[ Microfinance ]

Reorientation overdue

Competition is growing among microcredit providers. A polarisation is arising between more commercial micro-finance institutions and those that offer products that make socio-political sense, but are more costly. The latter will probably have to rely on subsidies over the long term, though such dependence does not conform to how they have so far seen their role.


[ By Bernd Balkenhol ]

Investment returns of 40 % and interest rates of nearly 80 %, as have been reported by Mexico’s Compartamos bank, have fanned discussion over the self-perception of microfinance institutions (MFIs) as development organi­sations. Many institutions have shown that it is possible to provide financial ser­vices to poor families and still cover costs. Pro Mujer in Bolivia, Al Amana in Morocco, Kashf in Pakistan and PAMECAS in Senegal are a few examples. But only about 250 to 300 of all MFIs have achieved that status – no more than five percent of all institutions. Nonetheless, the mere fact that it is possible to achieve returns unimaginable in the conventional finance sector has spurred a controversial debate. (The Economist, 17 May and 26 June; New York Times, April 5).


Diverging models

All MFIs claim to reduce poverty, to cover their costs and even to operate more or less profitably. But they take different approaches to reaching these goals:
– Some MFIs aim first to cover their costs and to secure commercial success. To do so, they charge hefty rates, which in certain cases may mean over 80 % a year. Their justification is that they can serve more and more poor households by focusing on financial services (mainly the credit business) and covering costs in order to steer clear of subsidies.
– Other MFIs try not to pass such costs onto customers, but to absorb them themselves. They often offer a wide range of services, such as literacy courses, legal assistance, advanced training, advocacy and social mobilisation. As all this is expensive, these MFIs tend to depend on subsidies for longer.

It is true that nearly all MFIs were massively subsidised in one way or another when they were founded and most con­-
ti­nued to be so for more than a decade later. These subsidies indirectly benefited clients who enjoyed cheaper services. This was seen as acceptable as long as the tendency to move towards market conditions existed. Some of these MFIs have reached this stage, as described above.

Size is the main difference between subsidy-reliant MFIs and financially indepen­dent institutions. The latter have more customers, a wider-ranging portfolio of microcredits and a higher overall turnover. Economies of scale give those institutions the ability to offer services at relatively affordable interest rates while simultaneously covering costs, and perhaps even making a profit. Accordingly, growth is the goal of every MFI.

But when MFIs compete, the interests of the MFIs, their customers and society as a whole can diverge. If they do not share the same goals, competition may be destructive.

When MFIs with similar aims and pro­ducts compete with each other, they gene­rally have to cut costs, lower default risks, or obtain financing from cheaper sources. Once such options have been exhausted, competition leads to lower profits. After all, MFIs are unable to raise interest rates or fees without sending customers to the competition. Customers benefit from such competition. They can count on lower interest rates, while the quality of products and services remains the same.

However, MFIs often substantially differ in terms of service, loan-granting practices, requirements for collateral, or in how they combine financial and other services. Two examples from India illustrate this issue:
– SKS is an innovative MFI, founded in 1997, offering different types of credit with different terms and purposes. It also sells a variety of micro insurance pro­ducts. SKS reports to financial regulators and had more than 600,000 customers in 2005, all of whom were women.
– SHEPHERD is a comparatively small MFI with only 20,000 customers. It only offers group loans. It also sells life insurance for a commercial insurance company, and supports self-help groups for setting up savings accounts at a state-run bank. Legally, SHEPHERD does not report to financial regulators.

MFIs that are more commercially oriented, like SKS, offer credit for activities that boost people’s income. This is a lucrative market segment for an MFI. But taking in savings, selling micro insurances or even linking credits to educational programmes are expensive and, accordingly, much less lucrative.

While MFIs such as SKS win over customers with their prices, MFIs such as SHEPHERD try to develop a comprehensive financial-service package for exceptionally poor households.
Growing competition

Empirical studies show that as competition increases, MFI customers react more strongly to interest rate changes. Price competition ensues indeed. That is why a drop in demand forced the MFI Nyegisio in Mali – which operated a comprehensive education programme – to cancel a product called “Credit Plus Education”, which was offered at a very high interest rate, which covered its costs.

An MFI that wants to maintain expensive financial products to help the needs of the very poor requires subsidies. However, this contradicts the much often-stated mission of MFIs, which view microfinancing essentially as a self-supporting strategy to fight poverty. However, comparatively expensive products which focus on risk prevention and income stabilisation are those that help the poorest customers the most. As competition increases, the poorest tend to lose out, whereas the other MFI customers – mostly small businesses – hardly notice any difference.

Naturally, therefore, MFI managers currently view growing competition as the biggest challenge and even threat, accor­ding to a 2008 study by CGAP and CRI. This begs the question as to whether the anticipated commercialisation through greater competition will harm the MFI sector, thus reducing its potential to fight poverty. In other words: Increasing competition in the microfinance sector means it is essential to review how different types of MFIs are supported. This is all the more pertinent as tougher competition may force international donors into the dilemma of either paying more subsidies, or allowing microfinance to become completely commercial.

It is becoming clear that an substantial number of MFIs with a mission targeting the poor may have to rely on subsidies in the long run. This has consequences for the value of microfinance in development policy in general. A practical question arises: how are MFIs with different aims to be adequately supported without distorting the market or creating the wrong incentives through ill-schemed subsidies.


Smart subsidies

A book I recently published (Balkenhol, 2007) reaches the conclusion that the criteria for backing microfinance need rethinking, based on the heterogeneity of the institutions and their goals. Efficiency is the decisive principle here, because it allows the support of MFIs without forcing them to choose between poverty reduction and profitability. While social and financial success will of course remain the decisive criteria for microfinance, they are not enough to make an assessment that is fair and respectful of the goals of a particular MFI. Efficiency permits one to take into account whether resources are transformed into services in a cost-effective manner, regardless of which goals an MFI has.

In the book, Flückiger and Vassilyev show that in Peru, MFIs have had pronounced differences in efficiency, despite similar goals. There are always some organisations that make more economic use of their resources than others do. Support based on their relative efficiency would not distort the market. A savings and credit union in Burkina Faso would not be expec­ted to achieve the same revenue or have the mass market of a commercial bank in the same country, or be held to the same standard as a similar Indian institution. A motorcycle race, after all, doesn’t pit 75 cc motorcycles against 750 cc vehicles. Relative efficiency aims to measure MFIs in each country or global region against the most efficient institution in its own category.

Reorienting the support of MFIs in such a way would have practical consequences for making development policy. The continuation of subsidies is, on the one hand, necessary to ensure diversity in the sector. On the other hand, it is essential to eliminate market distortion and counterproductive incentives as much as possible. Moreover, it would help to link subsidies to fulfilling verifiable goals and making measurable gains in efficiency. Such smart subsidies would not only help the local financial market and taxpayer in donor countries, but all MFI customers – whether they are very poor or less so.