Microfinance Institutions & Interest Rate-Bank Rakyat Indonesia Shows the Way

Paper
Date Published: 
Jan 2005
Author: 
Patel, A. & Kalkoti, G.

Why are interest rate ceilings bad for the poorest of the population?

This paper examines the rationale behind the high interest rate charged by microfinance institutions (MFIs) and suggests enabling measures to reduce this rate so as to make it affordable to the poorest of the poor.

The paper states that:

  • High interest rates have induced the growth of the microcredit industry;
  • However, the poorest of the poor cannot afford to these loans because of their high costs;
  • MFIs meet their various operational costs from the interest they charge to their clients;
  • Imposing interest rate ceilings will adversely impact the MFI's ability to expand;
  • However, governments and central banking authorities in developing countries need to create an enabling environment to reduce interest rates progressively.

The paper identifies the following success factors of Bank Rakyat, Indonesia that provides microloans and is the largest sustainable financial intermediary in the developing world:

  • Loans at market rate;
  • Use of income to finance operations;
  • Low operating costs and attractive savings instruments;
  • Government abolition of credit ceilings;
  • Government permission to banks to set their own interest rates on loans and deposits.

The paper concludes that interest rates should be based on total cost recovery and this can be achieved through promoting more competitive markets, low operating costs and efficiency of MFIs rather than through government-led administrative measures that undermine sustainable development and growth of the microfinance industry.

Type: 
Paper