Interest Rate Debates

The assumption of inelastic demand for capital is a radical break from past thinking. In the 1970s and 1980s, usury laws were common, and they restricted interest rates on loans to low levels. These caps were often combined with directives on who should get subsidized loans and for what purpose.⁴ The laws were driven by the belief that high interest rates on working capital would consume most of the surpluses generated by small-scale entrepreneurs, leaving borrowers with little net gain. In Brazil in the early 1970s, for example, interest rates on loans for working capital were fixed at 17 percent per year while inflation rates ranged from 20 to 40 percent per year.⁵ Even where interest rate caps allowed positive real interest rates, they were seldom high enough to permit banks to cover costs. As a result, lending to the poor was a heavily-subsidized activity, monopolized by state-run banks. Too often, the subsidized resources went to non-poor households and political elites. Financial services tended to be low-quality, and scale was constrained by the size of government budgets.⁶

Microfinance advocates challenge the assumptions upon which the statesubsidized banks were built. Most microfinance interest rates now fall between 30 percent and 60 percent per year (in places where inflation runs no higher than 10 percent per year). Figure 1 [ PDF 161.4KB | 7 pages ] shows the range of costs charged by over 100 leading microlenders, averaged by countries. The figure gives real portfolio yields (calculated as the financial revenue from the loan portfolio as a fraction of the average gross loan portfolio, adjusted for inflation). The portfolio yields thus give average effective interest rates charged on loans, together with any extra loan-related service charges. The figures range from 0 percent at the bottom (for a single lender in Yugoslavia) to over 70 percent at the top, with a median of 30 percent; the 25th percentile has a real interest rate of 20 percent per year while the 75th percentile has a rate of 47 percent per year.

Donors who are shaping microfinance policy have spent much effort making the argument that raising real interests to 50 percent and higher is unlikely, in fact, to dissuade credit-worthy borrowers. The assertion stems from two ideas. The first is that marginal returns to capital diminish with scale. If that is so, poor borrowers who are starved for capital ought to have high marginal returns to their investments—and ought to be willing to pay high interest rates as a result (Consultative Group to Assist the Poor, 1996). The second idea is that poor households already pay very high interest rates to moneylenders (often 100 percent per year or more), so that if poor households can keep moneylenders in business, it should be no surprise that loans at half the moneylender rate are welcomed. Influential advocates now argue that poor households are so insensitive to interest rates that the standard practice ought to be to set fees high enough that institutions generate profits, cutting donors out of the loop after a short period of start-up subsidies.⁷ If this is so, microfinance can readily expand to serve the hundreds of millions of currently excluded households, without sacrificing depth of outreach.

This claim is far from clear as a general proposition. First, the assumption of diminishing marginal returns to capital disregards the possibility of non-convexities in production processes and unequal access to non-capital inputs like managerial skills and human capital. Moreover, raising interest rates can in principle exacerbate moral hazard and adverse selection, worsening loan repayment rates and screening out the most reliable borrowers.⁸ And, while microlenders may still find a pool of customers after real interest rates are raised, the customers may not be from the same pool that was willing and able to pay the lower rates. Fears like these, coupled with a strongly-felt moral imperative to keep costs as low as possible for the poor, have compelled the larger microlenders in Bangladesh to keep real interest rates below 40 percent per year, even if it means turning to subsidized resources to cover costs (e.g., Morduch, 1999). Figure 1 [ PDF 161.4KB | 7 pages ] shows that the average fees charged by two large lenders in Bangladesh are just under 30 percent. The Grameen Bank (which is not one of the two) keeps their interest rates and fees close to 20 percent per year (nominal) on their main lending products—and they deflect suggestions to raise rates. Figure 2 [ PDF 161.4KB | 7 pages ] shows differences in real interest rates across continents, with South Asia at the low end. Figure 3 [ PDF 161.4KB | 7 pages ] shows that institutions serving the poorest customers tend also to charge higher interest rates and face higher costs relative to lenders serving clients upmarket.

The views expressed in this paper are the views of the authors and do not necessarily reflect the views or policies of the Asian Development Bank Institute (ADBI), the Asian Development Bank (ADB), its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms..

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