Here is a question I have read on another page. I decided to give it a go.
The answer is simply because the costs of operating a microfinance institution (MFI) are slightly different from those required to run a regular bank.
Matching MFIs’ interest rates to those of banks would make it difficult, if not impossible, for micro-lenders in the formal or semi-formal sector to recover their costs, and force them to withdraw from the market (or prevent them from entering the market). Poor clients thus find themselves deprived of access to financial services or have to turn to informal credit markets.
Microcredit interest rates are established to enable the provision of large-scale financial services that are sustainable in the long-term. Until now, no suprises.
Like any regular bank, microfinance institutions will use these interest rates to cover most of their costs and losses and aim for an increase in their own funds. MFIs that do not follow up to this rule will most certainly function for a limited period of time, serve a limited amount of people, and will usually prioritize objectives established by a donor or a government rather than satisfying the needs of their clients. In this sense, only viable MFIs are able to provide permanent access to financial services to the hundreds of millions of people in need.
Now in an MFI, there are four major streams through which money is ‘flushed’, and that require a significant interest rate in order for the insitution to be viable:
1- Operational costs
MFIs carry out all their transactions in cash and often have to travel in order to collect money, resulting in high operational costs (personnel, vehicles, agencies ...). These are costs that traditional banks do not have to bear and that usually range between 10 and 25%. Operational costs usually weigh the heaviest when determining the interest rate to be set by an MFI, around 62% (Source Micro Finance Hub – «10 determinants of interest rates in microfinance»).
2- Costs related to credit losses
These costs can easily be controlled by the MFI. Though, regardless of the small sums lent, MFIs must ensure the sustainability of their activities. The default rate in microfinance must be maintained at up to 1% or 2% in the case of a high-performing financial entity.
3- Profits of operations
This is a political choice of each MFI which shall decide what strategy meets its goals best. Microfinance is after all a development-focused activity and therefore does not primarily aim at profits, at least not on paper. While my point here is not about condemning any profit-making process, it is certainly interesting to see what levels these margins stand at. In fact, profits make it possible to capitalize the institution and enable to invest in extending the geographical coverage and diversifying the products and services offered by the institution in question. The more money there is the more people can be assisted.
4- The cost of operating with loaned funds
MFIs usually lend money they have themselves borrowed from someone else. Their return rates are often close to 10%, which is significantly higher than those which conventional banks are entitled to. As a result, the cost of funds lent to MFIs makes for 23% in the interest rate requested to clients (according to Micro Finance Hub). In the same vein, while inflation is generally not taken into account by the MFI, it must nonetheless be anticipated as it regularly reaches 5% to 10% in developing countries.
Finally it is interesting to see that low-income borrowers are capable of returning the money back regardless of how high interest rates are. Any glimpse of common sense would find it risky (and offensive!) to charge poor people more than what rich companies already are. Yet empirical data shows that a very high rate of microcredit reimbursement by low income clients has been recorded all around the world. Indeed there is no evidence to this day of any microfinancing program finding difficulties because the interest rates applied were excessive and scared clients.
The fact that clients are honoring their credit debts and asking for more loans proves that the microcredit market is right in asking its micro-customers for high return rates that would otherwise suffocate any other larger company.