FINANCING DEVELOPMENT
Microfinance - Background
Microfinance consists of the provision of financial services in small increments, typically to very poor people.
History
The beginnings of the microfinance movement are most closely associated with the economist Muhammed Yunus, who in the early 1970's was a professor in Bangladesh. In the midst of a country-wide famine, he began making small loans to poor families in neighboring villages in an effort to break their cycle of poverty. The experiment was a surprising success, with Yunus receiving timely repayment and observing significant changes in the quality of life for his loan recipients. Unable to self-finance an expansion of his project, he sought governmental assistance, and the Grameen Bank was born. In order to focus on the very poor, the Bank only lent to households owning less than a half-acre of land. Repayment rates remained high, and the Bank began to spread its operations to other regions of the country. In less than a decade, the Bank was operating independently from its governmental founders and was advertising consistent repayment rates of about 98%. In 2006 Yunus was awarded the Nobel Peace Prize.
The success of the Grameen Bank did not go unnoticed. Institutions replicating its model sprang up in virtually every region of the globe. Between 1997 and 2002, the total number of MFIs grew from 618 to 2,572. Altogether, these institutions claimed about 65 million clients, up from 13.5 million in 1997 and still growing at 35% a year. The amount of money flowing to clients also continues to climb rapidly and the Grameen Bank has extended over $750 million worth of credit in the past two years alone.
Alongside the explosion of the microfinance industry in absolute terms, there has been a steady growth in private financing for MFIs. The bulk of microfinance funding is still provided by development-oriented international financial institutions and NGO's. Yet estimates place demand for unmet financial services at roughly 1.8 billion individuals. Even at its current growth rates, it is clear that microfinance will only be extended to meet this enormous demand by leveraging private capital, flows of which dwarf all other potential sources. Commercial financing has grown most rapidly in Latin America, where regulated financial institutions now serve 54% of the continent's microfinance clients and, importantly, are now responsible for 74% of the region's loans. Overall, 2005 saw private lending to MFIs jump from $513 million to $981 million.
This jump in investment is a reflection of an increasing number of sustainable MFIs worldwide. In addition to earning a profit, sustainable microfinance providers are in a better position than their subsidized peers to expand their operations and share of the market. Thus in a study by the Consultative Group to Assist the Poor (CGAP) in which operationally-sustainable MFIs represented only 46% of the sample, they accounted for 77% of borrowers served. The push towards sustainable institutions and the resulting growth of commercial financing raise some important questions about the true mission of MFIs and how best to expand their reach. These issues are further developed in the materials below.
Benefits of microfinance
The very poor are unusually susceptible to income shocks. Death, illness, natural disaster, or other catastrophes can have devastating effects on households existing at or just above a subsistence level. With no asset base on which to draw in the crisis, they may be forced to severely reduce their level of consumption, which can be dangerous if it means forgoing basic healthcare and nutrition. Additionally, they may sell off important, income producing assets, exacerbating their economic difficulties well into the future.
Financial services that allow poor people to save in times of prosperity and borrow or collect insurance when necessary allow them to maintain a consistent level of consumption without selling off income-producing assets. Microfinance can also provide an opportunity for expanding or pursuing new business opportunities that allow poor people to increase or diversify the sources of their income.
It has also been argued by advocates that microfinance can also promote the development of a traditional financial sector. Most obviously, by alleviating poverty, microfinance can deepen the market for more traditional financial services. In addition, MFIs and their clients can lobby for the creation of clearinghouses for information on borrowers' credit histories, easing of interest rate controls, greater foreign ownership of financial institutions, and opening local capital markets beyond a country's political elite, among other reforms. Such improvements could strengthen the financial sector as a whole, creating a feedback loop that could serve to lift even more families out of poverty.
Microfinance can also generate important non-economic benefits. For instance, many microfinance programs are aimed specifically at women. It has been suggested that access to financial services enhances women's power and influence in the household. Their ability to make decisions over certain purchases and their new status as important household earners has been linked not only to increased bargaining power, but also to a decreased incidence of domestic violence. (Lower incidences of abuse could also be the result of third party scrutiny from loan officers and, in the case of group lending, fellow borrowers.) Furthermore, the opportunity to pursue business opportunities may make women more likely to use contraceptives and lower fertility rates.
In addition, many MFIs couple their loan programs with educational efforts. For example, loan officers may provide information on contraceptive use or disease prevention or domestic economics as well as methods of controlling saving and spending habits and various aspects of small business management.
Challenges associated with lending to the poor
Ultimately, microfinance is designed as a tool to reach impoverish households that are not otherwise served by more traditional financial institutions. There are several reasons why it is difficult to lend money to the poor.
Hidden information
The primary problem with lending to the poor, and the main obstacle that microfinance is designed to overcome, is banks' lack of information about the inherent riskiness of potential clients. The transaction costs of evaluating individual borrowers are very high relative to the size of the loans likely to be made to poor borrowers. This means that to cover the expense of screening individual borrowers banks would be forced to charge correspondingly high interest rates to their clients. Moreover, it is doubtful whether screening will provide accurate information given that potential borrowers have incentives to misrepresent their credit history and the risks of their respective projects. Without accurate information, banks will still charge high rates to cover the frequent incidence of default among the risky borrowers that will inevitably join their client base. Either way, interest rates will be high enough to drive borrowers with safe but relatively low returns out of the market. This problem is referred to as adverse selection.
Governments sometimes respond to this problem by imposing restrictions on interest rates charged by financial institutions in the form of usury laws or interest rate caps. With rates constrained, it would become impossible to provide banking services to the poor without significant and costly subsidies.
Moral hazard
Even borrowers whose projects are not inherently risky may refuse either to use their loans productively or, if they do use the loans productively, to repay their loans if their lenders have no means of enforcing their obligations. This problem of moral hazard may arise because, for instance, local judges are biased in favor of debtors or police forces are stretched too thin to provide assistance. This problem can be exacerbated by competition among lenders, as in the absence of competition a lender can encourage repayment by refusing to provide future credit.
Absence of credit history
In societies with developed credit markets, problems stemming from inadequate information and moral hazard are mitigated by the fact that lenders routinely investigate borrowers' credit histories. . A record of a borrower's repayment history provides lenders with valuable information about the likelihood of future repayment. In addition, the ability to tarnish a borrower's credit history and thereby limit the borrower's access to future credit provides lenders with leverage that they can use to induce repayment.
Lack of collateral
Another response to problems of hidden information is to require that borrowers provide collateral, meaning an asset that the lender can easily seize and, perhaps, sell in the event of default. This allows banks to charge low interest rates even in the face of poor information about the borrower's prospects. But many of the impoverished borrowers that microfinance seeks to reach lack assets that can effectively serve as collateral. When they do have assets, they have are often illiquid. Livestock, for example, is not only subject to destruction, but can be very difficult to convert on the market for a traditional bank inexperienced in selling it. Furthermore, among these sorts of clients the only assets they have may be critical to their means of subsistence and legal or ethical restrictions may prevent banks from foreclosing upon them.
Typical features of microcredit
MFIs employ several innovative contractual devices, including group lending, progressive lending, short-term contracts, and targeting of women, in efforts to overcome the obstacles that have traditionally discouraged lending to the poor.
Group lending
Perhaps the most important of the microfinance innovations, and certainly the one for which it has received the most recognition, is lending to solidarity groups. Though many MFIs have departed from it, the original Grameen model required that loans not be made to individuals or singular families, but instead to a solidarity group of five women. As each group member was required to vouch for the creditworthiness of the others, these women were all likely to be from the same village and would self-select one another for membership. All members received equal financing and made repayments on the same, fixed schedule. Most importantly, if one member of the group defaulted on their payments, no other member of the group could apply for another loan until the default was cured.
Group lending provides several benefits to both lenders and borrowers:
- When the members of the group are self-selected from the same village, their knowledge of one another's habits and awareness of each member's propensity for risk will largely obviate extensive screening by the lender. Safe borrowers will select one another for membership and the MFI can avoid a highly costly and inaccurate interview process. Additionally, risky borrowers will be forced to select one another. As they will have to pay more often for their frequently defaulting peers, they will indirectly pay a higher effective interest rate. The risk for such borrowers is thus shifted from the MFI to the borrowers themselves. As a result, a lower nominal interest rate can be charged to all parties and a much wider segment of society can gain access to credit.
- The group members can also monitor one another much more effectively than the lender, and group lending gives them an economic incentive to do so. This monitoring can take two forms, the first being ex ante observation to ensure that group members are putting their money towards appropriate uses. Ex post, members will also ensure that returns from a loan-funded project are going towards repayment. They can report to the MFI on members who are withholding payments despite an ability to pay.
- Group members can help lenders overcome limitations of formal mechanisms for enforcing obligations. Members are able to exert pressure on each other, be it social, cultural, or even religious, that traditional institutions are unable to bring to bear. Also, under the Grameen model, a solidarity group of 5 women was a part of a larger village group, allowing for community leaders to pressure defaulting borrowers into repayment.
It is important to note though that borrowers only have incentives to screen and monitor their fellow group members if they expect to repay their own loan and obtain additional funding in the future. To the extent they plan to default, these incentives are no longer in place. Furthermore, if the group's losses are expected to outweigh the borrower's return on their own investment, the borrower has to no reason to attempt to cover those losses. She will lose all of her own profits, but as the loan will not be paid in full, she will see none of the gains that come with timely repayment, namely an increased loan amount in the next cycle. Additionally, borrowers may not be able to effectively evaluate either the inherent riskiness of their partners or the riskiness of each others' projects.
Progressive lending
Some MFIs adopt the policy that once a debt is repaid in a timely fashion the group will be eligible not only for a new loan, but for a larger loan as well. This structure creates opportunity costs for non-repayment, as a borrower stands to lose substantial future credit if they chose to default. A loan-ladder also gives MFIs the opportunity to “test” their borrowers with smaller loan packages, helping the institution to gather information about their potential clients. As loan sizes increase, the average costs of servicing those loans decrease, making the MFI itself more profitable. Although there is still opportunity for a borrower to strategically default, waiting until loan sizes have grown substantially larger before failing to make payments, the reputational constraints discussed above operate to reduce the frequency of this problem.
Short-term contracts
Finally, in yet another substitute for an MFI's lack of information about its clients, most microfinance loans have very short repayment periods, with cycles lasting as little as a week. As each payment is made directly to an officer of the MFI, these frequent meetings assist in monitoring investments and keeping track of repayment. Keeping the loan size small also limits the MFIs exposure in the event of borrower default or economic shock to a particular group or village. It is also important to observe that many microfinance clients report that they find it easier to repay their loans on shorter schedules.
Targeting women
Empirical evidence has demonstrated that women are more effective targets for microfinance than men, despite the fact that men are typically the targets of formal sector commercial institutions in developing countries. Women are not only more likely to repay their loans, they are also more likely to spend loan proceeds on their families basic needs, education, and health care, leading to a greater impact on household welfare. It has been suggested that women provide better targets for microfinance for a variety of reasons: They are typically less mobile than their husbands. As a result, the monitoring costs for bank managers is lower. Because they are less mobile, they are also more susceptible to the peer pressure that is critical to securing repayment in group lending contracts. Finally, as women have been traditionally relegated to small industry, they have a comparative advantage in the very businesses to which microfinance is targeted. While microfinance could thus, arguably, be seen to further entrench women in their traditional roles, as a counterargument these women have few opportunities outside of the home. Microfinance allows them to take the fullest advantage of chances that are available to them, limited as they may be.
Beyond microcredit
While the terms microcredit and microfinance are often used interchangeably, microfinance in fact encompasses a broad range of activities outside of lending. Many MFIs have expanded beyond microcredit to offer services such as savings devices, insurance, and in some instances, sales and marketing assistance specially tailored to meet the needs of the very poor.
Savings and deposit taking
There are a number of reasons why poor people find it difficult to save. Some people may lack a structured disciplined method of saving. Others may have difficulty controlling the consumption habits of other members of their household. This problem is particularly acute for women, who often have no control over household spending. Moreover, for those who are interested in saving, the only mechanisms available may be investments in illiquid assets that deprive them of the ability to take advantage of new investment opportunities or respond to sudden setbacks. In addition, those assets may themselves be risky investments. For example, investments in livestock are susceptible to the risks of disease and drought. Meanwhile, more liquid assets such as cash and jewelry are susceptible to the risk of theft.
A number of MFIs require that borrowers contribute a small portion of their earnings to a savings vehicle, often in small amounts on a frequent basis. These savings will often be unavailable to the borrower for a predetermined period and are designed to help microfinance clients develop effective savings habits. Alternatively, an MFI may allow its clients to make voluntary deposits. These deposits are intended to be safer and more liquid than alternative savings instruments.
It is important to recognize that these kinds of savings plans also serve the interests of MFIs by allowing them to accumulate capital and, because the deposits can be seized in the event of default, collateralize the debt obligations of their borrowers.
Microinsurance
Offering insurance services to poor people presents many of the same challenges as offering them credit. The difficulty of assessing the risk associated with individual clients makes insurers vulnerable to adverse selection, with the most most risky clients seeking insurance. Meanwhile, the difficulty of preventing clients from engaging in risky activities after they have been insured raises the problem of moral hazard.
In many developing countries informal mutual assistance schemes serve as a form of insurance. It is also possible to conceive of group lending as a form of insurance. A few microlenders have insured their clients as part of a loan package. Life insurance, perhaps because it presents the least moral hazard, has been the most successful, but property, health, and weather insurance have also been offered.
Empirical studies
There is conflicting data about the true value of microfinance as a development tool. While many MFIs advertise high repayment rates and a better quality of life for their clients, the evidence that microfinance creates appreciable reductions in poverty is inconclusive. To make a significant impact, microfinance must be made available to a very broad segment of society, and be coupled with entrepreneurial ability on the part of MFI clients. Faced with these sobering difficulties, much of the euphoria of the movement's early days has dissipated, and few now see microfinance, on its own, as a panacea for global poverty. Despite this emerging sense of realism, there is still a relatively broad consensus that providing financial services to the poor has tangible economic benefits, even if not the instant alleviation of client poverty.
Regulatory issues
Interest rates
Microfinance institutions may often be forced to charge higher interest rates than their traditional counterparts. Rates are generally higher because an MFI faces greater costs. Traveling to clients, meeting with them, and making and keeping track of larger numbers of small loans all serve to create costs well beyond those faced by a typical bank in a highly evolved credit market. As a result, capping interest rates or strictly enforcing usury laws can cripple an MFI by preventing it from charging sustainable rates. MFIs can operate under such laws if they remain unenforced or if there is an implicit exception for their operations, but this kind of informal non-enforcement is both awkward to defend from a rule-of-law perspective and subject to potential corruption.
Protection of depositors
Once an institution begins taking the savings of its clients as opposed to providing credit from other sources, regulatory issues arise. If an MFI is being run as a for-profit institution then its owners have an incentive to take great risks with their depositors' money. Without any of their own assets invested in the institution, rather than investing prudently they could rationally be expected to seek the largest return possible. Such management will be likely lead to a high incidence of MFI failure that will not only undermine the economic progression of microfinance clients, but could also serve to discredit the entire industry. Circumstances may therefore require the regulation of deposit-taking MFIs. Yet creating an effective regulatory regime with an eye toward the goals of microfinance presents significant challenges in itself. These issues are discussed further below.
An MFI also faces the same problems with taking small deposits as a traditional bank. Its transactions costs will be high and earning profits on small deposits will be difficult. It should be noted, though, that many MFI clients are not seeking returns on their deposits, but instead merely require a safe place to keep their money. As they grow more sophisticated, though, they may ultimately demand interest on their savings. Fortunately, an MFI can charge much higher interest rates on its loans than its traditional counterparts. Its impoverished clients enjoy a much higher rate of return on their investments, thus, using deposits to capitalize loans to its clients can provide the returns necessary to make deposit-taking profitable for an MFI. This solution assumes that the MFI itself can control the costs of its operation sufficiently to avoid large deficits. One of the reasons MFIs are so popular is that they provide great convenience to their clients, both by meeting them in their respective villages and by providing flexible loan structures. That convenience requires a large and devoted staff and prevents the MFI from taking advantage of standardization as a means of keeping costs down. Cost control is thus a general problem for MFIs, but can be particularly problematic for institutions that seek to fund themselves with client deposits, as taking deposits will further inflate those costs, and the MFI will be hard-pressed to earn sufficient returns.
There are several forms that such a regime might take. A special regulatory “window” can be created for MFIs, allowing them access to deposits and the local credit market without some of the strict reporting or capital requirements that are given to traditional institutions. Alternatively, MFIs can fall under the purview of existing banking regulations, or regulators can make individualized exceptions to those regulations.
Obstacles to enforcement
Given their small size and dispersion, monitoring MFIs would be a challenging task even for regulators in a developed financial market with an excellent informational infrastructure. In a developing economy, with limited regulatory resources, effective observance and control will be even more difficult. Collecting and processing data may be prohibitively expensive - for either the MFI or the regulators - or simply a poor use of a central banking authority's time and energy, as the collapse of smaller MFIs is unlikely to affect macroeconomic stability.
Additionally, as most MFIs are not funded by profit-oriented investors, regulators lose some of their most important forms of leverage. Specifically, mandating capital adequacy ratios becomes ineffective as means of encouraging managers to closely monitor the performance of their institution, as it is not the managers' equity on the line. Nor can a supervisor make capital calls of donors or NGO's. These institutions often lack further resources, or might refuse further participation in microfinance altogether if they would be responsible for recapitalizing failed institutions. Halting lending will remove an important incentive for an MFI's clients to continue their payments, exacerbating the financial trouble of the target institution.
Subsidies
While the ultimate goal of microfinance is self-sustainable services for the poor, subsidies can play an important role. The start-up costs of establishing an MFI can be significant, and might require extremely high interest rates during its first few years of operation. As a result, subsidies can be an effective method of getting MFIs off the ground, and can be provided through soft loans from a country's apex organizations (second tier lenders providing cheap, government credit to private retailers), tax breaks, technical assistance, and direct financial support. There may also be some cases in which populations are simply too expensive to reach, either due to geographic isolation or the extremely small loan sizes that their service would entail. In these situations, microfinance subsidies may be more effective than other, more direct forms of aid to their beneficiaries. However, there is always a risk of subsidizing ineffective or inefficient MFIs and thereby crowding out more efficient institutions.
The challenges of commercialization
The fact that substantial amounts of low-cost funding for microfinance is available from the international donor community has limited MFIs' demand for commercial financing. Both commercial actors and donors tend to be most interested in investing in large, successful MFIs. Nonetheless, some MFIs have begun to seek capital from profit-seeking investors.
Tapping commercial sources of financing dramatically expands MFIs' access to capital. Profit-seeking investors may also be more strongly inclined than donors to encourage MFIs to improve their efficiency.
On the other hand, MFIs that focus on maximizing returns for their investors may experience mission drift, in other words, they may find themselves drawn away from their focus on serving the very poor. For instance, they may find themselves drawn toward wealthier borrowers who are cheaper to service because they can provide collateral and require larger loans. In a worst case scenario, MFIs may attempt to take advantage of regulatory windows or donations to compete with traditional institutions that are already serving the middle income market. Then they will not only fail to serve their target market, but also drive out efficient credit providers
One strategy some MFIs have pursued in order to counter the problem of mission drift is to seek “socially oriented” investors
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