Don’t cap microfinance lending rates

Should lending rates of microfinance institutions (MFIs) — often 28-36 % — be capped? Some folk think so. Officials in Andhra Pradesh once closed down MFIs for usury, but the RBI came to the rescue, declaring there could be no cap on lending rates. Banning MFIs would only drive poor people into more expensive loans from moneylenders. MFIs have provided finance to 20 million poor people, whom nationalised banks could not reach. The RBI itself has promoted microcredit by classifying bank loans to MFIs as priority sector loans.

But now capping has again come to the fore. The finance ministry has apparently told banks to ensure that MFIs to whom they lend cap their lending rates at 22-24 %. This directly contradicts the RBI policy that there should be no interest rate caps, and the RBI is the regulator of banks. It remains to be seen whether the RBI will assert itself or give way on this.

Charging poor people 30% interest sounds terrible. Resentment is building up after the IPO of SKS Microfinance, India’s biggest MFI. Its shares were launched at Rs 1,000 and have soared to Rs 1,400. Other MFIs are queuing up for fresh IPOs. A sector that started as a service to the poor now looks a moneyspinner , attracting private equity funds with no social aims whatsoever. Some MFIs have a return on assets of 5-6 %, much higher than banks.

Is this unwarranted loot? Not at all, say the poor. They clamour for more such loans, and repayment rates exceed 99%, suggesting the interest rates are affordable.

Critics say the poor are financially ignorant and being duped. Wrong: the poor are astonishingly sophisticated money managers, simultaneously handling multiple assets and liabilities. Indeed, their annual financial turnover, as they juggle assets and liabilities, can be three times their net assets. This is detailed in a seminal new book, Portfolios of the Poor by four microfinance experts — Collins, Morduch, Rutherford and Ruthven. It should be compulsory reading for the finance ministry and all other critics.

MFI lending rates in India are lower than in Mexico or South Africa. Compartamos in Mexico lends at up to 100%, yet borrowers repay. How so? An annual rate of interest is meaningless for businesses with a daily churn. A vegetable vendor borrows Rs 300 to buy vegetables wholesale, selling these for Rs 450. Even if he pays 100% per year interest on his loan of Rs 300, it amounts to just 90 paise/day, a negligible portion of his profits.

Many poor Indians use MFI loans to pay off moneylenders. An MFI loan at 30% to pay off a moneylender’s loan at 100% is a blessing.

The poor try to save with chit funds, store cash at home, or deposit cash with ‘moneyguards’, who look after it. Yet all these bear risk: chit funds go bust, homes are robbed, moneyguards disappear. The poor will happily pay a fee for the safety, regularity and reliability of MFIs. If you exclude the loan processing fee or security deposit charged by MFIs, their effective interest is often just 24%.

The book tells the story of a woman who collects savings from poor housewives and returns these in a lump sum at the end of the year after deducting her fees — so the rate of interest is actually negative! Yet her services are popular because she enforces discipline in savings, and for this, people are willing to pay a fee. The same holds for the discipline of MFIs.

Critics say that since banks give priority sector loans to MFIs, they should control lending rates too. Others say MFIs with an IPO bonanza do not deserve priority sector loans. But why not? Exports are a priority sector, and Tata and Ambani are not denied export finance because they are big. Nor are they subject to caps on prices or profit margins. Some software exporters have operating margins of 100%.

Large MFIs can and have cut lending rates. But new MFIs lose money for years before breaking even at 36% interest. Weekly meetings with clients are expensive but inescapable: this enforces group solidarity and loan discipline. As loans rise from Rs 5,000 to Rs 15,000, operating costs fall and interest rates can be cut. When MFIs make large business loans with monthly rather than weekly repayments, then too interest rates can be cut. In semi-urban areas a single agent can handle 1,000 clients a week, but in remote areas no agent can handle over 200 clients, and that’s costly.

With such diverse conditions for different MFIs, a cap of 24% is a blunt, arbitrary instrument. Retained profits are vital for MFI expansion, but will disappear with caps, which will also bankrupt small, new MFIs. Caps will discourage MFIs from entering remote areas most in need of inclusive finance. A cap will benefit the haves (who already get microcredit) at the expense of have-nots.

Many MFIs want to become low-cost distribution networks for consumer goods. The poor buy tiny quantities of such goods, and so miss scale economies in buying. MFIs can agglomerate consumer goods for their clients, lowering prices. However, such diversification will entail initial losses. An interest cap will strangle diversification in the womb, financial infanticide so to speak.

Competition between MFIs is already lowering rates. Vinod Khosla, who has invested both in non-profits (Casper) and for-profits (SKS), says part of the bonanza from an IPO should go back to the clients. This excellent idea should become standard practice. MFIs should include this in their code of conduct.

If the finance ministry insists on MFI curbs, the least bad solution may be a cap on dividends. If high profits are ploughed back into expansion, it benefits new borrowers. That’s not the case if high profits go out as high dividends. Capping MFI dividends at 12% for the next five years will be better than an interest cap of 24%. This will still discriminate against MFIs: Infosys, Tata and Ambani don’t even try to promote inclusive finance, yet face no dividend cap.