In a previous blog, we explained the importance of financial inclusion in the socio-economic development of people. In addition to access to payment and savings accounts, microfinance forms a key part of financial inclusion. In this blog, we further explore the potential impact of microfinance and the challenges ahead.
By Thomas Maas & Jeroen de Bel of Olympus Advisory Services
Since the 1970s microfinance has steadily grown to a large, mature business reaching millions of people worldwide. In 2016, microfinance institutions (MFIs) worldwide reached 132 million clients with a loan portfolio of USD 102 billion.
And there is still a tremendous untapped market. It is estimated that at least 200 million micro, small, and medium-sized enterprises (MSMEs) in emerging economies have no or insufficient access to credit. There is an estimated gap of USD 2.2 trillion between what these businesses need and the amount of credit currently extended. Demand for financing by smallholder farmers alone is estimated at USD 450 billion, with less than 2% of this need being met.
Microfinance has received much interest for alleviating poverty in low-income countries, while at the same time also being a cost-effective solution to lending to poor households—a win-win situation. Poor households are typically excluded from the formal banking system because of a lack of collateral and official documents, but microfinance enables new contractual structures and organisational forms that reduce the riskiness and costs of making small, uncollateralised loans. It distinguishes itself from traditional charity because of its reciprocal character and its economic sustainability from a business perspective.
Over the past decades, microfinance has proven to be a powerful tool in raising welfare levels of the poor through increased disposable household income. Broader effects on social welfare such as health, nutrition, education and female empowerment, however, are yet to be universally acknowledged. Still, microfinance is commonly accepted as a useful tool to combat poverty in low-income countries.
MFIs, often subsidised by governments and NGOs, have been granting loans, and opening payments and savings accounts, for the last 35 years. Over the course of time, various researchers have tried to assess the impact of microfinance. In 2005 and 2010, the Grameen Foundation published papers summarising the available research thus far, concluding that microfinance improves household income and reduces poverty levels, especially for extreme poverty. Wider benefits regarding empowerment, birth control, nutrition, health and education, however, were not yet established.
Nevertheless, microfinance faces various challenges. While it saw a median return on equity of 8.1% in 2016, the financial viability of microfinance is one of the key issues. Operational expenses are relatively high due to expensive credit risk management processes and relatively small loan portfolios.
During his field trips, Thomas interviewed several MFI managers and executives in Kyrgyzstan, Mongolia and Cambodia. In all countries, the MFIs operated a country-wide brick and mortar network of branches, serving 300 clients per account manager on average. The high frequency of debt rolling over, the number of face-to-face visits to customers mostly in rural areas, and the lack of technology and digitalised data for monitoring customer loans all attributed to relatively high operational expenses. The median operating expense ratio (operating expenses / loan portfolio) for MFIs was 13.1% in 2016 and the portfolio at risk (30 days) 4.7%.
There is a strong link between the MFIs operating model and its financial performance. First, the cost efficiency decreases the more MFIs expand their depth and/or breadth of outreach. This leads to a trade-off in social impact: reaching the most rural clients versus operational efficiency by focussing on easier to reach clients. Reducing the need for face-to-face visits could tip the scale in favour of a larger social impact.
Second, cost efficiency reduces the higher the credit risk of a loan portfolio. The risk-return characteristics of microfinance lending are not in favour of high-risk portfolios because the required interest rates charged for these clients would be far beyond socially acceptable levels. Improvement of credit risk models could enhance the portfolio risk and simultaneously both lower the cost of risk and operational cost of managing risk. For example, alternative data sources can be used and artificial intelligence to better assess risk.
Third, lending more to existing borrowers is more efficient than lending to new customers. There is, however, a trade-off with social impact as fewer people are reached when focussing on existing customers. If MFIs could extend to the most rural areas within a country without opening and maintaining brick-and-mortar branches in remote areas, there would less of a trade-off between efficiency and impact. Using new technology, such as mobile banking, allows MFIs to both reach more customers and offer a wide range of financial services, such as payments and savings accounts and insurance and microloans to expand the business with existing customers.
Fintech could play a vital role in addressing the various operational challenges of MFIs. Fintech is a driver of new distribution models, mobile banking solutions, and alternative and improved credit risk models. Therefore, it could enable MFIs to better reach the 1.7 billion global unbanked population and 200 million MSMEs, helping them to progress out of poverty through a viable business model.
Bos & Millone (2015), Dalberg (2012), Grameen Foundation (2005 & 2010), ING (2016), McKinsey (2016), Microfinance Barometer (2017), Mix (2016), Morduch (2000)
Olympus Advisory Services is a management consulting firm specialized in the financial services sector. It helps clients with insights, market research and strategy consulting, tailoring assistance to clients’ needs and circumstances. The organisation has in-depth knowledge of both the traditional banking sector and new innovative players in the market, and is therefore well positioned to help bridge the gap between incumbents and new entrants.