Series 3: ‘Does Interest Rate Matters in Microfinance’: Interactions with PoP Authors

Microfinance Focus, June 11, 2010: The virtual conference based on the book ‘Portfolio of the Poor: How the world’s poor live on $2 a day’, conducted on June 8-9 by MicroSave and Financial Access Initiative (FAI) attracted hundreds of industry experts. The two days conference was moderated by its co-authors Stuart Rutherford, Daryl Collins, Jonathan Morduch, and Orlanda Ruthven, and MicroSave’s Graham Wright.

Based on the findings of the book, the conference participants raised pertinent questions to the authors and many vital insights emerged. On the first day of the conference, its authors discussed the topic: Does Interest Rates Matter and Financial Drivers– Lessons from “Portfolios of the Poor” and the excerpts from the discussion are presented below.

Participant’s Question: Interest rate is an oft discussed topic. But do interest rates really matter? If
yes, when does it matter, and when does it matter more?

Stuart: We give a chapter of the book (chapter 5) to describing some of the interesting things about pricing that we learned from the diaries. Jonathan Murdoch has put together some introductory notes for the topic which I copy below. The big message in Chapter 5 (on prices) is that interest rate policy is complicated. That sounds like an evasion, but our evidence shows – strongly and clearly – that the literature so far has been too quick to leap to conclusions. The families we met care about prices. Given that they live on tight margins, they’re not eager to spend needlessly. On the other hand, they’re willing to pay for quality services. If given the choice of a low-quality service at a low price or a better service at a higher price, the latter often wins out.

Households are willing to pay for quality savings services, for example. Convenient, reliable, and well-structured deposit services are often rare and always valuable. Even very poor families we met can and do pay to save. Of course, they’d rather be paid to save, but the choice is not always there. When it comes to loans, it is often asserted that microfinance institutions make a contribution as long as their interest rates are cheaper than the local moneylender’s rates. This gives a lot of latitude to microlenders. But households don’t see it that way. One reason is that the price of an informal loan is often zero (for an informal loan from a relative or friend). A second reason is that moneylender loans are often taken for short-term needs. The costs of borrowing are then best thought of as fees-for-service rather than as “interest rates” (which economists view as rental charges for money).

Another reason that comparing moneylender loans to microfinance loans is an oranges-to-lemons comparison is that moneylenders are usually much more flexible in their enforcement of loan repayments. Customers often end up delaying payments (without penalty) and thus pay far less in “effective” interest to moneylenders than the annualized value of the rate that was initially agreed upon. So comparisons have to be made carefully, and conversations about pricing can’t be divorced from considerations of the quality of loans. In short, it’s complicated — but in perfectly understandable ways.

Participant’s Question: In the course of the discussion, we have been realising that interest rates do matter to clients even if they are not looked at in isolation. Was the client need; whether the need was for a short term day to day cash flow management or for building lump sums a determinant in the importance of interest to clients?

Stuart: The third of Denny’s questions is the easiest to answer using the research done for the book. For loans, yes, generally speaking the shorter the term and the smaller the amount, the less the rate of interest mattered. And vice-versa for savings too. But there was lots of ‘noise’ in these findings because so many other factors came in. Remember that the biggest group of loans, in all three countries, were interest-free, between family or friends or neighbours or employer-employee. Then, especially for loans, there’s the issue of whether the borrower really believed he or she would have to pay the stated interest. Organised money-lenders in South Africa, for example, didn’t seem to adjust interest charged for the term – so that the longer you took to repay the lower your effective interest rate! (See hard-bound edition, pages 138-9). Then in Bangladesh we found moneylenders quoting a high interest rates a way of limiting the amount they’d be called on to lend – and once that small amount had been lent it wasn’t uncommon for interest to be forgiven or forgotten or at least negotiated down

Participant’s Question: There is a rarely a financial product which will score high on all attributes desired by both the users and providers. In terms of designing better products, both the providers and users of financial services thus have to make strategic tradeoffs e.g. doorstep delivery will be more expensive; greater the flexibility offered, higher the risks of error and fraud etc. What are the key competing attributes for users and providers; how to reconcile strategic priorities for users and providers; does this ranking of what is most desirable from the perspective of users and providers similar across diverse contexts? How such analysis can be practically undertaken by the providers

Graham: This is an excellent observation/question. The trade-offs are huge … and quite often MFIs will conduct market research and get over enthusiastic about what they might do for their clients, thus creating loss-making products. The answer may well lie in undertaking high quality qualitative research to pinpoint what customers really care about and then to focus on addressing that issue … we see too many MFIs struggling to re-engineer aspects of products that are incidental to clients buying decision. So, for example, the MFI is focused on offering a grace period to differentiate itself in a competitive market, when the clients actually only really care about the initial loan amount or the loan tenure (which affects the size of instalments). MicroSave uses product attribute and relative preference ranking to understand the basis of clients real demand drivers … then working with the MFI to look at how they can address that within their products and processes, and assessing the cost/price implications of doing so

Financial drivers

Participant Question: Money management by the poor is often driven by the needs of the poor. The financial diaries revealed three key issues which determine financial behaviour. Lets discuss the three drivers of financial behaviour of the poor, which also form the three key chapters of the book

Stuart: Not only did we find many tools in use, we found that they were intensively used. Often the amount of money that households would push and pull through these tools in a single year was equivalent to a large percentage of their total annual income sometimes indeed it exceeded their total annual income. Obviously, the need to manage money in this way was felt sharply by our diary households. We found many reasons for this, but three in particular stood out. They were:

1. The need to manage money on a day-to-day basis. If you are living on a small income and its likely to be irregular and unreliable, then you need to store a bit of money somewhere, or be able to borrow a bit from someone,  just to make sure there is food on the table every day, and not just on days when income happens to come in. We found that this daily grind of ensuring that somehow or other the household could find money for small-scale but vital daily needs  such as buying ointment to get an eye infection fixed  before a daughter went on to damage her eye permanently  was responsible for most of the saving and borrowing transactions we recorded. The sums were often very small, but they were frequent and needed careful management. Chapter Two of the book deals with this need.

2. Coping with risk. Poor people are exposed to many kinds of risks. Half the Bangladesh households (and two in five of the Indian ones) fell into financial problems because of illness. One in five of the Bangladesh households lost their home during the diary year to flood or fire or government bulldozing. No less than four out of five South African households had their finances strained by the need to contribute heavily to funeral expenses. Formal insurance is mostly absent, so poor households need to find as many ways to hold savings as possible, and keep open as many channels to lenders as they can. Then, when catastrophe strikes, they patch together all the sources, but may still have to sell assets, to deal with the problem. No wonder they maintain as many money-management tools as they can find. See Chapter Three for much more on this topic.

3. Raising lump sums. Of course, it’s not just emergencies that cause a need to raise large sums. Even if you are poor, you still have to find big chunks of money for life-cycle events like schooling, marriage, home-making, child-birth, funerals and so on. In India and Bangladesh finding a way to finance marriages (especially for daughters) was a constant headache for parents. In South Africa the tradition of expensive funerals led many households to plan for them in advance through many ingenious savings club schemes. Like everyone else, poor households aspire to own assets that make life more comfortable fans and TVs, for example, and for these you need to raise money somehow you just don’t have enough money to buy them out of your normal cash-flow. Beyond that there is the need, felt by many households, for productive assets cycles, farm machinery, retail stock and so on. The countless needs for large lump sums are described in Chapter

Participant Question: I would like to ask you, what your findings and the ones of your co-authors reveal about adequate marketing-mechanisms, messages and communication channels for the poor? This would be especially interesting for savings products. Are there any new insights on this from your research on the financial diaries?

Daryl: We do see mental accounting coming up again and again – as Graham has also mentioned.   People try to label one stream of income for one purpose and another for a different purpose.   Why do they do this?  I think that the reason is because they are trying to make financial management as automated as possible – once they think about it, they will find other uses for the money.   Mental accounting is the stop-order of the poor. With that in mind, we can surely do much more experimenting around labelling accounts in different ways.  The problem is that there is a large number of permutations of these labels - so which is the right one?    It would be great to see a global round of simple focus groups to get started on the right path – this is a generic solution, but the labelling is unlikely to be generic across communities.  IPA is doing a project in Ghana that works with this idea, although the results are still outstanding. Communications are also an interesting frontier.  IPA is doing an experiment in Bolivia using text messages reminding clients to save.   There are some interesting results, which you can see on. And I think that we can’t ignore the experience that we’ve seen from major successes – simply labelling an activity correctly really makes a difference in its take up – I’m thinking of the M-Pesa “Send Money Home” message.

Catch the Session-wise summary on the discussions, Visit the Link

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