“Best practice” in microfinance holds that interest rates should be set at profit-making levels, based on the belief that even poor customers favor access to finance over low fees. Despite this core belief, little direct evidence exists on the price elasticity of credit demand in poor communities. We examine increases in the interest rate on microfinance loans in the slums of Dhaka, Bangladesh. Using unanticipated between-branch variation in prices, we estimate interest elasticities from − 0.73 to − 1.04, with our preferred estimate being at the upper end of this range. Interest income earned from most borrowers fell, but interest income earned from the largest increased, generating overall profitability at the branch level.
That is the abstract of the paper "Do interest rates matter? Credit demand in the Dhaka slums," published in the latest number of the Journal of Development Economics by Dehejia, Montgomery, and Morduch. A draft of the paper is here.
The authors conclude:
Using between branch variation in interest rates we estimate elasticities in the range of approximately -0.73 to -1.04, with our preferred estimate being at the upper end of this range. Though SafeSave did, importantly, achieve financial stability as a result of the interest rate increase, our results also suggest that this came at a cost in terms of serving the bank’s poorer clients. Using initial savings balances as a proxy for total wealth, the bank’s loan portfolio shifted toward relatively wealthier customers (albeit still poor in absolute terms) in the year after the interest rate increase, as compared to the expected composition of the portfolio without an interest rate change.