Research InsightEfficiency is the key to lower interest rates in microfinance

Executive SummeryMarch 2014

Key findings

■ Microfinance provides hundreds of millions of low-income households with access to financial services. However, the small loan volumes and a lack of collateral or documentation lead to high operating costs for microfinance institutions (MFIs).

■ During the last five years, it was possible to reduce these operating costs by an average of 23% – resulting in a significant increase in efficiency.

■ Healthy competition, effective regulation and appropriate market structures – but also innovation – are key drivers of the increase in efficiency.

■ Borrowers also benefit from this enhanced efficiency. Operating costs account for around 60% of the interest rates charged to micro-enterprises and households. The achievement of higher levels of operating efficiency allows MFIs to charge lower interest rates on a sustained basis.

■ Like operating costs, interest rates decreased in the period from 2008 to 2013. This means that both lenders and borrowers benefit from the development of the financial sector.

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Microfinance finds fertile ground in countries and markets where traditional financial institutions have failed to reach the poor. In these countries, the supply of capital to micro-entrepreneurs and low-income households is far below demand. Microfinance addresses this gap by providing previously ex-cluded populations with access to formal financial services such as credit loans, savings accounts and payment transfers. The alternatives to microfinance are either lack of access to these services or reliance on informal sources. The latter includes, at best, family and friends under similar economic duress or, at worst, unregulated private lenders with poten-tially predatory and usurious practices.

The access to formal financial services is clearly superior to the alternatives; however, microfinance faces severe restrictions in many countries due to weak and unreliable infrastructure. These limitations can include limited and costly access to electricity and a patchy and run-down transportation infra-structure. In addition, microfinance clients often lack formal proof of their economic activity. While a Western European businessman applying for a loan can readily provide a wage statement or formal business registration as well as financial statements, micro-entrepreneurs have difficulties proving their sources of income. Regardless of these circumstances, how-ever, microfinance institutions (MFIs) must still assess their clients’ repayment capacity and credibility.

Costly operations a major factorAs a result, MFIs must assess their clients differently. To verify the existence and feasibility of a business, for instance, a loan officer must visit the client, and in most cases also their private home. In distant and sparsely populated rural areas, this can be costly and time-consuming. Faced with these challenges since its early days, microfinance strives to meet them head-on. For example, an efficient organization of areas and routes to visit the clients with as little travel involved as possible is key. The introduction of group loans also lowers the costs of lending. In this concept, a loan is provided to a group of borrowers who are jointly liable for the loan. For the MFIs the

group liability reduces the risk of default1 by the borrowers, and lending to a whole group of people also reduces the time and costs spent to visit the clients.2 Furthermore, the imple-mentation and usage of credit bureaus,3 which has increased as the industry has matured, eases the credit assessment process significantly.

Thorough assessments of clients’ repayment capacity help reduce the likelihood of default and overindebtedness and pro-mote the sustainability of the MFI. The comparatively rigorous assessment methods required, however, increase an MFI’s operating costs. Personnel costs account for the largest portion of total operating expenses, representing around 60–70% of the total, followed by administrative expenses. In our core portfo-lio,4 the average MFI bears operational expenses5 totaling 18% of the provided loan size. This means that for every loan of USD 1,000 the MFI has to pay, on average, USD 180 are re-quired simply to carry out the operation. With this amount the institution has not yet covered the costs of refinancing itself and provisioned for potential loan losses or made any profits.

Size matters In addition to having different client assessment procedures, MFIs offer significantly smaller credit amounts than traditional financial institutions and often at shorter tenors. Loans pro-vided by the MFIs in our portfolio start at USD 100 and average around USD 3,000.

As illustrated in figure 1, the operational expenses for making a loan are closely linked to its size. In general, MFIs with smaller loan sizes and greater penetration into rural areas have a higher ratio of operational expenses relative to loan size.6 However, this does not necessarily mean that MFIs disbursing low amounts are inefficient. For example, assuming that the average cost of providing a loan stayed approximately the same in absolute terms, regardless of the amount dis-bursed, an MFI serving a low-income segment with small loan sizes would have relatively higher operational costs than an MFI serving a high-income segment with large loan sizes.

Lowering operating cost and interest rates in microfinance

1 Microfinance clients often do not possess any viable asset to pledge as collateral. In order to make borrowing also available to those clients, MFIs also provide loans without underlying securities. However, in case of a defaulting client, MFIs could potentially lose the whole amount lent and are not protected by the value of the collateral (as is generally the case in traditional banking). To overcome the lack of traditional guarantors or formal documentation, for instance, MFIs have introduced the concept of joint-liability group loans, whereby a group’s commitment to pay serves as collateral for the loan. At the same time (as explained above) this also allows the MFIs to process the loans more efficiently than if they had to interact with every individual client.

2 Instead of meeting every single client separately, the loan officer can interact with the whole group at once.

3 Credit bureaus record the client’s outstanding loans and their credit history and indebtedness. By accessing this information, MFIs are able to reduce the informational asymmetry.

4 The responsAbility core portfolio consists of 100 MFIs that are considered representative of the investable microfinance universe and currently account for a total outstanding loan portfolio of USD 28 billion.

5 Operational expenses usually consist of three main components: personnel expenses, administrative expenses and amortizations.

6 For example Hermes et al (2011): Outreach and Efficiency of Micro- finance Institutions. In: World Development, Vol. 39, No. 6.

On average, MFIs in South and Southeast Asia have substantially lower operational expenses. This is largely due to the fact that MFIs in this region – especially in India – mainly lend through groups, the advantages of which were described above. Further-more, population density and the rather low salary level certainly help as well. While MFIs in South America also exhibit compa-rably lower costs, this is not explained by a higher proportion of group loans. Rather, South American countries have more mature financial sectors and higher economic output than other regions. As a result, MFIs benefit from access to better infrastructure and labor, allowing them to operate more efficiently. Further-more, because they operate in a more developed economy, their clients require larger loan sizes to meet their financing needs. These elements help explain why South American MFIs tend to operate more efficiently than their counterparts in, for instance, lower-income countries in sub-Saharan Africa with less mature financial sectors. Nevertheless, there is clear indi-cation that these sectors will catch up over time.7

Clear efficiency gains over timeWhile the preceding section presented a static view of an MFI’s costs, this section sets out to demonstrate how they evolve over time. To do so we will examine responsAbility’s core portfolio, which consists of 100 MFIs that are considered to be repre-sentative of the investable microfinance universe and account for a total outstanding loan portfolio of USD 28 billion. As can be seen in figure 3, unweighted8 average operational expenses as a share of the loan portfolio have decreased by 23% between 2008 and 2013. In the meantime, the loan size in relation to the gross national income remained relatively stable.

Figure 3: Operational expenses over time

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Figure 1: Operational expenses in relation to average loan size

The two peculiarities of microfinance – more labor-intensive operations and smaller disbursement amounts – lead to higher costs as a percentage of credit disbursed.

Large variations across marketsA comparison of costs across different microfinance regions reveals significant variations in operational expenses (see figure 2). While these are partly explained by the size of the average loan amount, they are mostly the product of varying underlying sector- and region-specific factors. While there are significant variations within each of these regions, some general conclusions can nonetheless be drawn.

Figure 2: Regional differences in operational expenses

(median, in % of loan portfolio)

7 Rosenberg et al (2013): Microcredit interest rates and their determinants. 2004–2011.

8 The numbers in this report are all calculated as unweighted averages of the portfolio institutions in order to not overrepresent the largest institutions in the portfolio.

Source: responsAbility Research

50

45

40

35

30

25

20

15

103,000 5,000

Ope

rati

onal

exp

ense

s (i

n %

of

loan

por

tfol

io)

2,0001,0000

Average loan size (in USD)

4,000

Source: responsAbility Research

50

45

40

35

30

25

20

15

10

5

0Asia

PacificEasternEurope

SouthAmerica

Middle East,Northern

Africa

Central Asia

Sub-SaharanAfrica

CentralAmerica

Operational expenses (in % of loan portfolio)

Credit per borrower/Gross national income (GNI) per capita (median)

Source: responsAbility Research

24

23

22

21

20

19

18

17

16

15Dec. 08 Dec. 09 Dec. 10 Dec. 11 Dec. 12 June 13

55

50

45

40

35

30

25

20

15

This trend is not particular to the analyzed sample. It can be observed across the entire microfinance market. A recent study9 by the Consultative Group to Assist the Poor (CGAP), Micro-finance Information Exchange (MIX) and KfW, based on 6,043 observations made from 2004 to 2011, also found a clear trend of decreasing operational expenses. This is a strong indication that microfinance is delivering on its promise of making basic financial services more affordable for low-income clients.

Financial sector development at workAs microfinance sectors mature, they enable MFIs to operate more efficiently. Developments – both market-related and insti-tutional – can be broken down into the following four categories:

■ Regulation and market infrastructure: Governmental regu- lations for creating a favorable operating environment for microfinance are constantly improving.10 Enhanced regulations often go hand in hand with advancements in market infra- structure. Credit bureaus, for example, are increasingly recognized as crucial to the proper functioning of a microfi- nance market. In addition to increasing market transparency and decreasing the risk of lending without reliable collateral, credit bureaus allow MFIs to lower their operational expenses significantly. Since how well a credit bureau functions is highly dependent on market players’ reporting participation, regulations that make reporting mandatory will improve it significantly.

■ Competition: Microfinance institutions all over the world are finding themselves in increasingly competitive environments. Aided by developments in the underlying market infrastruc- tures, more MFIs are entering the sector or growing to become serious competitors. Given that microfinance is expected to behave as any other economic market, this competition is putting more pressure on end-client prices11 and transform- ing MFIs’ product offerings. In order to remain competitive, MFIs must continue to meet the needs of their increasingly financially literate clients. In today’s industry, in addition to lower costs, this means offering a more diverse product

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9 Rosenberg et al (2013): Microcredit interest rates and their determinants. 2004–2011.

10 The Economist Intelligence Unit (2013): Global microscope on the microfinance business environment.

11 CGAP (2006): Focus Note: Competition and microcredit interest rates.

base. Peru – widely acknowledged to be the gold standard of microfinance markets – has shown that market competi- tion can effectively drive interest rates down.12 This is illustrated by the substantial decrease in the median interest yield of all Peruvian MFIs that report to MIX: it decreased from 44% in 2003 to 29% in 2012.13 In addition to com- petition-enhancing regulations, the effect of competition on interest rates can be enhanced by increasing market transparency. That said, microfinance markets, as compared to traditional financial markets, are already quite transpar- ent as a result of the industry-wide reporting platform MIX market or initiatives such as MFTransparency.

■ Economies of scale: In addition to these market develop- ments, institutions are maturing and growing. As MFIs gain experience and increase the size of their operations, they are able to distribute their fixed costs, such as back office functions or MIS’, on a larger base of loans disbursed, which decreases the level of fixed costs per loan.

■ Innovations: A more favorable operating environment as well as competitive pressure can unleash innovation. A particularly striking example is the implementation of mobile banking in microfinance sectors across Eastern Africa,14 dramatically re- ducing costs for MFIs and their clients to process payments. In addition to product innovations, process innovations also allow MFIs to enhance productivity. For instance, consider a credit-scoring model that gauges a client’s payment credibility by using readily observable socioeconomic variables such as gender or place of domicile. If successfully implemented, such a scoring model would ease the assessment burden for each individual client and reduce the cost of each loan provided.

What it all means for end-client interest ratesAs described above, MFIs’ operational expenses – enabled by an increasingly mature industry as well as innovative products and processes – are decreasing as a percentage of their loan portfo-lio. The key question to explore now is whether these efficiency gains are translating into lower borrowing costs for clients.

12 See also responsAbility’s “Research Insight” regarding the development of the Peruvian microfinance market: Peru – Model Market for Micro- finance (2012), www.responsAbility.com/modelmarketperu/en

13 www.mixmarket.org

14 See also responsAbility’s “Research Insight” regarding the development of the East African microfinance market: The Microfinance Revolution in East Africa, (2013), www.responsAbility.com/microfinanceeastafrica/en

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16 responsAbility Research

17 Symbiotics (2013): Symbiotics MIV Survey. Market Data & Peer Group Analysis.

18 www.mixmarket.com

19 Deutsche Bank (2012): Microfinance in evolution.

15 The interest yield is a proxy for the average interest rate charged by the MFI. The interest yield is defined as the overall income from a loan as a percentage of an MFI’s average outstanding loan.

Figure 4: The relation between operational expenses and interest yield

Interest yields,15 a proxy for the interest rates charged to borrowers, have been observed to move closely in line with their largest component, operational expenses (see figure 4). This suggests that increasingly cost-efficient MFIs have tended to pass efficiency gains on to their clients.

Overall, microfinance clients are better served than they were some years ago. They benefit from more mature microfinance sectors that offer broader and improved product bases at lower costs. Furthermore, impressive political and economic pro-gress in many emerging markets has bolstered investments in microfinance. In addition to providing MFIs with the means to grow and operate, these investments have provided MFIs with powerful incentives to achieve sustainability.

able, as well as interest paid on debt financing. Unlike operational expenses, financial expenses have risen across the entire market in recent years.16 Several studies suggest that this is due to ongoing changes in the overall funding structures of MFIs. In creasing numbers of MFIs have switched from subsidized funding to private sector fund- ing in the last few years. The latter is more sustainable but is also more expensive.17

■ Provision expenses: This component accounts for around 2.4% of the total loan portfolio. MFIs record provisions to cover losses arising from restructured or defaulted loans. Since the average MFI portfolio contains very few loans of this nature, this component accounts for a relatively small proportion of the portfolio return. Overall, there was a slight increase in loan loss provisions after the financial crisis but these provisions have now returned to a “normal” level.

■ Net margin: An MFI’s profit is the sum left after the deduction of the above components. On average, it amounts to 2.6% of the total portfolio and – contrary to some criticisms – is therefore not disproportionately high. Equally, the commercialization of microfinance has not resulted in higher profit margins – on the con- trary: industry-wide data18 show that the average net margin of for-profit MFIs is narrower than that of non- profit MFIs.19

Figure 5: Components of the portfolio return as a % of the

loan portfolioBreakdown of the Interest yield The interest yield amounts to an average of 31% of the loan portfolio and consists of the following components:

■ Operational expenses: They are the largest determinant of the interest yield, accounting for 18.5% of the total loan portfolio. Since operational expenses have already been discussed in detail above, this section focuses on the three other components.

■ Financial expenses: They account for an average of 7.5% of the total loan portfolio and represent all of the costs arising from an MFI’s liabilities, including interest paid on client deposits, paid on client deposits, if avail-

Interest yield (in % of loan portfolio)

Operational expenses (in % of loan portfolio)

Source: responsAbility Research

Dec. 08 Dec. 09 Dec. 10 Dec. 11 Dec. 12 June 13

35

30

25

20

15

10

5

35%

30%

25%

20%

15%

10%

5%

0%Operational expenses

Financialexpenses

Provision expenses

Net margin Total Interstyield

Source: responsAbility Research

18.5 %

7.5 %

2.4 %

2.6 %

31 %

Don’t belittle the micro-entrepreneurIn the discourse about microfinance interest rates it is often forgotten that the client is an entrepreneur with limited access to capital. If the entrepreneur decides to address this scarcity with a microloan, it can be assumed that he or she has made this decision rationally and expects to generate a return that will cover the costs of borrowing.23 Data from Bangladesh24 suggests that annual returns from petty trading, a common

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20 The Smart Campaign: Responsible pricing – The State of the Practice (2010).

21 Alternatively, MFIs could also be tempted to increase the fees or other service charges to the costumer, in order to make their businesses still worthwhile. In this case the borrower would not profit from lower cost as the caps intend and the additional or higher fees charged together with the interest rates make the actual cost of his or her loan less transparent.

22 Birgit Helms, CGAP (2006): Access for all Building inclusive financial systems.

23 This does not mean that every interest rate that can be paid by the borrower is justified. Some institutions are overcharging the borrowers and those should be hindered doing so by market mechanisms discussed in the upper part of the report. This chapter, however, is focused on the typical microcredit client who is and behaves as – even though on a small scale – an entrepreneur.

24 Malcolm Harper (2012): Microfinance Interest Rates and Client Returns.

25 D. McKenzie and C. Woodruff (2008): Experimental Evidence on Returns to Capital and Access to Finance in Mexico.

26 Rosenberg et al (2009): The New Moneylenders – Are the Poor Being Exploited by High Microcredit Interest Rates?

27 The collection of comparable data about the interest rates of informal credit providers is challenging. This number relies on a study done by CGAP (see citation above) for over 35 developing economies in 2009. Therefore this rate is not directly comparable to the bank and microfinance lending rates, both valid for 2012. However, the data seems sufficient for a rough trend analysis.

28 Simple average of the lending rates prevailing in the countries we are invested in.

29 World Bank (2012): The lending rate is the bank rate that usually meets the short- and medium- term financing needs of the private sector. This rate is normally differentiated according to creditworthiness of borrowers and objec- tives of financing. The terms and conditions attached to these rates differ by country, however, limiting their comparability.

Interest rate caps are the wrong answerCaps – margin or interest rate ceilings – are often put for-ward as effective ways to keep interest rates low. Imposed by regulators in the name of client protection, such ceilings aim to prevent lenders from charging excessively high interest rates. More than 30 emerging and developing economies,20 amongst them India, Zambia, Ecuador and Bolivia, have different varieties of caps in place.

Despite their good intentions, interest rate caps can actually have adverse effects on borrowers and the market overall. If the caps are set too high, they may slow down the decrease of interest rates since the ceilings are seen as an anchor for the rate prevailing in the market. Moreover, if the ceilings are set too low, it could cause financial service providers to struggle to cover their costs,21 leading to slower growth, a reduction in services or even a full exit from the market. This would result in decreased financial access for the commu-nities in which they operate.

Furthermore, confronted with the pressure to decrease costs, MFIs are likely to increase their loan sizes or pull out of ru-ral areas as it is very expensive to operate there. As a result, the poorest clients, especially those living in rural areas, are excluded even further. Empirical data confirms these concerns: caps have predominantly negative consequences and the unintended side effects dominate.22

Rather than implementing limits or ceilings, regulators should help build a transparent market environment that enables competition. This would be a more viable and su-stainable way to decrease interest rates.

business for microfinance clients, can average an annual return of 200% or more. Data from Léon, Mexico,25 suggests that micro-entrepreneurs working in the same sector can generate returns of around 360% per year on an investment of USD 150. When compared with potential annual returns of 200% or more, borrowing rates of 30% certainly make sense to a micro-entrepreneur.

Even though these figures are not representative of the whole microfinance market – indeed some other sectors, for example agriculture, show a much lower rate of return – it can be as-sumed that in general microfinance businesses have the means to noticeably increase their invested capital. The overall repayment capacity of microfinance clients is also reflected in the fact that only around 3% of outstanding loan amounts are not repaid within 30 days of their due date.

Alternative funding sources for micro-entrepreneurs are scarce and often come at an even higher cost. If entrepreneurs do not have access to microfinance, they must rely on informal lenders, and these lenders tend to charge very high interest rates. According to a study by CGAP,26 the median interest rate charged by a money lender is between 120% and 300%.27 As illustrated in figure 6, the average interest rate charged by MFIs is substantially below the rate charged by informal lenders. Considering that the average bank lending rate to the private sector in the emerging and developing economies28 is at about 15%,29 MFIs perform rather well given the higher cost structures explained above.

Source: responsAbility Research, World Bank, CGAP

120

100

80

60

40

20

0Money lender Microfinance Bank lending

Figure 6: Comparison of lending rates in emerging and developing economies

Further informationYou can find responsAbility’s research studies, publications and webcasts as well as opportunities for ordering at www.responsability.com/multimedia/en

About responsAbilityWith assets under management of USD 1.9 billion, responsAbility Investments AG is one of the world’s leading independent asset managers specializing in the development-related sectors of emerging economies such as finance, agriculture, health, education and energy. responsAbility provides debt and equity financing to non-listed companies with business models that target the lower-income segment of the population and can thus drive economic growth and social progress. Serving both institutional and private investors, responsAbility offers professionally-managed investment solutions.

Microfinance provides low-income sections of the population in developing and emerging economies with access to essential financial services. Since borrowers are often unable to provide official confirmation of their income, it is necessary for the MFIs to conduct labour-intensive verification processes to assess the creditworthiness of clients. These processes are per-formed in countries with often challenging regulatory, economic and political environment. As a result, microfinance transactions give rise to higher operating costs relative to the outstanding loan volume than conventional banking transactions.

The majority of MFIs nevertheless manage to increase their operating efficiency. Over the last five years, the 100 MFIs that were analysed succeeded in reducing their operating costs by 23%. This progress also reflects the general development of the microfinance sector. Supported by a more stable political and economic environment, this development has taken the form of improved regulation, healthy competition, the expansion of operating activities and innovations in the areas of products and processes. The development of the financial sector has been supported by investors such as responsAbility, which as-sign importance to sustainable and efficient business models and to the active use of market institutions such as credit bureaus when evaluating their investments.

The generation of savings during the lending process allows MFIs to offer lower interest rates which, in turn, result in savings for borrowers. As in the case of the MFIs’ operating costs, the inter-est rates that are passed on to end-clients have been reduced significantly over the last five years. This means that microfinance clients not only enjoy a better and more comprehensive range of services but also benefit from lower loan costs.

Conclusion

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This document was produced by responsAbility Investments AG. The information contained in this document (hereinafter “information”) is based on sources considered to be reliable, but its accuracy and completeness is not guaranteed. The information is subject to change at any time and without obligation to notify the recipient. Unless otherwise indicated, all figures are unaudited and are not guaranteed. Any action derived from this information is always at the recipient’s own risk. This document is for information purposes only. The information does not release the recipient from making his/her own assessment.

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Carola Hug Research Analyst carola.hug@responsAbility.com +41 44 254 32 98

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