The Commercialization of Microfinance

By Shannon Bell
WCCN Intern

As the microfinance sector has blossomed over the past thirty years to become an invaluable tool for the poor, a new phenomenon in the industry has emerged—the commercialization of microfinance. The 1990s witnessed the start of corrosion in the stone wall that has divided the microfinance and formal financial sectors, as many nongovernmental organizations began “up-scaling” and many banks went “down-market.” Although the transformation that is beginning to take hold of the industry is allowing for growth in the microfinance sector, are these changes really benefiting the poor and encouraging development?

The microfinance sector has matured and proven itself over the past thirty years as a valuable poverty alleviation program that can sustain itself with high repayment rates, relatively low interest rates, and its ability to cover its own costs. Along with its success has come an increased interest in expanding the sector to meet the needs of every individual who lacks the ability to take advantage of traditional funding sources.

As microfinance has expanded to try to match demand, it has collided with a problem: Where will the funding for expansion come from? Traditional funding for microfinance institutions has mainly been received from subsidized funding sources because of the sector’s origin in NGOs. However, because of microfinance’s successful past, the industry has experienced a level of rapid growth and subsidized funding has been unable to fulfill the demands generated, thus causing microfinance institutions to experience a shortage in funding as resources have been stretched too thin.

In the 1990s, innovative microfinance institutions began looking towards the commercial sector as an outside, nontraditional source of funding that would allow them to expand their operations. These institutions understood that their programs had advanced to an efficiency level that would allow them to cover their costs even if they were to pay interest on their capital. Some microfinance NGOs entered into the commercial sector by appealing to international investors who desired a return on their investment but also wanted to contribute to a social cause. Other NGOs began utilizing the commercial sector for funding by offering savings deposit services to clients in addition to their loans. Although savings services are not completely in the commercial realm, they do overstep the conventional relationship between microfinance and NGOs by entering into services commercial banks traditionally provide.

The migration into commercial banking territory caused these pioneering microfinance institutions to be subject to government regulations similar to those applied to banking institutions. This recent “up-scaling” trend of non-regulated microfinance NGOs into regulated microfinance institutions has allowed the world to see that microfinance can operate in an open market and be sustainable. Witnessing the success of regulated microfinance institutions, some traditional banks are reassessing their previous prejudices against the poor and are beginning to offer microfinance services as well, in what has been dubbed going “down-market.”

According to an ACCION study in 2005, titled The Profile of Microfinance in Latin America in 10 Years: Vision & Characteristics, in the next ten years Latin America will experience a shift in their microfinance sector as regulated microfinance entities replace microfinance institutions and every commercial bank transitions into the microfinance sector by offering loans to low income populations.

In December 2004, regulated microfinance institutions alone served seventy-three percent of Latin American microfinance clients, or a total of eighty-eight percent of microfinance funds. Evidence of average annual growth rates in Latin America further supports ACCION’s conclusion that two models of microfinance will prevail in the region.

Although NGOs are still the most active in Latin America, they had an average annual growth rate of just 36% in 2005 compared to 41% by regulated microfinance institutions and 72% by commercial banks, the newcomer to microfinance. Even with data comparisons over time, regulated microfinance institutions, such as the former NGO turned distinguished financial entity Procredit in Nicaragua, have had higher growth rates than their NGO counterparts. The future of microfinance appears to be one dominated by regulated microfinance institutions and commercial banks, but will the commercialization phenomenon in the microfinance sector adhere to the founding principles of microfinance and benefit the poor and encourage development?

Critics claim that as commercialization takes hold of the microfinance industry and transforms NGOs into regulated microfinance institutions, the balance between business and development will tip in favor of the former. One criticism used to support the position that business dominates the development concerns of regulated microfinance institutions is that many NGOs become more of a banking institution under regulated microfinance, or pair with a banking institution. Then their social programs previously offered, for example business development services, are reduced or eliminated. Many people, such as Muhammad Yunus, one of the founding fathers of microcredit, believe that the social programs NGOs provide are not a necessity because the poor merely have under-utilized skills as their disadvantage and are solely in need of capital not training.

In exchange for diminished social programs, regulated microfinance institutions can provide the poor with much needed services such as savings, remittances, and other services depending on a country’s regulation of microfinancial activities. The potential for growth in regulated microfinance institutions, because of their increased access to capital and ability to gain funding for their services from diverse sources, allows the program to expand and reach many more people who lack traditional banking services than an NGO may be able to do.

Another criticism commonly leveled against regulated microfinance institutions is that they are permitted to charge higher interest rates to their clientele than the regulatory cap established by many governments for traditional banking institutions, and thus are hurting the poor with unfairly high interest rates. It is true that many governments allow regulated microfinance institutions to charge higher interest rates than banks are permitted to charge, however, that is because it costs more to make smaller loans. In order to cover the cost of funds, loan losses, and higher administrative costs involved with microloans, regulated microfinance institutions must be permitted to exceed caps placed on traditional banks. If the caps are not loosened for microfinancial activities, regulated microfinance institutions can not afford to lend small loans, and the damage done to the poor from the inability to access capital is much greater than the damage of a higher interest rate.

A final criticism of regulated microfinance institutions is that the regulatory framework is a hindrance to its development goals because increased resources go towards adding and training staff, there is decreased flexibility when dealing with clients, and there is an increased workload for staff because of the paperwork and requirements involved with reporting to the regulatory authorities. Although regulations do provide a level of bureaucracy that translates into more work for the microfinance institution, there are benefits to the formalities. Regulatory supervision of financial institutions improves the credibility of the institution by ensuring that risk is minimized and failing institutions are improved or closed. Regulations also protect borrowers from unethical lending and collection practices, protect depositors from losses, and provide transparency to borrowers about the costs associated with loans.

Although there has been a lot of research conducted on what types of government regulations countries should apply to microfinance institutions compared to traditional regulations applied to banking institutions and how these institutions should be supervised, a majority of the research in this developing field is theoretical. Very little research has been conducted to determine whether regulated microfinance institutions serve the “poor” or “very poor” in each country better than their NGO counterparts. This is mainly because it is difficult to determine which borrowers fit into the “poor” or “very poor” categories, and it is problematic to compare and draw conclusions among microfinance agencies and countries when data reports and definitions differ greatly.

What is certain is growth in the microfinance sector, which the commercialization phenomenon has stimulated, improves outreach, encourages new and better products for borrowers, improves sustainability, reduces average operation costs when fixed costs are significant, allows the industry the ability to attract more loans from potential lenders, and spurs on more growth. An environment of regulations for microfinance that is conducive to growth is necessary to maintain the sectors original intention to aid development and those without access to traditional banking services.

The commercialization of microfinance has created the need for governments to adopt specialized regulations for the sector that may differ from traditional banking regulations. One necessary specialized regulation specific to the microfinance sector is the ability to charge a higher interest rate than the traditional government cap in order to allow the sector to cover the higher transaction costs associated with its activities. The sector also needs regulatory authorities to create special provisions that allow unsecured lending to their clients that lack conventional collateral, the use of portfolio quality to assess risk, and the creation of simpler reporting methods for tracking loans and accounting procedures.

Government cooperation in every country is needed to adjust regulations to the realities of the evolving microfinance industry. With the support of each country’s regulatory authorities, the new, commercialized microfinance sector will be able to reach its full potential and increase its scale of services to meet the world’s needs.