Determinants of Microfinance Interest Rates: Case of Sri Lanka

This research attempts to identify determinants of microfinance interest rates with a view to control and reduce such rates for the betterment of microfinance clients. Data from 30 microfinance institutions were gathered using a set format to capture required variables. The variables covered the cost of funds, efficiency, competition and company characteristics. Variables such as return on assets, non-performing accommodations, competition and average loan size were considered as endogenous. Therefore, a two stage least square panel regression using random effects was used to analyse the data. The identified determinants of microfinance interest rates were the prior period’s interest rate, cost of funds, efficiency, the size of firm and profitability. However, competition, the nature of microfinance institution and the experience of the firm did not give significant results. Accordingly, it is recommended that appropriate action should be taken to reduce the cost of funds, improve efficiency and transmit the profitability of institutions to the microfinance client. Further, policies should be developed to improve transparency in the pricing imposed by such institutions and to enhance financial literacy of the public to derive benefits of competition. Thereby, the size of firm, experience and regulatory position can be stimulated to minimize interest rates.