All you ever wanted to know about microfinance -- Habitat for Humanity Int'l 1

All you ever wanted to know about microfinance

By Patrick Kelley

What is microfinance?

Microfinance can be viewed, most simply, as banking services for the poor. The provision of simple financial services such as savings, various forms of credit, and even insurance, has been shown to help the poor pull themselves out of poverty. A recent World Bank/CGAP (Consultative Group to Assist the Poorest) publication reviewed the mounting body of evidence showing that the availability of financial services for poor households is a critical contextual factor with strong impact on the achievement of poverty reduction[1].

Why not banks?

In the developed world, banking services are taken for granted. It is estimated that more than 90 percent of U.S. residents use the formal financial services sector[2]. In poorer countries, sometimes only the minority elite have access to such services. In some parts of Africa, less than 5 percent of the population has access to any form of banking service[3]. Banks are not attracted to working with the poor because the transactions tend to be very small; the poor usually lack collateral, which makes them risky clients; and the poor often live in more rural areas which may not have enough volume of business to support a typical bank branch.

How does microfinance address these issues?

Microfinance reaches out, through several innovative approaches, to people who are not served by the formal financial sector.

First, to avoid the administrative burden of so many small transactions, credit and savings transactions are often done in group settings. It may be hard to justify staff-time or even the paper used to record a repayment of US$1.35 on a loan, but 40 people making that same transaction makes it a US$54 transaction.

Second, social collateral is used rather than physical collateral. Thus, community members provide a group guarantee to a person based on his/her character or good reputation. So, for a microfinance client, it is often more important to convince one’s peers of one’s abilities to repay a loan than it is to convince the lending institution.

Finally, whereas banks typically receive clients in their secure urban offices, microfinance institutions send agents into rural areas and slums to execute transactions with clients in their own communities. These community-based meetings (often weekly) foster the empowerment of the participants in the group to help each other in their respective businesses and even to discuss community issues.

Why do microfinance institutions charge interest?

Microfinance institutions charge interest so they can cover the costs of providing the service. Covering the costs makes the service an ongoing, sustainable service rather than a one-time act of charity. A dependable and quickly accessible service helps the poor better deal with the cash flow needs of their small businesses and problems caused by household or business crises.

Charging interest to achieve sustainability also enables scale. When costs are covered, services can be greatly expanded. Some microfinance institutions (MFIs) have more than a million clients using their services. Even in housing, as Habitat celebrates its 200,000th house globally, the Grameen MFI in Bangladesh approaches its 400,000th house in just that country.

How do MFIs define sustainability?

At the most basic level, sustainability means that revenues from interest equal expenses of operations. There are more rigorous ways of looking at it to ensure that an institution’s capital keeps up with inflation, or even the cost of capital too. These would add the rigor of not only covering costs, but keeping the organization’s capital up with inflation or normal market returns on capital.

Are all MFIs sustainable?

Not all MFIs are sustainable, though nearly all of them have a plan for sustainability and a timeline on how to get there. Sustainability is a managed process. For example, an MFI may have good financial quarters offset by bad quarters with unexpected expenses. Additionally, some MFIs have a “sustainable business model” that is hidden by the high costs of constant growth.

A continually growing MFI may always have underutilized loan officers and the expenses of new branches that weigh down the overall performance. MFI managers must consider all these things as they chart the organization’s course toward long-term sustainability at an interest rate that is affordable and competitive with other MFIs.

Long-term sustainability usually takes several years to achieve, and requires a large number of clients to take advantage of economies of scale.

How are interest rates calculated?

MFIs want to charge interest that covers the costs of providing the financial service to clients. This requires considering economies of scale—aiming to achieve sustainability when 10,000 clients are served, rather than just 500. The interest rates can sound shockingly high—30 percent per annum and upward is quite common. However, it is important to keep in mind the difference in the cost of lending each individual dollar. It is much more expensive to lend a dollar in small loan transactions to the poor by sending agents to them, than it is to lend an additional dollar in larger commercial banking transactions.

However, despite the sound intuition, there are legitimate concerns. One is that though the interest rate is calculated to cover costs, to what extent do those costs include organizational inefficiencies? It is also important to ensure that the client is not burdened with interest that covers inefficient costs—such as unnecessary vehicles and unproductive staff positions.

Another concern is the recent occurrence of predatory lenders entering the market under the guise of microfinance.

How did the concept of microfinance develop and become such a trend in poverty alleviation?

Pioneers like Nobel Prize winner Muhammad Yunus used some of these innovative concepts and methodologies to small-scale success in the 1970s. The examples of entrepreneurs working out of poverty brought in ever more interest. Donors started funding the programs in the 1980s and 1990s through poverty alleviation programs. Early doubters were quieted as the poor were able and willing to pay cost-recovery interest rates and repayment rates reached up to 99 percent in many cases, earning the envy of commercial banks. This early success and the promise of sustainability gathered more attention and fueled more investment.

Can microfinance eliminate poverty?

Microfinance has drawn a lot of acclaim and attention, but it is just one piece of the puzzle in solving poverty. Much of the hype stems from the drastic change in thinking it provides to the traditional bilateral and multilateral aid communities. Development aid has traditionally been driven by consultants with large plans for mega solutions to poverty. Microfinance flips the equation by challenging the effectiveness of governments managing poverty solutions and makes a strong case for putting the funds into the hands of the poor. So, while that fresh air to the dialogue about poverty deserves great attention, that attention should not be construed to mean that microfinance is a single solution to eradicating poverty. Health, education and even infrastructure development are needed, while microfinance is an important cross-cutting and complementary intervention.

Who does microfinance?

Microfinance is done by microfinance institutions (MFIs) started as an intervention by NGOs, both local and international. However, many of those interventions have now been separated from their parent NGO and legally formalized as commercial for-profit entities. This is often required by law, but sometimes it is done voluntarily so that the MFI can mobilize savings deposits and provide more sophisticated financial products for its clients. These institutions are frequently subject to central bank supervision, often under a separate microfinance regulatory code. Despite the commercialization, many of them have shareholder agreements and corporate charters that retain the social goals of the original organization and limit or prohibit extraction of retained earnings.

Some popular MFIs are Grameen Bank in Bangladesh, Center for Agriculture and Rural Development (CARD) in the Philippines, Compartamos in Mexico and Faulu (Swahili for “succeed”) in Uganda. Often these institutions are members of North American or European-based support networks such as Opportunity International, ACCION, FINCA or Vision Finance Corporation (World Vision).

What are the risks to the poor?

There are cases when a microentrepreneur’s business fails and, indeed, not all people are cut out to be entrepreneurs. However, best practices of microfinance hold that a client should only incur loans incrementally, starting from very small loans that group members can cover if the client does not succeed. So a person who takes out a first loan, and later determines himself/herself to be risk averse and not entrepreneurial, would only incur a debt of the smallest loan amount (sometimes as low as US$25). Significantly large loans only become available over time, so both the client and their guaranteeing peers have a chance to learn much about each other (and oneself) before large problems occur.

Predatory lenders, on the other hand, seeking to maximize profits try to get large amounts of debt into the hands of the poor and often skip the slow incremental loan increases typically used in the microfinance industry.

What are the current industry trends?

Industry trends include a shift toward newer, more commercial forms of financing (debt and equity investors, rather than donors) and also by a drive to provide more diversified services.

There is a debate in the industry about how commercialization will impact the ability of institutions to serve the poor in the long run. Some fear that MFIs will move up-market to a relatively wealthier clientele, a phenomenon referred to as “mission drift.” On the positive side, commercialization should fuel growth of the industry, which would expand the poor’s choices of institutions and, in theory, drive down the interest rates and costs of services.

Diversification is the provision of multiple services to the poor, rather than just micro-enterprise loans. As such, many MFIs are also involved in multiple savings products, education financing, housing financing and even micro-insurance. Habitat for Humanity believes that it can help the industry serve the poor with housing solutions.

Patrick Kelley is director of International Housing Finance at Habitat for Humanity.


Some helpful microfinance resources

The joint awarding of the 2006 Nobel Peace Prize to Muhammad Yunus, founder of the Grameen Bank, and the Grameen Bank, has sparked a lot of interest in microfinance. Here are some good resources to use if you want to learn more:

  • The Microfinance Gateway: A CGAP (Consultative Group to Assist the Poorest/World Bank-sponsored Web site that serves as a clearinghouse for news and publications surrounding the microfinance industry: [http://www.microfinancegateway.org/]
  • An interview with Muhammad Yunus immediately following the announcement of him being awarded the Nobel Peace prize: [http://nobelprize.org/nobel_prizes/peace/laureates/2006/yunus-interview.html]
  • The Microfinance Information Exchange (MIX) is a clearinghouse of information about MFIs and microfinance investors: [http://www.mixmarket.org/]
  • The Small Enterprise Education and Promotion (SEEP) Network home page: The SEEP Network serves as a professional association of implementing/supporting organizations that share learnings from the fields of enterprise development and microfinance: http://www.seepnetwork.org/
  • A very comprehensive book about housing microfinance edited by Franck Daphnis: http://www.amazon.com/Housing-Microfinance-Practice-Franck-Daphnis/dp/1565491823
  • Links to two well-known training events for microfinance: http://www.bouldermicrofinance.org, http://www.mdi-nh.org

--------------------------------------------------------------------------------

[1] For more information, see CGAP Focus Note #24 http://209.131.193.149:9090/portal/site/CGAP/menuitem.da0167f15fefd30167808010591010a0/

[2] http://www.fisca.org/pr78.htm

[3] Claessens, Stijn, “Access to Financial Services: A Review of the Issues and Public Policy Objectives” (May 2005). World Bank Policy Research Working Paper No. 3589. Available at SSRN: http://ssrn.com/abstract=744644. See page 9 and table I.