India scenario analysis: What if microfinance was less profitable?
As observers of the current microfinance situation in Andhra Pradesh disentangle the contributing factors leading up to this current crisis, a number of proposals for avoiding future crises have emerged. Many of these proposals tap the same central argument -- that actors in search of high profits have foresaken their social mission in order to quickly gain market share among poor borrowers, leading to over-indebtedness among poor households and abusive collection practices.
A corollary to this reasoning is the need to rein in such motives by capping profits or the interest rates that generate them. If profits or interest rates are capped, the argument goes, then MFIs and the private capital backing them would have less incentive to maximize profits by means of growth and would not pursue aggressive expansion. While we may not be able to predict the effects of restrictions on MFI profits or interest rates in the future, we can simulate what it may have looked like in the past. What would have happened if MFIs had limited their interest rates or profits over the past few years?
This note focuses on testing these hypothetical scenarios using MIX historical data on MFI performance in India, in scenarios that limit interest rates to 24 percent and returns on assets to 3 percent. These caps, or very similar ones, have arisen as suggestions over the past several weeks as the debate around the crisis in Andhra Pradesh has unfolded. Overall, we see that these changes would have led to a smaller, riskier sector today with fewer and smaller microfinance institutions.
Number of microfinance institutions by scenario, India 2003 - 2007
Ideally, there would be a way to assess the potential impact of caps on profits or revenues for the whole sector going forward. We do know some facts about the environment today: most institutions operate with cost and revenue structures that are low compared to peers outside of India, current yield levels are close to 24 percent and profit levels are close to 2 percent. Capping rates or margins would certainly squeeze some MFIs’ operations. But if rates or profits were capped near these levels, just how many MFIs would be in trouble? How long would it take for the effects to be felt? How many borrowers would these changes effect?
Using MIX data from over 100 MFIs in India from 2003 to the present, we simulate here the effects of two hypothetical scenarios, as if had they been in effect during that period.
- Interest rates capped at 24 percent: While the AP ordinance does not directly propose an interest rate
cap, policy-makers have directly called for an interest rate cap during the crisis and a proposal to restrict bank financing to MFIs lending above this level acts as a strong signal to cap interest rates. We look at a world in which Indian MFIs keep yields at or below 24 percent for each year.
- Returns on assets capped at 3 percent: While no proposal directly caps returns either, several MFIs have been criticized for high returns and a cap on returns is seen by some as an alternative means of restraining high costs to clients or runaway profits, while allowing MFIs more freedom in their operations than an interest rate cap affords. We look at a world in which no Indian MFI has a return on assets that exceeds 3 percent for any year.
To support these simulations, we access historical data from MIX Market on the growth path of MFIs in India, including the evolution of revenue and expense structures across the sector. We use this data to play back history with adjusted revenue and profit levels and their impact on the MFI’s equity, keeping all else constant.
To simulate a cap on interest rates, we adjust historical revenue from loans such that yield levels never exceed 24 percent. While yields and interest rates are not the same thing, yields measure the level of income an MFI realizes from its clients over the course of the year, and consequently capping yield levels ensures that the MFI does not earn more than 24 percent on average from its clients. To simulate a cap on returns, we adjust historical operating income such that returns on assets never exceed 3 percent. In both cases, the amount of the adjustment is subtracted from the actual net income and equity levels for the period in question, and the loss is carried forward year-on-year through equity.
We only adjust those cases where an MFI exceeds the cap levels - if returns or yields are always low, everything stays the same. The losses from the adjustments accumulate through equity over time. If an MFI has high yields or profits for a period of time, they will realize less income. In some cases, these losses are enough to eat away the MFI’s equity base, after which they can no longer stay in business. When the total equity for an institution drops below zero, we assume the institution must shut down its operations. We assume the MFI continues to earn income during that year, but otherwise ceases to exist and has no future loans, capital or assets. We repeat this for all MIX Market data from 2003 to the present, covering over 330 MFI-years in total.
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