In a blog post titled “The Rigidity of Microfinance,” Eva Pereira discusses how the structure of microfinance loans inherently stifle risk-taking among clients:
Compared to loans in developed countries, microloans have far shorter repayment cycles, oftentimes as short as a week. In Field’s 2009 study she analyzed the effects of allowing borrowers a two month grace period before repayments began. The study aimed to find out how borrowers would behave without the looming burden of an immediate debt repayment.
As it turns out, borrowers were more likely to start new businesses or invest in existing ones given the two month grace period. Exactly as they had suspected, with the immediate burden of liquidity gone, borrowers put their money into projects with higher profit expectations. While profits overall were substantially higher, the variability of outcomes increased. The high risk, high return bet did not pay off for all. Baseline default rates went from 3% to 11% after grace periods were introduced.
In an effort to stress the importance of having realistic expectations, Field drew comparisons to entrepreneurs in the first world, where as many as one in three startups fail. The rewards for success may have long term residual value for the proprietor and the community. Under the previous model of condensed repayment cycles, the loans had very little impact on the average incomes of the poor. The liquidity demands of the loans made it risky to invest in entrepreneurial ventures.
This is basically one of the core criticisms of microfinance. By focusing on small loans, tight repayment cycles, and high interest rates, microfinance institutions make achieving scale in a business very difficult. Entrepreneurs with the skills to create sustainable businesses that produce jobs are unfortunately subject to the same loan restrictions as those who do not have those skills. There isn’t much diversity in the loan products of microfinance institutions, and it is a problem.
For one thing, having multiple loan products that are tailored toward different types of clients is difficult. The loan officers must be trained to identify and support successful entrepreneurs and provide them with a more flexible loan. Currently, loan officers at most microfinance institutions are underpaid and overworked. Adding another level of complexity to their job might cause service to the clients to suffer. One solution to this problem is creating a loan officer position that is focused entirely on a particular type of client and loan. At NWTF, the microfinance institution I worked for in the Philippines, successful clients that require higher loan sizes are promoted from the microfinance program to the commercial bank, which has different criteria for loans and high caps on the size.
Another problem with Fields’ proposed adjustment to the loan structure is that the default rate is simply too high. A 3% default rate, which is typical under the current loan structure, is acceptable, but not great. An 11% default rate, which is the result of the proposed loan structure, is unsustainable. That is enough to send the microfinance institution into a downward spiral that could lead to bankruptcy. If one out of every ten clients fails to pay back their loan, other clients will assume that the institution is approaching insolvency and will be more likely to withhold payment also. Think It’s a Wonderful Life, if the Bailey Savings and Loan were a microfinance institution.
In closing, Pereira summarizes:
These findings shed light on the fact that there’s no one size fits all solution. Credit extensions to the poor which intend to do good, often stifle real economic growth because of their rigidity. Perhaps there’s a need for a sub-class of loans to address the needs of entrepreneurs with viable business plans. While success is never a sure thing, those with sustainable, long term business plans would greatly benefit from the more flexible loans. This will require prudent lending by microfinance institutions (and possibly regulatory oversight) but could unlock the potential for long term, sustainable economic growth.
It is true that there is an unfilled gap between micro-entrepreneurs and bankable businesses. Clients that require higher loan amounts and greater flexibility have difficulty finding the right loan product at a microfinance institution. MFIs have programs to serve these clients, but serving them falls outside of their core competency. What is needed is mezzanine level between microfinance institutions and commercial banks. Identifying the right clients may be a challenge and offering them the technical and financial support they need to be successful will be difficult, but Pereira is right to surmise fostering these types of businesses is crucial to sustainable economic growth.