Fair interest rates when lending to the poor:
Are fair prices derived from basic principles
of justice?
M. Hudon
This paper addresses the fairness of prices, with a focus on fair interest rates as
they apply to microlending transactions for the poor. Under different assumptions
on fairness in interest rate policies and the principles of justice as described in A
Theory of Justice (Rawsl, 1976), the paper determines the extent of the ‘just’
range of a price. Using the original notion of fair reservation price and fair
bargaining range, it is shown that some unfair considerations can make the fair
bargaining range negative. Therefore, we propose an additional criterion for
fairness: a fair distribution of the benefits within the fair bargaining range
between borrowers and lenders. This new criterion is particularly useful and
relevant, at minimum, for sociallyminded ones active on the microfinance
markets.
JEL Classifications: L31, M54, O16, Q14
Keywords: justice, microfinance, interest rate, principles
CEB Working Paper N° 06/015
2006
Université Libre de Bruxelles – Solvay Business School – Centre Emile Bernheim
ULB CP 145/01 50, avenue F.D. Roosevelt 1050 Brussels – BELGIUM
e-mail: ceb@admin.ulb.ac.be Tel. : +32 (0)2/650.48.64 Fax : +32 (0)2/650.41.88
Fair interest rates when lending to the poor:
Are fair prices derived from basic principles of justice?
Marek Hudon
FNRS Research Fellow - Centre Emile Bernheim, Solvay Business School,
Université Libre de Bruxelles (ULB)
and Harvard University
mhudon@fas.harvard.edu
Harvard University, c/o Sue Wood, Byerly Hall
8 Garden Street, Cambridge MA 02138-3654
JEL Codes: L31, M54, O16, Q14
Keywords: justice, microfinance, interest rate, principles
Are fair prices derived from basic principles of justice?
A study of fair interest rates when lending to the poor1
Abstract: This paper addresses the fairness of prices, with a focus on fair interest rates as they
apply to microlending transactions for the poor. Under different assumptions on fairness in
interest rate policies and the principles of justice as described in A Theory of Justice (Rawsl,
1976), the paper determines the extent of the ‘just’ range of a price. Using the original notion of
fair reservation price and fair bargaining range, it is shown that some unfair considerations can
make the fair bargaining range negative. Therefore, we propose an additional criterion for
fairness: a fair distribution of the benefits within the fair bargaining range between borrowers
and lenders. This new criterion is particularly useful and relevant, at minimum, for sociallyminded ones active on the microfinance markets.
1
I thank Joshua Cohen and Amartya Sen for very useful discussions and comments on a first version. I also
thank Beatriz Armendariz, Firas-Eugen Faso, Sylvie Fanta, Cyril Fouillet, Gilles Raveaud, Jay Rosengard,
Guy Stuart, Ariane Szafarz, Philippe van Parijs, Jarl Verledens, Annabel Vanroose and Bernard Lietaer for
written comments or discussions on earlier drafts. No agreement with my views, however, should be
attributed to these persons, and all errors are entirely my own. I also thank the Marie-Christine Adam Funds
for financial support
This paper addresses the question of the fairness of prices, with a focus on fair interest
rates as they apply to microlending transactions for the poor. Different assumptions and
principles of fairness in interest rate policies are then explored. We will study what a fair
price would be under the principles of justice as described in A Theory of Justice and
ask how narrowly they define the ‘just’ range of a price. Rawls (1976) denies that
additional criteria beyond his principles are needed to attain a just price, because prices
are secondary norms that can be derived from his basic principles. When applying
Rawls’ theory to the specific case of interest rates of microcredits to poor people in
developing countries, it turns out that very high prices can lead to injustice in the system.
It happens when the interest rates are so high that none of their additional effects in the
system cannot compensate for the defects caused by that price.
Two comments are made on the relevance of Rawls’ theory to fair prices. We will first
question the rationality of the citizens in the original position: How critically minded can
Rawls’ citizen be in the original position when assessing a fair interest rate or a fair
wage? This paper only addresses the cases where the price taker can afford costcovering prices for supplier. In a credit case, it means that the clients can afford costcovering interest for the institution. In an employee-employer case, the assumption is
that employees can afford or live with cost-covering wages for the institution. In many
cases, this will mean a positive bargaining range. Nevertheless, the original notion of fair
reservation price and bargaining range shows that some unfair considerations can make
the bargaining range negative.
Second, we propose an additional criterion for fairness inspired by Amartya Sen’s critical
approach on global markets patterns: a fair distribution of benefits within the bargaining
range between borrowers and lenders. We explore to what extent this new criterion
could be relevant for the different types of investors, particularly for socially-minded
investors in the microfinance markets. We finally outline a mechanism to pragmatically
implement such a test, and show why it would be significantly preferable over usury laws
which artificially lock in maximum interest rates, and are gaining now popularity in many
developing countries.
1. Introduction on the case of the new institutions lending to the poor
The last few decades have seen a dramatic development of microfinance institutions
(MFIs) - institutions providing financial services to poor or very poor citizens. These
institutions have demonstrated impressive repayment rates on their loans, while serving
populations that were until now thought to be too risky for sustainable banking.
However, these institutions typically have a much higher interest rate policy than
conventional commercial banks. These higher interest rates are primarily due to the very
heavy transaction costs that occur when lending small amounts to poor people. While
microfinance interest rates usually range between 20 and 70% per year, depending on
the environment of activity, they can however reach very high level, as high as 90% per
year2. Ironically, many microfinance institutions have spread in countries where debates
on usury were still ongoing (such as the Islamic countries), sometimes eluding the
interest debates with the application of fees that are not subject to religious or cultural
laws.
The debate on microfinance services pricing policy is not only about ethics. It is also
pragmatically crucial since each of the parties will always be at risk for the success of
the transaction by the actions of the other one. The feeling of fairness, even if irrational,
can play a major role in such a transaction. In the case of lending, if the client does not
consider the interest rate policy fair, he or she could well choose not to repay3. This is
particularly relevant in microfinance programs where no collateral is required, which
obviously puts the lender at extra risk4. Moreover, the possibility of enforcing penalties
for defaults is often very limited. The lack of classic collateral or the application of
pressure may lead in some extreme cases to violent behavior5. Finally, if fixed too high,
interest rates might attract only very risky borrowers. Institutions would then face an
2
In addition to high interest rates, hidden costs or fees can also make the actual loan cost prohibitive to the
borrower (See Fernando, N. (2006), Understanding and Dealing With Interest Rates In Microcredit, Asian
Development Bank, Manilla, p. 5.) .
3
For instance, the new « Voluntary Mutual code of Conduct »adopted in April 2006 in South-India after
the recent debates on the microfinance conducts in Andra Pradesh can be understood due to the fear of
social movement where borrowers would refuse to repay after the publication of articles arguing that
microfinance institutions are exploiting their clients (Fouillet, 2006). Moreover, Cull et al. (2006) found
that raising interest rates above a certain level (60% in their estimate) is associated with lower returns for
microfinance individual-lenders.
4
Moreover, the negative domino effect where members of groups default due to the default of other
members (Godquin, 2004), can increase the consequence of the default.
5
Recently, publications on unethical loan recovery practices, such as abusive language or coercive
techniques of some of the microfinance institutions in the Andra Pradesh state of India motivated the local
microfinance sector to establish a self-governed five-point ‘code of conduct’ (Fouillet, 2006).
adverse selection. Innovations such as the use of social capital in group-lending
developed in Bangladesh or progressive loan6 practices, try to reduce the risk to the
lender. However, ultimately, any such transactions must still mostly rely on mutual trust
among the partners.
Many donors, experts or MFIs also deemphasized the debate on interest rates, arguing
that the access to credit is the most important issue, and that the high turn-over of the
activities of poor clients enables them to repay such high interest rates. Harper (1998)
explains that the return on investment in the larger business was generally lower than for
the smaller ones. Borrowers who would invest in micro-entreprise and particularly the
smallest ones can afford to pay the high interest rates charged by the MFIs. Interest rate
ceilings would limit access to market, but also the transparency regarding the actual total
cost of loans7.
A lot of governments, local and international leaders have praised for microfinance.
Although the real impact of microfinance is difficult to measure, some evidence point to a
very positive impact on many clients8. Yet, institutions charging high interest rates are
nonetheless recurrently attacked, often by representatives of the local civil society who
accuse them of usury or exploitation. A ‘purist’ deontological framework could then
consider this debate as a conflict between the intrinsically inappropriate nature of some
acts (such as charging very high interest rates), and the improvements that access to
credit may bring to the poor9. Therefore, microfinance provides a good case study for the
debate on the fairness of prices. The first question we need to assess is whether prices,
such as interest rates or wages, can be fair, or if morality is simply not relevant in this
setting.
Morality of prices has historically been argued almost exclusively from a religious
perspective. Heated theological debates on of the legality of interest have flourished for
6
Progressive loans are dynamic incentives used to secure higher repayment rates. In this methodology,
borrowers can “expect a stream of increasing larger loans”. See Morduch, J., (1999), The Microfinance
Promise, Journal of Economic Literature, 37, 4, p. 1583. Hulme, D. and P. Mosley (1996), Finance against
Poverty, Volume 1, Routlege Publications: London.
7
Helms, B., Reille, X. (2004), Interest rates ceilings and microfinance: The story so far, CGAP Occasional
Paper, 9, CGAP: The World Bank Group.
8
Impact studies in microfinance are a very controversial topic since few rigorous impact studies have been
completed. Nevertheless, most practitioners agree that microfinance has a positive impact in most cases, for
instance, by stimulating an empowerment process for the client.
9
On a similar debate, see Sen, A. (1993), p. 207.
centuries10. The Council of Nice condemned interest in 325 AD, on the basis of the Old
Testament’s prohibition of interest among fellow Jews. Aristotle denounced interest as
the unnatural fruit of a barren parent11. Most of the opposition came from the view that
interest was seen as a rent, an ‘unearned income’ and not as a result of a productive
activity. Later, the theory of the just price tried to provide some moral constraints upon
the formation of prices in medieval economic thought12. Recently, challenges on the
prices charged for AIDS drugs, repudiated bonds13 and on the debt-burden for
developing countries showed that the debates on interest rates and fair price are still
relevant, and could even be useful for current issues on the morality of markets and
contemporary ethics14. Moreover, the old debate about usury laws is still ongoing, and
has even been refueled in many countries with the growing importance of Modern
Islamic banking that prohibits charging interest.
Some recent evidences have put in doubt the assumption that the interest rate level
does not matter or impact poor customers15. The best available investment opportunities
involve moderate returns for many poor households (Fernando, 2006, p. 12). High turnover and high margins depicted for street or markets vendors are not obtained by
farmers in the rural area16. These could thus be more vulnerable to interest rate
increases. Dehejia et al. (2005) found empirical evidence for this: the demand for credit
by the poorest customers has been proven more sensitive to interest rate increases than
for wealthier borrowers. Very high prices can thus also potentially entail moral
consequences. On the one hand, we should wonder whether charging a very low
interest rate is automatically just, independently from its impact on an institution’s
sustainability. One has to recognize that the access to credit, even at very high interest
rate levels, is certainly a major impediment in many remote areas. On the opposite side
10
Sen (1993); Conard (1959); Nelson (1949)
Conard (1959), p. 97.
12
Johnson (1938); Hamouda and Price (1997)
13
Oosterlinck K., (2003);
14
Walsh (2004), p. 254.
15
Some clients surveys among poor tend to prove that these borrowers definitely care about the interest rate
level. In a client survey of Ugandan microfinance clients, Wright and Rippey (2003, p. 18) found that the
interest rate charged by the institution is one of the two main selection criteria (out of 18). clients have
repeatedly cited interest rates as one of the top determinants of their choice of the financial service
provider from whom they borrow. Furthermore, they found out that the main reason when borrowers
change institutions is the interest rate level. Authors argue that interest rates start to become important after
a certain development of the microfinance industry. Whatever the case, all agree that some very poor
borrowers, at minimum, are sensitive to the interest rate level.
16
Moreover, they exhibit specific risk inherent to the activity and characteristics of land property (Mees,
2003).
11
of the argument, is it a sufficient condition that borrowers demonstrate a capacity to
repay to assume that an interest rate policy is fair? Similarly, a very low salary or wage
will be easily accepted if no better alternative exists. But is it sufficient that employees
accept very low wages to say that the wage policy is fair? In order to further explore the
notion of a fair interest rate, we will examine next what we will call the procedural
approach to interest rate fairness.
2. The procedural perspective of a fair price
We can first consider a definition of fairness as the impartial and equal application of a
set of fixed rules. It is what Hooker (2005) calls formal fairness. Assuming a wellorganized market, fairness would then only require that its rules be correctly applied,
impartially and equally to all customers. The outcome could well be extreme. For
instance, if an institution decides to set its interest rate proportionally to the collaterals
provided by the client, poor clients may pay exorbitant prices to borrow money - but they
still would get a formally fair price.
Additionally, we can include transparency of the interest rate policy to the requirements
of a formally fair system17. Consumer protection laws can also help to prevent “abusive”
lending and collection practices, mandatory disclosure on total loan costs, clearly
defined complaint resolution procedures, mandatory consumer education to prevent
abuse, and effective enforcement mechanisms18. All such impartial application of the
rules, transparence and consumer protection laws are certainly useful, but represent
what we can call a “minimalist” or “procedural” approach to fairness. This procedural
requirement described for interest rate could also apply to other prices. For instance, a
procedural wage would be a wage that is impartially applied, transparent and subject to
some labor protection laws, for instance. It would certainly help prevent many major
abuses, but how do we know whether the final outcome is fair or unfair?
The first question to be addressed is: who determines the price19? The standard answer
is that the price is fixed by the institution according to its perception of the demand.
17
Indeed, interest rate policies are not always transparent to all customers. It is even more the case for poor
customers than can be easily abused. For instance, the structure of the interest rate, with flat or decreasing
balance installments is not always well understood by the customers. Some surveys exhibit very low level
of sophistication about interest rates among microfinance clients.
18
Helms, B., Reille, X. (2004), p. 10.
19
For comments on these sorts of difficulties, see Sen, A. (2002), Open and Closed Impartiality, Journal of
Philosophy, 99, pp. 445-469.
Nevertheless, the institution is not really independent from external influences and many
actors play a role in this setting. From the institutions’ perspective, targeting poor clients
may be based on getting additional clients to fulfill their growth objectives. These new
clients could even be an imperative for the institution if they are used, for instance, as a
proxy for additional disbursement of a third party such as an international donor agency
or a philanthropic foundation. This could force the institution to accept more clients than
desired and thus affect the supply of credit. From the borrowers’ perspective, because of
the lack of competitor the potential clients may not have any other alternative than this
particular institution, his relatives or friends and the moneylenders. The transaction can
also turn out to be distorted because of cultural, socio-economical or political elements
discriminating against the poor. In MFIs with social missions, employees can also
influence the price level. In these institutions, salaries are often low in comparison with
commercial players. Employees are also particularly sensitive to the values of the
institution, and therefore could influence the strategy.
In a cooperative structure where the clients are also the shareholders, the process is
even more complicated, especially when the cooperatives also take deposits. Lastly, the
environment in which the institution operates is particularly important. In some cases, the
rest of the society may consider very high interest rates as unethical while some clients
would just value the credit access. The same multiplicity of answers arises when one
tries to determine who should be involved to determine what a fair price such as a wage,
should be.
All these actors might have conflicting interests and feelings, different from those of the
current customers or lenders. The use of Rawls’ original position is a useful theoretical
one to tackle the problem of such actors’ interests. Under the veil of ignorance, all
deliberators ignore their personal position or social status. Rawls’ Theory of justice to
study the application should therefore be brought to bear on our question.
3. A Rawlsian just price?
Focusing our attention on the fairness of prices when lending to the poor, one may
wonder if transcendental principles are sufficient, or if only relative comparisons or a
specific sphere of justice could solve our particular case? On one hand, we can assume
that the best procedure to evaluate fairness of a price is the application of
transcendental justice principles, such as Rawls’ principles, and verify their impact at the
micro-level of the transactions. One the other hand, one could argue that Rawls’
principles are designed for citizens trying to construct bases for their society; and that
therefore economic transactions are out of order here. Private transactions between
citizens and economic institutions would be fair if it the market price applies, and Rawls’
principles would only need to apply to public spheres. While it is true that Rawls’ theory
and original position focuses on citizens trying to establish some justice criteria that are
directly related to the role of the state, it also deals with the private relations that citizens
have with their environment. Market interactions are certainly important to fulfill the
principles of justice. As explained by Rawls:
“There is no other criterion for a just distribution apart from background institutions and
the entitlements that arise from actually working through the procedure” (Rawls, 2001, p. 51).
In this transcendental approach, we focus on identifying some central arrangements that
will enable a global response. We can however examine further and find some particular
features of a just price. In a well-ordered society, Rawls considers that precepts and
norms arise from the requirements of economic activity. Principles of justice should
cover many cases of distribution in a perfectly competitive economy20. Rawls responds
to criticisms on the realism of the assumption of competitive markets by addressing the
case of exploitation. In Section 47 of his Theory of Justice, we can read:
“The sense in which persons are exploited by market imperfections is a highly special
one: namely the percept of contribution is violated and this happens because the price system is
no longer efficient. But as we have just seen, this precept is but one among many secondary
norms, and what really counts is the working of the whole system and whether these defects are
compensated for elsewhere” (Rawls, 1971, p. 272).
Any evaluation should thus be done on the basis of the whole system, not only on its
sole level of the secondary norm, the price. In our case study, many possibilities become
then possible. Advocates of higher interest rates would argue that access to credit can
be the solution that will solve credit constraint at the micro level and will enable to
develop activities or capacities. If social cares or free business development services
and training are provided by international relief NGOs and are linked to credit, the effect
20
Rawls, J. (1971), pp. 269-271.
on the system might be positive, especially for poor borrowers. The variations in prices
and the prerequisites of position aim at influencing the choices in order to get an efficient
and just outcome. The most important is the right of free association and the individual
choice of occupation (p. 277). In Rawls’ theory, unfairness would thus occur only if the
negative effects of price cannot be compensated by any other norm or precept in the
whole system!
The cause of exploitation is to be found in the background system. Exploitation is the
consequence of some lack of basic rights and liberties that should normally be
guaranteed by the application of the two first principles: equal basic liberties and equality
of opportunity. In exploitation cases, very high prices can be linked to abuses of civil
rights in absence of consumer protection laws, for instance. Such abuses should be
avoided through appropriate laws and social regulation. Rawls adds that “in fact the
notion of exploitation is out of place. It implies a deep injustice in the background system
and has little to do with the inefficiency of markets”. It is thus not the inefficiency of
markets that should be criticized, but injustice in the system. This is due to the deficiency
of the whole system which is supposed to prevent these behaviors.
Nevertheless, it is often the enforcement of the law, rather than simply its existence on
the books, that often proves to be the most difficult in practice. In such a context, a
stronger party may easily appear, take advantage of the weaker one and confiscate a
disproportionate share of the benefits. This is how Alan Wertheimer (1996) defines
‘exploitation’. 21 In Wertheimer’s theory, exploitation can occur in a just economic system
and non-exploitative transaction can take place in an unjust economic system22.
We will now address two particular comments related to Rawls’ approach on prices. The
first one will tackle the level of rationality available, i.e. to what extent are the citizens
critic-minded in the original position. The second one will deal with the egalitarian
criticism of Rawls and its application to fair prices.
4. How critically minded are Rawls’ citizens in the original position when
assessing fair price?
21
22
Wertheimer, A. (1996)
Kershnar, S. (2005), Giving Capitalists Their Due, Economics and Philosophy, 21, pp. 70-71.
We now have a vision of how Rawls’ handles a fair price in his theory. The first comment
we will make verifies the plausibility of Rawls’ assumptions in his procedure, and
explores the difference in outcome we would have when we remove them.
During the deliberation, the participants are placed under a veil of ignorance. The
bargaining advantages are equalized since the deliberators do not know their social
status or wealth23. Rawls has clarified the role and relevance of the original position in
his later work and the fact that the decision process is only part of the core of its moral
theory, when it is heuristic. As explained in Kantian Constructivism in Moral Theory:
“So understood, the original position is not an axiomatic (or deductive) basics from which
principles are derived but a procedure for singling out principles most fitting to the conception of
the person most likely, at least implicitly, in a modern democratic society” (Rawls, 1980, p. 572).
A fair negotiation can then happen among citizens of a given society. We can take this
process to the micro-level of the loans to poor borrowers. Rawls argues that free and
equal citizens make up their mind impartially in the original position. The rationality
involved in the decision under the veil of ignorance can however still contain some nonneutral elements, such as the fact that markets are suitably regulated or efficient. The
citizen should then be already critically minded before entering the original position24.
The way Rawls “constructs the citizens in the original position” implies that they do no
have any strong reason to be dissatisfied with the society they live in25. There are some
“fundamentals” that he would not want to put at risk. If we challenge the assumption of
“suitably regulate competition”, the whole system could be unstable since it can be
considered as one of these “fundamentals”. While the outcome of Rawls’ original
position is plausible and realistic or is made so that it is sensible in democratic societies
with efficient markets, why could we not imagine that in our context, the citizens could
well come up to a different order of the two principles, or even to different principles. The
basic question becomes than: up to which level will he be able to doubt the system. One
could for instance argue that under the veil of ignorance, a rational citizen would
consider interest rates as a normal burden to finance activities or any investment26. Even
23
Rawls, J. (2001), p. 87.
For this criticism, I am indebted to Arnsperger, C. (2005), What Is Utopian about the Realistic Utopia?
Relocating Rawls in the Space of Normative Proposals, Revue internationale de philosophie, Spring 2005.
25
Arnsperger, C. (2005), p. 11.
26
For a good review of complementary currencies see Lietaer, B. (2001), The Future of Money, London:
Random House or the forthcoming Of Human Wealth. (2006)
24
at this level, doubt could be raised on the neutrality of this rationale. Recent research on
complementary currencies, that operate in parallel to the conventional ones, show that
many communities successfully use complementary money without interest rates. This
could, for instance, already, challenge this first assumption of this rationale man.
Building on this point, very high interest rates for poor citizens could be more easily
legitimized as rational for the citizen in the original position.
The underlying principle could well be that when we rationally assess the risk of the
borrowers, we invariably find out that poorer borrowers almost always lack collateral and
are thus more risky. There is no doubt that people with no collateral, few assets, and low
income would be very risky. Furthermore, cultural reasons or disparities in educational
levels may exacerbate risk. In this case, an ordinary citizen from a modern democratic
society might consider the relationship between wealth, risk and the interest rate to be
rational.
Even if the financial impact on the clients has not yet been clearly proven, the
microfinance movement has shown that very poor clients can exhibit impressive
repayment rates and that some of them are profitable for the financial institutions. The
major problems of asymmetry of information or moral hazard could be partly addressed
through features such as group lending and progressive lending. To obtain a good
repayment rate, the methodology of the credit is what matters; suiting the needs of the
client is more important than the intrinsic risk level. We can then say that all additional
charges due to cultural or socio-economical elements would in this case be unjustified.
But would the rational citizen living in 1960, before the success of MFIs was
demonstrated, put that into question? Similarly, would the rationale citizen living in 1900,
before the social laws fixed a minimal salary in Western Europe, put any level of wage
into question?
One could well argue that such new information would not lead to changes in the basic
principles of justice but only to alterations in secondary norms or their application. The
information would not in and of itself require new principles of justice. Only the
secondary norms designed to reach the basic principles of justice would change.
One could however consider that this new information is critical enough to broadly affect
these societies and their principles of justice. It would therefore influence the citizens’
values and their relationships. For instance, all agree that the risk perception of the
citizens and the access they have to credit affect the role and the scope of the markets
in low-income countries. If taken to an extreme, some changes in the perception of the
basic structure and assumptions would lead to paradigm changes that shape much more
than the simple norms. Notions and principles of justice could therefore change, and the
notions of justice would then be related to the current knowledge at the time of
negotiation; the theory would not be transcendental anymore. One should not
underestimate the importance of the “fundamentals,” but one must also wonder to what
extend citizens are able to objectively criticize the system.
5. The inequality criticism and its application to fair price
In G.A. Cohen’s view, there is hardly any inequality that satisfies the requirement set by
the difference principle when it is conceived as Rawls does. Therefore, justice would
require unqualified inequality rather than the “deep inequalities” justified by Rawls27.
Rawls is well aware of market imperfections and presents his theory as an ideal scheme
to provide some notion of what is just. He further adds that the “rational autonomy of the
citizens in the original position contrasts with their full autonomy in the society”. In the full
autonomy of everyday life, the citizens think of themselves in a certain way and think
and act from the first principles of justice that would be agreed to”28. The basic structure
is such that when the rules of cooperation are followed, the distribution of goods that
result is acceptable as just or at least not unjust, whatever it is29.
In order to enter into this debate, we can use the microeconomics notion of reservation
price. The bargaining range is the space between the parties’ reservation prices. In the
case of microfinance institutions, many assumptions could be made on what would be a
reservation price. The institution’s reservation price could be the price enabling it to
cover its costs. In microfinance, this is called the operational self-sufficiency. In a more
conservative way, it could even include adjustments due to the cost of funding, if the
institution did not receive subsidies. We can also adjust the income for inflation, in-kind
donations, loan loss provisions etc. This institution is then the financially self-sufficient.
Alternatively, donors or any public actor or philanthropist can certainly influence the
reservation price, for instance through long-term subsidies. The institution then has
lower reservation prices since it counts on the donors’ funds. Nevertheless, in many
cases, these reservation price are not fully sustainable, since they bear the risk that the
27
Cohen, G.A. (1997), Where the Action is: On the Site of Distributive Justice, Philosophy and Public
Affairs, 26, 1, pp. pp. 3-30.
28
Rawsl, J. (1980)
29
Rawls, J. (2001), p. 50.
donor withdraws30. A withdraw would automatically lead to an increase of this
reservation price.
On the other side of the bargaining table, the borrower’s reservation price depends on
his or her income, the profit margin if the loan is used for an income-generating activity,
and the turn-over of that activity. If the borrower can afford the institution’s reservation
price, the bargaining range will stretch from the break-even point of the institution to the
customer’ break-even point31. If the negotiation in the bargaining range turns out on an
interest rate entirely in favor of the institution, the clients’ loan will not provide him any
surplus after the repayment of his loan. In contrast, if the interest rate is too low for the
institution, for instance below its reservation price as defined earlier, its sustainability is
put in danger. If both sides have the correct information on both real break-even points,
there is little chance of the transaction getting completed, since the actual price is one of
the two extremities, partly because the opportunity cost of the involvement in the
transaction is high.
The long-term sustainability of the institutions can also matter in the process, not only on
the institution’s side but also from the customer’s perspective. For instance, consider an
institution with a standard debt ratio and no other funding possibilities that is facing a
choice on its funding policy for new loans to its borrowers. If no other source is possible,
and the additional debt would lead the institution into a risky situation, the borrower
might rationally prefer to bear a higher interest rate rather than put the institution at risk.
A trade-off appears between the additional burden represented by the debt32 and the
long term risk of bankruptcy. This is certainly the case when the borrowers are also
savers or shareholders (such as in cooperatives). When the markets are not competitive,
the loss of the institution also matters for the borrowers.
Similarly, for wages, employees can be afraid that they will not find any new employer if
their enterprise goes bankrupt or decide to outsource its activity to an area with lower
salaries. The bargaining process is thus particularly complicated. What would then be a
fair outcome?
On the one hand, a Rawlsian understanding of the difference principle would mean that
for every price that is higher than the break-even, the principle is respected since the
30
Nevertheless, one can estimate that some donors’ investment are on a sufficiently long term to be
considered as sure. For example, a well-known foundation can decide to support a particular project of an
institution during the next ten years.
31
On could even consider that that it is not the break-even point of the activity but of all his revenues.
32
The same logic might be introduced for any event that would affect the institution sustainability.
poor are better-off. This position is also defended by many donors, as we have seen.
Moreover, a strict interpretation of the difference principle condemning all incentive
inequalities can make unreasonable expectations on our willingness to serve the good of
others33. On the other hand, we can assume that it is not only the relative distribution of
the two that matters. What matters also is how much the poor will benefit within the
bargaining range.
A parallel with Amartya Sen’s position on the current globalization challenges can be
drawn and provides valuable input in understanding and developing this alternative to
Rawls’ argument34. In his book, Sen (2006) comments that while many argue that
globalization benefits all parties in comparison with the absence of cooperation, it is the
distribution of the benefits of globalization that matters to assess the fairness of the
process. The argument that the poor are better-off is not sufficient to legitimize the
current international trade process. Transposing this argument to our field of interest, the
fact that the poor take out a microcredit, manage to repay it and are better-off after its
use is not sufficient to legitimize any rate of interest. If an institution wants to act fairly,
the critical issue to address is not only whether the poor are getting marginally poorer or
richer but also if they receive a fair share and a fair opportunity within the bargaining
range among the lender and the borrower. The question is whether the distribution of the
bargaining range is fair.
The evaluation of the bargaining range should address all possible options and should
take into account their impact on the borrowers. For instance, one should analyze the
variety of funding policies practically and theoretically conceivable and their impact on
both the sustainability of the institution and on the interest rate applicable to the
borrower. Two funding policies policy could be equivalent from the viewpoint of the
institution, but have a different impact on the client. The just price would then assess the
fairness of the negotiation by the poor within the bargaining range.
For instance, let us assume that the bargaining range of the transaction is worth 100%.
Under Rawls’ assumptions, a split of 30% of the benefit accruing to the lender vs. 70%
for the borrower could still be considered “just” if there is no other solution that would
maximize the benefit of the poor taking into account the institution’s potential offer. In
contrast, from the second perspective, such a distribution of benefits can be considered
too lopsided to the lender’s benefit to be considered fair by some citizens.
33
34
Cohen, J. (2001), p. 364.
For a similar argument but on globalization, see Sen (2006), pp. 132-136.
In “Taking people as they are?” Joshua Cohen provided another perspective on the
inequality debate. The right application of Rawls’ basic principles would in fact not lead
to such levels of inequality:
“Some inequalities will be condemned directly by a principle of justice, while others will not
emerge in a just society because of the operations of just institutions." (Cohen, p. 22)
The difference principle is subordinate to the first principle guaranteeing equal basic
liberties but also to the principle of fair equality of opportunity. The intuition is that if they
are correctly fulfilled, application of the difference principle as defined by Rawls could not
lead to very unequal outcomes. Indeed, one of the basic problems in the case of lowincome countries is that they have far from perfect competitive markets. he principle of
fair equality of opportunity would also be insufficient. Because of this, the result of the
application of the difference principle could be very unequal. If the two first principles of
justice would be fulfilled, the borrower would not or should not be obliged to accept
higher interest rates or lower wages. When the background conditions are not fair,
market transactions are likely not be to be fair and unjustified inequalities among people
will develop35. Our elaboration on the basis of Sen’s argument on globalization would
then be no real alternative to Rawls.
The additional principle of balanced distribution of the bargaining range that we have
drawn would then become useless, since all its content should be already addressed in
Rawls’ two first principles. “While nothing guarantees that inequalities will not be
significant, there is a persistent tendency for them to be leveled down by the increasing
availability of educated talent and ever widening opportunities”36. However, are there no
contexts that would legitimate the use of our proposal?
6. Which price is fair when lending to the poor in today’s society?
In this section, we will tackle the potential trade-off between Rawls and Sen’s approach,
and what we will call the fair reservation price. We first study two potential scopes of
application of the criteria and then how its application.
35
36
Rawls, J. (1999), p. 42.
Rawls, J. (1971), p. 137.
We saw above that a Rawlsian could argue that if the two first principles are truly
applied, our additional criterion would automatically be contained in these two principles.
In any case, our additional criterion could be used as an “acid test”, a sort of security for
socially-minded investors or international donors.
The actors’ sense of responsibility and duty of assistance should be taken into account
to assess the relevance of our indicator. The question is, does the institution feel
responsible for the poverty of the borrowers and their community. Furthermore, how
much responsibility does the institution acknowledge37? When the background
conditions are not fair, which is the case in most areas where the MFIs are active, one
could argue that an additional criterion should be added to balance the unjustified
inequalities among people. For instance, the debate on global justice between the
countries can be invoked to justify the use of the additional criterion in international
transactions. A principle of global difference, similar to the difference principle used in
the domestic case in A Theory of Justice,38 can be a justification for the global
application of the additional criterion.
The scope of application of this criteria can be either unrestricted or limited to some
determined cases. On one hand, if taken to an extreme, a society would always require
a fair bargaining range in order to apply its conception of justice. All investors,
philanthropists, and donors coming from Northern countries should then behave in a
socially responsible manner and fairly distribute the bargaining ranges.39 To make a
parallel with the trade debate, this would be equivalent to a state that requires that all
products would be fairly traded, for instance through the application of “fair trade”
criteria.
One the other hand, some could however argue that there is no reason to think that forprofits investors would favor a system of global difference. Most for-profit investors do
not feel that they have directly caused the unfair background conditions and thus do not
feel responsible for it. Consequently, one should not oblige them to pay the additional
cost caused by the distribution of the bargaining range. Rawls’s rationality on the level of
37
The sense of responsibility can be due to a direct or indirect involvement but also from a cultural,
historical perspective.
38
For instance, Beitz, C. (1999, p. 137) argues for a principle of distributive justice between societies since
he believed that richer countries are richer because of the greater resources available to them. In our case,
the most important is not the rationale but the principle of distributive justice.
39
In this paper, we have only addressed the case of positive bargaining range. Positive bargaining ranges
occur when the reservation price of the borrower is bigger than the institution’s reservation price. These
proposals also focus on this case. When the bargaining range is negative, one can consider that subsidies
should be awarded by donors or that microfinance is not the best tool to alleviate poverty for these citizens.
criticism could then prove to be correct and sufficient for traditional for-profit investors.
As in Rawls’ theory, abuses and violations of the contribution precept would end up
being judged as “exploitation”. The application of the criteria is then much more limited. It
could then be used by socially-minded investors or international donors and put an extra
emphasis when the mission of the investor clearly requires that there is no possible
doubt on the benefits to the borrower. We can suppose that any deviation in this test
would be more sensitive for social, non-profit investors or international donors. In both
cases of international donor using funds from higher-income countries’ taxpayers, or
social investors accepting lower return at the condition of a social result, the imperative
of egalitarian outcome is supposed to be greater.
The second point of this section is to define what should be a MFI’s reservation price.
The goal is to determine what a good criteria of fair share would be. A potential difficulty
is that an institution may well for good or bad reasons decide not to lend to some clients
without a substantial incentive. This incentive would typically be an additional margin on
the interest rate. Similarly, a top manager may only hire some categories of employees
with a lower salary40. This additional price would then de facto decrease the bargaining
range and thus ultimately affect the distribution within that range. In order to solve this
problem, one could then define a real fair reservation price. This reservation would be
the reservation price less, in some cases, the price of some elements that do not fulfil
our principles of justice. If we keep thinking within Rawls’ theoretical framework, all
prices that would be issued or related to a violation of one the two first principle of justice
should be eliminated from the reservation price. If the additional margin does not violate
our principles of justice then if would be accepted but the size of the margin must still be
assessed. Indeed, even if one considers fair that a worker with higher qualification
deserves a better wage, one will not automatically consider fair any additional margin
due to the higher qualification. Similarly, it is not because some clients are more risky
that any additional margin would be fair.
The main challenge would then become the gathering of the relevant information,
involving a variety of actors, in order to fix the fair reservation price. In the microlending
40
We can also take two examples provided by Joshua Cohen (2001). Let’s for instance imagine a Brahmin
manager would consider all benefits to Dalit as a cost. An example for wage would be a manager of an
institution who regard economic benefits to women as a cost. See Cohen, J. (2001), Taking People As They
Are?, Philosophy and Public Affairs, 30, 4, p. 372.
case, some accepted additional margins could be due to the cost of fund, the level of
transaction costs or the risk of the transaction or the borrower. The fixation of the fair
reservation price therefore requests a constant effort and creativity to lower or put into
question the relevance of these margins. For small and fragile institutions, this
represents a continual challenge.
The last question to address concerns the people involved in the evaluation of the
potential unfair elements. Even when they are socially minded, top managers face some
clear conflicts of interest if they have to fulfil these tasks alone. The idea of a fair
arbitration could also be useful in the process. Adam Smith invokes "impartial
spectators". The impartial spectators are imagined observers who need not be members
of the society41. They would not be the sympathetic spectators of the utilitarian doctrine
but people whose situation and character enables to judge in accordance with these just
principles without bias or prejudice42. The outcome on the fairness of the reservation
price would come from the judgments of disinterested observers who are not themselves
parties to the societal decisions. Taking this idea to the level of an MFI lending to poor
people, one could imagine that the fairness of the interest rate could be judged by
disinterested observers from the civil society. These could be independent
administrators of the board. Alternatively, Ethics Committees could take into account all
elements cited above. These disinterested observers should be independent from
political abuse43. Concretely, after having gathered all information, the distribution of
what would become the fair bargaining range would be examined by the Committee.
The main caveat would be if this procedure turns out to be very costly for the institution.
Nevertheless, if the cost is reasonable44 and not too time-consuming, one could justify
this sort of an “ethical quality label” with potentially positive impact for the institution, its
employees and the community it serves.
8. The issue of usury laws
41
Sen, A., What do we want from a theory of justice, mimeo, pp. 25-27.
Rawls, J. (1971), p. 165.
43
In this case, the impartial spectator would play a similar role as the independent board members present
in public institutions.
44
We can assume that the members from the civil society, such as NGOs working in another sector of
activity, or other members of the Committee would provide information and participate for free. It is
therefore mostly the cost of the organization of such a committee that would be involved. On the other
hand, one such committee could be set up by donors to serve for many MFIs as the data would be of similar
nature for all.
42
The last topic we will tackle concerns usury laws. After reading the above arguments,
one may wonder which regulatory framework should emerge from the debate. Could a
regulator make sure that an interest rate is fair for poor borrowers? We have seen that
clients have limited bargaining power whenever there is insufficient competition. Some
institutions have therefore charged exuberant interest rates, similar or just below to
levels of moneylenders. In reaction, many governments are introducing new usury law or
simply stronger usury laws in countries where they already exist in order to protect poor
citizens. Helms and Reille (2004) found that about forty developing and transitional
countries have introduced regulations about interest rate ceilings of some kind.
Usury laws are certainly not new and have been largely studied. For instance and
surprisingly, while Adam Smith was against the ban of interest rates, he recommended
legal restrictions preventing the extortion of usury in the form of maximum interest rates.
He was concerned that if interest rates rose too high, money would only be lent to
“prodigals and projectors” who alone would be willing to pay exorbitant interest rates45.
Thinking in Rawlsian terms, a usury law in a society is a secondary norm that could be
designed to achieve a principle of justice. Theoretically, if a regulator could gather all the
information on cost factors of an institution, he could try to determine the real bargaining
range according to the institution’s potential market. The usury law could then be an
effective norm to fulfil some principles. Nevertheless, one can doubt that all
environmental contexts can be taken into account into the law. The law will probably lack
the required flexibility to consider all singular cases and could easily violate some
privacy rights if it had to do that correctly. Furthermore, if the maximum rate is fixed too
low, the institution’s sustainability would be at risk, which would harm the leastadvantageous borrowers that have no other credit access. We conclude therefore that
legislating maximum ceilings is a path that can easily backfire.
9. Conclusion
In this paper we have studied a few notions of fair prices when lending to the poor. A
procedural or “minimalist” approach of fairness would require the equal treatment or the
non-discrimination of the clients, as well as transparence and consumer protection laws.
45
Smith, A. (1776), The Wealth of Nations, New York : Dutton, pp. 356-357 (quoted by Sen (1993))
In Rawls’ theory, any evaluation should be done on the basis of the whole system and
not only on the sole level of a secondary norm such as the price. We express some
doubt however that the rationality involved in the citizens’ decision under the veil of
ignorance will not contain some non-neutral elements.
We have then suggested an additional criterion that the borrowers should get a fair
share and a fair opportunity within the bargaining range among the lender and the
borrower. We have highlighted two approaches on the use of this criterion. The first one
considers that this criterion should be applied to all investors. The second approach
argues that it would be suited to the exigencies of social investors or international
donors. To apply it, the involvement of a variety of actors and disinterested observers
enables to gather a maximum of information and fix a fair reservation price. In both
cases, this criterion would be preferable over the introduction of usury laws that easily
can produce counter-productive effects. If applied to the current state of the microfinance
sector, this criterion could shape the pricing strategy of many institutions targeting poor
clients. Even if its application could sometimes represent an additional burden for
institutions already working in difficult environments, the legitimacy of the disbursement
of public funds could be at stake.
This paper offers a first step to propose a new approach to fair prices. Further research is
needed to assess and determine the various criteria of "fair shares" and their impact on the
pricing policies.
References:
Armendariz de Aghion, B. and Morduch, J. (2005), The Economics of Microfinance, MIT
Press: Cambridge.
Arnsperger, C. (2005), What Is Utopian About the Realistic Utopia? Relocating Rawls in
the Space of Normative Proposals, Revue Internationale de Philosophie, Spring 2005.
Beitz, C. (1999), Political Theory and International Relations, Princeton University Press:
Princeton.
Conard, J. (1959), An Introduction to the Theory of Interest, University of California
Press: Los Angeles.
Cull, R., Demirgüç-Kunt, A. and J. Morduch (2006), Financial Performance and
Outreach: A Global Analysis of Leading Microbanks, World Bank Policy Research
Working Paper, 3827.
Cohen, G.A. (1997), Where the Action is: On the Site of Distributive Justice, Philosophy
and Public Affairs, 26, 1, pp. pp. 3-30.
Cohen, J. (2001), Taking People As They Are?, Philosophy and Public Affairs, 30, 4, pp.
363-86.
Collins, D. (2006), Financial Diaries, mimeo.
Dehejia, R., Montgomery, H. and J. Morduch (2005). Do Interest Rates Matter? Credit
Demand in the Dhaka Slums, ADB Institute Discussion Paper, No. 37, Manilla.
Fernando, N. (2006), Understanding and Dealing With Interest Rates In Microcredit,
Asian Development Bank, Manilla.
Fouillet, C. (2006), La Microfinance Serait-Elle Devenue Folle ? Crise en Andhra
Pradesh (Inde), BIM, 26 April 2006.
Gauthier, D. (1986), Morals by Agreement, Oxford University Press: Oxford.
Godquin, M. (2004), Microfinance Repayment Performance in Bangladesh: How to
Improve the Allocation of Loans by MFIs, World Development, 32, 11, pp. 1909-1926.
Hamouda, O. and B. Price (1997), The Justice of the Just Price’, European Journal. of
the History of Economic Thought, 4, 2, pp. 191-216.
Haprer, M. (1998), Profits for the Poor, Cases in micro-finance, ITDG, London.
Hausman, D. (1989), Are Markets Morally Free Zones?, Philosophy and Public Affairs,
18, 4, pp. 317-333.
Hayek, F. (1978), Law, Legislation and Liberty, vol. 2 (The Mirage of Social Justice).
Helms, B. and X. Reille (2004), Interest Rates Ceilings and Microfinance: The Story So
Far, CGAP Occasional Paper, 9, CGAP/ The World Bank Group: Washington D.C.
Hulme, D. and P. Mosley (1996), Finance against Poverty, Volume 1, Routlege
Publications: London.
Kershnar, S. (2005), Giving Capitalists Their Due, Economics and Philosophy, 21, 1, pp.
65-87.
Labie, M. (2001). Corporate governance in micro-finance organizations: A long and
winding road, Management Decision, 39, 4, pp. 296-301.
Lietaer, B. (2001), The Future of Money, Random House: London.
Luchas, R. (1990), Why Does Not Capital Flow From Rich to Poor Countries ?,
American Economic Review Papers and Proceedings, 80, 2, pp. 92-96
Mees, M. (2003), Interest Rates in the Field of Microfinance: A Technical or Political
Choice?, Zoom Microfinance, 9, pp. 1-8.
Morduch, J., (1999), The Microfinance Promise, Journal of Economic Literature, 37, 4,
pp. 1569-1614.
Nelson, B. (1959), The Idea of Usury, Princeton University Press: Princeton.
Oosterlinck, K., (2003), The bond market and the legitimacy of Vichy France,
Explorations in Economic History, 40, pp. 326-344.
Porteous, D. (2006), Competition and Microcredit Interest Rates, Focus Note, 33, CGAP:
World Bank.
Rawls, J. (1971), A Theory of Justice. Harvard University Press: Cambridge.
Rawls, J. (1980), Kantian Constructivism in Moral Theory, Journal of Philosophy, 77, 9,
pp. 515-572.
Rawls, J. (1999), The Law of Peoples, Harvard University Press: Cambridge.
Rawls, J. (2001), Justice as Fairness: A Restatement. Belknap Press: Cambridge.
Sen, A. (1985), The Moral Standing of the Market, Social philosophy and policy, 2, 2, pp.
1-19.
Sen, A. (1993), On the Ethics and Economics of Finance, Economics and Philosophy, 9,
pp. 203-227.
Sen, A. (1995), Inequality Reexamined. Harvard University Press: Cambridge.
Sen, A. (2002), Open and Closed Impartiality, Journal of Philosophy, 99, pp. 445-469.
Sen, A. (2006), What Do We Want from a Theory of Justice, mimeo.
Sen, A. (2006), Identity and Violence. The Illusion of Destiny, Norton: Boston.
Smith, A. (1776), The Wealth of Nations, Dutton: New York.
Stiglitz, J. and A. Weiss (1981), Credit Rationing in Markets with Imperfect Information,
American Economic Review, 71, 3, pp. 393–410.
Walsh, A., The Morality of the Market and the Medieval Schoolmen, Politics, Philosophy
& Economics, 3, 2, pp. 241-259.
Walzer, M. (1983), Sphere of Justice, Basic Books: New-York.
Wertheimer, A. (1996), Exploitation, Princeton University Press: Princeton
Wright, A., and P. Rippey (2003), The Competitive Environment in Uganda: Implications
for Microfinance Institutions and Their Clients, MicroSave Working Papers, Microsave.