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42 Chapter 3 - Interest Rates: Paying for RiskFigure 3.1 Percentage Components of Real Interest Rates 2004 – 05AfricaSouth AsiaEast Europe and Central AsiaBoliviaEcuadorColombiaEast Asia and PacificMiddle East and North AfricaPeruRemaining Latin American countriesAverageSource: Presentaon by Adrian González (2008).0 5 10 15 20 25 30operational costs financial costs loss profitFigure 3.1 also gives an indication of how capital costs contribute to interest rates, as calculated by measuringthe MFIs’ financial expenses against portfolio returns, 3 which were between 3 and 10 percent. The cost of capitaltypically includes weighted averages of the rates paid by the MFI on the loans or deposits used to finance itsportfolio, as well as the cost of equity. 4 Costs are adjusted for subsidized loans and grants. Self-sustaininginstitutions paying market rates will have higher financial costs.Sustainable interest rates also cover the risk that the loan will not be repaid. The risk price can be set on thebasis of the historical loan loss rate for the entire portfolio, or it can be estimated and priced for categories ofborrowers. The first method is a simple calculation based on the portion of the gross loan portfolio that must bewritten off due to borrower defaults every year. The MFIs analyzed in figure 3.1 averaged loan losses of about2 percent of their portfolios, which translates into roughly 2 percentage points in the interest rates that theinstitutions must charge borrowers, on average. 5More complex risk-pricing methodologies assess the probability of default at the client level and assignhigher interest rates to riskier classes of borrowers. Using segmented risk-evaluation techniques, forexample, one can analyze groups of borrowers with similar characteristics to determine how thosecharacteristics correlate with loan performance. The data and analysis for this segmentation can be drawn froman MFI’s own database or, preferably, from a database that contains information from other MFIs, as well asbusinesses that are likely to have payment and transaction histories for lower-income borrowers (domesticgoods retailers, agricultural input suppliers, and mobile phone service providers). 63. Financial expenses as defined by Microfinance Information Exchange are the “total of financial expense on liabilities, net inflationadjustment, cost-of-funds adjustment and other expenses from financial services.” See González (2008).4. In theory, the cost of equity is the return shareholders require on the capital they invest in an enterprise. While MFIs rarely haveshareholders expecting dividends, Rosenberg (2002) recommends they calculate the expected erosion in the value of their equitycaused by inflation and add this component to the cost of capital.5. A 5 percent loan loss rate would translate into about 5.25 percent as a component of an interest rate calculated using this method, becauseMFIs must plan to earn enough interest on the loans that are repaid to cover the losses on the larger amount that is lent. See Rosenberg (2002).6. For more information about the development of credit reporting systems that include data relevant to lower-income borrowers, see theInternational Finance Corporation’s Credit Bureau Knowledge Guide, http://www.ifc.org/ifcext/gfm.nsf/Content/FinancialInfrastructure.
Managing Risk and Creating Value with Microfinance43Using data from their own client histories, however, MFIs can improve their assessment of client risk byanalyzing how characteristics like gender, length of time at current address, and length of time at currentemployment correlate with loan performance. From this analysis, the loan officer can determine if a prospectiveborrower is more or less likely to repay the loan on the basis of the performance of clients with similar profiles.For repeat borrowers, the performance of their past loans also enters in the calculation (Schreiner 2003).Using segmented risk evaluation along with traditional risk assessment methods, like workplace visits andinterviews with references, MFIs can determine which borrowers pose the highest risk of default. Usually,the highest-risk clients are rejected, but other clients may be grouped into risk categories of average to high,average to low, and low, for example. The risk component of the interest rate charged on their loans would thenbe priced according to the historical loss rates associated with borrowers in their same category.Finally, the profit component of an interest rate should be determined on the basis of the MFI’s growth targets.Without additional equity, the institution is constrained in the amount of money it can borrow and lend to itsown clients. To support long-term growth, MFIs should target a capitalization rate between 5 and 15 percentof the average outstanding loan portfolio. Internally generated capital is arguably the best source of new equitybecause it enables the MFI to expand services to more borrowers or loan more money to existing clients. TheMFIs represented in figure 3.1 were earning between 3 and 7 percent returns on their portfolios.Are Microfinance Interest Rates Too High?Some observers seem to think that MFIs are taking advantage of their clients with abusively high interestrates. Worldwide, the MFIs for which data are available charge their borrowers an average interest rate of 35percent (Kneiding and Rosenberg 2008). Is this too much to charge poor people for borrowing money? Thereare several ways to approach this question. First, from the borrowers’ perspectives, the costs and other terms of aloan from an MFI must generally be better than the terms offered by alternative sources. Otherwise, borrowerswould not take the loan from an MFI. Indeed, thousands of MFIs extend credit to the poor around the globe.This finding suggests that the price is not a determining factor for a large pool of low-income clients. 7 Inaddition, while 35 percent may be high compared to rates in mainstream banking, the costs of making manysmall loans are higher than the costs of making larger loans—box 3.1 explains why. Moreover, most MFIs arenot profiting greatly from their customers. Most of those MFIs that report their financial data declare a modestmedian rate of return on capital of only 1.1 percent.7. See the interview with Richard Rosenberg (CGAP 2008). See also, for example, Rosenberg (2007) and Epstein and Smith (2007).The data suggest that MFI rates are less than informal moneylending charges (CGAP 2008).
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