profit margin on top of that makes the price that much higher. The industry needs to offer a reasonable profit to attract investment, but there is no industry definition of “reasonable profit.” It isn’t uncommon to find return on equity* consistently in excess of 25%.
* [Return on Equity is the amount of net income returned as a percentage of shareholders equity. It measures profitability by revealing how much profit a company generates with the money shareholders have invested.]
Why are microfinance interest rates not as simple as they seem?
It is rare to find a microloan with interest of less than 30%, and in many countries the average rates are 75% to 100%. It’s embarrassing, so there is motivation to hide the true price, especially if other lenders are hiding their true price. For example, it is very common in many countries for the price of microloans to be quoted as 3% per month “flat,” while commercial loans are virtually always calculated as “declining balance.”
With declining balance, the client each month would pay interest only on the balance of the loan. With flat, the client would be charged, say, 3% of the original loan amount of $1,000, for the entire duration of the loan even as they pay down the principal. Flat interest is nearly twice as expensive as declining balance interest because clients are charged interest for money they don’t owe.
What can be done to make interest rates more transparent?
The microfinance industry world-wide has tried voluntary self-regulation since 2008 but with varied success. Lending works better in countries where governments require “truth-in-lending” transparency rules for all lenders, and when that legislation understands the differences between microlending and conventional lending.
There are dozens of countries where microfinance is widely practiced and there is some truth-in-lending legislation in place, but in many of those countries, the legislation is not enforced. Some countries enforce legislation that has accidental or intentional loopholes to not reflect the full price. In other cases, the legislation only applies to one segment of the market, such as regulated banks, and not all lenders, such as private businesses and cooperatives.
Some countries with solid legislation are India, Cambodia, Bosnia and Herzegovina, and Ecuador, and the microfinance industry is urging other countries to learn from their example.
What happens if interest rates are too high? Doesn’t market competition naturally correct high interest rates?
Prices are hidden, so there is little price competition, and even if there were, there is no “one market price” for all microloans, but rather prices get dramatically higher for the smallest loans. That confusion means that high prices do not always mean high profits. One lender can charge 60% on their $200 loans and break even, while the competitor across the street charges 60% on their $500 loans and generates huge profits.
It might be assumed that interest rates would come down if a lender got more efficient, but market principles say market pressures set prices, not efficiency ratios. If the market is competitive, the most efficient lender will survive as the market drives down the price, but if the market is not competitive, profits come from the prices management chooses to set.
For more in WSJ’s ‘Financing the Future’ series, go to financingthefuture.wsj.com