Best Case: Transparency in Microfinance
Microfinance, originally a donor-funded innovation of the non-profit world, now more often makes headlines for its movement towards commercialization. As the debate about profit and social responsibility heats up, the importance of pricing transparency is growing increasingly apparent. Microfinance has long been a highly transparent industry, but unfortunately the true prices of microloan products have rarely been accurately measured or reported and remain widely misunderstood. In its next phase of development, improvements in interest rate disclosure and the standardization and communication of prices will be essential to the functioning of a healthy, sustainable microfinance industry.
The Evolution of Non-Transparent Pricing
One of the main reasons that non-transparent pricing in microfinance has evolved and spread is that the prices of microloans are usually higher than those of mainstream loans. The cost for a microfinance institution (MFI) to grant a loan is fairly flat relative to loan size. This means that the cost represents a higher percentage of the loan amount for smaller loans. Therefore, in order to cover the costs of these smaller loans, MFIs must charge higher prices than they would for larger loans.
Due to the challenges of explaining why MFIs need to charge higher interest rates than the commercial sector, and have to charge the poorest clients the highest interest rates, the easier alternative has been to use pricing methods where the quoted price appears significantly lower than the actual price. Once the industry began widely employing confusing product pricing, it became very difficult for any single MFI to maintain transparent pricing. To do so would leave that MFI advertising what appeared to be the highest price on the market, even though their true price could actually be the lowest. As a result, the vast majority of MFIs practice non-transparent pricing even though many would prefer to do otherwise.
In many countries, non-transparent pricing practices have proliferated in the absence of the type of truth-in-lending legislation that protects borrowers in the United States. Such laws were enacted to help consumers make informed decisions loans that seem comparable, though in actuality one loan is significantly more expensive. Coupled with the fact that many microfinance clients are poorly educated, illiterate and have no knowledge of formal financial products, it is nearly impossible for borrowers to make informed decisions about the products available to them. An important question for us to consider is: Shouldn't the same principles of transparent pricing applied in the commercial finance industry in many countries also apply to the microfinance industry?
Pricing in Microfinance
In the microfinance community, there is a significant gap between the strong desire to understand true prices and the limited technical knowledge about how to calculate these true prices. To illustrate this point, let us consider three very straightforward loan products. How would you compare their prices?
|Product||Loan amount and term||Payment schedule||Total paid|
|1||,000 for 12 months||Pay ,120 on the 12th month||,120|
|2||,000 for 12 months||Pay /month for 12 months||,066|
|3||,000 for 12 months||Pay /month for 3 months, then
Pay 7/month for 9 months
As you may intuitively have guessed after looking at the cash flow, the true prices of these three loans (when expressed as annual percentage rates) are identical, even though the total amounts paid are very different. Among borrowers the most common approach to loans is to ask “How much do I have to pay back in total?” When comparing loans, the intuitive approach fails.The most fundamental point to understand when discussing prices of loans is that the borrower is not buying a loan but rather is renting a specified amount of money, for a specified amount of time. What makes the pricing of loans confusing is that usually both the amount of money and the amount of time vary, making it difficult to compare options. Using annual percentage rates (APR) to express the price of a loan essentially communicates the rental price per dollar (or other currency) per year, enabling comparison between loans of different amounts and terms.
The problem in microfinance is that APRs (or effective interest rates) are seldom communicated to clients. In order to appear competitive, MFIs tend to give a myriad of complicated, confusing descriptions of fees and prices that make it nearly impossible for clients to make informed decisions about the products available to them. These can include some of the following non-transparent pricing practices:
- Charging flat interest rates. Typically, interest over the course of a loan term is charged on the remainder of the principal amount that the borrower still has. This is known as a declining balance rate. With a flat interest rate, interest is charged on the initial loan amount even though the borrower has less and less of that amount over the course of the loan term. There is no theoretical foundation for charging interest on money the borrower does not have. From a practical standpoint this practice can be very useful, however, as a flat rate appears inexpensive when in reality the amount the borrower pays can be equivalent to a declining balance interest rate of nearly twice as much.
- Hiding fees. Microfinance institutions often omit fees from advertisements, repayment schedules and even loan contracts. This gives the impression that the cost of the loan is only the interest rate, whereas in reality, and in terms of APR, the cost of the loan includes all payments a borrower is required to make in order to access the loan. MFIs often omit upfront fees such as mandatory insurance, taxes and processing fees from loan documentation to create the impression that the loan is cheaper than it really is.
- Collecting security deposits. In some cases borrowers are required to “save” a percentage of the loan amount in order to borrow. MFIs sometimes argue that this encourages a savings culture, but in reality it acts as a guarantee for the loan in the absence of collateral. Often borrowers do not have access to these “savings” during the loan term and do not earn interest on the amount. Furthermore, they are required to pay interest on the full loan amount although in reality they never had that much. This too is a cost of borrowing that is not presented as such.
These non-transparent practices increase the cost of borrowing because of the way they impact cash flow. APR calculations are based on cash flow, or the amount of money the borrower has over the course of the loan term, and specifically the concept that the longer the borrower holds on to an amount, the more valuable it is to him/her. For example, where compulsory savings increase the cost of borrowing because the client has less money from the start, a grace period decreases the cost of borrowing because it allows the client to use the full loan amount for longer. For the same reason, a longer loan term is better for the client because it means the client has more time with more money in their possession. Because APR takes cash flow into account, it is a much more accurate way of communicating the price of a loan than simply stating the total amount the client will have paid by the end of the loan term. Unless the APR or EIR of a loan is communicated, the true price is not known and the transaction is not transparent.
The Importance of Transparency
The most obvious issue with non-transparent pricing is that clients are unable to make informed decisions about borrowing. In reality, no industry stakeholder can make an informed decision if true prices are not known. This makes it difficult for MFIs to compete effectively, for regulators to implement appropriate policies and for funders to select and manage partnerships with MFIs.
In the absence of transparency, free market forces cannot operate properly and the industry cannot develop efficiently or sustainably. In an industry where consumers are often poorly educated, without experience in accessing financial products and unprotected by regulations, the potential for exploitation is profound. When MFIs operate in a very opaque pricing environment – where nobody really knows how the price of one product compares to the price of another – there is a very real opportunity for an MFI to charge a price that generates high short-term profits but harms its clients. This is bad for the poor and bad for the microfinance industry. High profits generated from the poor by charging high, non-transparent prices can create a very bad public image for the microfinance industry and result in a strong backlash. It may ultimately work against the institutions charging high prices as well, as clients find alternatives that better meet their needs.
An industry-wide effort to practice transparent pricing is essential to the long-term survival, growth and effectiveness of the microfinance industry. We must create a forum where the industry reports actual interest rates– in a clear, consistent and fair fashion – and explains why interest rates in competitive microfinance markets need to be higher than in commercial finance. By practicing pricing transparency we can contribute to building a healthy and vibrant market for microcredit products in each country, providing a valuable component that free and competitive markets need to develop – transparent, open communication about the true cost of products. In so doing, we ensure that our microloan clients receive the same information that we expect to receive when we take out a loan ourselves.
MFTransparency seeks to meet this need by gathering product prices on all microloan products around the world and publishing them using a common, objective measurement system. This allows all microfinance stakeholders to work with a full understanding of the costs paid by clients. MFTransparency has also undertaken the equally important role of developing and disseminating straightforward educational materials to enable all microfinance stakeholders to better understand the concept and function of interest rates and product pricing and to implement this newly available information for the betterment of the industry as a whole.
MFTransparency was launched at the Microcredit Summit in Bali on July 28, 2008. In the two years since, we have published transparent pricing data for the microfinance markets in Azerbaijan, Bosnia and Herzegovina, Cambodia and Kenya, representing 56 institutions and 270 loan products sold to more than 3 million clients. Data for India, Bolivia, Ecuador, Malawi, Burkina Faso and Senegal is forthcoming and projects are underway in 15 additional countries. In each of these countries we have provided local industry stakeholders, including MFIs, funders and regulators, with training on how to calculate interest rates and implement transparent pricing practices. We have also developed a wide range of educational materials tailored to the needs of different stakeholder groups for their local markets. In support of this work, we also advocate the importance of transparent pricing and encourage discussion of this important topic as speakers at industry events around the world.
By providing a valuable component essential to free markets and currently virtually absent in microfinance – transparent, open communication about the true cost of the product – MFTransparency is the venue where the microfinance industry can publicly demonstrate its commitment to transparency, integrity and poverty alleviation. We believe that transparency is a right for all stakeholders, and seek to engage a range of industry actors in building an effective, sustainable microfinance market on the foundation of transparency.