Monday
September 26
2011

Christopher Cuellar

Microfinance at a Crossroads: Balancing Good Intentions with Critical Industry Structuring

In the quest to reduce and eventually eliminate poverty, there exists no silver bullet. Poverty is a complex problem that requires the cooperative assistance of people from the top to the bottom of the economic pyramid. Economic stimulus through access to capital for microenterprise or personal use is one instrument that has experienced widespread accolades as well as criticism as it has grown in size and popularity.

Microcredit, or microfinance, more broadly, has taken the bottom-up approach of providing access to capital to those who previously did not have the opportunity. As microfinance has grown, its overlay between driving “real” impact using semi-traditional economic methods has made it the darling of social enterprise. Early successes and rapid growth have even inspired some Microfinance Institutions (MFIs) to go public. As access to capital became more widespread, perfect-storm-like conditions began forming in conjunction with a global recession. Repayment failure rates have started to rise, and areas like Andhra Pradesh have been saddled with accusations of corruption and abusive lending practices.

Initially utilized to provide small amounts of capital infusion to microenterprises that were considered “unbankable” by larger institutions, microfinance has evolved to provide an increasing number of financial instruments to consumers at the bottom of the pyramid (BoP). This shift has not come without growing pains – pains experienced on both the lending and borrowing side of the equation.

As the industry matures, the cracks in the model have become more apparent. When an idea built from good intentions scales, hidden costs begin to grow and the call for more structure becomes louder. These cracks are not just on one side of the equation, and need to be addressed through collective effort by borrowers and lenders.

Splitting it out even further, lenders and borrowers can be categorized into two groups: bad-intentioned and good-intentioned.

Bad-Intentioned

Good-Intentioned

Lenders

Abuses position of power to extort profit from borrowers

Provides access to capital with ample attention paid to borrowers’ needs and lenders’ limits

Borrowers

Exploits (multiple) MFIs to seek rapid financial gain

Seek capital infusions with effective means and the intention to pay back over time

This post does not focus on the larger picture of whether or not microfinance is an effective tool towards improving social welfare, but instead outlines some “next steps” moving forward to structuring the industry in a way that limits the impact of bad-intentioned lenders and borrowers, while providing a smoother experience for good-intentioned participants.

Improved Regulation of Lenders

The idea around regulating MFIs is nothing new. In 2001, The Financial Sector Development Department of The World Bank put together a self-described “work in progress” entitled “A Framework for Regulation Microfinance Institutions.” In 2006, a team from the IRIS Center at University of Maryland published a piece that compared microfinance regulation in seven countries.

The issue that remains is the inconsistent adherence to and implementation of these regulations and experiments. The experimentation stage needs to graduate to more collaborative and larger-scale implementation.

One of the causes of strife that has been clearly publicized by the media is abusive lending practices by MFIs. After the alarm was sounded, the Andhra Pradesh government took action and “introduced a new law to ban unfair debt collection practices and prevent borrower suicides and trauma.” The lack of oversight into interest rates and debt collection allows bad-intentioned lenders to prey on borrowers.

MFI oversight and regulation in conjunction with synergizing best practices among MFIs and NGOs from different countries is a step in the right direction toward preventing abuse. Cross-collaboration between MFIs that have experienced unique situations can help to build a strong set of best practices for the various lending environments and cultures that MFIs face.

Good-intentioned lenders, on the other hand, can be equally abused by bad-intentioned borrowers looking to obtain multiple microloans from various lenders with no plans of repayment. Understanding that many MFIs operate in areas with little-to-no (technical) resources, many lenders still rely on a paper tracking method. How are they to know that the borrower has received loans from five other MFIs in other areas before this one? Technology needs to be utilized (even in the most basic forms) to create a more effective tracking mechanism for borrowers and their ability to undertake another loan.

Support of Borrowers

The other side of the coin, especially relating to over indebting, comes back to financial knowledge and management of borrowers. Good-intentioned borrowers who unintentionally overburden themselves with more debt than they can handle pose another challenge to lenders. These borrowers should not be shunned by MFIs, but instead educated, encouraged, and advised on how to manage finances. The good intentions that microfinance was predicated upon need not be restricted to simply providing capital and walking away. There is a “soft” opportunity here to educate consumers and strengthen their credit position when they are able to take on more debt.

A quick scan on MixMarket.org can tell you the social responsibility provided to the clients that the MFI serves. Ranging from financial education to training and consulting, these services often correlate with the rating differential of the coveted “5 Diamonds” to the concerning “1 Diamond.” With an increased amount of effort, the MFI can protect itself from lending to borrowers who will end up defaulting and causing losses, while at the same time protecting borrowers from bankruptcy and increased hardship.

The deeper you go into the solutions, the more you start to understand that what is good for the lender is good for the borrower. Losses benefit no one, especially when the borrower does not have sufficient collateral to fall back on in the instances of default.

These growth pains are indicative of an industry that has achieved partial success but needs continued refinement. These enhancements should balance the industry’s mission to serve the unbankable with improved regulation to limit bad-intentioned participants.

Categories
Entrepreneurship
Tags
microfinance, poverty alleviation, social enterprise