MICROCAPITAL PAPER WRAP-UP: From Revolution to Evolution: Charting the Main Features of Microfinance 2.0 by Ronald U. Mendoza and Brandon C. Vick

Written by Ronald U. Mendoza of the Office of Development Studies, United Nations Development Program (UNDP) and Brandon Vick of Frodham University, this paper speculates on the future of microfinance and elaborates on the role to be played by private innovations and public policies in this regard. The 43 page document was published by Fordham University, Department of Economics in its Fordham Economics Discussion Paper Series in February, 2008 and the full text is available here.

What follows below is a summary of the report:

Since the 1970s, several organizations, development practitioners and policy makers have devoted considerable resources towards improving access to financial services for the poor. However, in terms of outreach, approximately only 16 percent (p 3) of the world’s poor have access to formal financial services. Categorizing the past thirty years of microfinance as the ‘first phase’ of the industry’s development, the authors (Mendoza and Vick) theorize that progress on both the private and public sector are essential for microfinance to reach a wider a group of the world’s low income population. The ‘next’ phase of microfinance requires innovations in the private sector to mitigate costs and to develop products which are more responsive to clients’ demands. Public policies will need to be designed in ways that meet the challenges of a maturing microfinance industry.

Innovations in the Private Sector:

Organizational structure, products and processes of microfinance institutions (MFIs) should be changed such that production costs are reduced and the MFIs are better able to meet specific customer demands. Apart from the well-known innovation of group lending by MFIs (which reduces loan defaults), further innovation is required for MFIs to overcome cost-related constraints and achieve financial sustainability. In this regard, the following opportunity areas in the private sector are suggested (p 6):

1. Overcoming cost-related constraints: Scarcity and asymmetries in client information, unstable political and economic conditions and the geographical terrain of the poor in rural areas lead to increased operational expenses for MFIs. The study suggests the following methods for MFIs to reduce associated operational costs:

  1. Screening and Monitoring Costs: To mitigate costs associated with screening, enforcement and monitoring of clients, the study proposes offering dynamic incentives to MFI clients, such as the threat of exclusion of defaulting borrowers and access to higher loans for borrowers of good standing. Additionally, Credit bureaus or information sharing devices which offer information on credit history, employment, income, overall loan exposure, defaults and arrears (if any) would also help MFIs avoid risky borrowers. The authors quote CREDITREF, the centralized microfinance credit bureau in Guatemala as an example of a successful credit bureau.
  2. Improving Product Design: Financial services and products should be designed keeping in mind the landscape of low-income market. In the case of an unstable political set-up, the products should account for crisis that may arise due to political reasons. In a similar manner, frequent risks associated with natural disasters (eg: floods, droughts, etc) should also be accounted for. Such products in general would help overcome screening and monitoring cost constraints. To explain this, the study cites the example of the weather index insurance product devised by the Indian microfinance organization, BASIX in association with the Indian general insurance company, ICICI Lombard, where the payout is made to clients when rainfall exceeds a certain amount pre-specified in the contract. This differs from traditional weather insurance products in that it is no longer dependent on information specific to the farmer covered and hence the associated administrative and monitoring costs are reduced.
  3. Mitigating the Cost of Capital: Capital constraints impede financial service providers from expanding financial services to areas with low levels of access. One of the models (p11) suggested to overcome capital constraints is partnership between banks and MFIs where the bank has direct contract with the borrowers and MFIs manage collection and supervision. The MFI shares risk on the portfolio with the bank through a guarantee structure. This also creates incentives for the MFI to perform well. Several examples of such existing partnerships are provided on page 12 of the report.
  4. Mitigating Distribution and Marketing Costs: Leveraging existing telecommunication networks offer low-cost alternatives for MFIs to distribute and market their financial services. Innovations in telecommunications decrease the cost for money transfer substantially in addition making distribution faster, more efficient and more secure. Further, leveraging such networks offers a range of possibilities for MFIs to improve access to money transfer services.

2. Meeting Client Product Demands: The report suggests the need for MFIs to focus on context specific products where applicable and required, such as technology adoption for fishermen, higher yields for farmers, employment related training, etc. Such ‘Integrated lending models’ that include training, health services, advice on legal rights, political education, etc in addition to lowering interest rates strengthen customer loyalty which in turn leads to increased profits for the lenders.

Innovations in the Public Sector:

From a public policy perspective, the role of public officials can be divided into two types – market developing and market enabling roles.

Market developing roles: These consist of building the framework upon which a country can engage in financial transactions. From a financial regulation perspective, government bodies should have prudential regulation of MFIs to mitigate problems of fraud or incompetence and enhance legitimacy of operations. There has to be stringent regulations demanding transparency of all MFIs (i.e disclosure of all MFI activities, risk management and financial health). Policies should promote competition, easy of entry and lower barriers to expansion for MFIs and also implement controls to prevent system-wide over-lending. Further, the government should also focus on policies that improve information and communications technology and transport infrastructure quality as this could reduce overall cost of doing business for MFIs, including information gathering and transaction costs. Public credit registries that provide more universal information for consumers and small businesses should be set up by the government. In addition, the government should facilitate infrastructure like the automated clearinghouse (ACH) for exchanging payment instructions and settling obligations electronically.

Market Enabling Role: The report suggests that the governments could either adopt a ‘soft’ approach by leveraging existing private MFI actors or take direct ownership of banks to deploy market-oriented strategies that expand access of financial services to non-included areas. Governments should be careful about grants and subsidies as these tend to impede competition and expansion in a market driven economy. One option would be to reserve grants strictly for geographical expansion of financial activity into poor and unserved areas to avoid undermining competitive markets. Public credit guarantee systems where the government pledges to guarantee loans given to a particular group of borrowers also helps expand access to credit for sections of the population which otherwise do not have access to formal financial services. Governments should also play an effective role in bringing private sector actors together to work together towards the common goal of expanding financial access.

The report concludes that to improve broadband access to financial services – beyond credit and into other products such as savings, insurance and money transfer services – product and process innovations should be accompanied with strong market enabling and development public sector initiatives.

By Bharathi Ram, Research Assistant

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