An Appropriate Interest Rate: The Character of the Microfinance Industry

By Dennis A. Espinoza, KF10, El Salvador

When I first heard about microfinance I saw it as a great way to make reliable returns. The emphasis on the social returns was great and the possibility of financial returns was even better! I’m in!

Turns out it isn’t that simple.

A recent New York Times article as well as other news like a recent initial public offering have stirred an old debate. Essentially that limited borrower options, comparatively high interest rates, low default rates and an estimated total asset base of over $20 billion may be fertile ground for excessive profits. An important concern.

So how do we figure out what is an “appropriate” rate of return? Or, in other words, what is a reasonable interest rate?

It’s a tough question but I think we can get some insight from a recent exploitation of sorts.

There are various factors that led to the recent financial crisis but most theories explaining the severity can be boiled down to inappropriate measures of risk and return. Put simply, some investment risks were made incorrectly, some were made irresponsibly, and some were blatantly done with the intension to see failure for the sake of greater returns. The result essentially shut down capital markets and crippled industry leading institutions.

The situation is personally difficult to understand. How is it that an industry based on the allocation of funds for the development of ideas and innovations has done exactly the opposite?

Could something similar happen in microfinance?

Maybe.

Beside the fact that microfinance has a philanthropic connotation and Gordon Gekko personifies current thoughts on the broader finance industry, the differences between the two are limited. One industry just pulled the rug out from underneath retirement accounts, hard earned savings and longstanding businesses and the other is hoping to empower the poor… yet the two have very similar foundations. Hmmm?

So why are gains, growth and returns in microfinance different?

Two reasons:
1) The microfinance industry’s unique qualification of character.
1a) Interest rates in microfinance are skewed towards covering fixed costs while interest rates in traditional finance are skewed towards covering default risk.

Borrower’s character: One of the cornerstones of the microfinance industry is the high overall industry repayment rate. It’s impressive, and it’s based on character. Unlike lending based on the questionable attributes of a credit score, corruptible debt rating agencies or easily manipulated quantitative analysis, microfinance institutions usually vet clients based on extensive personal interaction. This ends up being a much better qualifier of character. It is also very expensive (see often referenced prior blog posts). If the qualification process is completed properly microfinance institutions will have high interest rates and maintain high repayment rates, avoid economic bubbles (maintain integrity of loans), and continue effective social returns.

But only if it’s done properly…

MFI’s character: Unlike traditional financial institutions intended to maximize shareholder’s equity, a microfinance organization’s character is based on its ability to maximize a borrower’s opportunity to improve his or her quality of life. It’s important to note that this may not mean reaching a rock bottom interest rate. Much has been made of what may seem like exorbitant interest rates but the argument ignores two important factors. (1) The services that an MFI provides in addition to a loan. Services such as healthcare coverage, life insurance, basic education and counseling among many others. Microentrepreneurs who work with MFIs with high interest rates aren’t always doing so out of ignorance or a lack of options – some borrowers choose to do so, which leads to the second oversight. (2) Borrowers must eventually determine what is in their best interest – more so than regulators. The most important tools we can provide to borrowers are more lending options and an understanding of how they should be evaluated. Education and options will encourage competition and ensure the institutions that most effectively provide solutions gain market share. (Instead of asking, “why are interest rates so high?” we should eventually be asking, “who can do it better?”)

So an MFI’s character may necessitate high interest rates but that still doesn’t explain how to avoid excessive finance charges. To ensure MFIs are acting in the best interest of their clients they must be held accountable…

Social Investor’s character: I’d venture to say that a social investor’s character is presently as important as a borrower’s in the future of microfinance. While I don’t want to deter future contributions, I believe making a social investment without properly monitoring the social return is similar to investing in a corporation without much concern for your financial returns or the value of your investment. At best you aren’t seeing the true impact of your investment and at worst you may actually be perpetuating the problem. I personally believe that the development of this industry will be based on the fact that a microfinance loan is not the same as a donation and we should act as such. In the same way that a financial investor looks for the best mix of risk and return, a social investor should ensure funds are attributed to the MFIs that are maximizing impact at limited financing rates, i.e. effective social returns. Doing so should keep MFIs accountable until we see sufficient competition within the market.

How can we understand and monitor social returns?
Mass social investing organizations like Kiva are in a unique position to provide transparency and help us understand the quantification of each stakeholder’s character. Initiatives such as the new platform to monitor social returns is one example. If you haven’t heard about the important development you can read about it here. Another example is the extensive qualification process to become a Kiva Field Partner. These measures will be very important in helping us validate effectiveness, social returns and interest rate practices.

There are also various other organizations that are working towards evaluating social impact such as, Microfinance Information Exchange, Inc. (MIX), Consultative Group to Assist the Poor (CGAP) , & Microrate among many others.

In the long run, I expect the industry to see more educated borrowers and more lending options . With more players in the market we should also see more innovations, efficiencies, and competition. In the same way that small businesses build an economy, the entry of new lending institutions should naturally regulate interest rates, maximize social returns, and determine reasonable financial gains. It should also prevent an MFI from becoming too big to fail. But until we reach that level of maturity the integrity of the industry will be based on each stakeholder’s character. Kiva and several other organizations are working towards developing transparency to avoid the inappropriate investments that occurred in the broader finance industry’s collapse but, in the end, it will be each stakeholder’s character that ensures the industry is on the right path, seeing the most effective social returns, and educating others to do the same.

Dennis A. Espinoza is a Kiva Fellow working with Apoyo Integral in El Salvador.