Understanding Micro-Finance Interest Rates: Some Fundamental Issues to Consider...

There has been a lot of debate about interest rates in micro-finance and rightfully so and in this post I look at what I see as some of the fundamental issues in this debate...I hope the RBI sub-committee looks into this aspect closely...and especially, at the key issues highlighted here... Let us start with the different costs that are incurred in delivering financial services to low income people. I see four major costs and they are: 1. 2. 3. 4. Transaction/Financial Transaction/Financial Transaction/Financial Transaction/Financial Costs Costs Costs Costs
Institutions Intermediary Clients Total

= = = =

TFC Institution TFC Intermediary TFC Clients TFC Total

Eq1

TFC

Institutions

+ TFC

Intermediaries

+ TFC Clients

= TFC

Total

This is the Basic Equation

Total Costs (TFC Total ) and Apportioned Costs of Delivery Will Vary Across Models, Contexts and Related Parameters: First, the total and apportioned costs will vary by the model used (group versus individual, bank/MFI branch based Vs centre meeting based Vs agent based), the number of years in operation and life cycle stage of the different channel partners, the economies of scale and scope available including aspects of fixed/variable costs, the trade-off between risk, efficiency and controls in delivery, the product strategy (in terms of savings versus loans versus savings + loans +others), the number of channel partners, the strategic context (including clients and geography), the basis for the competitive strategy in terms of differentiation Vs quality Vs cost leadership (this can also be thought of the overall strategy of managing total costs). The equation below should explain this better: First, Total and Apportioned Costs of Financial Services Delivery to Low Income People = Function of Model Chosen, Life Cycle Stage and Age of Channel Partners, Economies of Scale and Scope Available, Trade-Off Between Risk, Efficiency and Controls, Product Strategy, Length of Channel, Strategic Context and Competitive Strategy And we need to recognise that all of the above are INDEED strategic choices exercised by organisations, depending on various factors... Therefore, we must understand that it would not be appropriate to expect all institutions to be able to deliver financial services to low income people at the same interest rate/level of fees. That said, I am not arguing for any (high) level of interest/fees to be charged from low income people all I am saying is that, we need to be sensitive to the fact that, it may not be possible for all different models to come under a specific rate. The key question would be to determine the following for a typology of contexts, models and related parameters: Given a context, model and related parameters, what constitutes the optimal range of interest/fees that need to be charged from low income clients to fully cover total costs?

The above critical aspect is best understood through the following example: For Grameen MFI A Full Cost is 36% as it is operating in a hilly and difficult terrain; For SHG MFI B 22% is the full cost as it lends directly to SHGs; For SHG federations or Cooperatives, 18% could be the full cost because they accept deposits which are the cheapest source of non-subsidized capital and so on. [There numbers given above are merely illustrative and they can vary from context to context and model to model so, please do not join issue with me on this. Thanks]

This would be fair approach in my opinion and the RBI Sub-Committee must try and recognise this, study this aspect1 and make recommendations accordingly. Please note that my emphasis is on understanding what the full (total and apportioned) costs are and this could be very different from full (total and apportioned) cost recovery (taken up next). Now, with the total and apportioned costs for different contexts, models and related parameters - that need to be charged for a full cost recovery out of the way, let us get to next aspect...how much to recover? How Much To Recover and In What Manner?: This is again a strategic choice aspect and different models do it differently. There are two major ways in which this cost recovery can be handled: a) Apportion the same across the institution, intermediaries and clients; and b) Decide on the extent to which costs will be recovered and balance will be subsized. We will look at each of these issues separately.
S No Eq1 Eq 2 1 TFC TFC
Institutions Institutions

= Recovered Cost (as Interest plus Fees etc) + Unrecovered Cost Eq 3 TFC Institutions + TFC Intermediaries + TFC Clients = TFC Total = Recovered Cost (as Interest Plus Fees etc) + Unrecovered Cost (Direct Subsidies + Cross Subsidies + Indirect Subsidies + Hidden Subsidies). I make no value judgment on subsidies here except saying that subsidies represent an opportunity cost to society and need to be used appropriately and carefully.
Intermediaries Total

+ + TFC + TFC

2
Intermediaries

+ 3 + TFC Clients + TFC Clients

= = TFC = TFC

4
Total

This is the Basic Equation

As you can see above, the full (total and apportioned) costs comprise of two portions Recovered and Unrecovered. And the Unrecovered Cost contains a range of subsidies Direct, Cross, Indirect and Hidden Subsidies. Therefore, in some sense, there is always full cost recovery through interest plus fees and a range of subsidies. Therefore, a second strategic choice entails decision making with regard to the extent to which full (total and apportioned) costs are to be recovered and extent to which different kinds of subsidies are to be provided. Second, while there is always FULL cost recovery in a sense, what needs to be clearly understood is how much of this is actually recovered (from clients etc) and how much of this subsidized in various forms?

I will also try and outline the methodology, for under taking such a study, to determine full costs for different models, in a separate post.

The above critical aspect is best understood through the following example: MFIs perhaps charge 2436% or more and recover all/most costs and sometimes even have a surplus. Banks charge 12% and cross-subsidize costs; SHG federations or Cooperatives charge 24% and recover full costs and Government programs perhaps lend at 3-6%, with the major costs being subsidized. [There numbers given above are merely illustrative and they can vary from one organisation to another so, please do not join issue with me on this. Thanks] So, in some organisations, the whole cost is recovered where as in others, there is only partial cost recovery and the rest is subsidized. MFIs perhaps charge what they charge because they have less of subsidies and practice door step banking; Cooperatives and Community models perhaps charge what they do because of using local and low cost staff and community for various aspects and also have access to savings (which is the cheapest source of non-subsidized capital); Banks charge what they do because of the norms set by regulators and supervisors and manage the actual (unrecovered) costs differently through cross subsidies, outsourcing etc; and Governments directly subsidize clients and charge as low as they do for various reasons

Some special comments with examples are in order here: Fully sustainable organisations (as brilliantly explained by Jacob Yarons SDI) recover all costs. Also, sometimes, the recovered cost could be so high as to generate a surplus, even after accounting for subsidies perhaps. There are also models which recover full costs and yet receive subsidies! For example, in certain urban models, clients remit money at the institutions office as loan repayment and same happens with loan disbursement, which clients collect from the teller counter. This reduces TFC Institutions and increases TFC Clients , on relative terms [Relative to each other]. In other models, loan disbursement and repayment occurs through cheques (and the banking system) and SHGs take responsibility for this. Here, the TFC Intermediaries increases and TFC Institutions and TFC Clients decrease. In the traditional bank linkage model, the SHG is the intermediary and all transactions are through it. The SHG leaders withdraw and deposit money. Here too, the TFC Intermediaries increases and TFC Institutions and TFC Clients decrease. In a classic Grameen model, the Centre (or equivalent) at the Village (local) level is the intermediary and its cost becomes part of the institutions cost. Thus, TFC Institutions increases where as TFC Clients decreases as this is almost doorstep banking

Also, different models try to reduce overall costs by doing things differently as shown below: 1. As many models have demonstrated, a creative way to reduce transaction cost is to off load some activities to be performed by either the clients or another low cost outsourced intermediary (SHG Bank linkage). This is one way to reduce transaction costs o Urban models have got clients to make repayment at their offices and also disburse loans at offices, often using the Solidarity or Neighbourhood Group Methodology this aspect can greatly reduce costs for the institution. To reduce costs for clients, some models get the group leader or different members to make repayments on a monthly basis as the costs are then shared between them. The use of monthly repayment is yet another strategy to reduce transactions costs and there are many more o Likewise, SHG leaders perform these tasks for and on behalf of their Principals and Agents

2. 3. 4.

5.

6.

7.

A second way is to cross-subsidise activities as Banks/MFIs have demonstrated by lending to not-so-poor clients A third method is to directly subsidize the transaction costs and this is done by the Government in many cases A fourth way is to use local staff/intermediaries to drastically reduce costs and information asymmetries and enhance social acceptability. This is done by CDFIs, Cooperatives and others. Peer monitoring, outsourcing of the loan sanctioning function to peers on a segmented basis etc are some practical strategies here A fifth way is to employ technology to reduce transaction costs. Many experiments are being tried and we need to really evaluate these closely in terms of the additional infrastructure costs. A good MIS is a great strategy to reduce transactions costs and for example, member details can be incrementally changed on the MIS on an as is required basis rather than re-writing details over and over again as in case of manuals loan forms and there are several strategies that can be used here to reduce costs. The use of imaging technology also perhaps helps reduce costs A sixth way is to segregate standard/non-standard tasks and derive economics of scale in standard tasks. For example, at some MFIs/Banks field workers/officers sometimes manage 700-1000 good borrowers where as delinquent borrowers are managed by special task field workers, where the case load could be even less than 50. A seventh way to derive economies of scope in distribution by delivering a range of financial services to same set of clients insurance layered on savings, insurance layered on credit etc but there are (lock in) issues in using the same set of clients

To summarise, the aspect of transactions and financial costs primarily centres around strategic decision making that organizations make on the following basic aspects. What brings diversity in terms of the costs is the strategic choice that organizations exercise with regard to the following basic decisions: Whom to serve Clientele? Especially, the decision on whether to serve the poor, not-so-poor, unreached, reached, men, women etc How many clients to cater to? Where to operate? And How to Expand? Outreach, Geographic Dispersion and/or Growth Strategy (Incremental, Quantum etc) What Specific Services to offer to the clients Products (financial intermediation encompasses a large number of products and combinations there of) What methods of service delivery to employ Channels? and How to organize these channels? like, Groups, Individuals etc and their Tasks/Roles and outsourcing if any the implications there of? What organizational mechanisms to use Legal/Institutional Forms?, and How to communicate the availability of various services etc Promotion? What the long term objectives are Single versus Double versus Triple bottom lines?

Therefore, it is humbly submitted to the RBI sub-committee that interest rates should be better understood in terms of: a) the range of full costs to be recovered for alternative models in different context; and b) the actual proportion of cost recovery through interest/fees and various kinds of subsidies. Without this understanding, condemning the interest rates charged by MFIs seems somewhat unfair and unjustified...and it is sincerely hoped that decisions on (regulating) interest rates would be made only after undertaking a rigorous national study...encompassing alternative models in various contexts...