managing risk.pdf

Managing Risk and Creating Value with Microfinance41IntroductionAccess to commercially priced credit can have a positive effect on the welfare of low-income households.Credit can finance new equipment purchases or enable new business opportunities. It can provide betterhousing or help parents feed, educate, and clothe their children. In addition, it can help households andbusinesses recover from disaster. However, to provide regular access to credit, microfinance institutions (MFIs)must be able to sustain their operations independently and grow to meet demand.To that end, MFIs must charge an interest rate that covers their costs and risks and generates a profit. Theserates are high compared to banks—sometimes by a large margin. This comparatively high cost of microloanshas led to questions about whether MFIs are overcharging and overindebting the poor (see, for example,Epstein and Smith 2007).This chapter presents data on the rates MFIs are charging their customers and examines the componentsof microcredit interest rates, especially the pricing of risk. The chapter then addresses the question whethermicrofinance interest rates are too high and points to a number of key actions MFIs can take to lower rateswithout jeopardizing institutional sustainability or growth potential. Finally, it discusses the reasons whygovernment policies and programs that aim to lower interest rates by imposing rate ceilings or subsidizingcredit usually yield poor results. 1Interest Rate SettingTo succeed, MFIs must be able to meet a number of fixed and variable costs and guarantee a certain profit.Costs include operating costs, the cost of funds, and expected loan losses. Operating costs include office spaceand supplies, employee remuneration and training, transportation and communications, and equipment andbuilding depreciation, among others.Operational costs often make up the single largest component of the rates MFIs charge borrowers. In a 2002study, operating (also called administrative) costs were between 10 and 25 percent of the average loan portfolio.In a 2007 study, average operating expenses for 894 MFIs in 94 countries were around 19.2 percent of a loanportfolio (MIX 2007; Rosenberg 2002). 2 Figure 3.1 shows that for a set of sustainable MFIs, average operatingcosts in 2004 and 2005 accounted for about 10 percent of the interest rates (using returns on loan portfolios asa proxy for interest rates).1. This chapter is based on the June 2007 dialogue with Adrián González (the Microfinance Information Exchange), Juan Buchenau(formerly with the Consultative Group to Assist the Poor, now with the World Bank), and Narda Sotomayor (Superintendency ofBanking, Insurance, and Pension Funds, Peru).2. Rosenberg (2002) includes investment income as a component in his interest rate calculation. This chapter does not discussinvestment income, but an MFI should deduct the revenue it earns on its assets, not including its loan portfolio (such as a certificateof deposit), when calculating the interest rate. Where necessary, the MFI might also need to include taxes in its calculation.