Download Microfinance is a `bottom-up` approach to ending poverty in

Microfinance
Microfinance is a ‘bottom-up’ approach to ending poverty in developing nations. It consists
of making small loans, sometimes less than $50, usually to women, so that they can start or sustain a
small business. For example, a woman may need to borrow a small loan to be able to buy a sewing
machine so she can make clothes to sell in the local market. This approach is incredibly simple and
relies on traditional skills and entrepreneurial instincts1. The key to microfinance is the recycling of
the loans. When a customer repays their loan they are immediately eligible for another loan, usually
of greater size. This multiplies the value of each dollar.
The traditional ‘top-down’ approach focuses on developing infrastructure and building a
national financial system as a mechanism for economic development. I do not disagree with this
statement, and I believe to combat poverty both a macro and a micro perspective are needed,
however, when providing a large sum of aid to a government in a developing country, the largest
percentages of the aid is absorbed in costly logistics or, unfortunately, political interference. Corrupt
practices by the recipient’s government often reduce the amount of aid to villages and very little goes
to individual citizens, if any at all. National planners focus their efforts on commercial banking
because these investments carry less risk, but this neglects the households of the economy even
though they are of the largest population.
The practice of microfinance began in 1976 with what economists call the beginning of the
microcredit era. Muhammad Yunus, an economist who received the Nobel Prize for his efforts in
microfinance in 2006, secured a loan from the government Janata Bank (one of the largest banks in
1
http://www.grameenfoundation.org/what_we_do/microfinance_in_action/faqs/. Retrieved 8/27/2008
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Bangladesh). He then started lending to the poor in Jobra, Bangladesh. Because most of these loans
were made to women, Yunus’ efforts were often compromised by radical religious groups who told
women that they would be denied a Muslin burial if they borrowed money for entrepreneurial
ventures 2. Yunus continued to operate by securing loans from other banks and in the 1980s he
established an independent institution renamed Grameen Bank. Today, there are thousands of
microfinance institutions (MFIs) that provide the same services, although the size and scope of the
MFIs differ substantially.
Informal financial service providers are the longest standing contributors to poor
communities. During the microcredit era of the 1970s the goal was to put these ‘moneylenders’ out
of business because they often charges in excess of 10% per month on their loans 3. Today the
microcredit efforts were replaced by a ‘financial systems’ approach that recognizes these providers as
a key player in the microfinance movement. These shops live in the same community as their
borrowers and understand each others financial circumstances. This knowledge leads to very
flexible and convenient services. By this nature the loans are very short-term and thus very costly
and limit the scope of products 3.
Member-owned organizations are the newest of the MFIs and resemble the western worlds’
credit unions. They are generally small and local which means they are convenient and operations
are generally low cost because they are managed by poor people . But these institutions have a large
exposure to the health of the economy because their financial skills are limited when adverting the
2
Mhammad Yunus: The Triumph of Idealism, New Age Special, The New Age, 2007-01-01
3
Brigit Helms. Access for All: Building Inclusive Financial Systems. CGAP/World Bank, Washington, 2006, pp. 35-57.
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risks. These institutions are rarely regulated or supervised so members can lose their money if a
political stronghold gains control.
Non-governmental organizations (NGOs) are responsible for lending to over 113 million
clients by the end of 2005 4. Grameen Bank is the pioneer of this sector and has proven success in
the microfinance movement over the past three decades. Most of these institutions are singularly
servicing poor populations and thus new banking techniques were needed to serve their niche market .
For example, traditionally banks use a form of collateral to secure their loans. To eliminate this
need, village banks run by NGOs rely on a variation of the solidarity lending methodology. It relies
on cross-guarantees where each member of a village ensures the loan of every other member . The
cost of social embarrassment motivates the members to repay their loans in full and makes is possible
for even the poorest people to receive loans. The simplicity of this banking method causes worry but
FINCA International, a leading MFI, yields a repayment rate of over 97% in its worldwide network 5.
Most NGOs are dependent on external donors like The World Bank as a source for raising capital.
However, access to private marketing financing and technology moves NGOs from reliance on
generosity to self-sufficiency. Grameen Bank has proven that experience and diversification can lead
3
Brigit Helms. Access for All: Building Inclusive Financial Systems. CGAP/World Bank, Washington, 2006, pp. 35-57.
4
Microfinance Information Exchange, Inc. MicroBanking Bulletin, Issue #15, Autumn, 2007, p. 48.
5
"A Brief Primer on FINCA", a lecture by John Hatch at the University of Berkeley's Haas School of Business, July 21, 2004".
Retrieved on 2008-08-21.
1
http://www.grameenfoundation.org/what_we_do/microfinance_in_action/faqs/. Retrieved: 8/27/2008
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to independence. Thirty years after its first loan, Grameen Bank now does not accept donations and
is totally self-supported 1.
Formal financial institutions are the last player in the financial systems approach . The scale
of these institutions is very small. They have a high cost of operation and very poor individuals fall
below the break even point when providing loans is profitable for the bank. For example, onehundred $1,000 loans total revenue is not that different than one $100,000 loan, but the costs of
transactions are nearly 100 times greater. The future of microfinance institutions seeks to link selfhelp unions with commercial banks. And arrange member-owned organizations together to achieve
economies of scale. Roml Batla, VP at Microfinance International Corp, predicts that the
microfinance sector will undergo some consolidation, increased competition and deepen its market
penetration. MFIs will need to do this not only to stay on the path towards profitable growth but, in
many cases to stay competitive.
Microfinance is a fairly new industry and thus the size and boundaries of the MFIs is often
debated. Originally when financing the poor was referred to microcredit in the 1970s, the informal
institutions were rarely regulated and the borrowers could use their funds for whatever need they
sought. This meant that moneylenders or pawnbrokers were the dominant source of capital for
villages. Some of the time the loan was used for a microenterprise much like how microfinance is
used today. However, microcredit was also used for other reasons like school fees, healthcare, or
food 6. Today, moneylenders are used for the same purpose and are supported by the financial
systems approach mentioned previously but are simply providing loans for credit needs. Modern
6
Robert Peck Christen. What microenterprise credit programs can learn from the moneylenders, Accion International, 1989
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microfinance is an approach in addition to informal lending that operates as a source of funds
focused on microenterprise with the objective that people create a good or service that will allow
them to repay the loan. Microfinance has broadened the breadth of microcredit in that MFIs provide
services. Usually these include savings, insurance, and housing loans.
Collection of microfinance loans is incredibly simple. Microfinance institutions are very
client-friendly by nature of the environment in which they operate. Collection is usually eon by the
MFI representative visiting the client, usually on a weekly basis. This is not only to collect the loan
but to also ensure the client is succeeding in their venture . What is becoming more popular is the use
of focal centers where clients gather to conduct financial transactions and receive other social
services. This adds to the uniqueness of a microfinance loan. As mentioned previously, collateral is
generally not used in the loan process. These village centers are another way for borrows to remain
accountable for each others loans. The smaller support groups discuss ideas for solving problems
and empower each other to stay out of the path of poverty 1. This idea is often criticized as relying
too strongly on the ‘word’ of the borrowers. Microfinance clients are excellent credit risks. The
repayment rate is between 95 and 98 percent which is higher than the repayment rate of student loans
and credit card debts in the United States. Before MFIs, poor people borrowed solely from
moneylenders whose interest rates were very high. An analysis of informal lending rates from Asia,
Latin America and Africa found that 76% of moneylender rates exceed 10% a month and that 22%
exceeded 100% a month 7. The benefit is that they are very fast and flexible and unlike microfinance
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7
http://www.grameenfoundation.org/what_we_do/microfinance_in_action/faqs/. Retrieved: 8/27/2008
Centre for the Study of Financial Innovation. Microfinance Banana Skins 2008: Risk in a booming industry.
http://www.citigroup.com/citigroup/microfinance/data/news080303b.pdf, pp 7-39.
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loans, do not require a specific purpose for the funds. MFI loans generally charge an interest rate
between 18-60% and are usually longer than 6 months.
Microfinance has an international scale. There is a need for microloans in developing and
even developed countries. However the business model in one economy cannot be replicated in
other due to political regulations, culture, geography etc. For example, the use of solidarity lending
has not been successful in the United States. Previously mentioned, solidarity lending is creating a
network in which each borrower is responsibly for other borrows loan; as a form of collateral . One
of my personal beliefs as to why this is successful in place like sub-Saharan Africa is that in mobility
is near impossible. Also, social disgrace is the greatest form of punishment in villages in remote,
rural areas.
The international community has accepted microfinance as a viable way help reach the end of
poverty. The G8 summit (annual meeting of world leaders) met in 2004 to discuss developmental
practices. Among the key initiatives is that microfinance must evolve to pay for itself. Subsidies
from donors and government cannot reach the grand scale of those people in immediate need. This
means that the needs of poor people must be integrated in the country’s mainstream financial system
to ensure continual growth. Another key discussion was that there is a shortage of strong institutions
and managers and MTIs and donors should focus on capacity building 8. Some of these risks are
discussed later.
8
Brigit Helms. Access for All: Building Inclusive Financial Systems. CGAP/World Bank, Washington, 2006, p. 12.
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The microfinance industry is still undergoing significant changes because it is still in the
growth period and thus attracting large volumes of outside investment. The Consultative Group to
Assist the Poor (CGSP), operating from The World Bank estimates the foreign capital investment the
have more than tripled to $4 billion between 2004 and 2006 7. None of the risks are surprising for a
young, emerging industry. Investors’ first priority among risks is to mitigate default risk. However,
as mentioned previously this risk is very minimal. CGSP and CitiGroup conducted a survey that
identified the greatest risk facing microfinance is the uneven quality of management at MFIs at this
time of rapid change. Investors view this industry to be lacking professionalism and management
skills are obviously in short supply in most of the countries where microfinance can play a role .
With this comes corporate governance. The countries with the greatest need for microfinance
institutions often have radical political insurgents that try to control entrepreneurial groups in order to
maintain their control over the region. Structured governments often do not help either; they have
few incentives to promote regulation and want to control interest rates.
Other high risks involve what CGSP recognized as ‘mission drift’; a shift from serving the
poor to creating high interest rate consumer finance products. The profits are more attractive but the
mission has changed and has an adverse reputational impact 79. MFIs face what they see as
conflicting pressures to deliver to social goals, such as poverty alleviation, and create larger
7
Centre for the Study of Financial Innovation. Microfinance Banana Skins 2008: Risk in a booming industry.
http://www.citigroup.com/citigroup/microfinance/data/news080303b.pdf, pp 7-39.
7
Centre for the Study of Financial Innovation. Microfinance Banana Skins 2008: Risk in a booming industry.
http://www.citigroup.com/citigroup/microfinance/data/news080303b.pdf, pp 7-39.
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investment returns. In 2004 during the G8 Summit, world leaders discussed that MFIs must have full
disclosure on their performance-both socially and financially in hopes to eliminate this risk.
Unbalanced funding is among a global risk for MFIs. Microfinance is a high priority for
many international corporations and considered ‘in style’ for many investors. However Africa and
Asia reveal shortages on capital while Latin America and the Pacific Rim have an over-abundance of
funds. Along with this, many institutions fear a refinancing risk if microfinance falls out of fashion.
With its growing popularity, microfinance institutions are concerned with the rise of
competition from new entrants. Critics feel this will allow for lower interest rates to consumers thus
promoting the goal of poverty alleviations, however, MFIs argue that not only is it squeezing the
already narrow margins but it is also putting a downward pressure on standards.
The biggest calculated risk is inflation. On a basic level, MFIs biggest challenge is the cost
associated with transacting thousands of microloans. Operating as efficiently as possible is difficult
due to management shortcomings as mentioned before, nonetheless cost control as a central concern.
In countries where there is consistently a hyperinflationary environment, controlling costs is
especially difficult.
Regulatory risks are also on the rise. As the microfinance industry continues to grow,
governments are struggling to keep up with the securities they create to raise capital . The
international scope allows passive government to easily lose jurisdiction which may lead to
questionable practices by the banks and investors. Many people pose an ethical issue: is it acceptable
to profit from the poor. The Economist probed this issue when CompartamosBanco, a Mexican
lender to the poor, went public a year ago. Critics claim the ‘loss of mission’ threat if capitalists start
to control the industry. However, a profit motive can provide more incentive for success of the
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company. Muhammad Yunus is a strong advocate against the IPO and has said that microfinance is
about “protecting from the moneylenders, not creating new ones.” Inadequate regulatory structures
are restricting MFIs’ operating freedoms and creating legal uncertainty 7.
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A US investor that was
surveyed by the CitiGroup study said that “the relative lack of sophistication and inconsistency of
many regulators in sub-Saharan Africa is going to stifle growth”. Some microcredit institutions face
the opposite challenge among regulations. In Bosnia, MFIs are being forced by new microcredit law
to transform into for-profit agencies. Management, regulation and supervision changes all pose
difficulties in this type of re-regulation. In Kenya the opposite is happening. Phyllis Mbungu, CEO
of the Small and Micro-Enterprise Proramme, said tightening regulation of banks has made smaller
institutions opt to become MFIs instead, which adds to the competition.
To investors, the largest risk is liquidity of the securities issued by MFIs. Funds that are
issued to consumers internationally are often only sold on broker/dealer websites (ex.
Microplace.com, offshoot of Ebay). Expenses can be high and you usually have no right to
withdraw before the announced close-down date (7-10 years) so you would have to try and sell it
yourself on the secondary market. For MFIs themselves, liquidity is not an issue because (so far)
funds have been plentiful.
With all these risks presented in the Banana Skins survey by CitiGroup, over a quarter of
respondents (typically practitioners) say that MFIs are well prepared to handle risks, attributing
management and the popularity of microfinance as the drivers in success7. Many respondents felt
7
Centre for the Study of Financial Innovation. Microfinance Banana Skins 2008: Risk in a booming industry.
http://www.citigroup.com/citigroup/microfinance/data/news080303b.pdf, pp 7-39.
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that present trends of competition and commercialization and growing dependence on management
and technological skills would widen the gap between MFIs that were are well prepared and those
that are not. Although microfinance is a relatively new idea and is still developing globally, I believe
this industry will be a major player in alleviating extreme poverty and promoting economic
sustainability.
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