An Interest Rate Example
By Alex Duong, KF9, Vietnam
“That’s my philosophy. The key is to get up in that batter’s box and take a swing. And all you have to do is hit one single, a couple of doubles, and an occasional home run out of every 10 at-bats, and you’re going to be the best hitter or the best business leader around. You can’t play in the major leagues without having a lot of failures.
- John Donahoe, eBay CEO
Substitute “hitter” and “business leader” for microfinance institution and the quote is absolutely relevant. Microfinance is still in its infancy and far from perfect. So long as more players enter the batter’s box, exciting innovations will appear on the horizon. And interest rates are likely to come down assuming healthy competition takes place. Until that time, however, the following is one rationale for current interest rates from the perspective of interest rate spread (click “more” below).
Imagine being offered 10% to open a savings account. Though too good to be true in the US, it is a reality in Vietnam. The table below was obtained from Vietnam News, a local Vietnam newspaper (Feb 27, 2010 edition). Savings rates offered at some of the largest banks in Vietnam hover just under 10.5%. From a US perspective the rates are hard to believe. Consequently it can be important to step into the shoes of others; only then might we make sense of the situation.
Consider that MFIs are essentially banks serving the poor. When it comes to lending, banks make money by borrowing at a low rate (e.g. taking in money via savings accounts) and lending at a high rate. In the US, a one-year CD is offering around 1%. Currently, someone with good credit might get 5.5% on a fixed mortgage or 6.5% on an auto loan. Lets assume a US person with good credit could get 6% on a personal loan overall. That means a US bank has an interest rate spread of 5% (obtains funds at 1% and lends out at 6%).
MFIs receive grants, offer savings accounts, and borrow from major banks (think Citigroup or Oxfam) to obtain financing. Sometimes MFIs obtain a large amount of financing from major banks; as much as 70% of an MFI’s portfolio could have been financed by major banks. Informal surveys and discussions with MFIs and Kiva fellows show the major banks charge between 8-14% interest. Assume the average is approximately 11%.
Now we have some numbers to apply. If MFIs borrow at 11%, it implies they must lend at 16% interest to have a 5% interest rate spread like US banks. However, lending to the poor who have no collateral or credit history is often seen as more risky. So lets tack on another 2% to address the extra risk. In addition, US banks have other means of generating revenue to cover fixed and operational costs (ATM fees, credit card balances, etc.). MFIs on the other hand generate nearly all revenues through lending. Lets add another conservative 5% to cover these costs given Kiva fellows’ stories on the topic here and here. The minimum interest rate MFIs must charge on average has suddenly become 16% + 2% + 5% = 23%.
In specifically looking at Vietnam, it has been shown that savings accounts offer nearly 10.5%. A Vietnam bank wanting a 5% spread would therefore charge a Vietnam MFI 15.5%. Again, the Vietnam MFI would in turn have to charge borrowers 15.5% + 2% + 5% = 22.5%. This comes close to the portfolio yield for Vietnam MFIs listed on Kiva’s website.
Of course country-specific complexities have not yet been considered. Local regulations described by Kiva fellows here and here can increase operational and regulatory compliance costs beyond that of a US bank. Countries suffering constant currency devaluation must still repay Kiva loans (and ultimately you Kiva lenders) in US dollars. A linear regression of quarterly Vietnam exchange rate data for the past 10 years shows an annual currency devaluation of 3.25%. Not counting interest, a five-year loan would require an extra 16.25% just to repay the principal amount! If borrowing in non-local currency is the only option, devaluation becomes a heavy burden in helping the poor. And of course people, process, and technology inefficiencies necessitate higher interest rates to cover additional time and money.
Kiva fellows present observations from ground zero. Whether we personally support the interest rates or not is irrelevant. We merely attempt to rationalize what our own eyes see for the Kiva community. Although an approximation, the above calculations provide another perspective on what are seemingly high interest rates. Perhaps the bigger question, however, is why the major banks charge MFIs so much more. One single US individual qualifies for 6% on a personal loan. He could at any moment lose his job or run into tragic events. However, tens of thousands of borrowers (e.g. an MFI’s customers) collectively don’t qualify for the same rate. Statistics around the web show that the MFI industry successfully pays back nearly 98% of all loans. So perhaps there is more misunderstanding as a whole to sort out before interest rates truly reflect the amount of risk involved in serving the poor.
Hopefully this has shown current interest rates are at least plausible and sometimes necessary just for an MFI to survive. So keep doing what you do best Kiva community and click here to lend!
For the quant jockeys out there, consider the additional following:
- Ideally, one should begin with the lending rate charged to businesses. However, it would have meant considering market capitalization and financial statements. The intent was to keep the above analysis rather straightforward. Most everyone is familiar with mortgage and auto loan interest rates.
- The interest rate is based on how risky the bank perceives the customer to be. It is a rate that covers default risk and provides reasonable profit for the amount of risk taken. I assume MFIs act in a similar manner. However, because an MFI’s customers are generally more risky, I believe MFIs charge a spread equal to or greater than what a major bank would charge. Kiva fellow Dennis Espinoza presents an interesting and slightly different view here.
- Notice the near absence of change between 3-month and one year rates for Vietnam savings accounts. This alone could be an interesting area to explore and recount as a blog post.
- Kiva fellow Josh Weinstein presents another layer to the equation here. Josh states there are subgroups amongst microfinance borrowers that have different needs. This could possibly sustain different interest rate charges.