"These fixed costs of administering a loan can explain why interest rates for small loans are so high, why they vary so much across borrowers, and why the poor pay higher interest rates. Since borrowers with little wealth must get small loans, the fixed administrative cost has to be covered by the interest payment, which pushes the interest rate up. But high interest rates exacerbate the problem of getting borrowers to repay. Total lending therefore shrinks further, pushing up interest rates even more, and so forth, until the loan is small enough and the interest rate high enough to cover the fixed cost for even a small borrower. In other words, the presence of fixed costs introduces a kind of multiplier into the process of determining the amount lent and the rate charged... And if the borrowers are poor enough or the fixed administrative cost is high enough, the interest rate could become infinite: these borrowers will be unable to borrow at all."
The sequence of events goes something like as follows
1. The lender has to incur a fixed cost on maintaining a large recovery machinery and general administration of the loan. In view of the large numbers of these borrowers and the specific nature of such loans (no collateral loans to those without any prior credit history), the fixed enforcement costs (due to more enforcers, need to collect information on a larger number of people etc) are likely to be large. The larger fixed costs coupled with smaller loan amounts means higher interest rates.
2. Higher the interest rates, the less credit-worthy borrowers will "crowd-out" the more credit-worthy ones, and an adverse selection effect will be generated. The higher interest rates would attract borrowers who are intrinsically more likely to default. This too adds to the administration cost at the margins.
3. Higher interest rates will naturally lower the size of loans. This also means that the absolute interest repayments will form a larger percentage of the loan principal. In other words, smaller loans means that the fixed costs as a percentage of the loan amount will be higher, thereby driving the interest rates even higher up.
Here is a graphical illustration of how the high administration charges of micro-loans drives up the rates, crowds out the best borrowers, lowers average loan amounts, and thereby forces rates even further up.
The moral hazard is amplified by the presence of multiple and competing lenders. The cost of a likely default is often lowered by the possibility of another lender waiting in the wings to step up when the need arises again. In this context, it would be interesting to examine the moral hazard effect on private micro-lenders arising from the presence of government micro-finance (if they default there, they can always fall back on the government)?
The cost of default has to be higher than the interest payment so as to minimize the possibility of default. As Banerjee and Duflo point out, the incentive of a continuous relationship with the bank/micro-lender often provides the deterrent against default.
The fundamental issue being raised here is this. Micro-finance has emerged as one of the major sources of channeling credit to poor people. It is arguable that even as micro-finance has grown in importance, it may have had unintended effect of taking away the focus from penetration of conventional banking into rural areas and among the poor.
However, as the aforementioned reasoning/modelling suggests, micro-finance services only a specific category of customers among the poor. While regular consumption needs and business working capital requirements (with their focus on adequacy and timeliness) are optimally serviced by micro-loans, small-business capital investments (which need larger and longer tenor loans) would require conventional banking.
Conventional banking will always be the preferred choice for customers borrowing higher amounts with longer tenors. Further, there will be a large share of the poor who cannot afford the higher rates charged by the micro-financiers. Under the circumstances, the total consumer welfare among the poor can be maximized only if micro-loans complement, and not substitute, conventional banking sources.