Saturday, June 26, 2010

Microfinance ... what is the "right" interest rate?

Dear Colleagues

I am interested in the area of microfinance. This question has been asked:
Dear Group members,

We are going to start a new MFI and very keen to understand about setting interest rate for borrowers. We are going to fund it from personal sources through friends and relatives. We want to give some returns to our lenders also. Our main objective is to give loans to women entrepreneurs and don't want to charge them on high interest rate. Please suggest optimum level of interest rate to charge to borrowers. In future we are looking for commercial funding, please suggest how to approach them and at what rate they lend normally.

Look forward to your responses, thank you.
The financial analysis of microfinance institutions (MFIs) is something I follow with some interest ... but mainly because I do not want financial analysis to be the only way the performance of the MFI is measured.

I responded to the writer as follows:
Dear Colleagues

Personally, I would argue that there are many questions that need answering before addressing the rate of interest question.

Why is the MFI being created?

Is it to help people progress in some way ... maybe to progress in a very small step towards something just a little bit better ... maybe ... and there are hundreds of little things that can be helpful? Or is it to be more than anything else to become a financially viable institution that will eventually be able to do an IPO and make the founders of the MFI wealthy?

What is the source of financing?

In this case the financing is from family and friends ... who are expecting some rate of return. This is likely to be confusing because the scale of operations you are likely to be having is going to make your unit cost of loan operations high ... and to cover costs interest rates are likely to need to be 100% per annum and more. At the outset smaller operations almost all get some sort of financial break ... grant financing, for example ... and only move to sustainable and eventually profitable operations when scale has been achieved.

What is the value of the financing?

I am not totally opposed to high interest rates. The question that is important is how do the costs of borrowing compare to the value of borrowing. If access to money is going to save the lives of family members, then even if the access has a high cost, it is still worth doing. If high interest rates are merely to help extract as much profit from the lending process as possible ... then there are big questions and I would argue for something better. The key here is to understand the value adding dimension of the various transactions in play.

Personally, I am more interested in the cost and value interaction in the microfinance space than I am in comparing different APR interest rate calculations. In my view, the worst thing that can happen to an MFI is for it to start to look like and behave like a small commercial bank ... or worse, a big commercial bank.

The money from an MFI is of value to the client ... but it is the combination of money and mentoring where the MFI becomes truly valuable for the clients. Mainstream commercial banks forgot this years ago and the world has paid a high price for their "money only" focus behavior ... and in all likelihood it will be a very long time before all of the mess gets cleaned up.

Up to now, there are no mainstream banks that embrace the idea of value accounting ... it might happen one day ... but I am not holding my breath!

Peter Burgess

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