Regulation in its Right Place

Alright, after over a week of fickle internet, I'm back with another post. I promised in my last post that I would discuss how lack of oversight and management in certain MFIs have made interest rates the mistaken target for regulation. Earlier this year, in a New York Times opinion article, Dr. Yunus proposed that all MFIs impose interest rate caps of 10-15 percentage points over the cost of funds to prevent them from over-extracting profits. Yunus says that MFIs whose profits account for over 15% of the cost of funds are those that fall in the "red zone." However well-intended this proposal may be, as a Microfinance Information eXchange study points out, a significant number of MFIs in Latin America, Africa and South Asia fall into the red zone because operation costs are what drive interest rates to be so high. The study shows that for 2009 data from 1,027 MFIs around the world, 62% of all expenses were operating expenses that needed to be covered by the average yield and 80% of expenses that needed to be covered by the premium.

In addition, there are several other issues that come along with putting a limit to interest rates. For one, interest rate caps do not account for inflation, something which is not so uncommon in a time like this when the global economy is still recovering from the recession. Just here in Honduras, the price of food has soared, leaving many people scouring to find better prices. Secondly, interest rate caps would have the double effect of increasing demand for loans by the less poor clients, thereby undercutting the costs necessary to meet this demand, and abandoning the poorest clients (since the smallest loans are the most expensive to handle). This abandonment will have the very likely effect of pushing the poorest clients towards "loan sharks." What is a loan shark? Loan sharks is a term used to describe informal moneylenders who charge extremely high rates and who will most likely take advantage of the borrower's desperate situation by guaranteeing immediate cash flow but then will use unethical and sometimes violent methods to enforce repayment.  

This last point is an extremely important one to remember since the objective of all MFIs should be, in my opinion, to increase their outreach to the poorest of the poor. Surely capping interest rates would benefit the less poor, but losing the poorest of the poor would mean admitting that microfinance can only serve the more capable payers, the ones who pose the lesser risk. But supposing that the point of microfinance is to provide formal financial services to those who have been rejected because of their risks, if MFIs have already sent out the message "we'll accept you for your risks, as long as you pay for it," what happens when capped interest rates force them to say "nevermind your willingness to pay, we can't afford it"? It hinders an important mission of the industry for the sake of stability. And yes, stability is important, but we have to look at what has really caused the industry to become unstable.

One of the main reasons that has made interest rates a target for regulation is MFIs overlending beyond their capacity, lack of examination of borrowers' credit histories, and the use of unethical methods to enforce repayment. The most prominent example I can use is the state of Andhra Pradesh in India, one of India´s most microfinance-active states. A few MFIs in this state began lending to clients with bad credit histories, lending out too many loans at the same time, and then when the consequences of over-lending were felt, excessive debt collector harrassment led to the worst--a succession of client suicides-- tainting the mission of microfinance as a selfish mega-profit-seeking industry. It was obvious to the local government that something had to be done right away, yet the real cause of the problem, in turn, was not so obvious. For them, it made most sense to target the one thing that had caused a lot of controversy in the media--interest rates--instead of first investigating what actually led up to the crisis. And so, all microfinance borrowers were demanded to stop repayments, all MFI assets in major banks were frozen, and the interest rates were capped at 24%. Disaster.

Since then, the situation has gotten better and MFIs are beginning to gain back their independence but with much healing left to do. This brings me back to Yunus's second point in his proposal which said that in order to enforce the cap, there needed to be a microcredit regulatory authority in every country where microfinance activities take place. This is something that I hope will happen in the future since I think it lies at the root of so much of the turmoil that's happened lately. Having an overhead authority that can provide oversight over a district/state/country's microfinance activities would put pressure on MFIs to adhere to more cautious lending strategies. It would force MFIs to reevaluate the scope of their capacities by realizing that lending to their limit will only lead to their own demise and that using abusive debt collection will severely jeopardize the industry's integrity. 

So if the argument is for sustainability and stability, then capping interest rates is the absolutely wrong thing to do because it contradicts the mission for MFIs to attract private capital, and thus prolongs the path towards reaching economies of scale. And economies of scale should be the ideal trigger to lowering interest rates. For now, the question remains of whether costs of loans can be driven down to their absolute most affordable level for clients; MFIs have the challenge of proving that they are as cost-efficient as they can be as evidence that their interest rates are truly necessary. But this also means that clients have to value this affordability and stay loyal to it. If the microfinance industry wants to wash away some of the stains it has acquired for itself, it needs to focus on changing its lending and debt collection policies so that MFIs don't incur risks they truly cannot afford. Hopefully this will lead to the development of microfinance authorities in the future.