Understanding Micro-Finance Interest Rates: Some Fundamental Issues For The RBI Sub-Committee to Consider...

Ramesh S Arunachalam

Rural Finance Practitioner

There has been a lot of debate about interest rates in micro-finance and rightfully so and in this post I look at what I see as some of the fundamental issues in this debate...I hope the RBI sub-committee looks into the key issues highlighted here...

Let us start with the different costs that are incurred in delivering financial services to low income people. I see four major costs and they are:

1.      Transaction/Financial Costs[i] _Institutions        =          TFC _Institution          

2.      Transaction/Financial Costs[ii] _Intermediary       =          TFC _Intermediary

3.      Transaction/Financial Costs _Clients            =          TFC _Clients

4.      Transaction/Financial Costs _Total             =          TFC _Total

TFC _Institutions   + TFC _{Intermediaries}  + TFC _Clients = TFC _Total         (This is the Basic Equation)

Premise # 1 - Total Costs (TFC _Total ) and Apportioned Costs(TFC _Institutions   + TFC _{Intermediaries}  + TFC _Clients) of Delivery Will Vary Across Models, Contexts and Related Parameters: First, the total and apportioned costs will vary by:

ð   the model used - group versus individual, bank/MFI branch based Vs centre meeting based Vs agent based,

ð   the number of years in operation and life cycle stage of the different channel partners – the experience/learning curve aspect should reflect here,

ð   the economies of scale and scope available including aspects of fixed/variable costs – enhancing major product outreach to larger number of clients as well as offering them a range of other products as well,

ð   the trade-off between risk, efficiency and controls in delivery – efficiency can be gained by reducing controls by that level of risk will have to be tolerated,

ð   the product strategy - in terms of savings alone, credit alone, savings + credit + others including risk management products,

ð   the number of channel partners (or intermediaries) – this decision is very critical to the cost and more intermediaries should just the additional costs

ð   the strategic context - including clients, geography, etc,

ð   the basis for the competitive strategy - in terms of differentiation vs quality vs cost leadership (this can also be thought of the overall strategy of managing total costs) and other such factors

Thus, we have the following:

Total and Apportioned Costs of Financial Services Delivery to Low Income People = Function of Model Chosen, Life Cycle Stage and Age of Channel Partners, Economies of Scale and Scope Available, Trade-Off Between Risk, Efficiency and Controls, Product Strategy, Length of Channel, Strategic Context and Competitive Strategy

And we need to recognise that all of the above are INDEED strategic choices exercised by organisations, depending on various factors...

Therefore, we must understand that it would not be appropriate to expect all institutions to be able to deliver financial services to low income people at the same interest rate/level of fees.

That said, I am not arguing for any (high) level of interest/fees to be charged from low income people – all I am saying is that, we need to be sensitive to the fact that, it may not be possible for all different models to come under a specific SINGLE rate.

The most appropriate strategy here would be to get answers to the following question for a typology of contexts, models and related parameters:

1. “Given a typology of contexts, models and related parameters, what constitutes the optimal range of interest/fees that need to be charged from low income clients to fully cover total costs?”

The above critical aspect is best understood through the following example: For a Grameen MFI 36% could be the Full Cost as it is operating in a hilly and difficult terrain and providing doorstep services; For an SHG MFI B, 22% could be the full cost as it lends directly to SHGs and thereby is almost a semi-wholesaler; For SHG federations or Cooperatives, 18% could be the full cost because they accept deposits which are the cheapest source of non-subsidized capital and so on. [There numbers given above are merely illustrative and they can vary from context to context and model to model – so, please do not join issue with me on this. Thanks] 

The above strategy would also be fair approach in my opinion and the RBI Sub-Committee must try and recognise this, study this aspect[iii] and make recommendations accordingly. Please note that my FIRST emphasis is on understanding what the full (total and apportioned) costs are and this could be very different from full (total and apportioned) cost recovery (taken up next).

Now, with the total and apportioned costs – for different contexts, models and related parameters - that need to be charged for a full cost recovery out of the way, let us get to next aspect...how to recover these full costs?

Premise # 2 – Full costs are Always Recovered As A Combination of Interest/Fees and Different Kinds of Subsidies: This is again a strategic choice aspect and different models do it differently. There are two major ways in which this cost recovery can be handled: a) Apportion the same across the institution, intermediaries and clients – this is a creative strategy as it transfers the costs from one stakeholder to another; and b) Decide on the extent to which costs will be actually recovered and balance will be subsized.  We will look at each of these issues separately.

          

As you can see above, the full (total and apportioned) costs comprise of two portions – Recovered and Unrecovered costs. And the Unrecovered Cost contains different types of subsidies – Direct, Cross, Indirect and Hidden Subsidies.

Therefore, in some sense, there is always full cost recovery through interest plus fees and a range of subsidies provided. This is a very critical aspect to note and much of the arguments over interest rates can be better understood, if this crucial aspect is noted.

Therefore, the second strategic choice entails decision making within the organisation on: a) the extent to which full (total and apportioned) costs are to be actually recovered; and b) the different kinds of subsidies that (need to be and) are provided to cover the balance portion of total costs minus recovered costs (i.e., interest plus fees etc).

The most appropriate strategy here would be to get answers to the following question for a typology of contexts, models and related parameters:

2. “Given a typology of models, contexts and related parameters, what is the proportion of costs that are actually recovered (from clients etc) and how are the balance (unrecovered) costs met through various subsidies?”

The above critical aspect is best understood through the following example: MFIs perhaps charge 24-36% or more, recover all/most costs and sometimes even have a surplus. Banks charge 12% and cross-subsidize costs; SHG federations or Cooperatives charge 24% and recover full costs and Government programs perhaps lend at 3-6%, with the major costs being subsidized. [There numbers given above are merely illustrative and they can vary from one organisation to another – so, please do not join issue with me on this. Thanks] 

So, from the above discussion, it is clear that in some organisations, the whole cost could be recovered where as in others, there is only partial cost recovery and the rest is perhaps subsidized. MFIs perhaps charge what they charge because they have less of subsidies and practice door step banking; Cooperatives and Community models perhaps charge what they do because of using local and low cost staff and community for various aspects and also have access to savings (which is the cheapest source of non-subsidized capital); Banks charge what they do because of the norms set by regulators and supervisors and manage the actual (unrecovered) costs differently through cross subsidies, outsourcing etc; and Governments directly subsidize clients and charge as low as they do for various reasons

To summarise, the aspect of transactions and financial costs primarily centres around strategic decision making that organizations make on the following basic aspects.  What brings diversity in terms of the costs is the strategic choice that organizations exercise with regard to the following basic decisions:

ð   Whom to Serve? – Clientele, especially, with decision making on whether to serve the poor, not-so-poor, excluded, included, men, women etc

ð   How Many Clients to Cater To? Where to Operate? And How to Expand? – Outreach, Geographic Dispersion and/or Growth Strategy (Incremental, Quantum etc)

ð   What Specific Services to offer to the clients? – Products (financial intermediation encompasses a large number of products and combinations there of)

ð   What Methods of Service Delivery to Employ? – How to organize these channels like Groups, Individuals etc and their Tasks/Roles and outsourcing if any and the implications there of

ð   What Organizational Mechanisms to Use? – Legal/Institutional Forms

ð   How to Communicate the Availability of Various Services? - Promotion

ð   What the Medium/Long Term Objectives Are? – Single versus Double versus Triple bottom  lines?

And while, as noted earlier, full costs are always recovered from various sources, the strategic choices exercised to above questions result in some models choosing to recover costs fully from clients whereas other models may recover these partially from clients and cover the balance through different subsidies.

Therefore, it is humbly submitted to the RBI sub-committee that interest rates should NOT be viewed in rigid terms. They must be understood in terms of their broader context and its implications in terms of full cost recovery from clients versus partial cost recovery from clients plus subsidies. However, at the end of the day, there must be sufficient justification for pursuing either of the above strategies and that must be ascertained and understood...

And it goes without saying that, without understanding the above issues, condemning seemingly normal interest rates (I am sure we can discern exhorbitant interest rates straight away)  charged by institutions would be rather unfair and perhaps even unjustified...and it is sincerely hoped that decisions on (regulating) interest rates would be made only after undertaking a rigorous national study...encompassing alternative models in various contexts...and bench marking a range of interest rates for different contexts and models...And that alone will bring the interest rate controversy to its logical conclusion…

Tomorrow: Examples of how organisation’s reduce/transfer their (apportioned) costs including transactions costs

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[i] Includes financial costs plus operational costs, loan loss provisions plus inflation adjustment etc

[ii] Same as above

[iii] I will also try and outline the methodology, for under taking such a study, to determine full costs for different models, in a separate post.