Microlending

Eduardo Kaplan

A new way to fight poverty

Development organizations have long grappled with the question of how to lift millions of people out of poverty. For decades, funds earmarked for the poor were funneled to local governments or international agencies. Money was poured into large construction projects designed to build infrastructure and improve living conditions in developing nations. New roads, dams, and bridges dotted the landscape of countries in which the poor remained alienated from the formal economy and depended on handouts to survive.

The idea of lending capital directly to those who needed it most seemed too risky or impractical. The poor were unfamiliar with the workings of the credit system and lacked assets to use as collateral for loans. Without jobs or steady income prospects, they could hardly be expected to pay back the original amount.

Or so the thinking went until the mid-1970s, when an economics professor in Bangladesh who was frustrated with conventional approaches set out to prove that lending on a small scale could have a broad and lasting impact.

Mohammed Yunus began by lending a small sum to help a struggling furniture maker and then went on to found Grameen Bank, an institution that has made business loans to people with no other access to the financial system. The bank and its partner institutions have distributed billions in small loans to nearly 7 million clients in 27 countries around the world by pioneering a practice commonly known as microlending, also called microcredit or microfinance. In 2006, Mohammed Yunus and Gameen Bank were awarded the Nobel Peace Prize. In that year the Microfinance Summit Campaign Report (see link at the end) estimated that there were more than 3,000 microfinance institutions serving 100 million poor people in developing countries. As its name suggests, microlending essentially consists of the disbursement of small loans to people locked out of the banking system, the idea being to help them to start or expand small businesses that generate income – for example, a one-cow dairy. Some loans are as small as $2 but typically they range from $50 to $1,000 and are made without conventional credit checks or collateral requirements.

The great majority of microlending's beneficiaries include people working in the informal, or underground, economy, and residents of remote rural areas. Many lenders have targeted women, traditionally discouraged from engaging in commercial ventures. Grameen Bank, for example, reports that 95 percent of its borrowers are women.

For the most part, microlending has proved that a small loan can become the start of a virtuous economic cycle, the benefits of which extend beyond individual borrowers because their businesses generate jobs and help improve living standards in their communities. Grameen's founder has seized on microlending's success to argue that credit should be at the top of the chain of other universally recognized human rights such as the right to food, the right to work, and the right to shelter. Once access to credit is established, Yunus has said, the individual recipients of a loan have the means to make the other rights possible through their own efforts.

Other microlenders, however, note that people lacking food and shelter are unlikely to benefit from their services. The Bangladesh Rural Action Committee, that country's largest microlender, has found that the very poor drop out of its program and that for many people microfinance is not a viable alternative to direct aid. Research in Bangladesh and elsewhere has found that until an appropriate level of economic security is reached, the poor are unable to risk taking on credit in order to generate income through small business activity. They need to be healthy enough to run a business, after all, and their customers – often, neighbors or people in nearby villages – also must have money to spend, even if it is a very modest amount.

Studies in Bangladesh also have shown that microcredit borrowers tend to use their loans for the same limited range of small-scale activities – setting up a teashop or husking paddy, for example – and that they soon reach a ceiling on the amount of income they can earn. In any given place, there is a limited range of economically viable small-scale activities available to poor people with limited skills and limited demand for their products or services.

Even so, microlending has dispelled the notion that those on the lowest rungs of the income ladder are not able to follow basic rules of commerce. Rather, the poor have proved that they are as entrepreneurial as graduates of top business schools and fully capable of launching a business and earning profits.

Despite early misgivings and a few setbacks, discussed below, microlending has turned out to be good business, boasting loan repayment rates – as high as 97 percent for some institutions – far in excess of those seen in commercial lending.

Because their business has been so far removed from the worlds of high finance, microlenders in a number of developing countries weathered financial crises so deep and widespread that they left almost no domestic commercial banks standing in their wake. In a few cases, as in some Andean nations, microlenders emerged as the only source of private sector funding after financial crises obliterated almost every commercial lender operating in the market.

Most microlenders have developed a loyal following among their customers. Not only have they become the sole source of funding for entire communities, they also lend at interest rates below those charged by traditional local moneylenders. Because they are part of the community and know their customers, microlenders can generally make an educated estimate of the risk involved in lending and they are able to contain that risk by organizing clients in groups or by operating revolving funds within a neighborhood. Thus, borrowers feel pressure from the community to repay the loan on time and can risk social isolation if they do not.

Industry growth sparks debate about goals and directions

Growth and diversification in the microlending industry has sparked debate about its mission and the direction it should take. There is no clear consensus on the best approach for microlenders, especially when it comes to striking a balance between profits and the loftier goal of poverty eradication.

Some microlenders have emerged as competitive banking powerhouses in the countries where they operate and have expanded their services to include savings accounts, debit cards, consumer loans, and retirement funds. Grameen Bank, for example, has sought to finance all its operations from its own funds and has gone beyond banking to offer telecommunication and health services in Bangladeshi villages.

While many microlenders are run as nonprofit organizations, relying on aid donors and development banks for funding, others have sought to attract investment. Bolivia's BancoSol, for example, issued a $5 million bond in 1996, opening the way for other institutions such as Mexican microlender Compartamos, which placed a $10 million issue in 2002. BancoSol was incorporated in 1992 as the first licensed bank exclusively dedicated to providing microcredit. Since then, it has lent more than $1.75 billion in loans to 320,000 customers, more than any other bank in Bolivia, and it now offers full banking services.

Across the world in Asia, Bank Rakyat Indonesia, a state-controlled microlender, sold a 30 percent stake through an initial public offering in 2003 and is now the second-largest bank by market value in the country, even though still some 80 per cent of its loans go to villagers and small enterprises.

For some who follow these developments in the industry, this kind of growth and pursuit of investment isn't just an interesting evolutionary aside. Rather, it represents the best hope of expanding microlending's benefits to an even larger public. Demand for microcredit outstrips current demand, they reason, so it becomes necessary for microlenders to achieve financial sustainability, to diversify their business, and to borrow from investors in order to enlarge their operations. In addition, it is thought that the process of raising investment capital will help microlenders – already among the most effective financial intermediaries in their markets – to achieve greater efficiency.

However, others question how a microlender preoccupied with becoming a full-blown financial entity can stay focused on its original mission of providing loans to the poor. In their view, the requirement that microcredit institutions be financially sustainable and preferably profitable has favored strictly financial programs at the expense of those which combine loans with training and other services to help people start and build their own businesses. Such broad-based programs can offer the best hope of creating jobs in the community but their costs and risks run higher than those of more narrowly focused microlending schemes. As a consequence, the broad-based initiatives attract less investor interest.

Microlending spawns a new cottage industry in support services

Ongoing debate about goals and directions notwithstanding, many microlenders have borrowed business practices from corporate boardrooms and Silicon Valley. In turn, a number of privately funded organizations run by former bankers have emerged in recent years to provide business support and consulting services to the microlending industry.

One such organization is Unitus, a self-described ''microfinance growth accelerator'' that works closely with microlenders in Asia and Latin America. Using techniques common among venture capitalists, Unitus helps selected microlenders to secure donors and investors. Often, the process involves transforming a nonprofit microlender into a regulated business entity.

BlueOrchard Finance SA, a microfinance investment advisory firm based in Geneva, Switzerland, manages an investment fund dedicated exclusively to microlending institutions around the world. Started in 1998, the fund, known as the Dexia Micro-Credit Fund, targets small microfinance banks in emerging economies. It is 60 percent invested in Latin America, and the rest is divided among East Africa, Asia, and Eastern Europe. Even with the onset of the global financial crisis in 2007/08, defaults have remained low for most funds (as recently as late 2008, the Dexia Micro-Credit Fund had registered no defaults since its inception 10 years earlier). This is because recipients of the loans are far removed from the turmoil of the global financial markets and economy.

A need for financial regulation

This does not mean that microlending is without risk. Microlending was a booming business in South Africa until May 2002, when the government had to bail out one of the largest microlending institutions – Saambou Bank, at the time the eighth largest in the country overall – after the central bank froze all accounts to forestall bankruptcy. An estimated 60 percent of South Africa's 43 million people lack direct access to the financial system via a bank account and can only receive funds through microlenders. Aware of the relevance of Saambou for the country's general economic well being, the government stepped in until the microlender was sold and resumed operations.

Saambou Bank and similar cases in other countries raised questions about the need to regulate microlending institutions.

Being profitable does not exclude risks, and microlenders are generally perceived to be more vulnerable to certain risks than are traditional commercial banks. Because their loan exposure often is concentrated in a specific geographical area, microlenders are vulnerable to natural disasters and other such economic shocks, as rating agency Standard and Poor's has noted.

In 1999, South Africa created its own Micro Finance Regulatory Council, charged with promoting the sustainable growth of the microfinance industry. Similar organizations in several countries have been working with development institutions to establish basic accounting and financial analysis procedures and to set appropriate interest rates.

In the private sector, an independent risk analysis agency called Microrate (see link below) has been tracking a number of microfinance institutions in Africa and Latin America since 1997. Based in Washington D.C., Microrate is the first rating agency solely dedicated to evaluating microlenders. Its stated objective is to create a transparent operational framework that microlenders would want to follow when seeking private funding in capital markets. Microrate has developed a ranking of the top performing microlenders in the areas it covers as well as a database that includes more than 200 microlending institutions. Microrate also has worked with development and multilateral institutions such as the Inter-American Development Bank, Women's World Banking, and the International Network of Alternative Financial Institutions.

Efforts such as Microrate's are aimed at responding to needs that are common to both profit-oriented and nonprofit microlenders: the need to operate within the legal system of the country in which they work, and the need to have a legal and regulatory system that can accommodate the peculiarities of microfinance.

Just as important is the need to establish broad standards that can apply to, and that can be used to gauge the performance of, all microlenders. This is a complicated business, as microlenders operate in different cultures and regulatory frameworks, and the definition of who should have access to small loans also tends to differ widely.

The Inter-American Development Bank has noted that the problem of creating widely accepted practices is compounded by the fact that the microlending marketplace is diffused by thousands of small organizations that operate in widely different ways. Finding the right organization to educate these institutions about the benefits of adopting accounting practices and external audits will take time.

One initiative under way is run by the Consultative Group to Assist the Poorest (CGAP), an association of more than 30 bilateral and multilateral donor agencies involved in microfinance. The CGAP publishes a set of Microfinancing Consensus Guidelines designed to provide transparency and to encourage the industry to agree to common and consistent standards to measure performance.

The details of regulation and business practice standardization may seem arcane but this work will determine, in large part, the future course and complexion of an industry that so far has evolved unevenly. Of Latin America's 400-plus microlending organizations, few are constituted as banks. Microlending has done well in Central America and the Andean region but was slow to take off in Mexico and Brazil. Despite Grameen Bank's international prominence, microlending has not expanded widely through Asia, Africa, and Eastern Europe.

And although it has taken root in some wealthy countries with more advanced financial sectors than those of developing economies, its growth has been very limited. In the United States, for example, a microlending program was started in 1992 using nonprofit intermediaries that extend loans mainly to small businesses with average loans in the $2,000 range. But the clientele and experience of such efforts remain distinct from those in developing countries, so there is little scope for institutions in rich and poor countries to replicate each other's models.

Tips for covering microlending

  • There are thousands of microfinance institutions throughout the world and they use distinct approaches. Since there are few generally accepted guidelines to measure performance, it can be difficult to get past an institution's good intentions to find out if it is well run and to gauge the impact it has on the ground. Reporters who have physical access to the microlender's area of operations should question actual loan recipients about their experiences. How much have they benefited? How do they keep up with loan repayments? Was the money used as intended and if not, why not? (Some women have reported, for example, that their husbands took the money they borrowed, nevertheless leaving the women liable for repaying the loans. Some lenders have developed ways to protect their customers against such losses; others have not.)
  • Because many microlending programs are in remote areas, journalists who can't reach borrowers should at least try to contact workers at these institutions to get a sense of the day-to-day operations. Reporters also should seek out analysts who follow microfinancing. Useful links to some analysts appear below. In addition, a number of countries have established microfinance regulatory agencies and reporters should try to locate and consult these.
  • Aid groups with operations in areas served by microfinance institutions often provide their own assessments of microlenders' impact on the ground. Some aid groups also support microfinance programs and tend to have distinct views about what direction the industry should take. Many of these groups are local but some of the larger international non-governmental organizations also have produced reports on microfinance. They include Action Aid, Christian Aid, and Oxfam.
  • Most microlenders say they enjoy very high repayment rates. Although this may be true, it is important, when reporting on the financial performance or sustainability of a microlending institution, to look at the extent to which that institution remains dependent on donor funding. It would not be surprising for a fairly new institution to rely quite heavily on donors not only to provide it with lending capital but also to subsidize its daily operations. But is this also the case for older, more established institutions? If so, why?
  • On a related point, how do donors or investors choose which microlenders to support or invest in? Financial accountability is an obvious criterion but how much weight do donors and investors attach to impact in terms of actual poverty reduction, and how do they define and measure this impact? The answers to these questions can help explain the relative strengths and weaknesses of different microlenders.
  • Finally, if microlending is supposed to help the poor build wealth and become creditworthy, then how many borrowers actually ''graduate'' from microlending to mainstream banking? Apart from providing a critical framework in which to look at the industry as a whole, this question can provide a useful starting point for examination of trends within the industry or within a specific country or region.

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