CHAPTER ONE
GENERAL INTRODUCTION
1.0 Background to the Study
A Microfinance Institution’s (MFI) main objective is to provide poor and low income households with an affordable source of financial services. Interest charged on loans is the main source of income for these institutions, and because they incur huge costs, the rates are correspondingly high. Four key factors determine these rates: the cost of funds, the MFI’s operating expenses, loan losses, and profits needed to expand their capital base and fund expected future growth (Ghatak, 1999). Many policy makers question why microfinance interest rates remain high even when some MFIs receive concessional funds to finance lending.
Although some micro lenders receive loan funds at concessional rates, they must cost these funds at market rates when they make decisions about interest rates to ensure the sustainability of the institution’s operations. Donors provide concessional funds for a particular usage only for a limited period, as do some governments. However, concessional funds cannot be considered a permanent source of funds for MFIs, and provision must be made through interest rates to sustain the lenders’ operations (Ghatak, 1999). Inflation adds to the cost of microfinance funds by eroding microlenders’ equity. Thus, higher inflation rates contribute to higher nominal microcredit interest rates through their effect on the real value of equity. Microlenders have two kinds of operating costs: personnel and administrative. Because microlending is still a labor-intensive operation, personnel costs are high. Administrative costs consist mainly of rent, utility charges, transport, office supplies, and depreciation of fixed assets.
Making and recovering small loans is costly on a per unit basis. Often loan recovery is executed by staffs who visit clients, increasing costs in time taken and transportation used. Poor physical infrastructure-inadequate road networks, transportation, and telecommunication systems-in many countries in which microlenders operate also increases administrative costs and adds significantly to the cost of microfinance operations. Inadequate law and order also contribute to high administrative costs as microcredit operations often involve cash transactions and the physical movement of cash (Pitt, and Khandker, 1998).
In many countries, the majority of microcredit is provided by a few leading institutions, and competition among them is mostly on non-price terms. This might not be the case in Nigeria where Microfinance Institutions (MFIs) spring up every day. Today in Nigeria the MFIs compete with traditional Banks in the cities as well as have dominance in the rural areas. Large-scale commercial banks with access to low-cost funds, low operating costs, extensive branch networks, and vast human and other resources to provide financial services efficiently are presently not significantly involved in microcredit. The lack of participation of such conventional financial institutions in the microcredit market also limits potential competition. Although it is widely recognized that microfinance alone will not end poverty, it is a vital step in that direction. Microfinance institutions, also known as MFIs, offer financial services to underserved, impoverished communities.
Previously, entrepreneurs seeking loans in impoverished communities had to provide collateral to borrow from unlicensed lenders at inequitably high interest rates. A number of factors, including high administrative costs relative to small loans and small returns, had kept banks from setting up branches in impoverished communities when surer profits were to be had elsewhere. The lack of an efficient financial services industry has held back many would-be entrepreneurs with viable business plans from realizing their own potential. Women, in particular, have been excluded as loan candidates in developing communities. The lending practices of many emerging microfinance institutions have given people living in extreme poverty the opportunity to realize their potential in the business community (Rahman, 1999)