Interest Rates: What Are the Lessons from Russia on "How Much Is Too Much?"

This is the final post in the short series on microfinance in Russia.

In the two previous blog posts on this topic, we wrote on the situation with exorbitant interest rates charged by a few Russian commercial lending companies calling themselves “microlenders” (though we prefer to label them “payday lenders”).  We also shared suggestions from the Russian MFI community to the Russian regulatory authorities, which have been favorably received.

Certainly, Russia is not alone facing this issue; there are many other countries struggling with the question whether it is possible to draw a meaningful line between “justifiable” and “exploitative” interest rates – in other words, trying to answer the question “how much is too much?” The question has enormous political as well as operational relevance.  In this final post of the series, we would like to explore the issue by going back to the basics of what can – and should – go into setting the price of a loan.

As we know, an interest rate is a function of several factors. In 2002, CGAP published Occasional Paper No. 1 “Microcredit Interest Rates” that laid out in a single formula combining all the costs and other elements that go into a sustainable interest rate. These are now well-accepted in our industry and basically include: an MFI’s cost of funds (including inflation), operating costs, costs of delinquency and loan losses, and target rate of returns. The situation in Russia and other countries is now leading us to want to revisit each of these factors, “deconstructing” the concept of “sustainable” interest rates and review each of these factors, to see if this process sheds some light on whether any given interest rate can be considered responsible.

• Clearly, MFIs have no control over the inflation rate and little control over the cost of funds. So logically, higher interest rates would be typical in markets where funding is more expensive and inflation is higher.
• As for the critical elements of operational costs and loan losses, the most accepted approach is to compare MFIs with their peers. There are a lot of resources on accepted benchmarks and standards for various contexts.  But markets like Russia trigger the question of how to determine peer groups, especially when an institution’s performance metrics are far from transparent.  For operational costs, the peer comparison would usually take into account the size and age of the institution (on the assumption that lending benefits from some economies of scale and MFIs get more efficient over time), as well as product and client segment (with the understanding, for example, that providing smaller loans to more remote rural borrowers generally would be more expensive than providing larger loans in cities). Compared to “classic” MFIs (as they are thought of in Russia and many other markets), the payday lenders might have an edge in some operational costs (e.g., urban focus) and disadvantages in others (e.g., younger institutions). But for the most part this is mere speculation – for a very important reason. Peer group comparisons are either impossible or not of much value without transparency on the standard performance metrics that allow one to assess the assumptions that are built into an MFI’s business model.  Russian payday lenders do not report their basic financial data to the Russian financial authorities (though this is to change soon as supervisor regulations come into force), let alone the MIX Market.
• The challenge of transparent peer group comparisons is even more pronounced in the area of loan loss costs. For example, “classic” MFIs  tend to keep their loan losses very low (below 1-2 percent of the loan portfolio per annum) through careful client screening and selection.  Many consumer lenders and credit card companies, by contrast, often use rough credit scoring or forego client analysis altogether, relying on high volume and passing high projected loan loss rates onto their clients in the form of higher interest rates.  Going back to Russia, one of the “microlenders” discussed earlier in this blog series publicly disclosed its loan loss rate of 17 percent as a conscious business decision. In our view, this should raise a question whether this provider’s business model is “responsible.”
• Covering unacceptably high loss rates is just one way the proceeds of high interest rates can be deployed, of course.  High profits are another.  Since the Russian “microlenders” we wrote about in the previous blogs are not transparent, we can only speculate about the levels of returns on equity and assets that result from the high rates they charge.  Benchmarking the “responsibility” of profit margins against others in the market (whether are not they could be considered peers) is simply not possible in the absence of this data.
• There is one newer dimension of responsible pricing that the microfinance community has only recently begun to discuss in earnest. The Compensation Transparency Initiative, among others, asks the question of whether the total pay received by MFI CEOs (including commissions, bonuses, in-kind benefits, and other compensation in addition to salary) is consistent with a commitment to responsible finance. From the perspective of assessing the reasonableness of interest rates, executive compensation is not likely to raise prices much, since it will always be a fairly low share of overall operating expenses. However, given the potential fall-outs such as customer confidence, incentives for unsustainable growth, and reputation risk to the industry, this cost element indeed deserves a thorough, evidence-based, and spirited debate.

We would argue that any discussion about responsible pricing – whether in Russia or in another market that has a range of lenders with diverse business models targeting the same or similar client segments – benefits from analyzing WHY those costs are as high as they are. The story of a young MFI seeking to extend small loans to economically active borrowers in more remote regions through a careful lending methodology is very different from that of the lenders that kicked off this series: the Russian payday lenders using its partnership with the post office to target pensioners and other potentially vulnerable postal customers. Regulators and policy makers who are seeking to determine “how much is too much” and draw the line between “justifiable” and “exploitative” interest rates need to insist on greater transparency and to undertake a more nuanced analysis of the facts in their market. Distinguishing between the cost drivers, with a particular focus on the elements of projected loss rates and profits, will stand them in good stead.

We would also argue that it is a sign of maturity that the global microfinance industry has demonstrated a renewed commitment to transparency and a willingness to open the discussion about the concept of “balanced returns,” including the level of profits generated by different MFIs and how those profits are allocated. The outcome of this dialogue will be important to ensure fair treatment for consumers. It is also essential to ensure fair competition for lenders that seek to be recognized as responsible.