Microfinance Interest Rate: A Factor of Operating Expenses or Cost of Funds?
By Asma Azmi, Microfinance Focus , March 19, 2010: The high rate of  interest rates of microcredit have been under the microscope of industry analysts for quite some time. A recent report by Mix Market analyses the methodology proposed by Dr. Yunus and its shortcomings for evaluation of microcredit interest rates, in his book ‘Creating a World Without Poverty’. The proposed methodology categorizes microfinance institutions into zones based on their interest rate premium, defined as the difference between the interest rate charged by the MFI and the cost of funds at the market rate paid by the MFI. With this definition, organizations for which the premium is up-to 10 percent points come under Green Zone and are categorized as ‘poverty-focused’ microcredit programs. Those which charge a premium of up-to 15 percent point fall under yellow zone. Prof. Yunus classifies institutions charging more than 15 per cent point as ‘profit-maximizing’ MFIs and calls them commercial enterprises whose main objective is to earn large profits for shareholders or other investors. He also refers to this zone as the zone of moneylenders and loan sharks. On doing an in-depth analysis, the report claims that the proposed methodology is an imperfect tool to sort out which MFIs are not serving the poor and which MFIs have abusive interest rates. It rather sorts out MFIs whose clients are easy to serve from those whose clients are harder to serve as measured by the operating costs. The analysis produces some ambiguous conclusions like, three out of four MFIs worldwide fall into the ‘red zone’ but still there is no evidence that institutions in any zone are making super-normal profits. Most MFIs that have low average loan sizes, suggesting that they reach poor are being mislabeled as in the red-zone. Non-profit NGO MFIs are found to be more likely in the red zone than for-profit MFIs like banks and credit unions. If the methodology is explored in the perspective of NGOs, only 9 percent of 349 NGOs fall in the green zone while 82 percent fall in the red zone. Whereas in reality NGOs tend to be more committed to serving the poor than other types of MFIs, but these results imply that they are profit oriented. As per Prof. Yunus methodology, a high premium indicates a high profit. But on the analysis of 761 MFIs which reported profit to Microfinance Information Exchange, Inc. (MIX) in2008, it was found that profits are a minor driver of interest yield and interest premium. Premium, which is the difference between the MFIs interest rate and its cost of funds, is largely governed by loan sizes and operating expenses. Fully 80 percent of the interest rate premium is explained by operating costs, with profits accounting for only 9 percent of the measure. MFIs disbursing smaller loans and reaching out to remote underserved populations tend to fall under red zone due to their high operating costs. MFIs disbursing relatively larger loans and having operating efficiency find a place in the green zone. The study illustrated the negligible role of profits in raising the interest rate premium against Prof. Yunus assumption. It showed that even if all profitable MFIs lowered their yield in the amount of their profits, so that their net returns are zero, it will still leave 61 percent of world’s MFIs in the red zone. On the other hand, if MFIs are assumed to be operational with the same operating cost as Grameen Bank in 2008, the percentage of MFIs in the green zone will be 35%, 26 % will be in the yellow zone and only 39 percent will be in the red zone. Clearly, the operating costs are more important in determining the level of premium than profit. Looking at the average component of the premium in 2008, 88 percent of it covers operating expenses, 10 percent covers loan recovery and provisions and 2 percent cover taxes. However the simple metric proposed by Prof. Yunus does not account for the single largest driver of interest rates, the Operating Expenses and the differences that exist between or within countries in the cost of service delivery. The main reason why microcredit interest rates are higher than those of other financial institutions is the higher operating cost necessary to deliver small loans, including administrative and personal expenses. “Lending $100,000 in 1,000 loans of $100 each will obviously require a lot more in staff salaries than making a single loan of $100,000. Recent researches also support the fact that international comparisons are very difficult to make, unless there is a way to consider the differences in cost structure between countries. This also explains why the best operating MFIs are from Asia, given the prevalence of low salaries and high staff productivity that contribute to the lower level of operating expenses. The appearance of Bolivia is explained by a combination of factors like mature market and relatively larger loan sizes which reduces its operating costs. The report does not legitimizes the high interest rates as the inevitable outcome of the costs of serving the difficult-to-reach clients but nonetheless it is a young industry and administrative costs appear to be declining rapidly with growing efficiency.  The core challenge to the microfinance industry is reduction of the cost of service delivery which will ultimately lower the cost of credit for the poor.

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