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Microfinance: Dream vs. Reality

Asli Demirgüç-Kunt's picture

Microfinance started as a simple idea: to provide loans to poor entrepreneurs.  Today it is a much more diverse and dynamic sector, and includes institutions that provide savings and remittance services, sell insurance, and offer loans for a wide range of purposes.  The idea now is to focus on bringing a range of financial services to the underserved.  The institutions that focus on this mission vary in the income levels of the customers they serve, their use of subsidies, and the breadth and quality of services offered.  This diversity also presents microfinance providers new opportunities as well as trade-offs.

When Muhammad Yunus and Grameen Bank won the Nobel Peace Prize in 2006, the world community celebrated the ways that expanding financial access can improve the lives of the poor.  Many microfinance “insiders” have been working toward a second goal as well: to find ways to provide microfinance on a commercial basis, without long-term subsidies.  The argument that microfinance institutions should seek profits has an appealing “win-win” resonance, admitting little trade-off between social and commercial objectives.  Should institutions move up-market to provide larger loans and improve financial performance?  Is deposit-taking feasible at such scales?  Can socially-minded institutions survive commercial competition and regulation without re-defining their mission?

Robert Cull, Jonathan Morduch and I have been analyzing a global survey of microfinance institutions compiled by the Microfinance Information Exchange (MIX) to try and answer some of these questions.  The data set includes microfinance banks and credit unions which tend to be for-profit.  Nongovernmental organizations (NGOs) have non-profit status.  And there are also non-bank financial institutions, a category that includes both for-profits and non-profits.

So what do the data tell us?

  • Microfinance banks make up 10 percent of the institutions in our sample, but they are large, accounting for over half of the assets.  NGOs are smaller, and although they make up 45 percent of the institutions, they only have 21 percent of the assets.  NGOs reach more of the borrowers, though – they serve over half of the borrowers in the sample as opposed to the quarter served by microfinance banks.
  • Financial self-sustainability and serving poor households are not necessarily incompatible.  But most institutions serving the poorest customers earn profits too small to attract investors seeking purely commercial returns.  This accounts for the continued importance of subsidies and noncommercial funding to NGOs.  Still, a substantial share of "non-profits" in fact earn profits, even if they are relatively small.  Nevertheless, a typical larger and older institution in our sample does not achieve profitability and deep outreach simultaneously.
  • Non-profits do not duplicate the work of commercial lenders: they tend to make far smaller loans on average and serve more women as a fraction of customers, relative to commercialized microfinance banks.  On average, commercial microfinance banks make loans that are about four times larger than loans from NGOs, suggesting that they tend to serve a substantially better-off group of borrowers. As a group, NGOs charge interest rates roughly double the size of those charged by commercial microfinance banks.
  • These findings suggest that the poorest customers tend to pay the most for loans.  As a group, NGOs make the smallest loans and, hence, face the highest costs per loan. To break even, NGOs must then charge the highest interest rates.  Raising interest rates improves profitability for many institutions but, after a point, higher rates are associated with increased loan delinquencies and diminished profits.
  • Rigorous and regular supervision is critical for deposit-taking institutions, but it is costly; regulatory supervision thus tends to push institutions to serve relatively better-off customers as a way to maintain profitability.  Regulatory supervision is indeed associated with larger average loan sizes and less lending to women.  Supervision is also associated with having a higher share of staff concentrated in the head office, a natural response to reporting requirements and formalization.
  • Competition, or potential competition from mainstream formal-sector banks, appears to steer microfinance institutions toward serving poorer customers as reflected by smaller average loan sizes and greater outreach to women, with little effect on their profitability.
     

Overall, microfinance promises to correct market failures by expanding the opportunities of the underserved.  For some, the microfinance dream is also to reach the world’s poorest and lift them out of poverty.  But evidence suggests it is difficult to realize both goals at the same time.  In reality, microfinance often entails distinct trade-offs between meeting social goals and maximizing commercial outcomes.  Reaching the very poor with small-scale services remains a tough business and often entails charging high fees or depending on steady subsidies. 

Further reading:

Cull, Robert, Asli Demirguc-Kunt, and Jonathan Morduch. 2007. "Financial performance and outreach: A global analysis of leading microbanks." Economic Journal 117(517): F107-F133.

Cull, Robert, Asli Demirguc-Kunt, and Jonathan Morduch. 2009a. "Microfinance meets the market." Journal of Economic Perspectives 23(1), Winter: 167-92.

Cull, Robert, Asli Demirguc-Kunt, and Jonathan Morduch. 2009b. "Does regulatory supervision curtail microfinance profitability and outreach?" World Development, forthcoming. (See the Policy Research Working Paper version.)

Cull, Robert, Asli Demirguc-Kunt, and Jonathan Morduch. 2009c. "Banks and micro-banks." Working Paper.

Cull, Robert, Asli Demirguc-Kunt, and Jonathan Morduch. 2010. “Microfinance Tradeoffs: Regulation, Competition, and Financing.” Handbook of Microfinance, edited by Beatriz Armendariz and Marc Labrie, forthcoming. (See the Policy Research Working Paper version.)

Comments

Submitted by Bhalchander Vishwanath on
Excellent post!! I think your post brings a great deal of reality to the microfinance world. The buzz today is about for-profit microfinance. However as you rightly point out, for-profit microfinance does not necessarily reach the poorest of the poor. NGO MFIs play an important role in reaching out to the poorest. However NGO MFIs cannot take 'investment grade equity' which gives returns to investors. Thus we need a new kind of equity which does not expect financial returns or we need to use instruments like guarantees. I hope the world bank will mobilize support for these kinds of financial instruments so that the poorest clients enjoy the same level of opportunities. If not we would not have truly tapped into the power of microfinance. Bhalchander

Submitted by Amit on
One of the key cost factors in delivering doorstep financial services in the microfinance sector is the "human" cost. Much more needs to be done in the human resource area of the sector to see opportunities for improving efficiencies and productivity. It is very clear that from recruitment to retention, more research is required and more efforts need to be put into the H.R. side of microfinance. Sustainable rapid growth in any industry (human resource driven sectors specifically) has a direct correlation to the time and energy spent on the H.R. dimension. Microfinance cannot hope to be an exception. http://www.MicrofinanceTraining.com

Submitted by Dr. V K Sapovadia on
The real question is whether MFIs are really helping small entreprenures to run their business, or do such borrowers really invest funds so received from MFIs to run their business and increase wealth? Though I have not formally studied the issue, my own understanding (built on the basis of informal conversation with such borrowers) is that the funds are used for personal or customary purposes in a large number of cases, and diversification of funds is common among small borrowers. It is also observed that to repay one loan, they take another loan and so on. The cost of funds is also too high, the reasons are many, but to list a few: Illiterate customers, middle men taking huge commission, corruption, window dressing cost much.... MFIs are aggressive in marketing, and to garner business, products are sold like detergent through offering incentives & schemes. There is a real need to evaluate the net value addition through micro loans.

Submitted by Ashim on
I believe that we need to analyse the whole issue from the perspective of the State, Market and Third sector. Microfinance today is a culmination of these three dimensions. Initially it was started as a developmental intervention, when both State and Market interventions were found to be inadequate to provide finance to the poor. But three decaded of effort to provide financial services to the poor has built a robust model, and it is now being considered as more of a financial asset class. This has attracted the attention of Market and State, which could see an opportunity to reach the poor and make an impact. I believe that everyone of us (Be it State, Market and Third Sector) has a pivotal role to play here, though the orientation may be different. Certain elements of cost(technology, infrastructure) which may have an impact on profitablity of MFI, could be absorved by both Markets and State, while the third sector could focus more on reaching the poorest segment of population. MFIs can provide a whole gamut of services to the poor, only when they could do so on sustainable basis ( though regular profit). But profitablity not at the cost of increasing burden on the poor.

Submitted by uche on
The main purpose of microfinance is no longer serving the poor masses but rather the rich, who source for loan with the meager savings of the poor. Poor people's money is trapped in so called MICROFINANCE BANK too bad.

Submitted by Diamond Hill on
We just started a transport business in South Africa, moving grain from point a to b. We signed a 5 year contract with one of the largest companies in South Africa. We want to help the poor in our rural areas in town that is a heartbreaking situation. None of our commercial Banks in South Africa wants to help us to finance our business with start-up cash to get started. It is a shame that if you want to help other people no-one will help you fulfill your dreams. Hundreds of people don't really know what good food and a warm bed is, because there is nobody to help them to realize the facts of life. We apply for 2.5million but that is too much for our bankers - but the end result will be to help to feed the poor and provide workless people with work in our community. We decided to place our story to let the world know that in our country the poor don't matter at all to the rich people.

Submitted by Jayshree Venkatesan | IFMR Mezzanine Finance on
One would have to agree with the data and the insights that have been presented in the blog post. However, mezzanine financing seems to provide the means to combine the goals of correcting market failures while reaching the world’s poorest. Like the article points out, NGO-MFIs do reach a larger number of borrowers and therefore form a critical channel to facilitate access to finance. However, as the article also points out, the profits earned by institutions that serve the poorest customers are too little to attract investors with a commercial intent. Further, transaction costs tend to be higher at a smaller scale, forcing the NGO MFIs to charge higher rates of interest. Most NGO MFIs come with limited equity capital. The lack of attractiveness that NGOs pose to other equity players acts as a barrier to raising further equity. Most lenders look at equity as a risk cushion against defaults. With a limited equity base, the ability for NGO MFIs to attract debt capital is also severely constrained. The lack of access to capital, in turn, prevents NGO MFIs from growing further, which in turn results in high transaction costs that get translated into higher interest rates. Mezzanine finance acts as an intermediate, cushioning layer between debt, which is provided by banks and the promoter’s equity. Mezzanine finance instruments could range from long term subordinated debt instruments to preference shares with variations to product structures that fall between these two categories of mezzanine products. In case of a potential default situation, mezzanine finance providers recover their money only after all the lenders get paid, thereby acting as an additional risk cushion. Since mezzanine finance providers undertake risk that is almost akin to equity, it is also in their own interest to ensure that process related issues are addressed in the MFI, which in turn has an impact in reducing overall transaction costs. Since most NGO MFI clients work among the poorest clients, this can allow the poorest to access funds at a lower rate of interest. In keeping with IFMR Trust’s overall mission of ensuring that every individual and every enterprise has complete access to financial services, IFMR Mezzanine Finance is working towards providing access to capital to smaller, capital constrained MFIs in the sector.

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