Like every Friday, from Raj Nallari and Breda Griffith's teaching notes.
(This posting draws heavily and exclusively on ‘Microfinance and the Poor – breaking down walls between microfinance and formal finance.’ Littlefield, E. and R. Rosenberg (2004) Finance and Development, June.)
There is a growing awareness that building financial systems for the poor means building sound domestic financial intermediaries that can mobilize and recycle domestic savings of this segment of the population. Microfinance institutions (MFIs) have emerged over the past three decades to address this need and provide financial services to low-income clients who for centuries had to rely on a wide range of informal credit providers such as money lenders.
Early micro-credit agencies operated on nonprofit basis and did not require collateral. They reduced risk through group guarantees, appraisal of household cash flow, and small initial loans to test clients. Experience shows that the poor are reliable in repaying uncollateralized loans and that they are willing to pay a somewhat higher cost for receiving services that would not otherwise be provided by the mainstream banking sector.
The poor need and use a broad range of financial services, including deposit accounts, insurance, and the ability to transfer money to relatives living elsewhere. Experience has shown that the poor can be served profitably, on a long-term basis, and in some cases on a large scale. It has been noted that well-run MFIs can:
- outperform mainstream commercial banks in portfolio quality
- function as a more stable business in turbulent times compared with commercial banking
During Indonesia’s 1997 crisis, for example, commercial bank portfolios deteriorated, but loan repayment among Bank Rakyat Indonesia’s 26 million microclients barely declined. And, during the recent Bolivian banking crisis, MFIs’ portfolios suffered but remained substantially healthier than commercial bank portfolios.
Other studies illustrate the social function of microfinance. Microfinance has been credited with improving a large range of welfare measures such as income stability and growth, nutritional needs, health and school-attendance. It has also been widely credited with empowering women by increasing their contribution to household income and assets.
Moreover, examples of financially sound, professional MFIs suggest that microfinance can be made available for the long term, well beyond the duration of donor government subsidies. There is little doubt that microfinance is highly valued by the poor, as shown by their strong demand for such services, their willingness to pay the full cost of those services and a high loan repayment rate motivated by a desire to have access to future loans.
On the policy level, microfinance has been embraced by politicians and the development community, with the predictable result that some of its merits have been oversold. To achieve its full potential and aim of serving poor households, MFIs will need to become a fully-integrated part of a developing country’s mainstream financial system. Of course this will require financially sound, professional organizations capable of competing, accessing commercial loans, becoming licensed to collect deposits and growing to reach significant scale and impact. The majority of MFIs do not fit into this category – most are weak, heavily donor-dependent and unlikely to ever reach scale or independence.
The commercial success of some MFIs is an encouraging sign for integration into the formal financial system. The form of integration will depend on the country context and the requirements of customers. The options being pursued range from:
- a partnership approach with a commercial bank;
- MFIs seeking their own licenses;
- retailers, consumer finance groups, and other institutions, such as building societies, adopting microfinance methodologies; and
- MFIs tapping into mainstream credit bureaus to increase their productivity, portfolio quality and to reduce their spreads between borrowing and saving rates.
Partnerships enable MFIs to cut costs and extend their reach, while banks can benefit from the opportunity to tap new markets, diversify assets and increase revenues. Partnerships vary in their degree of engagement and risk sharing. In some cases, partnership refers to sharing or renting front offices and in others to banks making actual portfolio and direct equity investments in MFIs. See Exhibit below.
Links between MFIs and Commercial Banks
Increasing numbers of MFIs are getting their own licenses as banks or specialized financial institutions. This allows them to finance themselves by accessing capital markets and attracting deposits from large institutional investors as well as poor clients. Several MFIs, especially in Latin America have accessed local debt markets by issuing private placements that have been taken up by local financial institutions. Other countries are considering legislation to create new types of financial licenses, usually with lower minimum capital requirements specifically designed for MFIs.
MFIs are beginning to tap into mainstream credit bureaus, which allow their clients to build a public credit history, making them more attractive to mainstream banks and retailers. More than 80 MFIs in Peru are registered to use Infocorp – a private credit bureau. Similarly in Turkey, Maya Enterprise for Microfinance negotiated with a leading bank, Garanti Bankasi, to gain access to the national credit bureau. The central bank in Rwanda requires that MFIs communicate information about their borrowers to a credit bureau.
In general, improvements in information technology help to create new delivery channels for the provision of microfinance. To a large extent, the conduits are already in place – retail shops, Internet kiosks, post offices, lottery outlets – the challenge is to make it possible to provide financial services more cost effectively to the poorer and more sparsely populated areas.
While welcome, such a trend poses risk in terms of the capacity of supervisory authorities becoming overly stretched by taking over responsibility for another financial sector groups. Moreover, creating the infrastructure for specialized MFIs could also divert mainstream commercial banks and others from becoming involved in microfinance. Indeed, retailers, consumer finance institutions and building societies are often better placed to provide the smaller account and transaction sizes required by lower income customers. Advances in new technologies that are driving down costs and risks of providing services to poorer clients also facilitate this.
Next week: Emigrant Remittances