The Commercial Evolution of Microfinance Institutions—From Donor Dependence to Sustainable Financial Institutions

PART ONE OF A TWO PART SERIES

Magazine article

Microfinance is amongst the premier social or as currently termed impact investment sectors.  In the sector’s early years, 1980s to the mid-90s, if people knew anything of the microfinance sector, they knew of Grameen Bank (Bangladesh). Insiders knew of Grameen Bank, Bank Rakyat Indonesia (BRI), and Banco Sol (Bolivia). Apart from these institutions, most microfinance institutions (MFIs) were small non-governmental institutions (NGOs, regionally focused within a given country. They primarily provided working capital loans to the working poor, and, with the exception of BRI, none mobilized deposits to any scale.[1]

Microfinance seeks to provide financial services for that segment of the population in the developing world and in transition economies that generally lacks access to formal financial services. This population is often called the underserved. These are primarily the working poor, many of whom live on US$2 dollars a day in poorer developing countries, such as in Africa, Bangladesh, Cambodia, India, Peru, Bolivia and Mexico as examples.

Clients of MFIs are either self-employed or are micro-entrepreneurs that operate a micro-business.[2] Microfinance clients frequently live in urban slums or remote rural communities. Most of these people work in the informal sector, which in poorer countries may constitute up to 80% or more of employment. Poor people have various informal ways to secure financing: from family and friends, and from traditional financing schemes such as ROSCAs (rotational savings and credit associations) and from money lenders, who may charge over 10 % a month for loans. Money lenders can be compared to pay day lenders in the UK and USA who often charge 300-400% per annum for their loans. Microfinance clients generally do not have access to formal finance institutions either for borrowing or savings, and these informal sources may not be able provide financing in the amounts or with the timing needed.[3]

Microfinance refers to the provision of formal financial services to poor and low-income people. Microfinance refers not only to a range of credit products for business purposes, for consumption/income smoothing, and to fund social obligations, etc. but also to savings, money transfers, remittances, and insurance.[4]

While NGOs were the primary providers of microfinance during the 1980s and 90s, microfinance is now increasingly provided by commercial banks that have down-streamed into microfinance and by former NGOs that have transformed to become non-bank financial institutions or microfinance banks. There are still thousands of NGOs, cooperatives and credit unions that provide microfinance. Regulated MFIs, operating as commercial banks, are able to mobilize savings. This has two important advantages: first it lowers the cost of capital for MFIs, and second it provides a safe place for the poor to save. It turns out that the poor may need a safe place to save more then they need loans.[5]

Microcredit is often called character or cash-flow lending.  It is expensive to deliver microfinance sustainably, a fact not necessarily intuitive to those outside the industry. To be sound, MFIs must operate directly in the poor communities they serve. They provide small loans with relatively short maturities and without any or with limited collateral. This means that MFI clients pay more for their money than interest rates quoted at commercial banks. However, the poor have virtually no access to commercial banks.

Increasingly, larger MFIs that have scaled up to 30,000 to 50,000 clients and there are many such MFIs, also provide other financial services, such as micro-insurance, remittances and money transfers, and loans for education and home improvement, some of which may require different terms with respect to maturity, interest rates and fees when compared with the short-term working capital loans that are the “bread and butter” of microfinance. Although these new offerings are still a relatively small part of the product base of most MFIs, the demand for them is growing.

MFIs have scaled-up dramatically over the last fifteen years with compound growth rates exceeding 30% on average. Presently some 122 MFIs serve 100,000 or more clients and several over a million clients. (see Appendix Tables 1 and 2)

Rural microfinance differs from urban microfinance. Rural clients might require loans to grow cash crops or raise animals to be sold for cash, rather than the standard small enterprise end use of traditional microfinance products. Rural areas are also less populated than urban areas, so the market for microfinance clients is less dense and, hence, more expensive to recruit and service.

Increasingly the industry talks not just about microfinance but about access to finance or financial inclusion. The latter might also mean small business loans, since MFIs increasingly reach up to service the owners of small as well as micro-businesses.

Technology is potentially a powerful driver of access to finance, especially for rural populations. In a select number of developing countries, the providers of mobile phones are working with commercial banks or large MFIs to bring cell phone banking to the poor. For example, in Kenya, M-PESA (pesa means cash in Swahili) a product of Safaricom, Kenya’s largest mobile operator, has some 15 million clients primarily doing people-to-people money transfers.

While virtually all MFIs seek to be fully self-sufficient, covering their operating and financial costs, commercial MFIs seek to be sustainable, generating a profit and a return on assets and equity adequate enough to attract commercial funders. For the most part, they do not rely on explicit subsidies. In addition to their efforts to operate on a sound financial basis, MFIs seek to maximize their outreach to the working poor, thus also creating a positive social impact. This dual role—operating self-sufficiently and also serving the poor—is called “managing the double bottom line.”

The international microfinance sector has been subsidized from the beginning by the donor community and a number of foundations. Donors have included a large number of multilateral and regional financial institutions: the World Bank, the Inter-American Development Bank, the Asian Development Bank, various U.N. agencies, and the development ministries and aid agencies of the United States, Canada, Japan, and virtually all European governments. They have supported microfinance and have provided an array of different subsidies. Foundations, such as the Ford Foundation, the Open Society Institute (Soros Foundation), Omidyar Foundation, the Bill & Melinda Gates Foundation, and the MasterCard Foundation have also supported international microfinance.

Social and religious based institutions such as CARE, Save the Children, Oxfam, Mercy Corps, and Catholic Relief Services, to name just a few of the many such institutions, also support microfinance. Over time, these institutions have operated their microfinance activities separately from social services delivery, reflecting the two way flow of resources in microfinance inherent in lending operations; the recipients (microfinance clients) receive loans and are expected to repay the loans, while the social service activities of these institutions are grant based.

Subsidies have been provided to institutions in the sector for a variety of purposes:

·         As capital grants to expand the capital base of a sector that was predominantly populated by NGOs at that time;

·         Loans, mostly on soft or concessional terms, to expand the portfolios of MFIs to assist increasing outreach and in scaling up the sector;

·         Support for capacity building; for example, to support technology absorption by MFIs in the form of management and financial reporting systems, and  branchless banking, as well as training;

·         Support to improve knowledge in the sector through, for example, the development of regional microfinance networks, publication of a series of short notes and technical papers by the Consultative Group to Assist the Poorest (CGAP)[6] and others in the sector, the creation of various support institutions, such as an industry database available as a public good  (the MicroBanking Bulletin, subsequently expanded to The Mix Market),  and support for microfinance rating agencies to evaluate the performance of MFIs as they began to transform into commercial institutions.

By 2000 and thereafter, the private development arms of the multilateral, regional donors and bilateral donors such as the International Finance Corporation (World Bank), European Development Bank, European Investment Bank, the Multilateral Investment Fund (MIF) at the Inter-American Development Bank and a large number of bilateral agencies in Europe were providing loans and equity investments to MFIs at interest rates much closer to market rates than initial funding from donor agencies. In addition, microfinance investment funds, most of which were public-private investment vehicles, were providing increasing amounts of capital to the sector via both equity and loans.

Today, while donors continue to fund the sector, their role, relative to the size and needs of the sector, has diminished substantially. While still needed, funds for technical assistance to support capacity building on a concessional (grant) basis from donor agencies and foundations have become highly targeted to the poorer countries, such as those in Sub-Saharan Africa and Haiti, and are currently available in relatively small amounts. Foundations such as the Bill & Melinda Gates Foundation, the Open Society Institute (Soros Foundation), the  MasterCard Foundation, and the Ford Foundation all continue to fund microfinance, but their funding is focused largely on building capacity in the sector.

Since the mid-1990s, another layer of financial-service providers has entered the microfinance industry. It consists of international microfinance investment vehicles (MIVs) that provide intermediate term loans to, or make equity investments in MFIs. Starting in 1995 some 70 debt funds and 30 equity funds were created, many as a family of funds, and have assets in excess of US$7.5 billion as of December 31, 2012.[7]

With the commercialization of the sector and its dramatic growth, have come problems and criticism of the sector. In a recent issue of this journal, Kurt Hoffman indicates that microfinance has failed to deliver on claims made by many of its adherents to alleviate poverty, “the direct extension of microfinance to the poor (120 million families have now received microloans) has not transmitted as the escape from poverty that its grand narrative implied.”[8]

While it is generally well accepted that some highly acclaimed supporters of microfinance “over promised,” with respect to poverty alleviation, this has been well in the field for many years now.  Other criticisms of the sector also exist, amongst others that:

·         commercialization with accompanying high interest rates drives some borrowers into over indebtedness and eventually bankruptcy[9];

·         commercial MFIs focus excessively or even exclusively on their financial performance and forget the double bottom line, social impact.

It should be noted that the industry has been acutely aware of these criticisms and has responded with a Smart Campaign to increase transparency and disclosure on effective interest rates and fees. Also the industry has increased its emphasis on the social rating of MFIs. In addition, even critics such as Banerjee and Duflo cited by Hoffman, recognize that microfinance has done some very good things for the working poor[10]:

·         microfinance allows families to run micro-businesses or supports self employment opportunities so that the family or individual can take care of basic needs such as food, health care and schooling for their children Most clients of MFIs that I have met throughout the world have emphasized that their children were in school. I am convinced this benefit will be measurable in the next generation and not one I have heard discussed to-date;

·         At a minimum microfinance allows families to smooth their cash flow, preventing families or individuals from falling into deeper poverty;

·         Regulated MFIs are generally allowed to mobilize savings from the poor. It is the ability for the poor to save safely may be the greatest benefit of microfinance and only one that has been more widely discussed in the last ten years or so. In Africa savings accounts  and savings amounts often exceed the number of borrowers and the size of the loan portfolio; and,[11]

·         MFIs that have reached scale and operate sustainably can begin to offer their clients a range of products which meet their needs, as opposed to the “plain vanilla” working capital loans that have been the staple of the sector from its beginnings. These include—education loans, housing rehabilitation loans, micro-insurance, money transfers, remittances and we can expect to increasingly see mobile banking.

In conclusion, microfinance and MFIs were largely supported by donors and foundations in the 1980s and 90s. By 2000, the momentum had shifted dramatically with many MFIs transforming to commercial vehicles. This has allowed the sector to scale-up. In 1995 the sector served some 10 million clients, while at present it is over 120 million clients and has extended throughout the developing and transition economies. (see appendix Table 4).  Commercialization has also allowed the sector to absorb substantial private capital. More importantly, commercialization has opened the way for MFIs to provide a safe haven for the poor’s savings. Commercial MFIs are financed in a variety of ways, but mostly on commercial terms. Concessional funding from donors and foundations still support MFIs as NGOs, cooperatives and credit unions in a limited set of markets. Funding from foundations for capacity building is important but limited in amounts



[1] Grameen Bank did initially require compulsory deposits as part of its lending methodology. This provided some collateral for loan repayment and also encouraged the borrower to save. With Grameen II, this requirement was dropped.

[2]  Micro-businesses in the developing world are defined as having 10 or fewer employees. In fact few have paid employees; most are family operated businesses.

[3]Daryl Collins, Jonathan Murdoch, Stuart Rutherford and Orlanda Ruthven, Portfolios of the Poor: How the World’s Poor Live on $2 a Day (New Jersey: Princeton University Press, 2009) spells out in some detail the diverse sources of financing for the poor and how they manage their cash flow onUS$2 a day or less. An average ofUS$2 dollars a day may mean no cash flow some days and more on other days, so cash-flow management, including safe savings through MFIs may, in fact, be more important to these individuals than loans.

[4] This definition borrows from Robert P. Christen, Kate Lauer, Timothy Lyman, and Richard Rosenberg, “A Guide to Regulation and Supervision of Microfinance, Microfinance Consensus Guidelines” (CGAP, Public Comment Version, April 1 2011), 10

[5] See Stuart Rutherford, The Poor and Their Money (U.K.: Practical Action Publishing, 2009) which discusses the importance of safe savings for the poor. Marguerite Robinson has also written a seminal work in two volumes to date. Volume I discusses the importance of savings for the poor, and Volume II, focused on Indonesia, extensively discusses Bank Rakyat’s Uni Desa system, which mobilizes savings from the working poor in over 3,000 villages throughout the country.. Marguerite S. Robinson, The Microfinance Revolution: Sustainable Finance for the Poor (World Bank and the Open Society Institute, 2001)

[6] CGAP is a multi-donor forum focused on microfinance. It was founded in 1995. The CGAP Secretariat is housed in the World Bank and operates de-facto as the world secretariat for microfinance. Starting by nine donors in May 1995, two years later there were 26 donor members plus the Ford Foundation. CGAP has operated as the primary knowledge source for the sector and also created The MIX Market a data base on MFIs throughout the world. In its early years, from 1995-1999, CGAP provided capacity building grants to MFIs throughout the developing world that were seeking to become sustainable.

[7] MicroRate, Annual Report 2012 on MIVs reflects reporting of 103 MIVs representing an estimated 93% of the sector..

[8] Kurt Hoffman, “Giving Can Save the World or Not,” Philanthropy Impact, Issue 1 Spring 2013. Hoffman cites two highly respected economists from MIT, A.Banerjee and E. Duflo (2012) Poor Economics, “Microcredit and other ways to help tiny businesses still have an important role to play in the lives of the poor, because tiny businesses remain the only way many poor can manage to survive . But we are kidding ourselves if we think they can pave the way for a mass exit from poverty.”

[9] See Luis Vlada and Scott Gaul, “The Tipping Point: Over-Indebtedness and Investment in Microfinance.” The Microbanking Bulletin, February 2012 and Dannet Liv, “Study on the Drivers of Over-Indebtedness of Microfinance Borrowers in Cambodia: An In-Depth Investigation of Saturated Areas,”, Cambodia Institute of development Study March 2013

[10] See also David Roodman, Due Diligence, Center for Global Development, Washington D.C., 2012 for an extensive analysis of the pluses and minuses of microfinance

[11] See Stuart Rutherford, The Poor and Their Money, Opus Cited and Marguerite Robinson, The Microfinance Revolution, opus cited for extensive discussions on the benefits of savings