Where do poor households and small enterprises turn when the doors of mainstream banking are closed to them? Increasingly, microfinance institutions are meeting the needs of clients who have low and uncertain income, conduct only small-scale transactions, have little usable collateral, and are unfamiliar with formal business procedures. In meeting these needs, the institutions can also play a significant role in poverty reduction and financial sector deepening.
Microfinance comes of age
In many countries, microfinance institutions are numerous; in some, they hold a significant share of total deposits and lending and serve millions of clients. They are especially well developed in Asia and Latin America—notably in Bangladesh, Bolivia, and Indonesia. But even in countries where the micro-finance sector is not large, its institutions may be the only ones operating in more remote regions.
When microfinance institutions first began operations in the early 1970s, they principally extended credits. Now they offer a greatly expanded range of services. Increasingly, secure savings facilities is their central function, but many now also offer insurance, business training, and financial planning. But individual transactions and financial stocks remain small. The range of loans may extend from $50 or less for institutions targeting the very poor to several thousand dollars for institutions targeting successful small businesses. Deposits might be even less (as low as $5).
Road to success can be rocky
Microfinance services, however, are not cheap. These institutions face relatively high overhead costs vis-avis the value of their loans and deposits, and their loans are often considered risky because their borrowers typically have uncertain income and limited usable collateral—for example, because title to land may not be documented.
With these handicaps, microfinance institutions have had to be inventive in generating incentives for repayment. A system of dynamic incentives, for example, can provide small loans at first, with amounts increasing as a repayment history is established. Institutions may also require up-front savings for screening purposes, lend to groups jointly responsible for repayment, or request personal guarantees.
Significant costs and numerous risk factors have forced microfinance institutions to charge high interest rates on loans. Borrowers are presumably willing to pay these high rates because the alternatives are either borrowing elsewhere at even higher rates or not borrowing at all. Similarly, microfinance institutions may offer rather low yields on deposits, but clients may be more concerned about the availability of secure, liquid savings than about a direct monetary return.
Nonetheless, profitability and sustainability remain concerns. Most microfinance institutions continue to be subsidized directly through grants and indirectly through soft terms on donor loans. Many lose money, and the “financially self-sufficient” ones are not those celebrated for serving the very poorest clients. There is also a distinct learning curve: these institutions typically need to survive and grow for an extended period before they can be reasonably cost-efficient and profitable.
Making the most of financial support
Microfinance institutions have attracted considerable support from national governments, bilateral and multilateral donors, and numerous nongovernmental organizations. The support is chiefly motivated by a desire to help the poor. These institutions seem to offer a very direct means to deliver assistance to the poor, yet in a way that empowers them to gain financial autonomy. The financial support can be cost-effective, if these institutions can return the funds and leverage the support by mobilizing savings and additional borrowing. These institutions may also have an informational advantage in that they may be able to distinguish more precisely who can benefit most from the assistance, because they screen their clients carefully, and savers decide for themselves when to build up and withdraw their deposits.
But support for microfinance institutions must compete with other claims. Support could be channeled to direct income support or the provision of human capital, which the poor may prefer. And support can be counterproductive if it weakens incentives to become self-sustaining, operate efficiently, and instill financial discipline in clients.
Experience suggests that support is best used to encourage financial independence and sustainability. This goal might be achieved through one-time startup grants or long-term loans, allocation of subsidies by periodic auction, and promotion of a central support organization (called an apex organization) or ancillary institutions (such as a credit record agency). It should also be recognized that not all microfinance experiments will succeed, and a certain amount of failure will inevitably accompany the development of a flourishing microfinance sector.
How useful is microfinance regulation?
An appropriate legal and institutional framework is one form of support that can boost the prospects for a viable microfinance sector. Especially once micro-finance institutions begin to mature, effective regulation can help to promote the sector, because well-regulated and sound institutions are likely to be able to attract more financing.
Regulation is principally intended, though, to protect clients, especially those who place their savings in these institutions. Typical depositors are relatively poor and would be gravely affected if an institution failed. With few alternative investment or borrowing opportunities, and scant information and skills to evaluate the soundness of the local microfinance institution, the clients are also not in a position to exert market discipline on these institutions. There may also be a need to protect the financial system as a whole, notably when the failure of a major microfinance institution could provoke doubts about the soundness of the whole financial system and discourage mass participation in the financial sector.
Notwithstanding the obvious benefits of regulation, there can be significant costs, given the small size of these institutions. These costs include staffing costs for the supervisor, especially in countries with scarce capacity, and expenses for the microfinance institutions in complying with regulations and satisfying on- and off-site supervision. These costs are ultimately passed on to clients. Regulation may also constrain innovation—for example, by forbidding new forms of loans.
Sound and sustainable microfinance institutions require honest and transparent management.
The cost-effectiveness of regulations is linked to the breadth of activities undertaken by microfinance institutions. Those that do no more than lend donor funds may not merit any special form of regulation. Indeed, in many countries, deregulation is needed to permit this generally innocuous activity. Large micro-finance institutions that attract unrestricted deposits present a greater danger to “innocent bystanders.” A reasonable approach would recognize the heterogeneity of the microfinance sector and accommodate the flexibility and scope for development it needs.
In finding this balance, it is useful to distinguish between prudential and nonprudential regulations. Prudential regulations (for example, capital adequacy norms) are concerned with the financial soundness of the regulated institutions. These are generally relatively complex, are costly to comply with, and often must be implemented by a specialized financial authority. Nonprudential regulation (for example, full disclosure of charges or establishing the integrity of individuals controlling a company) serves other purposes, such as consumer protection and, after obvious modification, applies equally to financial and nonfinancial businesses.
For many microfinance institutions, especially those in the early stages of development, nonprudential regulation may be much more appropriate. Sound and sustainable microfinance institutions require honest and transparent management. Thus the integrity of their founders and senior managers, and their ability to track their own performance (for example, on loan loss recognition and operating costs), may be more important than meeting a battery of prudential ratios.
Why the IMF is interested
The growth of the microfinance sector in recent years has begun to receive increased attention from the IMF. This attention is motivated in part by the IMF’s interest in promoting stable economic development and financial sector development, notably through adjustment and reform programs supported by its Poverty Reduction and Growth Facility (PRGF). Microfinance institutions normally fall under the World Bank’s purview, but the IMF must have an understanding of all aspects of PRGF-supported programs.
The IMF’s increased attention to microfinance institutions also reflects the organization’s involvement in encouraging sound financial systems. The microfinance sector must be robust enough to provide more benefits than problems, and the design of measures directed at other parts of the financial system must take account of the effects on microfinance institutions. The needs of the microfinance sector must then be factored into a wide range of IMF work, including the policy programs it supports, its oversight (surveillance) of country financial sectors (notably through its Financial Sector Assessment Programs), and its technical assistance, especially that related to banking supervision.
For more information, see Microfinance Institutions and Public Policy, by Daniel Hardy, Paul Holden, and Vassili Prokopenko, IMF Working Paper WP/02/159. Copies of the paper are available on the IMF’s website (http://www.imf.org) or may be ordered, for $10.00 each, from IMF Publication Services. See page 341 for ordering details.
World Bank, CGAP lend crucial support
The World Bank has actively promoted microfinance institutions and their integration into the financial systems of numerous countries. The Bank’s main strategies include fostering an appropriate environment for the institutions, promoting sound practices, building institutional capacity, and seeking innovative techniques, methods, and products. Its support has evolved from lines of credit to assistance with policy formulation and saving mobilization, often tied to technical assistance. The World Bank Group’s aggregate portfolio for microfinance currently amounts to about $210 million. The International Finance Corporation has approved investments in microfinance amounting to almost $90 million.
The Consultative Group to Assist the Poorest (CGAP) is a consortium of 29 bilateral and multilateral donor agencies that actively assists microfinance institutions, donors, and others, such as regulators. It provides technical assistance and strategic advice, develops and disseminates technical guides and services, provides training, and conducts field research on innovations. CGAP also operates a small grant facility that funds these activities and strategic investments in microfinance institutions.
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