By putting a ceiling on interest rates, are we protecting the borrower?

April 8, 2010

By: Monica Ann Bernadette

By Monica Hamlett, KF10 Managua, Nicaragua

Nicaragua is in limbo of a new law as we speak, one of the mandates is an interest rate ceiling for microfinance institutions. So I did a little research to keep up with the current events.

The Consultative Group to Assist the Poor (CGAP) published a donor brief titled, “The Impact of Interest Rate Ceilings on Microfinance”. Because I know how intoxicating the title is and the temptation to read is nearly unbearable, I will take the liberty of highlighting a few key points.

So, if we put a cap on the rate will we protect the borrower?

Research says no. Here’s why…

Adverse effects of interest rate ceilings:

Stifles Competition
- By creating barriers of entry for new microfinance institutions to emerge, and
- Creating a difficult environment for existing institutions to survive
Inhibits Transparency
- Institutions are more apt to hide costs to help their bottom line
Withdraw of service from poor/rural locations
- The poorer the client the riskier, the more rural the more expensive to reach, thus, those most in need are once again neglected of financial services

“But I still think interest rates are ridiculous, there must be another way!” You’re right, there is…

Alternatives to interest rate ceilings:

Public disclosure of loan costs
- This open air environment allows potential clients to “comparison shop” and naturally stimulates competition amongst institutions. In Cambodia full disclosure was made mandatory, interest rates began to drop 3.5 to 5% monthly
Consumer protection laws
- In addition to disclosing all costs, “…clearly defined complaint resolution procedures; consumer education to prevent abuse; and effective enforcement mechanisms.” …mandates which encourage transparency

So there you have it, turns out interest rates are just what we can see on the surface, a ceiling or cap doesn’t fix problems. Full disclosure, fair practice, and educating involved parties is the best protection for our clients and borrowers.