Students from Drake University (Des Moines, IA, USA) and Makerere University Business School (Kampala, Uganda) discuss their experiences during a joint seminar on sustainable development in Uganda.
Sunday, June 6, 2010
Microfinance Interest Rates as a Function of Transaction Costs
It is often observed that the interest rates charged to borrowers of micro-loans are quite high. According to the United States Federal Reserve Board, the average interest rate charged by commercial banks for a 24-month personal credit loan was 12.22% in the third quarter of 2005. The average annual percentage rate charged on credit card debt was only slightly higher at 12.48% for Q3 05; yet the APR charged for a typical loan by microfinance institutions (MFIs) in India ranged from 20% to 40% (p.4) in 2003. In lesser developed nations such as Indonesia or the Philippines rates reached up to 80% (p.4).These rates are quickly and errantly decried as exorbitant and usurious, when, in fact, they are the product of some of the most fundamental principles of economics and are advantageous not only for the lender, but the borrower as well.
Interest rates charged for lending are a function of a number of factors, of those, transaction costs and risk figure prominently into the derivation of microlending interest rates. Microlenders are subject to significantly higher transaction costs than banks in the developed world, both in absolute and relative terms. Three types of costs (p.3) are associated with the lending process: the cost of funds for on-lending, the cost of risk (loan loss), and administrative costs (identifying and screening clients, processing loan applications, disbursing payments, collecting repayments, and following up on non-repayment).
With regard to loan administration, Microcredit is an industry that is heavily dependent on personal contact for its execution (p.2). This is very time-consuming and resource intensive, and allows each loan officer to reach only a limited audience of potential borrowers.By contrast, much of the administrative process for commercial banks leverages technology for computerized credit scoring, communication with clients and payment processing. Not only is the administrative process less efficient for a microlender for each loan, but the problem iscompounded further by the fact that while a developed commercial institution may lend a large sum of money to one borrower, a micro-lender will lend very small sums to many borrowers, thereby multiplying the total administrative costs by X number of borrowers.
“Compare the costs of two hypothetical lenders, Big Lender and MicroLender, each of which lends US $1,000,000. Big Lender makes a single loan, while MicroLender makes 10,000 loans of US $100 each.
The costs of capital and loan loss risk vary proportionally with loan size. Both lenders need to raise US $1,000,000 to fund their loans and will have to pay the same market rate—say, 10 percent—for the money. If both lenders have a history of losing 1 percent of their loans to default each year, they will need a loan loss provision of that amount. Both lenders can cover the cost of their capital and their risk by charging 11 percent (10% + 1% = 11%) on the loans they make to their customers.
Administrative costs are not proportional to loan size. Making a single loan of US $1,000,000 might cost Big Lender US $30,000 (3 percent of the loan amount) in staff time and other expenses involved in appraising, disbursing, monitoring, and collecting the loan. Big Lender can cover all its costs by charging the borrower an interest rate of 14 percent (10% + 1% + 3% = 14%).
However, MicroLender’s administrative costs for each US $100 loan will be much higher than 3 percent of the loan amount.Instead of US $3 per borrower, MicroLender is more likely to have to spend US $20 or more per borrower. Big Lender has to deal with only a single borrower, but MicroLender has to deal with 10,000 borrowers who typically do not have collateral, financial statements, or records in the database of a credit reporting bureau. Many of these clients may be illiterate. Lending to, and collecting from, such clients, requires time-consuming personal interaction.
Assuming Big Lender’s loan is repaid quarterly, it has to process four payment transactions per year. MicroLender’s borrowers probably make repayments monthly or even more frequently, generating at least 120,000 transactions per year. While Big Lender’s administrative cost is US $30,000 per year, that of MicroLender is at least US $200,000. Covering this cost requires a 20 percent charge on loaned amounts, resulting in an interest rate of at least 33 percent (10% + 1% + 20% = 33%). Note that administrative costs may be much higher in young MFIs that are too small to take advantage of economies of scale.”
It quickly becomes apparent that a considerable portion of the higher interest rate charged to borrowers by microlenders is derived from increased costs associated with the transaction. It is a simple fact of business that costs must be covered in order to continue operation. Further premiums must still be added to the interest rate to account for the many and varied risks assumed by a micro-lender. These factors will be explored in greater depth in a subsequent entry.
At this point, it is important to keep in mind that despite these high interest rates, micro-loans still provide positive marginal benefits for borrowers. Moreover, the potential to increase these benefits exists as the infrastructure of the industry grows, lowering costs. And finally, the high rates charged by microlenders are still considerably lower than those charged by informal sources, such as local money lenders. These important topics will also be examined in full in the coming days