Unreasonable Interest Rates
The CGAP argues: “It is fair to criticize an MFI’s interest rates as unreasonable only if its profits or some controllable element of its costs is unreasonable.”64 In fact, many MFIs are very profitable. In the CGAP study, MFIs earned a 2.1 percent return on assets annually, which is well above the 1.4 percent earned by banks in the same countries. MFIs are usually not as highly leveraged as banks, which lowers their return on equity. Despite this, 10 percent of worldwide microcredit loans earned return on equity above 35 percent in 2006. These are high profits by any business criteria. The CGAP study concludes that MFI profits are high because “the microcredit market is still immature, with low penetration of the potential clientele by MFIs and little competition so far.” Monopoly rents and vulnerable consumers are the cause of high prices and profits in the microcredit industry.
The industry response is that the high interest rates are not due to high profits, they are due to high costs. Due to fixed costs in servicing a loan, it is proportionally more expensive to service a microloan than a larger loan. Moreover, the poor infrastructure in developing countries leads to high costs as well. However, this argument is not consistent with the empirical evidence. Chuck Waterfield analyzed 22 MFIs in Mexico (thus holding the infrastructure environment constant) and showed “a very wide range of prices (from 38 percent to 90 percent) within a similarly sized loan product.”65 Analysis of 48 MFIs in the Philippines and 31 MFIs in Ecuador yielded similar results. Using data from the Microfinance Information Exchange, figure 2.2 shows the
Figure 2.2 Wide range of interest rates Source: Microfinance Information Exchange.
average interest rate charged and the average loan size for 40 MFIs in Mexico in 2008. For MFIs with an average loan size in the $160-$210 range, the interest rates ranged from 29 percent to 118 percent. Since this analysis holds the loan size and environment constant, the price differential is likely due to local monopoly power which leads to high profits. Costs measured by operating expenses as a percentage of a loan portfolio also vary widely— from 25 percent to 55 percent—for Philippine MFIs with similarly sized loan products. Once again, since the analysis controls for loan size and the environment, the cost differential is likely due to some MFIs having unreasonably high controllable costs. In Bangladesh, the state-backed wholesale funder of microfinance publicly voiced concerns about poor borrowers having to pay high interest rates because of inefficient MFI operations.66 In a competitive industry, such wide differentials in costs and prices would not persist, and firms with inefficient operations and high prices would be penalized. This is further evidence that microcredit is a monopolistic industry, and supports the position that regulated interest rate caps are needed.
Nimal Fernando of the Asian Development Bank argues that interest-rate ceilings will reduce the availability of microcredit.67 The CGAP concurs that interest-rate ceilings “often hurt rather than protect the most vulnerable by shrinking poor people’s access to financial services.”68 The flaw in this argument is the implicit assumption that microcredit is a competitive industry. Price controls in a competitive industry will lead to reducing supply, but that is not true in a monopolistic industry. Figure 2.3 depicts the supply and demand curves for a monopolist with and without price controls. An unregulated monopolist produces output y* at price p*. Regulation imposes a price ceiling at p0. The outcome of the regulation is that price falls to p0 (from its original value at p*) and output increases from y* to y0. Even at this lower price, the monopolist is still earning positive economic profits. The intuition behind this is that the unregulated monopolist maximizes profit by restricting output (as compared to a competitive market) and charging high prices. The regulated monopolist increases
Figure 2.3 Price controls on a monopoly
y*, p*: output and price for an unregulated monopolist y0, p0: output and price for a regulated monopolist
output (as compared to the unregulated monopolist) and charges the maximum price allowed by regulation (so long as the price is above the marginal cost). Setting an appropriate interest-rate ceiling will actually expand the availability of microcredit given the current monopolistic nature of the industry. This should not be difficult since the gap between the competitive price and the monopoly price prevailing today is so large.
The CGAP paper also argues that interest ceilings can “lead to less transparency about the cost of credit, as lenders cope with interest rate caps by adding confusing fees to their services.” This hardly seems possible, since the industry already exhibits no transparency and adds many confusing fees even in the absence of interest rate ceilings. Moreover, as argued above, the industry should also be regulated with regard to pricing transparency.
The microcredit industry is characterized by too little competition and vulnerable consumers. There is enough empirical evidence that a significant fraction of the microcredit industry earns very high profits or has unreasonably high costs to warrant interest rate regulation.