Interest rates on the small loans made by microfinance lenders have always been higher than the typical rate on commercial loans in the developed world, but over the past decade, they have become even higher. A recent paper, using data from over 1,500 microfinance institutions around the world, reveals that for the smallest loans, typically those less than $150, the average rate increased steadily from 30% in 2004 to 35% in 2011.
Although small loans have become more expensive, they have also become more popular. The global microfinance industry grew by 30% annually from 2004 to 2011, according to figures from MIX Market, a data microfinance provider. Strong growth has increased competition and given more market power to lenders. Banks and mid-market microfinance institutions realized microfinance can be profitable and started targeting the poorest clients. As a result, those borrowers have increasingly been taken away from low-end microfinance institutions, as banks and bigger microfinance institutions can make use of larger infrastructure and favourable economies of scale. The average loan size in the portfolios of many microfinance institutions decreased after 2006, suggesting that they were lending to a wider range of socioeconomic groups. To replace lost customers, low-end microfinance institutions started serving borrowers they had previously rejected as their credit risk had been judged too high.
Targeting riskier client has proved costly: More frequent defaults seem to have forced lenders to raise their rates to compensate for higher risks and funding costs. Development agencies that tend to finance most microfinance institutions have not been able to adequately respond to the industry’s expansion. This has forced some microfinanciers to raise capital from commercial lenders, whose substantial interest rates are then passed on to the microfinance borrower. Funding costs for low-end microfinance institutions increased by 70% between 2004 and 2011, according to Rosenberg (2012). Rising rates may seem disadvantageous for the poorest borrowers, but they are still preferable to the usurious rates of traditional moneylenders in African communities, who charge an interest of 100% or more. Karlan (2013) claims that overall borrowing costs might even have fallen, which is instrumental in alleviating poverty.
In Kenya, ATMs attract plenty of petty thieves. Unsurprisingly, cashless transactions have been increasingly popular in Nairobi and in other large African cities. Microfinance institutions were one of the first industries to implement cashless transactions. In Kenya, they started using M-Pesa, a mobile money application, to deliver loans to small-sized businesses soon after the launch of M-Pesa in 2007. Musoni, a Kenyan microfinance firm which has more than 10,000 customers and a loan portfolio valued at around $6.3m, is now attempting to use M-Pesa in an effort to break microfinance dependence on banks and make it more efficient. Cashless transactions are generally more secure: they could be traced and are hard to redirect, but transferring mobile money from lender to borrower with the intermediation of banks increases funding costs. Using mobile money services alone does not seem to be effective in streamlining the microfinance business model. Most microfinance institutions in Kenya already experience high repayment rates, at an average of around 97%. If efficiency gains are to be achieved, a more revolutionary approach would be needed. In order to make this happen, Musoni is transferring its activity to the digital realm. Its loan officers use tablets and a special application developed by the firm to collect and manage client data. They carry the devices around and use them, for example, when negotiating with owners of portable toilets in Mukuru, an informal settlement on the outskirts of Nairobi. These owners are entrepreneurs and charge their neighbours for using the toilets. They then sell the waste the toilets generate to Sanergy, a partner of Musoni’s, which turns it into fertilizer and biogas.
Loan officers could use their tablets to estimate how many people live around a toilet’s to calculate the business’s future cash flows, and to interview potential borrowers. The information is then stored in their tablets and on Musoni’s computers. If Musoni’s loan officers approve a loan, the money will arrive by text message to the applicant’s M-PESA account. The tablets’ wireless connection also allows loan officers to consult borrowers’ payment history when making a decision. Loan officers could also enlist potential clients to receive automatic payment reminders and advertising messages. This allows them to establish and maintain relationships with far more borrowers than they could do without the technology. Musoni will soon start paid licensing of its system to other microfinance organisations to tap into the desire of its competitors to harness technology in order to gain competitive advantage in an industry that is getting increasingly overcrowded. If this use of technology becomes more widespread, it will help decrease the cost of credit for many of the world’s 2.5 billion people who have no access to conventional banking. Some criminals have sensed the coming change and have started targeting mobile phones instead of cash as a coveted object of theft.
What effect do higher interest rates have on access to microfinance? It has been argued that demand for microfinance loans is highly price-elastic, and borrowers closely adjust their demand for microfinance with every change in interest rate. It follows that if interest rates increase, fewer borrowers will take out loans. This means that lowering interest rates could increase access to microfinance.
Another argument that has been put forth is that demand for loans is inelastic, and higher interest rates do not reduce demand from borrowers. One possible reason for this is that in Sub-Saharan Africa, the only viable alternative to microfinance is usually contracting with a moneylender, who would usually charge extortionately high interest rates. If this is true, increasing interest rates would broaden microfinance access as more funders will be tempted by higher yields to do microfinance. This will increase the total amount of microfinance capital in the economy and could eventually bring down prices again, as more lenders will enter the industry and undercut each other’s rates. However, an important point that could be overlooked here is that higher yields would invariably be associated with higher risk of default, so pricing the risk into the equation is a prerequisite for the efficient working of the model.
The research of Dean Karlan and Jonathan Zinman from 2013 attempts to identify a conclusive winner from the two theories above. Their research focuses on a microfinance institution in Mexico called Compartamos Banco. It has extended a mixture of expensive and cheaper loans across 80 different regions in the country. The difference between the high interest rate and the low interest rate has been about 10 percentage points.
The authors conclude that lower interest rates are the ones which improve access. Regions with lower interest rates had significantly more first-time borrowers after the first three years since the lending began. Moreover, lower interest rates did reduce profits for the lender: the number of loans increased, but the resulting higher income was counterbalanced by the cost of servicing additional borrowers.
The study concludes that the Mexican lender managed to expand while remaining financially stable. For microfinance institutions which aim to both make a profit and have a wider social impact, lowering interest rates could be a sensible way to improve access to microfinance. However, more research needs to be done on the effects of increased microfinance interest rates in more competitive microfinance markets, such as those in Sub-Saharan Africa.