Using Technology to Build Inclusive Financial Systems

January, 2006     Gautam Ivatury

NProviding financial services to poor people is costly, in part, because they have small amounts of money, often live in sparsely populated areas, and rarely have documented credit histories. During the past few decades, specialized microfinance institutions (MFIs) have begun to solve the latter problem by developing techniques that permit safe lending in the absence of borrowers’ credit histories. Still, MFIs must charge relatively high interest rates to cover the administrative costs of handling small transactions for dispersed populations. MFIs with operating costs of 12–15 percent of assets are considered efficient, while the similar ratio for banks rarely exceeds 5 percent.

Despite significant inroads in microfinance in recent years, such as through widespread wholesale lending to MFIs, most commercial banks still view microfinance as unprofitable. Unlike MFIs, many commercial banks cannot compensate for high costs by charging high interest rates. Banks in many developing countries are legally required to limit interest rates on loans to low-income and rural borrowers, particularly when they use government funds. In India, most commercial banks cannot charge more than their prime lending rate (roughly 11%) for loans below Rs. 200,000 (US$ 4,500). Public-sector banks are particularly sensitive to the political implications of charging poor borrowers relatively high interest rates.

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