Understanding the Price Curve in Microfinance

Ironically, there is no standardized terminology in transparent pricing in formal regulation around the world.  At MFTransparency, we are working at developing a consistent terminology within microfinance, and we use APR and EIR to denote the two different approaches to annualizing the interest rate for a period of time.   I’ll give an example of an identical loan in the US and in the EU.  This loan has a monthly IRR of 1%.  In the US, this monthly rate would be multiplied by 12 and the APR would be 12.0%.  We call this nominal annualization.  The identical loan in the EU would be converted with compound annualization – 1.0% per month becomes 12.7% annual EIR.  To muddy the situation, the UK uses compound annualization but calls their transparent price an APR.  Therefore, more precise terms might be “nominal annualized rate” and “compound annualized rate”, but these don’t seem to catch on very well….

There are arguments for and against each approach, which I can’t go into here, but MFTransparency argues that APR (nominal annualization) makes far more sense.  Here’s why – a 1% monthly rate converts to 12.0% or 12.7%, not enough of a difference to cause much confusion.  But the gap between the two increases exponentially with higher numbers.  A 10% monthly rate would be 120% nominal, but a 213% compound rate.  How do you explain to anyone that 10% a month is the “same price” as 213% a year??

This was something we had to give a lot of thought to when we started MFT, in order to increase participation of MFIs (“I won’t participate if I know others are lying”) and to increase trust in the data (“How do I know this is accurate and truthful if it is all voluntary?”).

Our solution was to completely practice transparency.  We don’t collect data, calculate prices, and then publish a figure and say “trust us.”  We tell each MFI that everything they give us will be published in its entirety.  They fill out a survey with background information on their loan products, but to calculate the actual prices, we request real loan repayment schedules of real loans that went to real clients.  Our team then calculates the APR/EIR of those loan samples.  And then we don’t just publish the prices, but we publish every single repayment schedule of every single price.  Anyone curious – or suspicious – can look at that repayment schedule.  They can run the calculations themselves and confirm the price we published.  This transparent process catches any mathematical errors we might make, and it would catch any falsified repayment schedules that were given to us, as the institution’s competitors – and staff – are able to look at those repayment schedules and compare them to the “real things”.

First, I strongly advocate that they set standards on profit levels.  Most investors already say “If the MFI is not profitable, we will reject the proposal.”  But how many have policies that state “If the MFI is too profitable, we will reject the proposal.”  Social investors need to have limits on how much profit to make off the poor.  You’ll find my detailed explanation on that here.

So my starting point is on profits rather than prices.  But understanding prices is also something all investors and funders need to understand better.  If the MFI they are considering is in a country where MFT works, they can study the prices of that MFI on our website and see how they compare to the market.  And if the MFI has chosen not to participate in transparent pricing, they should completely reject the proposal.  There is no legitimate excuse for not being transparent when 90% or more of our competitors are being transparent.  If the MFI is not located in one of our countries, check the ratings reports.  Planet Rating has posted pricing analysis in their reports for years, and other rating agencies are now doing the same.  And if no other source is available, or even if a source is available, build price calculations into your due diligence.  You can find the software and instructions right on our website.  Investors and funders should never, ever, simply ask the MFI “What is your price?”  History is littered with failures with that approach.  Investors don’t say “What is your profit?” and “What is your risk?” and take the answer as accurate…. they investigate carefully the financial information.  Do the same for pricing.

I agree with your concerns.  This is far from easy or straightforward.  Part, and only a part, of the problem is that you’re based in the UK, where the 1790% APR (compounded) is really “only” about 300% APR (nominal).  I think a person can understand that 25% a month is high, and it translates to 300% a year.  When some “government doc” says some definition of the price is 1790%, they can’t come close to figuring that out, and they go back to asking “What do I have to pay back?”  Another area we at MFT are investigating is the interesting issue of very short-term loans (like payday loans are supposed to be) and micro-credit, which tends to be designed with the expectation that the client pays interest for years for nearly continual credit.  It actually makes sense, if I’m in need of some urgent cashflow for 2 weeks, to borrow a small loan at a rate that would give an annualized rate in the hundreds or thousands of a percent.  My benefit over those two weeks is worth paying $50 to get use of $500 until my next paycheck.  To pay micro-credit rates of 75% APR on a loan that goes on day-after-day can be much more draining financially.

MFTransparency focuses first on the transparency of rates so that MFIs, funders, regulators, and the press can see what prices are.  Transparency at those levels already results in institutions being much more thoughtful about the prices they charge.  In addition, we higher-level stakeholders are increasing our understanding of what prices are, and how they work (see here for a link to an article I wrote about how we can now start making wiser decisions).  Stage II is then to expand how we can communicate those prices to clients in a way they can understand.  MFT is working with regulators right now, sharing examples of good legislation that can make prices more transparent and more intelligible.  MFT is also working on development of financial literacy materials that MFIs can use with their clients, and you’ll find those in our resources section.

Our ultimate goal is that first, governments require all lenders to state clearly their true price using a standardized formula.  Then, second, our financial literacy training is nothing more than “Ask for the official APR, compare with their competitors’ APR, and lower-is-cheaper.”

First, the general reason for the tendency for prices to be higher in one country than the other has much to do with “where they are on the curve”, as I believe the webinar addresses.  Indian MFIs tend to be clustered around avg loan balances of 25% GNI per capita, and in Mexico they are under 5% GNI per capita.  As for the very interesting question about whether one product can and should subsidize another product, you’ll find my thoughts on that in this paper here.  In short, we face some very interesting issues when we discuss cross-subsidization.  We’ve had those discussions for decades, and generally we say something like “It’s okay to make a profit on my larger loans, to the less poor, in order to subsidize my smaller loans to the very poor.”  Is that what we do sometimes?  And is it “fair”?  And would it be fair to make profit on the very smallest loans to subsidize my larger loans to more knowlegeable clients in the more competitive formal market?

MFTransparency’s goal is to advocate transparent pricing.  We do no reporting on profits, we don’t collect profit information, and we don’t have the goal for MFT to establish how much profit is too much profit.  Personally, I do advocate that the industry engage in discussion of this topic and work toward industry-wide standards, but these would not be standards established by MFTransparency.  You’ll find my personal views on this here.

As for your second question, on acceptable prices for similar products, we are working with the industry to see if we can come up with definitions on that now that we actually do finally have pricing data.  My general answer is that “prices should be close to the market price for other similar products”.  If you’re looking at the high-level data we showed in this webinar, that means “If you’re off the curve, why?”

I cannot give a answer with statistical backing yet, but both the scattering of data we have, as well as logic, argue in favor of lower prices.  When nobody knows true prices – even the sellers of the products, let alone the consumers –  prices are not competitive.  Prices are set by different reasons than price competition.  Free markets are not free, and do not function, when essential data is missing.  And no data is more essential than the  price of the product!  Pricing transparency introduces this missing data, and then more thought, and wiser thought, go into pricing decisions.  Imagine you’re sitting in your management meeting, deciding pricing.  If the true price is unknown, because of the complicated pricing system in place, you can easily make it look like you lowered your price when in fact you have actually increased it.  When true prices are known, and your competitors, your funders, and the press are watching, then you make more prudent decisions.  Transparency makes prices competitive and allows consumers (and other stakeholders) to make more knowledgeable decisions about if they want to associate with your institution.  For all these reasons, we should expect average prices to drop, all other conditions being equal (e.g., financial costs, risk, inflation).

Have we seen this?  We have numerous examples where individual MFIs approached MFTransparency and lowered their prices, once they saw that their prices were, in fact, higher than the competition.  We even have a few cases of MFIs raising their prices when they could finally see what the market price was.  In other words, transparency not only should result in lower average prices but should also result in tighter pricing spreads, as pricing decisions would now be made understanding the market price.  However, at MFTransparency we don’t yet have enough time series data to say that transparency has resulted in a price change of x%.  We are in the midst now of updating all of our pricing data, and one exciting result of this will be that we can then start to run this sort of analysis and increase our understanding of how pricing decisions are made.

Pricing transparency uses a single formula for all products, and risk is not one of the factors that goes into the analysis.  In theory, riskier products would be more expensive than other products that had exactly the same characteristics.  For example, an MFI might say “the price of this loan without collateral is x% APR, but if you can provide the following collateral or cosigner, the price drops to y% APR.”  An important point about pricing transparency is that we are providing one important factor that the client needs, but the client puts the price into the context of other information.  A client might say “I can get a loan for x% APR there, but only if I put up my house as collateral, and the process takes a long time.  I can go over there, get a quick loan, no collateral, but the price is higher at y% APR.  Given these factors, I choose….”  And with a true APR, the client actually has better information to make a better decision.  Currently, with confusing prices, they make poorer decisions.

Much like what I wrote in the earlier question, if the government can require a standardized formula that all lenders must respect, then the client can say “Tell me your APR, and I know that lower-is-cheaper, even though I don’t really understand the formula that the government makes you use.”

No we don’t, yet do this.  First, there is a Truth-in-Lending law in the US that all microfinance lenders must follow.  Clients are told the true price before signing the contract.  Second, there are really not that many microfinance lenders in the US that give really small micro loans, and the number of clients these organizations have is rather small.  When I looked at data some years ago, only a few had loans out to more than a thousand clients.   Third, I suspect that not a single organization is yet making profit, so we don’t have the same situation we have in the international microfinance industry – commercialization has not yet come to US microfinance.  And finally, we don’t have funders who have yet approached us asking if they could fund this work.  Having said all that, I think MFT would be very interested in exploring this in the next year or two.