SESSION 1 How Microfinance Differs from Traditional Finance

Microfinance is at a significanttransition point• 2005 to present• Microfinance has evolved into an established, fastgrowingbusinessBut has someactivity gottentoo commercial?

Profits in MicrofinanceReturn on Equity, Latin America

Compartamos ROE vs Mexican Banks

…the media continues to be skeptical

Maintaining a Healthy Industry1. Consumer Protection through:1. Self-regulation2. Certification3. Codes of Ethics2. Transparency of Financial Information1. Financial Statements2. Ratings Agencies3. Transparent Pricing3. Dialogue with governments about appropriateregulation

Client Protection Principles1. Appropriate product design and delivery2. Prevention of over-indebtedness3. Transparency4. Responsible pricing5. Fair and respectful treatment of clients6. Privacy of client data7. Mechanisms for complaint resolution

How did microfinance end up withnon-transparent pricing?

Which loan would you pick?Zero InterestLoanInterest andFeesAnd SavingsInterestOnlyLoan amount: $1,000 $1,000 $1,000 $1,000Loan term: 10 weeks 10 weeks 10 weeks 10 weeksInterest Rate: 0% 15% “flat” 12% “flat” 40% declUpfront fee: 5% 2% 1% 0%Security deposit: 0% 0% 20% 0%TCC $50 $50 $33 $42APR 49% 47% 49% 40%TransparencyIndex0 32 25 100

The Downward Spiral• How did prices get so confusing and nontransparent?• It is a combination of:◦ Lack of transparent pricing regulation◦ Initial motivation of a small minority tomask the true price• The result is a downward spiral drawing innearly all MFIs

The Downward Spiral• All MFIs have transparentprices• MFI 1:◦ Interest: 2.5% decl.• MFI 2:◦ Interest: 3.0% decl.

The Downward Spiral• All MFIs have transparentprices• Some MFIs shift to flatinterest• MFI 1:◦ Interest: 2.5% decl.• MFI 2:◦ Interest: 2.0% flat

The Downward Spiral• All MFIs have transparentprices• Some MFIs shift to flatinterest• All MFIs shift to nontransparentpricing• MFI 1:◦ Interest: 1.75% flat• MFI 2:◦ Interest: 2.0% flat

The Downward Spiral• All MFIs have transparentprices• Some MFIs shift to flatinterest• All MFIs shift to nontransparentpricing.. Andit continues• MFI 1:◦ Interest: 1.75% flat• MFI 2:◦ Interest: 1.6% flat, 2%upfront fee

The Downward Spiral• All MFIs have transparentprices• Some MFIs shift to flatinterest• All MFIs shift to nontransparentpricing• Consumers struggle tochoose…. Which wouldYOU choose?• MFI 1:◦ Interest: 1.75% flat• MFI 2:◦ Interest: 1.6% flat, 2%upfront fee

The Downward Spiral• All MFIs have transparentprices• Some MFIs shift to flatinterest• All MFIs shift to nontransparentpricing• Consumers struggle tochoose… Because theprices are far from clear• MFI 1:◦ Interest: 1.75% flat◦ APR: 37%• MFI 2:◦ Interest: 1.6% flat, 2%upfront fee◦ APR: 57%

The Downward Spiral• All MFIs have transparentprices• Some MFIs shift to flatinterest• All MFIs shift to nontransparentpricing• Consumers struggle tochoose• Profits are correlated toprice when loans areidentical• MFI 1:◦ Interest: 1.75% flat◦ APR: 37%◦ ROE: 10%• MFI 2:◦ Interest: 1.6% flat, 2%upfront fee◦ APR: 57%◦ ROE: 40%

The Downward Spiral• Prices are far from clear, and thus:◦ Consumers over-consume◦ Market competition is hindered◦ Strong temptation from high profits◦ The poor are harmed◦ Public image is tarnished◦ Governments urged to intervene• Transparency, and particularly pricing transparency,is a key element to correct this serious problem inthe microfinance industry

Two common questions withoutsimple answers:1) What is the “market price” ofmicrocredit?2) What is a “responsible price” formicrocredit?

AveragePrice

Too High!Responsible Pricing RangeTooLow!

Is there a curve in othercountries?

The interesting question:Are institutions “off-of-thecurve”pricing responsibly?

Why is there a price curve formicro-loans?

Are there cost curves in real data?

Cost Components that Affect PricingComponentFinancial Costs 10%Loan Loss 2%Operating Costs 20%Profit 3%Total Price 35%

In the Philippines, we find a curve not only forprices, but also for Operating Costs.

Common industry benchmark of 15-20%OpCost Ratio is appropriate for larger loans

But smaller loans generate an Op CostRatio well in excess of 20%

Notice that in all three countries there is aremarkably consistent spread between OCRand Yield

Understanding the cost curve formicro-loans

Efficiency: Operating Cost RatioThe formula for the ratio:Annual Operational Cost------------------------------Average Loan PortfoliioWe will analyze at the level of a single loan• Cost to process and disburse a loan (once per loan)• Monitoring cost (monthly cost)• We annualize these cost

Pricing for Different ProductsComponent$100 Loan $1000 LoanFinancial Costs 10% 10%Loan Loss 2% 2%Operating Costs 50% 15%Profit 3% 3%Total Price 65% 30%

Promoting Transparent Pricingin the Microfinance Industry

CONCLUSIONS