Is the high interest rate of microfinance always a curse?
Despite the high interest rate charged by MFIs, microfinance remains one of the most popular business financing choices in Bangladesh. However, making comparisons between the interest rates charged by commercial banks and those of MFIs is not always appropriate
Microfinance is a service that offers microcredit, micro-insurance, micro-savings, pension and other financial products to local entrepreneurs and low-income individuals who lack access to traditional banking services. Microfinance services are provided by non-governmental organisations (NGOs), commonly referred to as Microfinance Institutions (MFIs).
MFIs often face criticism for their higher interest rates compared to banks and other financial institutions. Furthermore, many researchers have also confirmed that microfinance institutions have been charging high-interest rates on loans given to impoverished individuals globally over the last few decades.
However, it is crucial to bear in mind that making comparisons between the interest rates charged by commercial banks and those of MFIs is not always appropriate.
Commercial banks provide large loans which means lower transaction costs which results in lower interest rates. On the other hand, MFIs do charge higher interest rates due to the higher cost of micro-lending. These loans serve as the primary source of income for MFIs, and therefore, the interest rates need to be sufficient to cover operational costs.
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Despite the high interest rate charged by MFIs, microfinance remains one of the most popular business financing choices in many nations including Bangladesh. This could be because many poor people in Bangladesh lack the education required to fulfil bank loan requirements.
Furthermore, many impoverished individuals do not have the collateral security that commercial banks require in the form of a secured mortgage, which is a prerequisite for obtaining loans. All of these intricate procedures prevent impoverished people from obtaining bank loans.
On the other hand, MFIs may provide loans to the poor without any collateral security. In addition, MFIs provide loans to help establish their businesses without any complicated procedures. Thus, MFIs create a window of opportunity for poor people to start their businesses through microfinance, a process known as financial inclusion.
However, in certain cases, there are inconsistencies while collecting instalment amounts from microfinance borrowers and that needs to be addressed. For example, on certain occasions, the officers of MFIs may reprimand the borrowers who are struggling financially, issue warnings, visit in groups to collect the instalment amount or even confiscate items from the borrowers' shops if they are unable to repay the instalment on time.
To maximise the effectiveness of microfinance as a development tool, it is crucial to address and resolve those irregularities. Therefore, field officers of MFIs involved in loan provision must demonstrate responsible behaviour when making and monitoring loans. MFIs should also hire responsible management teams with good governance to have a beneficial impact on the lives of the poor, ensuring financial inclusion and thereby poverty alleviation.
A review of our history reveals that before the establishment of microfinance institutions (MFIs), people from disadvantaged backgrounds in Bangladesh sought loans from individual moneylenders, also referred to as "Sudi Karbari" or "Sudi Mahajan." The interest rates charged by those money lenders were significantly higher compared to those of the MFIs. Borrowers in need often found themselves trapped in loans, as lenders would consistently collect the monthly interest without offering a way out. Individuals were required to pay interest for an extended duration, ultimately resulting in financial hardship.
In contrast, MFIs allow borrowers to pay both principal and interest over a certain length of time, typically one year. As a result, MFIs prevent local moneylenders from exploiting people in need and rescue them from such exploitation. This could be one of the reasons why microfinance is still so popular around the world, especially in rural Bangladesh. However, MFIs must ensure that loans are made available in income-generating and job-creating sectors so that impoverished people do not fall into a credit trap.
It is widely recognised that the primary objective of the Sustainable Development Goals (SDGs) established by the United Nations and its member states is to eliminate poverty. Microfinance has played a crucial role in poverty reduction in Bangladesh and has the potential to serve as an effective tool for promoting development and addressing poverty in the country.
The International Food Policy Research Institute (IFPRI) found that microfinance reduced rural poverty in Bangladesh by 10% over two decades, lifting 2.5 million Bangladeshis out of poverty. Today Bangladeshi MFIs serve 32 million customers and distribute approximately $7.2 billion annually.
Furthermore, microfinance can be utilised to foster entrepreneurship, stimulate job growth, enhance financial access for the underprivileged, ensure business longevity and more. MFIs should additionally provide appropriate training and development opportunities to educate individuals living in poverty. Thus, microfinance can contribute to achieving the goal of eradicating poverty as outlined in the Sustainable Development Goals.
Dr Sheikh Ashiqurrahman Prince is a professor at the Bangladesh Institute of Governance and Management (BIGM). sheikh.prince@bigm.edu.bd
Sayed Azharul Islam is an Assistant Professor at Khulna University. azharulsayed@hrm.ku.ac.bd
Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.
