NB Financial Innovation
Yes, Microcredit Requires Subsidies … and That’s Great News
introducing nb’s first monthly theme: microfinance
This post – the first in a series about social investment and innovation in microcredit related to the research paper referenced below – launches a new concept at NextBillion. Throughout the coming year, we’ll organize content around a monthly theme, dedicating special attention to a specific sector alongside our broader coverage; January’s focus is microfinance. The idea is to help bring coherence to our content and ensure we’re covering all the sectors that are important to our audience. You can view our 2017 editorial calendar here. For the second post in Ogden’s series, click here; for the third, click here.
Back in November, one of the more important research papers on microcredit was released and a funny thing happened: Almost no one noticed. I confess I’m partially at fault for that. Even though one of the co-authors is my colleague and the founder of the Financial Access Initiative, I haven’t done much to promote it. But there’s also a deeper reason. The importance of the paper isn’t immediately obvious because it overturns widely held beliefs about microcredit in almost contradictory ways.
The paper’s title is “The Microfinance Business Model,” but it’s more about the finance model; it’s a data-driven look at subsidy and sustainability in the industry. The authors first calculate the accounting profit of more than 1,300 MFIs. Accounting profit is simply revenues less costs – it’s the measure of business profitability that we’re all used to. In the social sector, however, accounting profit doesn’t give the full picture. The more important measure is economic profit, because it factors in the market-rate cost of capital. It establishes how much subsidy MFIs get from below-market rate debt or equity in order to achieve their accounting profit (or loss). While more than two-thirds of MFIs show an accounting profit, less than 20 percent show an economic profit. In other words, only those 20 percent are truly sustainable. The other 80 percent could not maintain their current operations without social investors providing below market-rate capital. And it’s not a question of subsidy flowing to new MFIs who are scaling up. Three-quarters of subsidy in the industry flows to MFIs which are 10 years old or older.
This research should finally put to rest the assertions that affordable microcredit aimed at poor households does not require subsidy: Serving poor customers well is always going to be expensive – more expensive than serving wealthier customers.
While the initial impression might be that calling out the prevalence of subsidy is just another kick at MFIs while they’re down, the research is actually quite good news if you have a realistic view of the costs of serving poor customers. Subsidies are widespread and persistent but they are actually quite small. The median institution receives a subsidy of just $26 per borrower per year. The detailed picture is even better because the average is skewed by some commercial institutions with large subsidies – yes, commercial institutions take more subsidy per customer than nonprofits – so subsidy per borrower falls off rapidly below the median.
That anyone would perceive this as anything other than great news is primarily a factor of the inflated expectations that the rhetoric around microcredit generated. Forty years ago, if you had told someone in the development sector that you could bring millions of people into the formal financial sector, employ tens of thousands of customer service staff and managers, and provide a financial service that would be modestly beneficial for most, significantly beneficial for some and with little evidence of harm (which is how you should read the results of the microcredit impact evaluations) for less than $30 (actually $7 in 1976 dollars) per customer per year, they would have been astounded. In fact, before the microcredit movement, the default belief would have been that widespread availability of credit to poor households would be disastrous.
The case for the status quo in microcredit – continued social investment and expansion with efforts to develop operational efficiencies and ensure client protection – is quite strong based on the findings of this research, especially if you value the extension of formal financial services to poor women. Admittedly, microcredit is not going to compete with the cost-effectiveness calculations for distributing bednets or deworming pills in areas with high prevalence of malaria and/or worms, but it doesn’t take much benefit to justify cost-effectiveness in comparison to most development interventions when your cost is less than $30 per person per year.
But there is also a strong case against the status quo: Surely we can do better than the current state of the art in microcredit. Understandably the impact research has captured people’s attention, but there has been a great deal of research over many years that focused less on impact and more on operational questions in the delivery of microcredit, such as: What drives repayment? What contract terms drive what sorts of behavior among borrowers? Why is take-up of microcredit so low? Why aren’t microenterprises growing? This rich body of research provides clear paths for innovation in microcredit that could boost impact. And again, it wouldn’t take much of a boost to dramatically improve cost-effectiveness estimates.
I’ve made the case for more social investment in microcredit and laid out the promising paths in a new paper. One approach is to cut the cost of microcredit for borrowers by lowering operational costs – and digital finance and fintech provide some hope of doing just that. But I’m actually more interested in and excited by another approach: Innovation around the core products and operational models that could deliver more useful products to more targeted customers.
But progress on either path is unlikely without continued social investment in microfinance. Innovation requires funding, and microfinance – at least the pro-poor kind – does not generate the kind of profits necessary. If, instead, social investors pull back from the space, then not only will innovation not happen, but MFIs will be forced to cut back outreach, raise prices and pursue wealthier customers – or all three.
Timothy Ogden is managing director of the Financial Access Initiative at NYU-Wagner.
- Financial Inclusion