Microfinance Meets the Market, But With High Transaction Costs

Sep 2008
Lagos, Nigeria, September, 08 2008 - Microfinance institutions have established that reliable banking services can be provided to poor customers. Researchers Cull, Demirguc-Kunt, and Morduch analyze the tensions and opportunities as microfinance institutions attempt to fulfill their second objective —to be commercially viable.

Drawing on data covering 346 of the world’s leading microfinance institutions and nearly 18 million active borrowers, they find a remarkable success in maintaining high rates of loan repayment. However, they also find that investors looking to maximize profits would have limited interest in those institutions that focus on the poorest customers and on women.

As a group, such institutions charged the highest fees in the sample studied, but they also faced the highest transaction costs, partly due to the expense of processing small transactions. Innovations to overcome information problems in financial markets have been a triumph, but more will need to be done to overcome the challenge of high costs, the authors say.

The data show that microfinance is not taking a single path, nor that it should.  The authors put forward eight basic findings that frame debates.

•Licensed commercial banks with for_profit status serve a growing share of customers and garner media attention, but the share remains relatively small.  Globally, microfinance continues to be dominated by nongovernmental organisations (NGOs), government-owned banks, and “non-bank financial institutions” that are a cross between banks and NGOs.

•Being a non-profit institution does not mean being unprofitable.  A large share of microfinance institutions with “non-profit” status in fact earn steady profits—but they re-invest their profits in the institution and cannot legally distribute earnings to shareholders.  Earning profits (and thus limiting dependence on subsidies) and becoming a commercial entity are thus distinct activities.  Neither implies the other.

•Microfinance institutions have found reliable ways to get customers to repay loans.  Use of the group-lending methods pioneered by Grameen Bank is best known but far from universal.  Microfinance institutions using standard individual-based loan contracts also boast high rates of loan repayment and gain added flexibility.

•Commercial microfinance banks, as a group, make loans that on average are about four times larger than loans from NGOs.  Since poorer customers generally demand smaller loans, average loan size is a rough proxy for the poverty level of customers.  On average, microfinance banks thus tend to serve a substantially better-off group of borrowers than do NGOs.  Banks also serve fewer women as a share of their customers.

•Most microfinance institutions charge inflation-adjusted interest rates between 20 and 40 percent per year.  Despite the evidence from Mexico’s Compartamos, NGOs as a group charge interest rates that are roughly double the size of those charged by commercial microfinance banks.  Thus, the poorest customers tend to pay the highest interest rates on loans.  The high interest rates are necessary to cover the added costs of making small loans, and the NGOs’ record of expansion and high loan repayment rates over time suggests that customers value the services, even at high costs.

•Despite the high interest rates, most of the institutions serving the poorest customers earn profits too small to attract profit-maximizing investors.

•Thus, subsidies and noncommercial funding continue to be important to nongovernmental organizations, while banks rely mainly on social investment and commercial sources of capital.

•Data on the financial side of microfinance is greater in quality and quantity than data on social outreach and impacts, but even data on financial basics like “profits” and “subsidies” are inadequate. Current reporting practices tend to overstate profits and understate subsidies.

The microfinance sector has grown tremendously, and institutions are continually reducing costs, improving quality, and expanding services.  Debating about a single, correct vision for microfinance—be it a non-profit approach or a commercial model—misses the reality that microfinance flourishes thanks to a diversity of strategies.  Improving and refining those strategies will require better data and the continuing embrace of experimentation.

Source : Vanguard

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