Margin Caps for the Microfinance Industry?

A lot of attention has been around the issue of interest rates charged by microfinance institutions. In his comment “Sacrificing Microcredit for Megaprofits” in the NYT Muhammad Yunus claims that with institutions such as SKS of India or Compartamos of Mexico going public, “microcredit would gave rise to its own breed of loan sharks.”

But what actually makes a lender a loan shark? The focus has been primarily on the interest rates charged. Yunus suggests a rule of thumb:

The maximum interest rate should not exceed the cost of the fund — meaning the cost that is incurred by the bank to procure the money to lend — plus 15 percent of the fund. That 15 percent goes to cover operational costs and contribute to profit. In the case of Grameen Bank, the cost of fund is 10 percent. So, the maximum interest rate could be 25 percent. However, we charge 20 percent to the borrowers. The ideal “spread” between the cost of the fund and the lending rate should be close to 10 percent.

This rule of thumb proves to be overly simplistic. It basically imposes a cost-target for lenders, suggesting that operational costs should be covered by a markup of 15% on the cost of raising funds. It has been noted that many institutions fall short of such a rule of thumb.

The Reserve Bank of India has suggested a whole range of regulations regarding lending practicies, in particular it suggested a interest rate caps and lending caps. And it clearly tried to push their interlinkage lending program through self-help groups.

  • MFIs should lend to an individual borrower only as a member of a JLG and should have the responsibility of ensuring that the borrower is not a member of another JLG.
  • a borrower cannot be a member of more than one SHG/JLG.
  • not more than two MFIs should lend to the same borrower
  • maximal loan size of Rs 25,000, that too from a maximum of two MFIs – this effectively introduces a cap on lending
  • There should be a “margin cap” of 10 % in respect of MFIs which have an outstanding loan portfolio at the beginning of the year of `100 crores and a “margin cap” of 12 % in respect of MFIs which have an outstanding loan portfolio at the beginning of the year of an amount not exceeding `100 crores. There should also be a cap of 24% on individual loans.

See the whole report by the RBI.

Clearly, there are certain things that need to change in the microfinance industry, following the problems in India and especially in Andhra Pradesh. But regulators need to be very careful about the type of regulations they impose. We have to remind ourselves that microfinance institutions such as SKS and Compartamos came into existence only through initial subsidies and donations.

Profits are important in markets, as they signal to competitors that entry can be worthwhile. If regulation essentially imposes a margin cap, I think that this entry decision may be distorted. A margin cap essentially protects the interests of incumbent firms. If the margin cap is too low, then investors may be not willing to finance the fixed costs of entry. And here, institutions like SKS and Compartamos had a historical advantage, as their entry was basically financed by donors and through subsidies, which did not have to be refinanced.

Hence, a margin cap could stop the markets to evolve in the dynamic way it has done so far. Clearly, high interest rates are by no means desirable, but if we believe that these interest rates can be a signal to other players that entry may be worthwhile, we should not distort this signal.

So what should regulation be primarily focused on? Transparency!

Financial literacy is typically very low in developing countries and the interest rates charged by institutions tend to not include other types of fees or security deposits. Any deposit basically represents a reduction in the effective loan size and implies an increase in the effective interest rate that is charged.

This is something where the RBI has pushed quite strongly, increasing transparency is very important. Not only for the borrowers who have to pay the interest rates and hidden additional charges, but also to donors and social investors. I started to have a look at interest rate data from MFTransparency, which is an NGO that tries to increase transparency of pricing of microfinance loans. On their website, around 200 institutions report data on their loan products and on the interest rates charged for each of the loan products. Typically, these include all additional fees, taxes and security deposits.

I try to have a closer look at this data, as e.g. Scott Gaul and David Roodman have already done. What is really exciting is to see whether there are systematic interest rate differences between for-profits and non-profits.

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