Across the world, there are a lot of poor people. In the developing world, 1.4 billion people live on less than $1.25 USD per day. While this catch-all gives an idea of who is struggling to get by, the impoverished are stratified in terms of desperation. Some live in extreme poverty, racked by hunger and disease with little hope of “pulling themselves up by their bootstraps.” Combating this type of poverty requires humanitarian and development aid. But those higher on the ladder can be served by microfinance institutions. But according to the latest statistics from the Microfinance Exchange (MIX), about 100 million people worldwide receive microfinance loans (these figures are self-reported, and the actual number is much higher). There is still a large underserved population, and microfinance institutions (MFIs) are working to close the gap.
As in any other industry, MFIs have to carefully evaluate areas for expansion. Demographics, geography, infrastructure, and the economy of a region influence the effectiveness of microfinance services. Here is a short list of the conditions that make microfinance a viable approach to development.
- Population Density
The population of a region needs to be concentrated enough to justify having a microfinance program. For one thing, the cost of transportation for the loan officer to visit clients in disparate rural areas is higher than in other places. More importantly, if the population density is low, the microfinance clients will need to travel further to attend weekly center meetings, resulting in lost income from the business, and pay more for transportation. The value proposition for these clients is much lower than for the woman who only needs to walk a few minutes to the center of her village for the meeting each week. Also, the group lending methodology used by most microfinance institutions depends on social collateral. Clients self-organize into small groups and agree to guarantee one another’s loans. In theory, institutions can mitigate the risk of default by making clients accountable for their friends, allowing them to monitor themselves. But when the population density is low, people are less likely to be close with their neighbours. The bonds of friendship that make default a disgrace do not exist, weakening the methodology to the point of failure. (In the United States, this is one of the main problems with using a group lending approach. We Americans are more likely to be islands.)
- Economic Diversity
When economies are too heavily weighted in one industry, they risk collapse when the conditions change. In Detroit, the economic crisis led to the decline of the auto manufacturers, crippling the city. In Iceland, the financial services sector grew 20-fold between 2001 and 2008, causing the country to default on its debt during the meltdown. And in a rural community in the Philippines where 80% of the population derives its income from agriculture, a drought can mean disaster. That is why it is important for MFIs to set up shop in areas with a diverse economy. In the Philippines, the ideal location is a region supported by a range of industries – agriculture, fishing, and manufacturing to name a few. If the clients of an MFI are too focused in one area, a collapse in the industry can lead to massive loan default. At that point, it becomes a negative feedback loop. Greater default causes clients to question the solvency of the MFI, leading them to withhold their repayments out of fear that they will not get another loan. Ultimately, it can drive the unprepared MFI into bankruptcy.
These are just two of the conditions an MFI must consider when looking to expand. Institutions need to take into account the types of businesses, poverty level, infrastructure (roads, electrification), etc. Like any business, it is important that the decision is informed.