How high is Grameen Bank interest rate?

Mo Chaudhury/ Financial Express August 28, 2012

The Nobel-winning microcredit institution Grameen Bank (GB) and its founder Dr Muhammad Yunus have of late been the subject of controversial moves by the government of Bangladesh (GoB) intended to gain governmental control of the acclaimed institution that is free from any formal influence of Dr Yunus. During a recent BBC interview, Sheikh Hasina, the Prime Minister of Bangladesh, made the rather thinly clad allegation that GB under Dr Yunus had been charging its (poor) member/borrowers such high interest rates that the practice borders exploitation by GB. Some simple arguments below show that this particular allegation lacks merit.

While GB provides several types of loans, we will consider here its bread and butter basic loan in a stylised manner. For a Bangladesh Taka (BDT) 1,000 (about 12.5 USD) basic loan, GB typically charges an annual interest of BDT 100. With 52 weekly equal installments of both the principal and the annual interest, each installment is BDT 21.15 in total (=19.23 principal + 1.92 interest). Consequently, the weekly financing cost in percentage annualised term starts at 10 per cent for the first week, but rises to very high levels toward the end. The exact calculation shows that the effective interest cost is 20 per cent per annum as intuition would suggest. Considering other loan features, the all-in effective interest cost could near the 27 per cent range. While some critics, including the Prime Minster of Bangladesh, have casually placed this cost to be even higher, exceeding 30 per cent or 40 per cent, the financial basis of such cost figures are not known that well.

Supposing the effective cost is about 27 per cent, the critical question is whether such a cost is too high. There are several ways to look at this issue. First, let us compare GB loans to loans from the scheduled banks and other financial institutions of Bangladesh, and for this purpose, we abstract from other loan features as they are difficult to compare. Data from the country’s central bank (http://www.bangladesh-bank.org/fnansys/interestlending.php) indicates that, as of July 2012, the scheduled banks’ lending rate was around 15 per cent on term loans and working capital loans to small, medium and large-scale industries, around 16 per cent on housing loans, and about 17 per cent on consumer credit. The April-June, 2012 lending rates at other financial institutions were in the neighbourhood of 20 per cent for trading commerce, agricultural projects, loans to industry, and housing schemes (http://www.bangladesh-bank.org/econdata/openpdf.php?i=4).

Granted that these lending rates represent a snap shot rather than historical averages, but they still provide useful benchmarks for GB loans. It seems that, the 20 per cent cost of GB loan is rather on the low side, considering that GB loans are not collateralised by any asset and the GB member/borrowers have very little equity, if at all. It is to be noted that the rate of interest on the outstanding amount of loans against credit cards, the closest to non-collateralised loans from the scheduled banks, is about 24 per cent, not too far from GB’s 27 per cent.

Second, in the absence of GB loan and microcredit in general, the member/borrowers would have to seek formal credit from the scheduled banks and other financial institutions or informal credit from the local private money lenders. It is well recognised that a typical GB member/borrower has virtually no access to formal credit, an outcome similar to an exorbitantly high interest cost at which the loan will not be sought. It is also widely accepted that the cost of loans from local private money lenders is substantially higher than 27 per cent, aside from the personally abusive nature of such loans.

Third, for solely income generating use of GB loan, the 27 per cent effective interest rate does not appear burdensome. To see this, pretend that the stated interest rate is 13.5 per cent and ignore other loan features, thus leading to an effective interest cost of 27 per cent. For every BDT 1,000 initial loan, the business income requirement is BDT 94.58 (=BDT 1,135/12) or 9.46 per cent gross return on asset (excluding own labor) per month to pay the weekly loan installments summed over a typical month. With such income, the borrower should in fact be left with the business assets she acquired using the initial BDT 1,000 loan even after paying an effective interest cost of 27 per cent. Any income in excess of BDT 94.58 per month would of course augment her capital accumulation and as such expedite the process of moving out of poverty.

Now say the member/borrower simply decides to hold the BDT 1,000 loan in cash and then work as a domestic helper at the very low wage rate of BDT 500 per month to generate the required business income of BDT 94.58 per month. This means that if she works 5.68 days per month (=94.58/500 x 30), she would have a saving (and capital) of BDT 1,000 in cash after paying off the loan and bearing the effective interest cost of 27 per cent. Such a plan is quite feasible, especially working on a part-time basis, for the typical female GB member/borrower and does not appear financially burdensome at all. In this illustrative plan, the part-time work is truly the source of savings and capital accumulation since the loan money was not invested in any asset or business with income and/or capital gain potential. To the extent such investments are made with prudence, the member/borrower’s savings and capital accumulation would obviously be augmented.

Now consider the case where the member/borrower simply spends the loan money for temporary consumption. In this case, she needs to work every month as a domestic helper just to meet the loan installments and would have little prospect of moving out of poverty. This is what the critics claim as the curse of GB loans or microcredit in general. GB, on the other hand, argues that it has managed to keep the incidence of such perils for the member/borrowers at a very low level, primarily due to its proven system of regular and frequent advisory and monitoring at the grassroots level.

Lastly, given GB’s business model of grassroots surveillance and advisory, the administrative cost of GB is rather high and accounts for much of the 27 per cent effective interest cost paid by the borrowers. GB is left with profitability that is modest, or at least is not higher than that earned by regular banks and financial institutions. In 2010, the return on equity (RoE) was 17 per cent t0 21 per cent for regular banks (http://www.thefinancialexpress-bd.com/more.php? news_id=123291&date=2012-03-13) and 10.74 per cent for GB (http://www.grameen-info.org/index.php?option=com_content&task=view&id=632&Itemid=664). This lends support to the premise that the 27 per cent effective interest cost of GB loans is there not to maximise GB’s profitability, instead it is a necessity to keep the programme on a financially viable growth path that in turn should help an increasing number of member/borrowers to gradually move out of poverty.

To conclude, the effective interest cost charged by GB does not seem burdensome for the member/borrowers or excessive in the sense of maximising GB profitability at the expense of the member/borrowers. It may, however, be worthwhile to explore ways to reduce the effective rate of interest further.

Mo Chaudhury, PhD, is Professor of Practice in Finance at McGill University, Montreal, Canada. His 27-year experience includes teaching and research in finance at reputable universities in Canada and USA and financial risk management of two large financial institutions based in USA.

mo.chaudhury@mcgill.camochaudhury@gmail.com