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46 Chapter 3 - Interest Rates: Paying for RiskBox 3.2 Effects of Subsidized Interest RatesThere are a number of important distorons that occur when interest rates are subsidized, for example,• Subsidized loans distort the opportunity costs of investments, leading to the misallocaon of capitalto higher-<strong>risk</strong> and lower-reward opportunies.• Subsidized onlending rates could result in a lack of financial discipline by the financial instuon orits clientele, since cheap loans are oen regarded as grants that do not have to be repaid.• Low-cost loans discourage savings mobilizaon because the loans preclude remunerave interestrates on deposits.• Government budget constraints, combined with subsidized interest rates and poor enforcement,mean that fewer borrowers will be served over me.• Below-market onlending interest rates aract rent seekers and result in credit raoning, whichtypically favors the wealthy and polically connected.• Subsidies constrain the financial instuon from achieving long-term financial sustainability, sincethe interest rate is inadequate to cover all operang and financial costs, and thus constrain thesupply of credit.• Withdrawal or cancellaon of subsidies by the government or donors could cause financial distressfor the financial instuon and its client.Source: Yaron, McDonald, and Piprek 1997.Governments also try to lower the price of credit by simply mandating that interest rates stay below a presetceiling. Oftentimes, such policies aim to protect borrowers from abuses. Unfortunately, this approach tends tohurt rather than protect microbusinesses and low-income households by rationing credit artificially. Interestrate ceilings make it difficult or impossible for formal and semiformal microlenders to cover their costs, drivingthem out of the market (or keeping them from entering in the first place). Potential clients either lack accessto finance or must go to informal credit markets, which are generally more expensive (see Helms and Reille2004). Interest rate ceilings can also lead to less transparency about the costs of credit, because lenders copewith interest rate caps by adding confusing fees to their services. Table 3.1 summarizes the effects on supplyand demand for microfinance services when governments impose interest rate ceilings.
Managing Risk and Creating Value with Microfinance47Table 3.1 Effects of Ceilings on Microcredit Interest RatesSupply SideShort-term effects• Lenders are compelled to reduce their rates.• Excess demand creates incenves for rentseekingamong lending staff.• Viability of lending to the poor is reduced.• Lenders’ profits on loans to the poor arereduced.• Incenves to make loans to the poor arereduced.• Incenves to increase investments to expandloans to the poor are reduced.• Policy <strong>risk</strong> on lending to the poor increases(threat of new ceilings).• A negave signal is sent to potenal investors.• Risk of lending to microlenders increases.• Incenves to commercial banks to enter themicrocredit market are reduced.Medium- to long-term effects• Microlenders’ creditworthiness declines.• Price at which microlenders can borrow in themarket increases.• Microlenders’ profit declines.• Supply of funds from some donors declines.• Some lenders leave the market.• Supply of loans to the poor declines.• Microlenders’ quality of services to the poordeclines.• Interest rates paid on deposits are reduced byaffected microlenders.• Microlenders increase transacon costs ofsmall deposits.• Supply of microlenders’ other financialservices to the poor also declines.Demand SideShort-term effects• Demand for loans increases at the ceiling rate.• Some new potenal clients seek loans at thenew rates.• An excess demand for loans is created at theceiling rate.• Price of credit to some of those who actuallyget loans is reduced.• Some borrowers pay higher transacon coststhan before.Medium- to long-term effects• Some borrowers shi to informal commercialmarkets.• Many former borrowers become worse offbecause of the decline in supply.• Defaults increase.Source: Adapted by authors from Fernando (2006).Although interest rate ceilings do not have the desired effect, concerns about the high costs of microfinance inmany countries are valid, and the government has an important role to play in expanding access to microfinanceand lowering its cost. If government can create the market conditions that lead to competition among lenders,evidence exists that lending prices can be driven downward, while access expands. In Peru, for example, rapidgrowth of the microfinance industry over the past ten years has led to microfinance penetration rates of between25 and 35 percent of eligible borrowers, and interest rates have been halved over the same period (Mapstone2009). Policies to promote competition among credit providers encompass a wide range of programmatic andregulatory issues: (1) market intervention, (2) financial sector supervision and regulation, and (3) macroeconomicand trade policies.
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