Microfinance: Capping Interest Rates

Microfinance Focus, November 22, 2010 (J. Charitha Ratwatte): India’s embattled microfinance industry, reportedly being unfairly blamed for  a spate of farmer suicides, brought about by poor and marginalized Indian farmers being indebted to rapacious money lenders and state sponsored micro lending schemes, have under pressure, been forced to cap interest rates on its loans in Southern Andhra Pradesh at 24%. Critics of microfinance claim that the suicides have been caused by company malpractice, heavy handed debt recovery and high interest rates.

Imposing interest rate caps is contrary to every known principle of microfinance, which has evolved over time. In Sri Lanka historically, generating the savings of village self help groups through Seetu schemes, savings and credit groups, thrift and credit cooperatives and Death Aid Societies, have a long and honorable history, going back over a hundred years. The dictum ‘Know Your Client / Borrower ‘, was the basis of operations of microfinance institutions (MFI), long before it became the fashionable cry of so called ‘anti money laundering’ commercial bankers.

MFI’s collected monthly savings from groups of cohesive, synergetic, homogenous, poor and marginalized people, mostly women, who when they had some experience of managing their own funds, were lent small amounts of money for their own income generating activities on an inter se guarantee basis, that group members guaranteed the repayment by a member of their group if any one defaulted. The micro lenders’ agents knew each family , intimately, their habits , were they spendthrift or wasteful, was the ‘pater familias’ ( head of household) an alcoholic, were the children attending school, were they healthy or sick, suffering from malnutrition , bad sanitation of lack of food etc.

Interest rates were fixed on the basis of a number of factors like the cost of money, how much had the MFI to pay as interest to depositors, at how much could the MFI raise funds from other sources, either subsidized sources such as donors or apex government agencies like Sri Lanka’s Janasaviya Trust Fund and its successor the National Development Trust Fund or at commercial rates from banks or investors.

In this kind of environment, it is an anathema to imagine capped interest rates. It is contrary to every known principle of microfinance which has evolved through the ages, both in Sri Lanka and other countries like Bangladesh, the home of Grameen and BRAC.

The Chief Executive of the Kingdom Bank in the UK has expressed the opinion that this situation in Andhra has developed due to a crucial change having taken place in microfinance that has contributed to the allegations of exploitation of borrowers, the change being of the motive, form none profit to profit. Initially MF was launched with the intent of benefiting the poor by using a commercial mechanism. Soon it became apparent that, firstly, the poor are good borrowers, who repay on time, unlike more up market individuals, and that if groups of poor people can be persuaded to assume joint and several liability for their individual debts, the probability of default drops sharply.

This is why bankers seek a third party guarantor for debts, an income tax payer, a government servant or a family member with assets. When this is coupled with an environment where the only competition is exploitative and usurious money lenders and loan sharks, demand for micro loans goes through the ceiling, naturally, and MFI’s scrambled to raise more capital from government, from banks, from donors, from high net worth individuals, investment funds and venture capitalists.

Many Indian MFIs converted to for profit companies and raised more than $500 million in private equity from foreign venture capital players.  Most of these investors expected a reasonable return on their capital, comparable to other investment opportunities available in the market environment. Just ahead of SKS microfinance’s $350 million IPO, its founder Vikram Akula, sold shares in SKS worth nearly $13 million. This happened with many more MFI’s such as Share and Spandana.

Indian policy makers and politicians have become increasingly uncomfortable with these large profits and personal fortunes being amassed in an industry ostensible dedicated to the alleviation of poverty. They conveniently forget that this rapid growth of micro lending which has been expanding in India at about 70% a year for the last 5 years, has boosted rural liquidity, helping to fuel a rural consumption boom, which kept India’s domestic consumption high through the world economic downturn, India kept ‘shining.

Before the cap on interest rates was imposed, Andhra’s MFIs offered their  6.7 million borrowers  the option of restructuring their outstanding loans totalling some $2.7 billion  in an effort to defuse the political backlash caused by the farmers suicides. Under the plan borrowers whose total debt service burden to all creditors, including the government and informal money lenders, exceeds 40% can restructure their outstanding debts to the micro lenders.

Alok Prasad head of the Microfinance Institutions Network said that the MF industry wanted to address the borrower woes and diffuse the state authority’s hostility towards microfinance. However the intense hostility and interference at the grassroots and were forced to agree to the cap on interest rates to counter the intense political back lash and the sector.

In Bangladesh too, Dr. Q.K Ahmad, the chairman of PKSF, a body that monitors microfinance has described Microcredit as a death-trap for the poor. He explains that poor people often borrow money without thinking of the consequences and that 60% of Bangladesh’s poor borrowers have taken loans from several sources. Further field officers of Bangladeshi MFI’s are judged on repayment rates, they sometimes use coercive and even violent ways of collecting instalments.

However some MFI’s like Grameen bank and BRAC, In Bangladesh have a policy whereby loans are re scheduled when clients face natural disasters, like floods, which are endemic in the country.  Prof Yunus of Grameen bank, the Noble Peace Prize winner of 2006, has labelled MFI’s that do not do so, as ‘the new loan sharks’! While the Nobel Prize may not create infallibility, there might be a point in his criticism, as Dr. Ahmed points out –‘there are some agencies which even take their payments from flood relief material! Prof. Yunus has been advocating a cap on interest rates in Bangladesh.

The latest news from Bangladesh is the regulator has placed a cap of 27% on the rate at which MFI’s could lend to their borrowers. The 1,200 MFI in Bangladesh, which has an estimated 40 million clients, must implement the cap by June 30, 2011.

In Sri Lanka, the state funded apex fund provider for MFI’s the National Development Trust Fund, the successor to the Janasaviya Trust Fund, has recently imposed a cap of 15% on their MFI partners on lending rate to beneficiaries. The apex provider lends to the MFI at 7%. This spread is considered by most MFI’s to be inadequate to cover their costs, risks and cost of money, particularly as there are restrictions imposed on the MFI’s taking deposits.

The draft law on microfinance regulation presently being discussed in Sri Lanka has a provision which would allow the regulator to cap interest rates. The regulator for licensed commercial banks and financial institutions has similar powers, but this power has never been exercised. However with developments in Andhra fresh in our minds, a cautious approach to such an enabling provision is sensible.

Farmer suicides in Sri Lanka are supposed to have taken place due to the inability of indebted farmers to sell their crop, especially paddy, for a reasonable price and thereby redeem their indebtedness. It is not over borrowing per se, as seems to be the case in Andhra. In any event in the Sri Lanka situation there are many safeguards both cultural and legal which work against over borrowing.  Culturally, people with high indebtedness are looked down upon in Sri Lankan society. The Buddhist philosophy of minimizing needs, the Christian dictum of ‘neither a borrower nor lender be’, Hinduism extols simple living and the Islamic dictum against usury, all militate against indebtedness.

Legally the Debt Conciliation Ordinance of 1941 provides a legal process for a debtor to go before a legally constituted panel to effect a settlement of all debts owed by him. On the present evidence, serious indebtedness is not an issue among clients of Sri Lanka MFI’s and it may be premature to try to impose remedies implemented in Andhra Pradesh and Bangladesh in Sri Lank at the present time.

About the Author: Mr. J. Charitha Ratwatte is an Advocate & Attorney at Law of Supreme Court of Sri Lanka since 1982. He holds 20 years experience in service of Government of Sri Lanka and retiring from the post of Secretary of Finance. He was Secretary to six Ministries and CEO of Apex Micro Finance whole sale lender and Youth Savings and Credit Micro Finance Cooperative Institution. Currently, Mr. Ratwatte is the Managing Director of Sri Lanka, Business Development Centre, a non profit provider of Business Development Services, International & National Consultant.

(Disclaimer: Views expressed in the article by the author are his own and do not necessarily represent those of Microfinance Focus. Microfinance Focus does not take any responsibility for correctness of the data presented by contributors.)

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