A DETAILED LOOK AT MICROFINANCE

The traditional banking system requires that a borrower have collateral to receive a loan; the world’s poorest people have no such collateral. And traditional banks aren't interested in issuing small loans—$50 to $150—as the interest return doesn't exceed the transaction costs.

That said, how has microfinance been so successful?

High Repayment Rates

Microfinance institutions (MFIs) exist in many forms—credit unions, commercial banks, and, quite often, non-governmental organizations (NGOs). Many MFIs utilize lending methodologies that use social collateral in the form of peer groups to ensure loan repayment. Under this system, borrowers take out loans in groups of five to eight individuals. If a borrower defaults on her loan, the entire group is often penalized and sometimes barred altogether from taking further loans. This peer pressure encourages borrowers to be very selective about their peer group members and to repay loans in full and on time, resulting in the higher than 95 percent repayment rates industry-wide.

Shorter Loan Cycles

Microcredit loan cycles are usually shorter than traditional commercial loans—typically 6 months to a year with payments plus interest due weekly. Shorter loan cycles and weekly payments help the borrowers stay current and not become overwhelmed by large payments.

Appropriate Interest Rates

Clearly the transaction-intense nature of weekly payment collections, often in rural areas, is more expensive than running a bank branch that provides large loans to economically secure borrowers in a metropolitan area. As a result, MFIs must charge interest rates that might sound high—the average global rate is about 35 percent annually—to cover their costs.

For a financial institution to scale and remain sustainable, at a bare minimum it has to cover its costs. In the example below, a large bank (big lender) can charge anything over 14 percent to recoup its costs, whereas the MFI has to charge a rate of at least 31 percent to cover its costs.

What about price regulations for microcredit loans in the form of interest rate ceilings or subsidies to help reduce the rates charged to borrowers? Although many types of price regulation might be well-meaning, in reality they can cause a fatal blow to the MFIs that they affect. When MFIs are required to charge a pre-determined interest rate—which is usually much below the cost that the MFI incurs to acquire capital for lending and to operate its business effectively—MFIs are often forced to go out of business. As a result, those whom the MFI would have served are left without access to any financial services at all, which is why this type of regulation often is a disservice to the very people it’s meant to protect.

One should note that although MFIs may charge rates of 30 to 70 percent to cover their costs, these interest rates are still significantly lower than the 300 percent to 3,000 percent annual rates that many borrowers were previously paying to money lenders, and are typical of the local credit card interest rates in many developing economies.