The Right Conditions for Microfinance

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.

  1. 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.)

  1. 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.

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5 comments for “The Right Conditions for Microfinance

  1. May 4, 2010 at 1:51 pm

    How about a high poverty rate and financial literacy of potential clients?

  2. May 4, 2010 at 8:05 pm

    A high poverty rate is important (I updated my post), but the exact level depends on the MFI. Some MFIs try to target clients below the poverty line, while others will accept the vulnerable non-poor, who are less risky and tend to have higher repayment rates.

    As for financial literacy, that isn’t as much of an issue. Very few microfinance clients are financially literate when they first start taking loans. That is why there is a push for education and training among microfinance clients (the barefoot mba, etc.)

  3. May 5, 2010 at 8:07 am

    I agree the level of poverty is subjective, but at the end of the day, microfinance is for the poor, whether they are destitute or slightly better off. In fact, I read someplace that enterprising students can also form a target market for MFIs.

    Perhaps financial literacy isn’t a pre-req, yet the varying success levels of mobile banking in Kenya and Tanzania was, among other factors, dependent on the differences in financial literacy between the two countries. Complicated products may penetrate slightly sophisticated markets quickly.

  4. May 5, 2010 at 10:48 pm

    I agree with you on both points. The big question nowadays is how far upmarket microfinance institutions can go before they are no longer adhering to the social mission. Financial literacy is also important. The stronger the existing foundation, the more likely something is to be adopted and stick. In the Philippines, mobile banking has picked up simply because everyone is already texting each other non-stop, so their familiarity with mobile technology is already high. The key is taking advantage where financial literacy exists and teaching it where it does not. Always appreciate the comments.

  5. May 23, 2012 at 11:06 pm

    Tom, I won’t reply directly now to your other two rcenet comments, because they go to the heart of the matter in ways I hope to pick up in my posts yet to come. However, I will reply directly to this comment. While I am open to finding otherwise as The Evidence Project unfolds, I’ll share that I am fairly well convinced by evidence to date that microfinance indeed can play a measureable role in ending extreme poverty globally. The operative words are in italics. Measurable allows a lot of latitude, from statistically significant but not programmatically significant to being a major factor in moving the needle. And extreme refers to the absolute poverty that manifests as inability to meet the most basic human needs consistently through the year. We’ll always have relative poverty, but I’m convinced that absolute or extreme poverty can be dramatically reduced (but never eradicated as long as there are natural and man-made disasters and more subtle evils stalking the world we won’t have to go to a museum to find it, but theoretically it could be rare). Microfinance, even if it does nothing more than help the poor smooth consumption and achieve food security, is very likely to be an important, if not major, contributor. Right now, I’d bet a lot of money (I’ve already bet my career!) that the evidence will eventually show that it will be major. However, there is a lot that must be done to and with microfinance to make its role in poverty reduction major, not just barely measurable.- Chris

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