Does Microfinance in South Asia Need Regulation?
The Thanksgiving dinner I attended last night at a professor’s residence had generous servings of turkey, fine wine, and, of course, a lovely side of international affairs debates.
One particularly heated conversation was about the growing regulatory backlash in South Asia against the microfinance industry, which some say has been partly transformed from a pro-poor solution as pioneered by Nobel laureate Muhammad Yunus into an exploitative profit-making machine. In response to complaints about usurious rates and coercive collection tactics, India’s microfinance industry recently agreed to a voluntary 24 percent interest rate cap on microloans in the southern state of Andhra Pradesh, while Bangladesh has restricted interest rates to 27 percent.
Is this increased regulation necessary or should the free market be left to find its own equilibrium?
In my view, increased regulation is clearly necessary. There is clear evidence of abuse on the part of these microfinance institutions (MFIs). In Andhra Pradesh for example, deaths have been attributed to exorbitant interest rates and abusive lending practices, and women who have fallen behind their payment schedules have been subjected to bullying, harassment, and public vilification. Getting exact numbers on this is tricky, but this pattern is clearly visible and even those opposed to regulation admit there are problems. Consequently, the poor, who are often ill-informed, illiterate and innumerate, do need some form of protection against these profit-seeking companies. The market hasn’t worked thus far.
The counterarguments also don’t make much sense to me. Some say these MFIs are angelic compared to ruthless moneylenders who charge rates beyond 100 percent (MFIs now charge a median of 28 percent). But just because a better option is more desirable than worse one doesn’t mean we shouldn’t try to make much-needed improvements to that better option to strive for the best possible outcome.
Others claim that many MFIs will go out of business if interest rates are capped. I suspect this threat is highly exaggerated. As was mentioned before, the median interest rate was 28 percent in 2009, and the capped rates of 24 percent and 27 percent are not radically lower than that rate. Plus, it’s not like these companies are barely floating above the water right now. One study by the Consultative Group to Assist the Poor (CGAP) found that MFIs earned an average 2.1 percent return on assets annually, which is 50% higher than the 1.4 percent earned by banks. There is also no evidence that this will adversely affect the health of nations’ financial systems.
Some fear that if interest rates are lowered, MFIs will cut their outreach to the poorest and most isolated areas due to higher transaction costs. But, again, these MFIs are by some accounts already cutting costs by poaching loan officers from their rivals, targeting the same borrowers and neglecting investing in new communities (which require additional training and preparation) in order to collect greater returns on equity. It thus doesn’t seem like regulation would prevent them otherwise reaching out to the most vulnerable.
I recognize that while interest rate caps may spur innovation and cost-cutting, they alone aren’t a panacea. Governments recognize this too. That’s why Bangladesh, for instance, included bans on forced deductions, caps on administrative charges and required loan grace periods as part of a package of restrictions in addition to interest rate caps. I suspect other smart measures will also follow suit, such as making it mandatory for all companies publicly disclose their loan costs (which caused rates to drop 3.5 to 5 percent in Cambodia) and other consumer protection legislation on complaint resolution procedures and education.
But there’s no question in my mind that some degree of regulation is required in the microfinance industry.