Micro lenders’ business model not sustainable

0
526

These days, not a single set of annual or interim results passes without making reference to the liquidity squeeze ravaging the financial markets; and to its negative impact on efforts to mobilise capital for growth purposes.
A direct result of this liquidity squeeze is the increase in the cost of credit, known to be as high as 35% per annum in traditional or primary banking circles while other providers of finance such as microfinance institutions (MFIs) have been known to charge 180% on an annualised basis.
While such interest rates are so unbelievable as to appear surreal, they are a fact of our current financial DNA and it is important to understand how they arise in order to react properly (if not rationally) to them.
The liquidity challenges dogging the economy have made banks more risk averse, so they will not lend to you simply because you have a heartbeat like what was happening in some parts of the world prior to the sub-prime mortgage crisis.
In addition to reflecting the underlying scarcity of money, high interest rates are also as much an attempt to suitably price the default risk inherent in the economy as they are a deterrent effect for speculative borrowers.
The inability (as opposed to unwillingness) of the banking sector to fully play its intermediary role has resulted in banks ceding some space to alternative providers of credit such as MFIs.
By enforcing stringent borrowing requirements, banks are acknowledging that they can’t be all things to all men and are thus leaving some room for MFIs to come in and play the important role of satisfying the credit needs of those who are unable to meet the minimum credit criteria of mainstream banking.
The essence of micro lending is financial inclusion for the poor and marginalised.
However, while MFIs are ostensibly playing an important role in the current financial set up, the sustainability of their business models— in particular their pricing models— has to be brought into question.
Typically, MFIs charge interest of 15% per month. This means that for an amount of $1000 borrowed over a period of 3 months, which is the typical period for loans by MFIs, the amount payable as interest is $450 in absolute terms and 45% in percentage terms.
If we were to extrapolate and assume a loan period of 1 year, the effective interest rate would be a whopping 180%, before even factoring in other applicable flat fees. Is the cost of funding for these MFIs that high?
Now the question is: Who is borrowing at such rates and for what purpose are they applying the proceeds of such loans? In this environment, which business activity can generate enough returns to remain profitable after meeting such high finance costs and accounting for normal operating costs?
These questions seem to discourage if not entirely prevent corporates from becoming borrowers of MFIs; and appear to confirm that such loans are primarily financing the consumptive impulses of desperate individual borrowers.
However, with average salaries for civil servants (the most likely borrowers) in the region of $200, the capacity to repay such loans cannot be guaranteed, especially at such high interest rates.
Why then do MFIs continue to aggressively push these loans without becoming risk averse as banks have become? The answer is simple and it lies in the security packages MFIs require for such loans.
Typically, MFIs lend against movable assets such as motor vehicles, jewellery, electric generators, laptops and other electronic goods, and the value of the security is set at twice the amount borrowed.
If a borrower defaults on the loan, the lender simply realises the security by selling it on the open market.
It would be interesting to know at what value the security is disposed and whether any surplus after settling for the capital, interest and other costs is refunded to the borrower? In their big, bold and full-colour advertisements, MFIs promise same-day approval of tailor-made loan solutions for various financial setbacks — in short they promise convenience and financial freedom — but at 180% annualised interest rates and such stringent security requirements, are they delivering anything other than financial bondage?
The conclusion one must regrettably come to is that their business model does not encourage repeat customers and is therefore not sustainable. It doesn’t rely on proper, creditable demand for liquidity but it preys on those deep in the throes of financial despair and desperation.
Desperation is however not a permanent, sustainable state so one must wonder if, in the fullness of time when the liquidity situation improves, these MFIs will still have borrowers beating up a path to their doorstep? Or maybe they will not care because they will have already made their money?
Perhaps if they had any pretensions about balancing their commercial considerations with their customers’ interests, they would reduce their interest costs and benefit from dispensing more affordable loans to more borrowers.
Of course, there are no illusions that this will happen soon because the get-rich-quick spirit of our inflationary yesteryear is still prowling the financial landscape, waiting to possess whom it may.
Naturally, supply and demand dynamics dictate that the price of something that is scarce must rise accordingly until the point of equilibrium is achieved; and we know that pent up demand for liquidity may make borrowers less sensitive to pricing, but where must the line be drawn, lest our worst fears about Proverbs chapter 22 verse 7 are confirmed?
In the meantime, MFIs would do well to heed this week’s principle of sound banking practice from Hugh McCullcoh, the then newly appointed (December 1863) US Comptroller of the Currency and later the US Secretary of the Treasury: “Treat your customers liberally, bearing in mind the fact that a bank prospers as its customers prosper, but never permit them to dictate your policy.”

l Omen Muza is a financial services sector expert