Making Microfinance Prices More Transparent: Ideas for improving regulation
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The prices we charge the poor are far from transparent. How did we get here?
In most countries, pricing in microfinance has been extremely opaque for many years. MFIs are generally selling products in markets lacking Truth-in-Lending legislation. In the absence of that regulation, a small number of MFIs are motivated to mask their price, a few more follow suit, and then the resulting “downward spiral” traps nearly all MFIs into complicated pricing schemes.
The problem of keeping your price transparent is obvious — it’s difficult to show a true price that looks higher than the competition when, in fact, it is lower than that charged by others.
How complicated have we gotten?
The examples in Figure 1 show a variety of ways a loan’s price can be hidden. The truly transparent price looks much more expensive than the other products, when the reverse is actually true. The MFT “Transparency Index” at the bottom shows the amount of the true APR that is communicated through the nominal interest rate.
What results from non-transparent pricing? Since prices generate profits, non-transparent prices can be a means to generate very high profits by: 1) pulling clients away from lower-priced competitors, and 2) leading consumers to over-consume.
Transparent pricing corrects this market imperfection by increasing price competition and more informed decision-making by other stakeholders.
How do we calculate transparent pricing?
Figure 2 shows how a product advertised at 36% interest, with a 2% fee and 15% “savings” (a security deposit returned to the client at the end of the loan) can, in reality, have an APR of over 100%. ¹
Because of the potential to mask the true price, many countries have truth-in-lending legislation requiring the combination of pricing factors to be distilled down to the equivalent of an annual interest rate.
This is a positive step, but where it exists, pricing transparency regulation often misses the tricks used in microfinance, e.g., compulsory savings and obligatory insurance tied to the loan product. The partial transparency laws give the illusion of full pricing, while leaving loopholes that can still lead to much higher prices than advertised.
In addition to laws requiring that an APR be stated, additional measures can help close the gap between advertised prices and true prices, i.e., improve the Transparency Index we demonstrated earlier. For example, several countries, including Cambodia in 2001, have banned the use of “flat interest.”
Flat interest has no bearing at all to any textbook definition of interest and serves only as a means to bring in significantly more income for the MFI. This is a very important law that should be replicated elsewhere.
And what are the true prices of micro-credit?
A common, and flawed, assumption is that all micro-loans serve the same market and therefore have one market price. However, there is a very significant difference related to the loan sizes of different MFIs.
Figure 3 shows a common way of analyzing MFIs in a country – putting them all together into one pool and calculating an average.
The graph shows the portfolio yield (a rough and rather flawed proxy for average price of their products) for 59 MFIs in the Philippines, using data submitted to the MIX. The yield ranges from 15% to 72%.
Figure 4 takes that same data, but correlates the portfolio yields to average outstanding balance per loan. The result is a dramatic curve.
Those MFIs with the lowest portfolio yields tend to have the largest average loan balances, whereas those MFIs targeting the smallest loans have the highest portfolio yields.
Why do we charge higher prices for the smallest loans?
Figure 5 helps to explain why there is a price curve. In examining the operating cost data for the same 59 MFIs, we again see that there is a strong correlation between average loan balance and operating cost ratio.
The rationale becomes obvious – if an MFI spends $100 to process and monitor a loan for a year, the OER is 10% for a $1000 loan balance, 20% for a $500 loan balance, and 50% for a $200 loan balance. In other words, there is an operating cost curve.
Figure 6 provides an interesting perspective by combining the information from the previous two graphs. Price (the blue information) is consistently higher than the operating cost (red information), with a fairly constant margin across the spectrum of average loan balance.
The spread between yield and operating cost is necessary to cover loan loss provisions and financial expenses, with any surplus being left over resulting in profit.
How usury legislation does not address the realities of the micro-loan market
Figure 7 shows, first, the common assumption that pricing is a gradually sloped line, that prices need to slightly increase for smaller loans.
Second, when consumer abuse takes place, regulators often try to protect the clients by placing a usury law limit, shown at 30% in the figure. Third, the reality is that for smaller and smaller loans, the sloped line converts into a curve.
Banks and MFIs are venturing into giving smaller and smaller loans, but with those smaller loans, the Operating Cost Ratio increases, and therefore prices need to increase, exceeding the usury law.
Thus, the usury law, intended to protect the poor, ends up reducing the supply of credit to the poor.
Figure 8 then shows a second drawback of the usury laws. All stakeholders assume that clients are protected from higher-than-market-priced credit.
However, two institutions can both be under the usury limits, where the one giving very small loans is charging a “market price” and the second, with larger loans, is charging well above market prices for that loan amount and likely generating very high profits.
Because of the realities and unique circumstances of microfinance, usury laws backfire, and a better approach to improving the market is to enforce transparent pricing.
With accurate, comparable information, all stakeholders can compare the prices of loans of identical sizes and purposes and make better informed decisions.
This data was presented earlier this year at the G20 summit.
¹The Effective Interest Rate, using the compounding method applied in many countries, including the European Union, would actually be 185% for this same product. To calculate both APR and EIR of different loan products, download our free calculator software from www.mftransparency.org.
MicroFinance Transparency is an international non-governmental organization founded in 2008 with the purpose of facilitating transparent markets through pricing disclosure, education and policy advisory. MFTransparency represents an industry movement toward transparent practices and responsibility. Based in the United States, the group has organized transparent pricing efforts in nearly 30 countries on four continents, including 18 countries in Sub-Saharan Africa. For more information please visit www.mftransparency.org. More than 900 industry professionals and organizations have committed to transparent pricing by endorsing MFTransparency and its initiative.