NextBillion - An Initiative of the William Davidson Institute at the University of Michigan

The simplest microfinance business model involves extending loans to a group of borrowers who agree to help each other by means of group savings and informal support. In order to decide whether to lend financial institutions require risk management systems customized to the informal nature of the clients. Relationship lending relies primarily on ’soft’ information gathered by the loan officer through continuous, personalized, direct contacts with customers and the local community in which they operate (Berger and Udell, 2006).

Over time this several alternative variations to the basic model have flourished, leveraging the interest of individual borrowers and the power of the Internet to channel their resources. Kiva, for instance, figured out a way of allowing individuals to lend to low income borrowers through microfinance institutions (MFIs), and Microplace helps individuals invest in microfinance institutions by purchasing securities. Additionally, low-income markets have experienced the rise of hybrid business models in financial services, most notably in mobile phone financial services, and financial services attached to particular products and services to help customers purchase them (as in Patrimonio Hoy for housing or Codensa for utilities).

Recently, we are encountering second generation evolutions that further sharpen the social impact of finance in low-income markets. In a recent post, I explained the case of Vittana, a start-up that offers micro-loans to individuals seeking to enter tertiary education. In this post I will explain another interesting refinement in the standard microfinance model offered by United Prosperity (UP).

UP was launched in May 2009, and its source of innovation lies in the proposed business model. UP uses a peer-to-peer microlending platform to raise capital, but, in contrast to models like Kiva, the capital is not disbursed directly in the form of a loan to entrepreneurs/MFIs but takes the form of a loan guarantee instead. This makes a huge difference as it at least doubles the amount of money that will ultimately reach the final borrower in addition to other benefits I will detail below.

Before continuing it is worth reminding ourselves what a loan guarantee is.

When a prospective borrower asks for a loan, the bank will disburse it on the basis of certain conditions. In many cases, a critical condition is that a loan guarantee or collateral is in place, which will be kept by the bank in case the borrower defaults. Guarantees can be physical (like an apartment or land) or monetary.

Moreover, the person who puts forward the guarantee (also called guarantor), need not be the same person who takes the loan. For example, young couples who buy their first house are often supported by their families who provide the loan guarantee and their own reputation as trustworthy borrowers. It is important to remember that the guarantee is always less than the loan taken out; depending on the risk of the borrower, the bank may ask for a bigger or smaller guarantee.

Then, how does UP work? First, individual lenders browse the profiles of entrepreneurs included in its website (UP profiles groups of 5-6 entrepreneurs, instead of individual entrepreneurs – the group is collectively responsible for the loan) and selects whom to support by sending their money via PayPal. The money from multiple lenders is then consolidated by UP and, with the aggregated amount, UP goes to a main commercial bank and places it as a guarantee for a loan to a MFI. MFIs have been previously screened by UP and the commercial bank after which the MFI is able to take a loan larger than the amount of the guarantee which will be lent to entrepreneurs in the end.

The loan taken out by the MFI will be at least twice as big as the guarantee. This means that, effectively, the money originally lent through the microlending website has doubled before reaching the final borrower. The individual lending through UP’s website is now not a social lender, but a social guarantor.

Accessing loans from commercial banks is critical to MFIs because they are usually not allowed to take deposits and therefore do not have their own source of funds. However, commercial banks are usually reticent to lend to MFIs because the MFI may not have adequate credit history with banks or may not be very profitable. Such reservations will increase with more “socially minded” MFIs. This is due to the perception that that the poorer the customers of an MFI, the less profitable/ more risky the MFI will be for the commercial bank to engage with.

There is another interesting variation in this business model. A social lender will ordinarily lose her money if the borrower defaults on the loan. In this case, it would appear that the social guarantor will lose her money if the borrower defaults as well, but that will not be the case. It is important to note that the guarantee is placed with the commercial bank and possible defaulting entrepreneurs are borrowing from the MFI. For the social guarantor to lose her money, the MFI has to default on the bank’s loan. MFIs will usually do their best to take the losses and not to default on the bank loan, not to put their reputation with the bank at risk. Most MFIs find it extremely hard to enter into such relationships with commercial banks and when they do so it gives them a halo of respectability and legitimacy vis-à-vis the rest of the financial community.

As a result, MFI have incentives to search for less risky entrepreneurs/borrowers, so they avoid defaulting on the loan from the commercial bank. A social guarantor will only lose their money if the MFI collapses and has to default on its obligations. Although there is no specific data on MFI default rates, it is estimated to be less than 0.5%.

Further it has been observed that after one bank starts lending to the MFI, other banks are more comfortable lending to the MFI, thereby strengthening the MFI’s self sufficiency and integration with the local economy. In helping MFIs build a credit history and gather the reputation necessary to do business with commercial banks, UP’s work resembles that of Grameen Foundation’s growth guarantees.

Being relatively young, UP has partnered with only one MFI so far, Ajiwika, which operates in the state of Jharkhand, India. Ajiwika offers micro-loans to extremely poor entrepreneurs living on $2 a day. Nonetheless, UP is also in conversations with other MFIs catering to similarly poor entrepreneurs. Moreover, UP has also signed a partnership agreement with a leading bank in India with has a long history of supporting MFIs. Currently, Ajiwika borrows money at a guarantee-loan ratio of approximately 1:2. This means that a $100 guarantee deposited by UP in favor of Ajiwika will result in a loan to Ajiwika of about $200. As the MFI develops its relationship and builds its financial record, UP estimates that the ratio could progressively fall to 1:3.

UP has already made $120,000 in loans available supporting about 650 entrepreneurs. Due to the location of Ajiwika, most of them are small rural entrepreneurs although UP is planning to extend this business model to urban areas without any significant problems. It projects to disburse $50-$60 million in loans in 5 years. The conditions of the loan offered to individual entrepreneurs are relatively standard in microfinance, although virtually unheard of for such poor borrowers. The average loan is $200 with interest rates of 24% annually on a declining balance, monthly repayment and full repayment of the guarantee after 18 months. The 24% interest rates charged by Ajiwika are amongst the lowest in Jharkhand. UP’s sources of revenue come from the interests accrued from the guarantees deposited in the bank. Additionally it encourages optional donations from the social guarantors or from the MFI.

Summing up, the strengths of UP’s business model are the following:

• It doubles the impact of the money invested by socially conscious investors.
• It builds self sufficiency in the local economy by creating formal relationships between MFIs and banks.
• The foreign rate risk is mitigated with UP’s social guarantee model. With social lending when individual lenders disburse their money they do so in their currency, for instance, dollars. If the money is directly sent to the final borrower, it first has to be exchanged into the local currency. Once the borrower pays back, it needs to be exchanged again to the currency of origin in order for it to be returned to the original lender. The risk is that, if the value of the original currency has increased, the MFI will have to cover the difference at a loss. In UP’s business model, the guarantee that is placed within the bank need not be translated into local currency and thus this model avoids foreign rate risks.

Finally, it appears that the business model developed by UP could be replicated in other development areas in partnership with local banks. In this vein, UP has already received inquiries for small rural schools for the poor, firms selling relevant small appliances, and organizations offering vocational training. There seems to be great hidden potential in the co-development of hybrid business models in which the financial aspect of the transaction requires a guarantee or collateral of some sort.