Microcredit: Will New Players Bring New Problems?

thePoint
June 10, 2005

Microcredit—the innovative financial tool that provides very small business loans to poor people—is moving into adolescence and must wean itself off non-profit donors to become an established part of the global capital structure, according to experts in microfinance.

Networks of microfinance institutions (MFIs) are springing up around the world, according to The Wharton School at the University of Pennsylvania. The United Nations has declared 2005 the International Year of Microcredit. "It's a growing market," says Keith Weigelt, Wharton management professor. "I view it as the good side of capitalism, using loans to give money to poor people so they can improve their lot in life."

Large commercial financial institutions, including Citigroup and Deutsche Bank, are now showing interest in microfinance, which could increase access to credit for the poor. At the same time, challenges remain in attracting private capital, lowering costs and interest rates, and developing regulation.

More than 500 MFIs around the world have loaned $7 billion to about 30 million small-business people, says Weigelt, but 300 million could benefit from microcredit to start viable businesses. So far, most of the loans made by MFIs have originated as grants from government or gifts from individuals and foundations. "The big jump now is for MFIs to wean off the donors and subsidies and operate like a commercial financial institution would," Weigelt adds.

Despite the perception that making business loans to desperately poor people is a bad bet, returns to MFIs rival those of commercial institutions. Studies conducted in India, Kenya, and the Philippines found that the average annual return on investments by microbusinesses ranged from 117% to 847%, according to the United Nations. "So now we are seeing more for-profit institutions moving in," says Weigelt. In many cases, MFIs are partnering with large financial corporations to expand the services they can offer clients, such as savings accounts and insurance.

Microcredit works because it's often arranged for a group, which leads to peer pressure on individuals to repay the loans or risk losing microcredit as a financial opportunity for their community. In addition, individuals in poverty are reluctant to default on microcredit loans because if they do, they'll have no other options. "This is their last hope," says Weigelt. "It's not as if they can just walk away and declare bankruptcy."

University of Pennsylvania economics professor Tayyeb Shabbir suggests that microfinance is entering a period of formalization that will give market forces a greater role in the process. That makes some long-time proponents of microcredit uneasy. "People committed to this movement for the last 20 years feel apprehensive. They worry that all these strangers are going to come in and want to dismantle everything. But I think this fear is somewhat misplaced. There will be room for, and a need for, non-profits and for-profit institutions."

He says the social mission of reaching many more people can't be achieved with continued handouts. At the same time, he notes, microcredit organizations arose because of a failure by markets to provide opportunity to the poor. "There's always going to be a part of the mission that is going to rely on non-market institutions," says Shabbir, who points out that market and nonmarket institutions exist throughout the economy. "Soup kitchens coexist with posh restaurants."

Before microcredit can begin to make a real difference in global poverty, Shabbir adds, interest rates must come down. Interest rates for microcredit, now at 40% to 50% in some areas, would have to fall to 10% to make a difference to lenders, he suggests. "If commercial microfinance is to fulfill its mission, interest rates have to come more in line with interest rates for the great majority of the borrowers," Shabbir comments. He warns, however, that for-profit financial institutions will not provide much benefit to the world's poor if they simply cherry pick the best borrowers for their microcredit lending. "Doing what seems obviously profitable, without taking any innovative risks, will be the end of the story,” he says. “To make a dent in terms of poverty, you have to innovate."

The microcredit movement has convinced commercial lenders that the world's poor are no longer unbankable and could become a market for other financial services, according to Nancy Berry, president of the Women's World Banking Network, a microfinance umbrella organization with 24 affiliate institutions in 19 countries. "This is not just about lending," she says. "This is about clients building assets." Business-lending relationships could expand into housing finance, insurance, or other products. Berry points out, however, that when institutions move from lending into savings and investment, they need more regulation.

The biggest problem facing microcredit lenders is the high transaction costs of making many miniscule loans, which drive up interest rates, she notes. The average loan officer working at affiliates of the Women's World Banking Network manages 600 clients at a time. "They're like little machines going to the barrio getting their payments and making new loans, but even at that level the administrative costs are 10 cents to lend each dollar," Berry says. High costs combined with inflation drive real interest rates above 25%, Berry points out, adding that poor clients are willing to pay these rates because the money lenders charge even more.

Microfinance institutions will not be able to squeeze more efficiency out of their workers. Future cost savings, Berry predicts, will come through improvements in technology. She points to the use of ATMs and charge cards to reduce costs, and cites an experiment in Kenya where cell phones are being used as mobile bank branches.

To attract private capital, MFIs have been looking for ways to bundle and securitize their loans, Berry adds. A major stumbling block for MFIs hoping to draw private investment capital from abroad is foreign exchange risk. Predicts Berry: "The big challenge ahead is to build local capital markets.”

Berry says people shouldn't be concerned that big global financial companies will squeeze out traditional nonprofit MFIs. "We believe it's very important that a robust financial system for the majority has to have strong MFIs as well as cooperatives and banks involved," she says. "The MFIs have to be smart in terms of their niche vis-a-vis the banks."

Even if commercial banks step in and use microfinance as a way to build deeper relationships with customers, says Berry, there will still be a tremendous need to provide microcredit through nonprofit institutions to the poorest of the poor. "Right now we are at about a 10% market share," says Berry. "MFIs will always have a market at the low end."

Berry also countered complaints that microfinance does not help the very poorest people. She said people benefiting from MFIs are still making only $1 to $2 a day. "I don't consider that the rich poor. Microfinance can't be the answer for every poor person on earth, but it's not true that it is only for the rich poor."

This article was prepared by the staff at the Point for Credit Union Research and Advice and is published online at http://thepoint.cuna.org/. Reprinted with permission.