Controversies around microfinance
► Adapting the services to the genuine needs of the populations
► Is there an explanation to the high interest rates?
► How can we boost the expansion of microfinance in the traditional financial system while preventing it from going too far?
► Microfinance and overindebtness
► Can the general public be the new main actor of microfinance?
► How can MFIs adapt their services to the real needs of the populations, especially in rural areas?
Rural areas gather 53% of the world population – and even more in developing countries. Microfinance has always been challenged by the characteristics of these areas..
Indeed, its characteristics are:
- It is difficult to get to, thus financial services spend more time and more money
- Incomes are lower than in urban areas
- The level of education is lower
- Weather events have an impact on the crops
- Activity are highly seasonal and income is produced on the long run, which can be incompatible with the mechanics of microcredit
In order to take up all of these challenges, microfinance institutions create specific products to answer the needs of the beneficiaries: term microcredits (so that farmers can wait for their crops) or insurances to cover a part of the weather risks. MFIs also organize in a different way and adapt their collecting methods: moving agencies, mini-agencies, mobile phone payment service…
MFIs need financing to adapt their services to rural areas; thus it is more and more difficult to find this money as investors give priority to profitability and safe investments however microfinance in rural areas tend to be more risky and difficult than in urban areas. And yet, it is a good answer to the needs of the beneficiaries who are amongst the poorest and more excluded of the financial services.
CGAP file: Financial services for the poor in rural areas (in French)
CGAP file: agricultural microfinance: manage the risks and create adapted products (in French)
► Is there an explanation to the high interest rates or is it a hollow debate?
The MFI interest rates are around 27% per year (effective interest rate), which can seem high for European standards but it is not necessarily if the aim is to lend small amounts to unbanked people on short periods. Hence we should not draw conclusions too fast about these “polemical” rates, and declare that microfinance is not as “social” as it claims to be.
These interest rates are high for various reasons:
• The interest rates MFIs have to pay to borrow money is higher to the rates paid by traditional banks, and are often close to 10%.
• MFIs must anticipate the local inflation that is between 5 and 10% in developing countries.
MFIs must cover irrevocable operating costs between 15 and 20% of their loan portfolio.
• In spite of the low lent amounts, MFIs must prevent the risks in order to make their activities sustainable for the future. Indeed, the default rate in microfinance is estimated to be around 3-4%.
• MFIs undertake all their transactions in cash and often have to move to collect the money. This creates high operating costs (personnel, vehicles, agencies…) that traditional banks do not bear.
These interest rates must not be seen from a "western" point of view
• MFIs ask high interest rates that may seem impossible to pay but this must be put into perspective. For example, the interest rates asked by our partner in Cambodia, Chamroeun, are 38%. However, this rate is not representative of reality as microcredits are small amounts granted on short periods. Consequently, rates should be considered from a monthly point of view. For example, a Cambodian beneficiary borrowing 150€ on 6 months (which are the average amount and maturity of the organization) has to pay a 19% interest rate (3.2% per month), and pays back a little less than 26 euro each month. Indeed the western perception of interest rates on a yearly basis is not representative of the situation faced by microcredit beneficiaries.
• Unbanked people who want to borrow money can choose between: borrowing to their relatives (no interests), borrowing to loan sharks (very high interest rates, often near 100%) or borrowing to microfinance institutions (average interest rate: 27%). Microcredit is an interesting alternative when the beneficiary cannot borrow money to his family.
• Costs are easier to pay than in western countries as microentrepreneurs operating in the informal sector do not pay taxes or payroll taxes.
• In addition, a study that was lead in 37 developing countries showed that in 30 countries, the interest rates asked by MFIs are lower than the banks’. This proves that interest rates in microfinance should be considered according to the local context and in comparison with the interest rates usually charged in each country.
CGAP file: Are microcredit interest rates excessive?
Occasional paper: CGAP: Microcredit and interest rates
►How can we boost the expansion of microfinance in the traditional financial system while preventing it from going too far?
Microfinance needs public and private funding in order to rise from 150 million beneficiaries to 500 million by 2020. Indeed, a growing commercialization of microfinance has been noticed these last few years through investment funds specialized in microfinance. The commercialization of microfinance is not negative; on the contrary, microfinance institutions can finance their activities and more beneficiaries can have access to its services.
However, as it is a traditional financial product, investors endeavor to make profits and this leads investment funds to finance profitable and low-risk MFIs first and foremost.
This phenomenon creates drifts in some microfinance institutions that favor profitable clients to the detriment of poor clients.
In order to avoid this kind of drifts and to make sure that MFIs actually achieve their social mission, best practices and social performance assessment tools were created and are widely in use today.
Money has to be considered as a means and not as an end for microfinance to maintain its social dimension and to keep on helping the poorest people living in remote areas.
CGAP file: Foreign capital investment in microfinance
►Microfinance and overindebtness
In some countries where microfinance is widely spread (Bangladesh, India, Mexico, Bolivia…), the overindebtness problem becomes a growing source of concern. In fact, in the areas where MFIs are numerous or when the beneficiaries do not know how microcredit works, beneficiaries in debt might ask a loan to another MFI to pay back their first credit. This could lead them to face a dangerous debt cycle.
MFIs are always more involved in the fight against overindebtness and establish tools to do so. They create “credit bureaus” to share their clients list and thus be able to refuse a credit to a client who is already in debt. MFIs also adapt their products in order to meet the needs of the beneficiaries regarding time limits and reimbursement flexibility. They also provide insurance and cancellation procedures in case of force majeure, they encourage their clients to save money and above all, they train their credit agents so that they can assess the clients’ ability to pay back.
The organizations working in microfinance are aware of the overindebtness threat and works hard to establish best practices and focus their efforts in order to avoid it.
File: Avoid indebtness
CIRAD file: Overindebtness, the path to extreme poverty
Smart microfinance and the client protection principles
► Can the general public be the new main actor of microfinance?
There are many actors in microfinance: beneficiaries, MFIs, governments, regulatory authorities… but also the financing entities. Today MFIs are financed by local financing for 75% on average – money borrowed to local banks or by collecting savings – and the remaining 25% come from lines of credit from private investment funds and international donors (Development agencies and multilateral foundations). These resources are very expensive for MFIs (10% each year on average) which are not able to allocate funds to the training or monitoring of the beneficiaries.
The general public may be a solution to this problem. By granting interest-free credits on microcredit lending platforms like Babyloan or solidarity funds such as the Babyfund, the general public allows MFIs to have access to a much cheaper financial resource. Thanks to this kind of philanthropic financing, MFIs can support the beneficiaries, reach their financial balance quicker and reduce their interest rates.
File: Microcredit websites: how can it affect microfinance?
Learn more about the Babyfund, the investment fund for genuine solidarity
