ADB urges lower rates on microlending

The key to reducing interest rates on microcredit in a sustainable manner, is to cut costs through improved market competition, innovation, and efficiency, according to a study made by the Asian Development Bank (ADB).

"Interest rate ceilings are not an appropriate intervention, and there are no quick solutions or shortcuts," Nimal A. Fernando, ADB principal microfinance specialist said in the study entitled "Understanding and Dealing with High Interest Rates on Microcredit."

The paper was published in view of policymakers in the Asia and Pacific region becoming increasingly critical of high interest rates charged by microfinance institutions (MFIs), and of some countries moving to impose ceilings on these interest rates.

The ADB, through the paper, hopes policymakers gain a deeper understanding of the issues surrounding microcredit interest rates.

"This understanding will hopefully further enable them to pursue measures that would ensure both the continued growth of the microfinance industry and the enhanced access of poor people to affordable microcredit."

Fernando explains that interest charged on loans is the main source of income for MFIs. Yet in order to survive in the marketplace, MFIs, just like any other business, need to charge prices high enough to cover costs. Thus, because microlending remains a high-cost operation, microcredit interest rates are high.

The nominal interest rates charged by most MFIs in the region range from 30 percent to 70 percent a year (on a reducing balance basis).

The effective interest rates are even higher because of commissions and fees charged by MFIs. Other factors – such as the compulsory deposits for obtaining a loan, frequency of repayments, and the systems adopted to collect repayments – also raise the effective interest rates.

"Many MFIs in the region have thus adopted cost recovery interest rates on microcredit. A significant number of such institutions have been able to expand the depth and breadth of their operations," he added.

Even with concessional funds, MFIs must cost these at market rates when they make decisions about interest rates to ensure the sustainability of their operations because concessional funds cannot be considered a permanent source of funds.

Microcredit interest rates should not be compared with those charged by both commercial banks and excessively subsidized lending organizations. Commercial banks, for example, most often deal with large loans, and their transaction costs are lower than those of MFIs on a per unit basis, allowing them to charge lower interest rates than MFIs.

However, the ADB paper recognizes the importance of lowering microcredit interest rates. Because of their high cost, microcredit has not reached a majority of the poorest people and is not widely used for financing farming activities.

"Lower microcredit interest rates will help increase the depth and breadth of availability of affordable finance for poor households," it said.

Still, the paper argues that price ceilings are not the answer. Lenders will incur losses if a rate ceiling is set at a level less than that required for cost recovery. This will reduce an MFI’s willingness and ability to expand operations, and discourage potential investors from supporting the industry.

Rate ceilings will also reduce the creditworthiness of MFIs, reducing their ability to borrow from the market to finance their operations, and prompting a decline in the supply of credit, contrary to expectations of policymakers who seek such a ceiling.