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44 Chapter 3 - Interest Rates: Paying for RiskBox 3.1 Microcredit Cost StructureCompare the costs of two hypothecal lenders, Big Lender and MicroLender, each of which lends US$1,000,000.Big Lender makes a single loan, while MicroLender makes 10,000 loans of US$100 each.The costs of capital and loan loss risk vary proporonally with loan size. Both lenders need to raise US$1,000,000to fund their loans and will have to pay the same market rate—say, 10 percent—for the money. If both lendershave a history of losing 1 percent of their loans to default each year, they will need a loan loss provision ofthat amount. Both lenders can cover the cost of their capital and their risk by charging 11 percent (10% + 1%= 11%) on the loans they make to their customers.Administrave costs are not proporonal to loan size. Making a single loan of US$1,000,000 might cost BigLender US$30,000 (3 percent of the loan amount) in staff me and other expenses involved in appraising,disbursing, monitoring, and collecng the loan. Big Lender can cover all its costs by charging the borrower aninterest rate of 14 percent (10% + 1% + 3% = 14%).However, MicroLender’s administrave costs for each US$100 loan will be much higher than 3 percent ofthe loan amount. Instead of US$3 per borrower, MicroLender is more likely to have to spend US$20 or moreper borrower. Big Lender has to deal with only a single borrower, but MicroLender has to deal with 10,000borrowers who typically do not have collateral, financial statements, or records in the database of a creditreporng bureau. Many of these clients may be illiterate. Lending to and collecng from such clients requireme-consuming personal interacon.If Big Lender’s client repays the loan every three months, Big Lender processes only four payment transaconsper year. MicroLender’s borrowers probably make repayments monthly or even more frequently, generangat least 120,000 transacons per year. While Big Lender’s administrave cost is US$30,000 per year,MicroLender’s cost is at least US$200,000. Covering this cost requires a 20 percent charge on loaned amounts,resulng in an interest rate of at least 33 percent (10% + 1% + 20% = 33%). Administrave costs may be muchhigher in young MFIs that are too small to take advantage of economies of scale.Source: Helms and Reille 2004.Lowering Interest Rates at the Institutional LevelYet, many MFIs can achieve substantially lower rates. Operating costs are both the largest and the mostmanageable component of interest rates, and efficiency gains at the institutional level could significantly lowerrates for the industry as a whole. MFIs can use a number of technological innovations (see chapter 8 ofthis volume) and operational strategies and tactics to improve productivity, better manage risk, and reduceadministrative costs.Operational risk managementOperational risks generally pose the greatest potential threat of loss to an MFI. They include credit risk, andthe risk of fraud and theft. MFIs can often greatly reduce the likelihood of losses and contain the scale oftheir damages by identifying vulnerabilities, designing and implementing controls, and monitoring theireffectiveness. 88. See the Operational Risk Management course developed by the Consultative Group to Assist the Poor (2009c), http://www.cgap.org/p/site/c/template.rc/1.26.4915/. See also chapter 1 of this volume.
Managing Risk and Creating Value with Microfinance45Loan officer incentivesOne particularly important way an MFI can reduce the risk of loan losses and generate higher productivity perofficer is to create appropriate incentives for loan officers to maintain large and healthy loan portfolios. Thereare many ways to design an incentive program. For example, the MFI can offer a bonus for each successful loanrepayment, or it can target specific productivity measures, like number of clients visited per day. 9Management Information SystemsThe MFI’s management information system is its system of collecting, archiving, retrieving, and usinginformation. The system tracks the loan officers’ productivity and clients’ repayment schedules and balances,among other things. A good information system is vital for making timely assessments of the quality of the loanportfolio and other variables that most affect cost and risk. 10Lowering Interest Rates through Government PolicyConcerned with the high cost of microcredit, governments want to enable microbusinesses and poorerhouseholds to have access to cheaper credit to improve productivity and engage in welfare-enhancing economicactivities. Governments also want to protect the poor from abusive lending practices. However, two of the mostcommon policy and programmatic tools used by the public sector to achieve these goals—subsidizing credit orsetting limits on interest rates—tend to lead to counterproductive results.Subsidized credit programs are usually administered by state-owned financial institutions or take the formof credit lines extended by the government to public or private lenders at below-market rates. Usually, thesubsidized loans are directed toward specific groups of borrowers, like poor women, or specific economicactivities, like housing or agriculture.Such programs often have many repercussions and serious problems. Government institutions maylack the incentives to monitor such loans effectively or control administrative costs, because success isoften defined in terms of credit disbursements rather than loan portfolio quality or operational efficiency.Subsidized credit can be an enormous fiscal drain on governments as well, because borrowers oftenview the loans as lightly disguised grants, with no penalty for incomplete repayment. This perceptionis especially true in countries with a history of debt forgiveness. Box 3.2 describes other effects of subsidizedinterest rates.9. See the MicroBanking Standards Project, http://www.gdrc.org/icm/rating/rate-5.html.10. See the management information system training offered by the Consultative Group to Assist the Poor (CGAP 2009b).
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