Monday, November 24, 2014

Microfinance’s Macro Potential

LONDON – Microfinance is, at its heart, an effort to provide financial services to people who are not served – or are under-served – by the formal banking system. With appropriate, accessible, and fairly priced financial services, people can build their savings, cover the costs of unexpected emergencies, and invest in their families’ health, housing, and education.

The International Finance Corporation estimates that microfinance has reached some 130 million people worldwide in the last 15 years. Over this period, microfinance has been lauded for its potential to advance financial inclusion and enable people to escape poverty. But it has also faced harsh criticism, with some lenders being accused of profiteering.

Despite the industry’s widely publicized pitfalls, its potential to improve the lives of the poor cannot be ignored. The question now is how to ensure that microfinance becomes the industry that the world needs. To this end, three important steps must be taken.

The first step is better regulation. Microfinance institutions (MFIs) come in many forms – mainstream banks, specially licensed banks, non-financial companies, finance and leasing companies, non-governmental organizations, cooperatives, and trusts – and follow a variety of business models. All of these intermediaries must be recognized and regulated according to the needs of the economies in which they operate.

Inadequate regulation is most damaging to those who need microfinance services the most. Nowhere was this more apparent than in the 2010 microfinance crisis in the Indian state of Andhra Pradesh – a hub of MFI activity – when a decade of explosive growth, fueled by aggressive and reckless lending practices, came to a head.

Over-indebtedness, together with coercive recovery practices, led to a series of widely publicized suicides, spurring local officials to implement new restrictions on MFIs and discourage borrowers from repaying their debts. As repayment rates plummeted, micro-lending ground to a halt.

In order to prevent such outcomes, governments must design regulations that foster a sustainable financial-inclusion model, one that enables MFIs to offer long-term support to borrowers. At the same time, regulation must deter MFIs from behaving recklessly with a vulnerable client segment. And regulation should be based not on past experience, as it is now, but on future possibilities; in other words, the regulatory framework must be flexible enough to accommodate new innovations.

The second step, to be taken by the microfinance industry itself, is to create effective mechanisms for assessing the industry’s impact. As it stands, some governments and academics are uncomfortable with the fact that MFIs, which are supposed to be providing a public good by advancing financial inclusiveness, are pursuing profits.

But the failure of some MFIs to differentiate between profit-seeking and profiteering does not mean that sustainable microfinance should not yield returns above costs. The business of providing financial services to the poor requires commitment. Without profits, MFIs are unable to invest in the talent and product development needed to serve people for the long term.

Many governments have now implemented interest-rate ceilings and margin caps to curtail excessive profits for MFIs, while ignoring the margins of the market’s non-organized alternatives, like pawnbrokers. In order to provide a more balanced perspective on the microfinance industry compared to other kinds of financial-services providers, MFIs need to do more to measure and explain their social and economic value.

The good news is that industry bodies, investors, and governments have already introduced metrics for factors ranging from pricing to conduct. While this has resulted in a rather disparate set of indicators, which must be standardized, such efforts are an encouraging sign of the microfinance industry’s commitment to securing its role in the financial-services ecosystem.

The third step concerns technology. Mobile connectivity is transforming the global financial system by enabling remote, rural populations to access financial services for the first time. Mobile-payment systems like M-Pesa are changing how people transfer, receive, and save money in many developing countries, including Kenya, Pakistan, and the Philippines.

For the microfinance industry, such systems represent an important opportunity, as they enable borrowers to apply for, receive, and repay loans on their mobile phones, using a network of local agents to deposit and withdraw cash. But, without robust regulation, MFIs cannot make the most of these developments.

Moreover, the mobile-payments revolution has so far been led largely by telecom providers. If it is to deliver real benefits to the financially excluded, the financial-services industry will need to play a much more active role.

Of course, microfinance alone will not eliminate poverty, or even financial exclusion, regardless of how well it functions. To have a truly transformative impact, MFIs’ operations must be supported by government-led efforts to improve access to education, training, and employment.

Although microfinance has already helped countless people worldwide, the World Bank estimates that some 2.5 billion adults still lack access to financial services. It is the responsibility of all stakeholders – including governments, regulators, banks, and civil society – to ensure that microfinance continues to be part of the solution.

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    1. CommentedMukesh Adenwala

      The essential question to ask is: Can finance be regulated successfully? All need for credit arises to smooth out the differences in cash flows. So far as micro-finance is concerned, poorer people need finance for various reasons like expenses required to be incurred on social customs, illness, etc. Also their cash flows are seasonal and not very robust. The mismatch in cash flows hence cannot have a viable solution. And it is this lack of viable solution that preempts regulation of micro-finance.

    2. CommentedMr Econotarian

      Microfinance is not a solution. It is a symptom of an over-regulated banking sector, often state-owned, and typically one that does not face competition from foreign banks.

      It is also something else. Studies of micro finance have identified micro finance as a tool for women to save money without it being raided by their husbands. They could save up for a purchase, but then their husband might find their money and drink or gamble it away. So instead they borrow the money for the purchase, then have to pay it back, or if they don't the shame falls on their husbands as well. If these women could open small personal bank a accounts, they would not need micro finance, but in some countries wives can't do that, or the stodgy bank sector can't even serve their community.

      Also if a country has a pro-woman culture where women can become educated and have opportunities to work (in a legal formal sector), they are less likely to need micro finance. They will be making more money as well.

    3. CommentedJoaquín Saldain

      I agree with Mr. Thakker's approach. In particular, with his last comment. Financial inclusion is only one aspect of exclusion, and should be fostered jointly with other dimensions of exclusion. We should worry about avoiding negative effects like this one:

    4. CommentedHugh Sinclair

      I applaud Mr. Thakker's suggestion that microfinance should be appropriate, accessible and fairly priced. Coming from someone as senior has Global head of Microfinance at Standard Chartered, with an obvious footprint in developing countries, this is encouraging. However, perhaps Mr. Thakker could explain how Standard Chartered managed to invest in the Nigerian microfinance institution LAPO while the MFI was charging interest rates of 126% to poor, mainly female clients? The bank was described as "illegal" in a number of rating reports, all of which were publicly available, due predominantly to capturing savings from the poor without a license. This was merely one of an extensive list of criticisms two seperate rating agencies reported over an extended period. When the New York Times investigated the bank and wrote a particularly critical piece on it, most investors pulled out of LAPO, including the darling of the sector, Kiva. Indeed, about the only positive thing the rating reports were able to conclude about LAPO was it's astonishng profitability, presumably related in part to the exploitatively high interest rates.

      It seems only one of two possible explanations are possible here. Either Standard Chartered is prepared to turn a convenient blind eye to such practices if the financial upside is sufficient. Or their due diligence was sub-standard and they actually had no idea they were lending to such a questionable institution. I suspect the latter, as the deal was actually manged and guaranteed by Grameen Foundation USA.

      There is a lot of debate currently about the effectiveness of microfinance, as Mr. Thankker aludes to. Some praise still remains, but for some reason this tends to emerge from people with direct interests in the sector recovering. I firmly agree with Mr. Thankker's suggestion for improved regulation of MFIs, but I have one remaining question: who is regulating Standard Chartered's activities in this sector, and what did they think of their investment in LAPO?