Understanding and Dealing with High Interest Rates on Microcredit

In this brief document, Nimal Fernando defends the high interest rates currently charged by microfinance institutions and cautions against policy interventions (such as an interest rate ceiling). His main points are summarized below:

  • Just like any business, MFIs must charge prices high enough to cover their costs
  • Concessional funds (donor funds) cannot be seen as a permanent source of funding for MFIs and provision must be made through interest rates to sustain the lenders’ operations
  • Because of the vast difference in transaction costs and sizes of microfinance loans it is inappropriate to compare them to conventional loans
  • A rate ceiling will prevent lenders from recovering costs and cause a flight of lenders form the markets, depriving microfinance customers of adequate service providers
  • Empirical evidence shows that liberal interest rate policies breeds strong growth in the microfinance industry, whereas interest rate regulation does not

In conclusion, Fernando states:

Microcredit interest rates are high because microlending remains a high-cost operation. The key to reducing these rates in a sustainable manner is to reduce costs through improved market competition, innovation, and efficiency. Interest rate ceilings are not an appropriate intervention, and there are no quick solutions or shortcuts. To provide affordable finance to poor households in Asia and the Pacific, policy makers need to recognize, and rectify impediments such as a lack of physical, human, and financial infrastructure, promote competition and efficiency, and be proactive in providing an enabling environment for MFIs to develop in a sustainable manner.

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