Finance

Efficiency is the key to lower interest rates

Microfinance research

02-Efficiency-in-microfinance

Microfinance provides millions of micro-entrepreneurs and low-income households in developing and emerging economies with access to essential financial services. While the importance of microfinance institutions (MFIs) in reaching unbanked sections of the population is widely acknowledged, they frequently also attract criticisms due to the level of interest rates they charge. 
In a Research Insight study dedicated to this topic, responsAbility looks at the correlation between microfinance operating costs and high interest rates and explains that increased efficiency can help to reduce the cost of microloans.

In view of criticisms about the interest rates charged by MFIs, responsAbility Research decided to analyse the factors that determine the cost of borrowing for microfinance clients. In a study first published in 2013 and subsequently updated, responsAbility Research identifies microfinance as a cost-intensive business. It explains that microfinance clients often lack traditional types of collateral or formal documentary evidence of their business activities and sources of income – making it more difficult for MFIs to check their creditworthiness and repayment capacity. As a result, MFIs have to employ different methods to traditional banks to assess their clients – such as sending loan officers out to visit clients in order to verify the existence and viability of their business. In remote rural areas, this can be a costly and time-consuming process.

The size of the loans granted by MFIs is also a factor determining operating costs and interest rates. MFIs generally offer smaller loans with shorter terms than conventional financial institutions. Given the labour-intensive process of handling credit applications, MFIs that disburse large numbers of small loans incur higher costs in relation to the amount of credit granted than financial institutions serving a high-income segment with larger loans. These operating costs account for around 60% of the interest rates charged to micro-enterprises and households.

Against this backdrop, responsAbility found that the enhancement of efficiency is key to sustainably lowering interest rates for clients. According to the study, progress is being made as the microfinance sector matures – with healthy competition, better regulation and market structures, increased economies of scale and innovation paving the way for improved efficiency. In fact, the MFIs analysed in the study were able to reduce their operating costs by an average of 28% over the last six years – led by MFIs in Asia – with interest rates also falling over that period. This means that both lenders and borrowers can benefit from the development of the microfinance sector.