Transaction costs of micro credit

Microfinance is the provision of financial services to low income or poor clients. These services include micro credit, remittances, insurance and counseling. Although, there are so many services that Microfinance Institutions (MFI) could provide to their clients, micro credit has become the primary activity of almost all MFI. Micro credit has been accepted as a basic human right and it is said that every poor person has a right to credit to improve his/her life. Micro credit empowers the poor to break the vicious cycle of poverty by opening the door for self-employment and generation of income.

Around 95% of the assets of MFI, all over the world, represent micro credit and on an average around 80% of their operational income is generated from the lending activity. Other services such as savings and insurance are complementary to the provision of credit. Hence, this paper focuses only on the transaction cost of provision of micro credit. Micro credit is different from the other types of credit provided by banks and other financial institutions. These unsecured loans are in small amounts with high frequency of repayment and shorter tenures. The transaction cost of any loan given by any financial institution is not directly proportional to the size of the loan amount. Most of the time, the transaction cost of a small loan may not be vastly different from that of a large loan. However the interest income generated from the small loan is certainly much less than that of the large loan. If an MFI is to survive on a long term basis, its operations should be financially sustainable. Sustainability can be achieved only if the total income generated (mainly from the loan portfolio) is more than the total of all operational costs. The cost of an MFI can be grouped into three categories as shown below:

i) Variable costs such as costs of loans officers and recovery officers and loan loss provision which are proportional to the quantum of the loan.

ii) Fixed costs such as salaries of management and administrative staff, rent, transport and other fixed overhead.

iii) Costs of borrowings and equity

Some consider only the cost shown under (i) as transaction cost as these are directly proportional to the quantum of the loan while others consider all costs shown under (i), (ii) and (iii) above as the transaction cost of any loan granted by a financial institution smaller loan may not be vastly different from that of a larger loan. One of the main ratios used to measure the sustainability of a MFI is Operational Self Sufficiency (OSS). If the OSS of MFI is higher than 100% that MFI is said to have achieved sustainability. In addition to recovering all costs, MFI should also generate surplus as a return to the providers of its equity capital. The difference between the total income and the total cost, which is known as profits, is the residual available to providers of capital. This is called the financial bottom line, one of the two bottom lines which all MFI are trying to achieve maximized. Without burdening the client by increasing the rate of interest, the only way that the MFI could improve its sustainability is to reduce its transaction cost.

If MFIs are to effectively contribute to the reduction of world poverty, they must reach a large number of poor and low income people who are not presently served by any financial institution. The transaction cost of provision of microfinance services has a direct relationship to MFI outreach. The transaction cost of MFI with a low outreach is much higher than that of the MFI with very high outreach. MFI can reduce their transaction costs by increasing their outreach and by achieving economies of scale. The question here is whether there is an adequate market for MFI to expand. The answer is yes. The current market potential for microfinance is enormous. Microfinance is two types of poverty, namely absolute poverty (also called extreme poverty) and relative poverty. People who live in absolute poverty lack basic human needs such as food, shelter, healthcare, clothing, education and sanitation. People under this category live below the poverty line and the internationally accepted poverty line is the level of income of less than US$ 1 per day per person. According to the Microcredit Summit Report 2012, out of the total world population of seven billion people, 1.4 billion live below the poverty line of US$ 1 per day. This group of people is the potential market for MFI to increase their outreach. The relevance and importance of transaction cost will depend on the type of the MFI and also the sources of funding of each MFI. MFI operating all over the world can be broadly categorized into five groups: i) Government owned MFI or Government- sponsored programmes ii) Co-operative type institutions - Owned and managed by members iii) Non-Governmental Organizations (NGOs) - Not for profit organizations iv) For profit private sector Micro

banks and MFI v) Commercial banks and finance companies Most of the state-owned MFI and government-sponsored programmes are not concerned about the transaction costs or sustainability as they get funding from their respective governments. Whether their operations are sustainable or not, money will flow from the government due to political reasons. Other types of institutions are concerned about the sustainability as their survival will depend on whether they generate an adequate income to offset all their expenses including the cost of funding. They mainly raise commercial funding and this commercial funding comes from the general public in the form of deposits, loans from commercial banks, international development agencies, charitable trusts and also from the capital markets. All these investors and lenders would insist that their money is used in a sustainable manner enabling MFIs to service the borrowed loans and also generate a return to the shareholders. Although MFI at their early stage of operations may be able to raise some funds in the form of grants, they will not be able to depend continuously on grants. If they are to be in business on long term, one day they need to resort to commercial funding. Lenders and Investors in the capital market will consider only the MFI with financial sustainability for lending and investments. Today most of the MFI in South Asia (particularly India) and Latin America secure their funding from banks and capital markets. In India, the percentage of funds raised from banks by MFI is around 70 per cent of their requirement. Efficient and more profitable MFI can get very favourable rates from banks enabling them to reduce their transaction costs. As mentioned earlier, the main source of income of an MFI is its interest income and if the MFI are to achieve sustainability, the rate of interest they charge should be adequate to generate an interest income sufficient to offset all operational expenses. In deciding the optimal rate of interest to be charged, the MFI should take into account the entirety of the transac- tion costs involved in granting a loan. In deciding the rate of interest, it is not only the transaction cost those MFI should take into account but also should consider the reasonableness of the rate, ability of borrowers to repay and regulations, if any.

Although the reduction of transaction cost is not an easy task, many MFIs over time have reduced their transaction cost by improving their operational efficiency and productivity and also by achieving economies of scale through expanding their breadth and depth outreach. The improvement of efficiency and productivity of this staff can bring down the transaction cost. There are several efficiency and productivity ratios used by MFIs to measure the efficiency and productivity of direct staff such as loans officers. Some of these ratios are: No of active borrowers per loans officer Portfolio outstanding per loans officer Total amount disbursed per loan officer The number of loans handled by a loans officer will depends on the method of credit delivery and the level of technology used. If the group lending method is used, a loans officer can handled a larger number than the number handled under the individual lending method. Another factor that will affect the number of loans handled by a loans officer is the frequency and the system adopted in recoveries. Loan recoveries can be on weekly or fortnightly or monthly basis. On the other hand, MFIs use different ways of collecting repayments. In some cases borrower will come to the MFI office and pay. In some cases the loans officer will go to the borrower and collect the repayment. In some cases MFIs use electronic payment methods. In view of this, the number of loans that a loans officer can handle will vary. MFIs should endeavour to select the most cost effective method for credit delivery and recovery. The selection of a very efficient system of credit delivery and loan recovery will reduce the transaction cost . One of the factors that strongly affect the transaction cost and the sustainability of an MFI is the quality of its portfolio. The amount that should be provided for loan losses, an element of the transaction cost, will depend on the quality of its portfolio. So many ratios are used to measure the portfolio quality. The Portfolio At Risk (PAR) is the principal ratio used to measure the portfolio quality. Other ratios are Current Recovery Rate (CRR), Loans At Risk (LAR) and Write-off Ratio (WR). If the portfolio quality is poor, the MFI would be compelled to make a high loan loss provision.

Loan loss provision is part of the transaction cost and the MFI should earn through the rate of interest to look after this cost component. The international norm for PAR is to be less than 6% of its portfolio and a provision of 1% on lending portfolio is adequate to cover this level of PAR. When the PAR is more, it is essential to provide more resulting in increased transaction cost. The process to maintain a quality portfolio should begin at the time of granting the credit. At the approval stage, the MFI should take measures to avoid "Adverse Selection" and during the tenure of the loan MFI should avoid "Moral Hazard". The proper evaluation of the borrower and the proposal for which the credit is granted will avoid the "Adverse Selection". Evaluation of the borrower and the credit proposal should be done in a professional manner and credit officers should be properly trained to evaluate borrowers and credit proposals. The professional evaluation of the borrower and the credit proposal will reduce the probability of the loan falling in to Non-Performing category. The close supervision after loan disbursement and taking timely and strict action against willful defaulters can avoid the "Moral Hazard" if the loan goes bad after disbursement.

The other major cost component in the transaction cost is the interest cost. Most MFIs need to borrow from banks or other sources for lending purposes. The quantum that can be borrowed will depend on the required capital adequacy ratio the MFI should maintain. In the above example, a capital adequacy ratio of 12% has been assumed. The MFIs can reduce this cost to have a very strong balance sheet to convince the lenders that their money is safe with them and risk involved is minimal. Impressive ratios of PAR, ROA, ROE and OSS could be influenced lenders to reduce the cost of lending thereby reducing the transaction cost. From the above it can be seen that the transaction costs of micro credit has a direct impact on the sustainability of an MFI. All steps need to be taken to reduce the transaction cost for the benefit of Borrowers as well as the MFI: (The writer is a banker with nearly 35 years of experience specializing in SME and Microfinance. He was former CEO of Nationwide Microbank - Papua New Guinea, General Manager of SPBD Microfinance - Fiji, Programme Advisor at IFC and Vice President of NDB. He can be reached on lionel.somaratne@ gmail.com).