Microfinance reality check

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The Wall St. Journal recently published an important article on microfinance (http://blogs.wsj.com/indiarealtime/2015/03/18/calls-grow-for-a-new-microloans-model/). The article wasn’t important because what it said was news. The industry has known for years that very few well-designed studies have been able to detect a measurable impact from microfinance on poverty. No, what was important about the article was that if the Wall St Journal has reported it, then it’s certain that the shine the industry got when Mohamed Yunus won the Nobel Peace Prize in  2006 has now completely tarnished.

The problem with that original shine was that it was, well, a bit too bright. The idea that borrowers were investing in their business using microfinance services that were both convenient and affordable became part of the foundational belief system of the industry and its supporters. This belief system held even as the industry shifted from microcredit to microfinance when evidence began to show a limited developmental impact from credit. Under the microfinance model, clients would use credit coupled with savings (or, occasionally, insurance) to raise themselves up out of poverty.

As the Wall St Journal points out, the evidence for this is scant. Demonstrating how the past always finds a way to repeat itself, recently microfinance has morphed into “financial inclusion”, which places heavy emphasis on (mobile) payments to bring those who are neither borrowers or savers into the financial system. How this will lead to socio-economic development is not clear, but it seems that underneath the new paradigm, the old belief that financial access itself confers benefits continues to hold sway.

Financial access is important because financial exclusion is a monumental problem. But financial access is not sufficient. It doesn’t solve problems related to skills and education or household financial management practices. In other words, just because someone has a bank account and access to credit doesn’t make them less poor.

Critics like the Wall St Journal have a field day when the evidence comes to light that finds little correlation between financial access and socio-economic development. And because its attacks the industry’s foundational belief system, this criticism strikes very close to home.

But it’s always been a weak argument. Financial access creates possibilities, not opportunities. Surely, how someone uses financial services matters more than simply having access. But probably not even Warren Buffet would be able to squeeze a lot of additional income from the small farm or retail shop that is the primary livelihood activity for most microfinance clients. As long as the source of income is low-margin and not scalable, even optimum usage of financial services can only have a small impact on income.

Still, there are at least 200 million microfinance clients in the world, and the number keeps growing every year. If the services aren’t “helping”, then why to people keep using them?

The answer is that microfinance services are helping, just not in the way microfinance’s foundational belief system says it does.

A recent CGAP analysis of M-Shwari, a mobile savings and credit provider in Kenya, provides some clues (http://www.cgap.org/sites/default/files/Forum-How-M-Shwari-Works-Apr-2015.pdf). In only two years, M-Shwari has racked up some impressive numbers: 9.2 million deposit accounts, 20.6 million loans, PAR90=2.2%. This is what we’ve been waiting for: massive scale using mobile technology.

But dig a little deeper and you find the following:

  • The number of active savings accounts is 4.7 million — half of all accounts. This is an organization that has only been around for 2 years, and already half their savings accounts are dormant. Based on the numbers they give, those dormant accounts have an average of just $0.40 in them.
  • There has been a total of $1.5bn deposited since launch. A huge number. But the current amount of deposits is just $45.3mn. Just 3% of the funds that have been deposited have stayed on deposit.
  • Why the quick turnover? Because most people make a deposit in order to access the credit service. It seems many borrowers reduced their deposit after they paid off their loan. Many others who didn’t qualify for a loan many also have drawn down their deposit.
  • Still, isn’t it great that someone figured out how to make loans using mobile technology? Well….the average loan balance is less than $10. Loans carry a term of 30 days but can be rolled over.
  • The interest rate is 7.5%/month … and is charged each month the loan is rolled over. That’s basically 7.5% FLAT (90% APR)! And yet surveyed clients said the interest rate was “cheap”.

So what’s going on here? It turns out that only 14% said they borrowed to invest in their business. Most people use it to cover shortfalls in income vs. expenses­­––what the authors of Portfolios of the Poor call “consumption smoothing”.

Although perhaps it is more accurate to call it “household liquidity management”.

The problem for most microfinance clients­­­­, and perhaps the main reason why they do not have access to the mainstream banking system­­, is that their income is not just low, it’s unpredictable. In such circumstances, household liquidity management becomes a regular­––if not daily––activity. And that makes long-term planning more difficult.

This is important because if Warren Buffet really were a  client intending to use microfinance services to build wealth, he would need to think long-term. Delaying current gratification for long-term benefits is the mindset shift that underlies financial literacy.

If few clients actually use microfinance services in the way they original designers of microfinance programs expected them to, that doesn’t mean it is a failure. Microfinance does address the problem of income unpredictability. A stable, reliable source of credit, combined with savings, allows clients to meet their spending needs even as income ebbs and flows.

There is no doubt that this is important. There is no way to get ahead tomorrow if you have to scrounge to find money to eat today. But contributing to better household liquidity management is not, as the Wall St Journal points out, the same as contributing to increased income.

Another reason the Wall St Journal article is important is it because it shines a light on an important issue that the microfinance industry needs to address. A more nuanced analysis of microfinance’s “failure” to deliver the goods might look something like this:

  1. Microfinance says its loans are being used to “invest” in farms/micro-enterprises. This is wrong. The loans are used partly for working capital (purchases of inputs/inventory) but rarely used to expand production or move up the production chain to higher value-added goods/activities.
  2. In fact, there is a possibility that less than 50% of loans actually go into the borrower’s enterprise, with a large proportion being used to smooth consumption. Instead of the loans being used for the business, as the foundational belief system says, in reality the cash flow of the business is the underlying collateral for making a loan that partially finances consumption.
  3. Enabling people with low and unpredictable income to manage household liquidity stop has an enormous positive impact, but it is really only the first step. The next step is to enable people to use the breathing space created by these short-term loans to plan for the long-term. If anything, this is where microfinance has failed. How many MFIs offer long-term savings plans? How many MFIs offer a real investment loan, which would be larger and a longer term than a typical working capital loan?

This is easier said than done. Saving for the long term is not an automatic habit of low-income households, while borrowers as well as lenders may be cautious about taking on the increased risk of larger and longer-term loans. Financial education can address the former, and technical backstopping for farm and enterprise development may address the latter.

 

This post was contributed by Ron Bevacqua, ACCESS Advisory Managing Director. 

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Cashflow lending: Towards more appropriate micro-enterprise loan products

There are two basic microfinance loan products – group loan and individual loan. Group loan scheme is used for very poor clients for them to have a support group, which also functions as the pressure group for defaulters, and to develop financial discipline necessary for a sustained financial access.  Individual loan scheme most often is provided for the “entrepreneurial poor” who has the capacity to venture into income-generating activities which we can call “livelihood activities”. These are simple buy-and-sell activities where the clients buy in bulk, place a mark-up and sell the products in the neighborhood or in areas with high foot traffic. Most of these activities are done by individuals and sometimes assisted by other members of the family including children.

 At certain point, some of the more enterprising among the clients move up and increase their volume of trading. Some enterprises evolve from livelihood to “micro-enterprises” – economic activities that exhibit growth potentials, that when given the right inputs and resources can become big. To sustain the growth, entrepreneurs have to transform themselves from a jack-of-all-trades to  managers with knowledge and  skills in inventory control, marketing, finance, and the other requisites of an enterprise. As the operation goes more complex, profit also increases that further motivates the entrepreneur to go on further.  Seizing the opportunity is the name of the game as the entrepreneur takes advantage of bulk sales, consignment from suppliers, and other marketing arrangement and balancing these with fast turnover of goods through credit sales, promotions and other schemes that ensures sales.

 At this point, one of the most important factors is cashflow.  Start-up and growing enterprises need cash to cover inventories, operating expenses to pay suppliers, workers and lenders.  The entrepreneur may need big amount at one time, but he can also have big cash inflows in another time which allows him to immediately pay back his loans. Effective cashflow management is one of the marks of an entrepreneur, and to have it, the entrepreneur need a standby source of cash, or credit that he can access every time there are cashflow concerns.

This is where the mismatch happens. Most of the loan products of MFIs are inflexible and still in the context of developing financial discipline as if  entrepreneurs are first-time borrowers. Despite the track record developed by entrepreneurs who are long-time clients of MFIs, they still has to contend with the standard loan features such as fixed amount, payments are in equal installments and made at regular intervals. The worst feature is at certain amount, hard collateral is required, limiting the amount that can be availed by the entrepreneur. The option for the entrepreneur is to borrow small amounts from different lenders to cover for his total cashflow requirement. This I think is a missed opportunity for MFIs.   With minimal skills in assessing enterprises, credit staffs are limited to determining the value of the collateral as the basis for the loan amount.  The danger of falling into the collateral lending trap was emphasized in the previous article.

 A more appropriate loan product would be cashflow-based with the following main features:

  •  credit-line type of loan with a maximum amount based on the historical data of cash requirement;
  • risk covering  is not  limited to hard collateral but a combination of  real estate, chattel, inventory and even collateral substitutes like savings;
  • fast processing of  draw down from the  approved amount;
  • business development services to enhance the skills of the entrepreneur are a must. 

Providing appropriate loan product should also be coupled with business development services to develop the soft skills of the entrepreneur. These skills will enable the entrepreneur to transform the economic activity from a livelihood to growing micro-enterprise and minimize risks as well.

The main skills that should be developed include but are not limited to the following:

  •  Basic management skills which covers how enterprises are systematically run. This involves skills in planning both for the short and long term; organizing different functions and delegating them to hired workers; and coordinating the overall operations.
  • Marketing skills which covers understanding the needs of the clients and aligning the products, doing market research, price setting and promotion.
  • Financial management and accounting to ensure that the funds of the enterprise are separated from the personal funds of the entrepreneur. Record keeping to develop track record for the formal financial institutions specifically for MFIs.

 In the end the assistance is an investment that will be mutually beneficial to both the MFI and the micro-enterprise client.