Growing microfinance: Going beyond conventional banking

Microfinance is now a widely accepted tool that has a significant role to play in the eradication of poverty. The success of Grameen Bank and several other entities has been a catalyst for the microfinance industry’s growth worldwide. Even though this funding tool is growing at a substantial rate in Africa, it faces many challenges. The Microfinance Information Exchange reports that operating expenses in sub-Saharan Africa remain among the highest in the world. The report also says returns for microfinance in the region are falling and portfolio-at-risk is rising. High operating expenses are particularly common where skilled labor is scarce and labor costs are rapidly increasing. A large percentage of microcredit in sub-Saharan Africa is still funded by outside parties in the form of grants. Therefore, while microfinance is based on the concept of sustainable financing and the empowerment of people through loans, funding these loans via grants is not sustainable. The industry needs to shift from nonprofit to profitable or at least utilize equity and self-funding models. This requires a thorough and innovative examination of the industry from new perspectives. Current challenges Financial institutions in sub-Saharan Africa are reporting that in some cases, 25 percent of clients enter arrears during the loan term and that the portfolio-at-risk ratios in the region are the highest globally. Most providers, therefore, focus their efforts on seeking low-risk clients — those who are likely to repay — based on their credit history and available collateral. Research has not been focused on finding new ways to ensure that high-risk clients do repay but rather on increasing the predictive ability of credit-scoring models in order to avoid risky clients altogether. This reduces people’s access to financing and discounts potentially profitable markets. Another road block to industry growth is that creditors are not partnering with clients in finding solutions to repayment hurdles. At the recent launch of “Advocates for Change: How to Overcome Africa’s Challenges,” a book he edited, Moeletsi Mbeki said that South Africa continues to approach problems with a hardened stance rather than partnership. Similarly, many banks’ attitudes when talking to clients about debt is often intimidating, which leaves little room for seeking out ways to restructure the payment scheme and help clients meet their obligations. On the other hand, financial providers who take on a solution-seeking approach are likely to find innovative ways to ensure that loans are repaid. Also, conventional banks continue to use the same risk assessment methods for microlending as they do for large borrowers. They assume that the causes of default in microlending are the same as those for conventional borrowers. Furthermore, most credit-scoring models are based on Western models developed in countries where the cultural, social, political and economic environments are different from Africa. The high number of portfolios-at-risk in sub-Saharan Africa — despite strict credit rating and risk assessment — suggest that attempting to limit financing to low-risk clients may not be the most appropriate approach for microcredit and providers should identify other ways to increase repayment rates from both low and high-risk clients. Potential solutions Some quarters are suggesting what could be seen as unconventional solutions to these challenges, among them the use of psychological tests as predictors of risk. Several South African financial institutions have investigated the potential of this method: One study showed a correlation between a client’s “honesty” and default risk. Honesty was first measured among entrepreneurs through a psychometric test. The results were then analyzed and correlated to their repayment behavior. The test could either replace or supplement conventional credit-scoring models and be embedded in traditional banking models. One issue with this approach is that psychometric tests are often used to reject high-risk loan applicants, which contradicts the goal of increasing access to finance. Another problems is the assumption that honesty is the best predictor of the ability to repay a loan. While honesty might be a significant factor in Western societies, it may not be the most accurate measurement in places where honesty is not similarly valued. Despite these concerns, the idea that psychological factors can determine risk potential and that such tests can improve microlending models is worth looking at. Further research could give us answers on which psychological examinations or indicators should be utilized in emerging economies. Studies could also examine how assessors can build these tests into business models in order for so-called high-risk loan applicants to be included in the risk assessment process and, most importantly, help find ways to ensure they are able to pay. Cultural and societal approaches Another possible solution would be to abandon the credit-scoring methodology entirely and create a business model based on cultural, traditional and socio-economic factors. The most famous example of the enormous potential of this approach is Grameen Bank. Its success is rooted in its business model, which turned the conventional banking model on its head. Using solidarity groups — those who borrow collectively and encourage members to repay — Grameen eliminated the need for credit history, credit scoring and collateral. The bank’s success hinged on a group of mostly women and a morally binding system that guaranteed repayment. Solidarity lending paved the way for cultural and possibly gender-based factors to determine the women’s ability to make the payments. This way, clients who may have been high-risk creditors individually were given access to credit. Many financial providers who were quick to establish microlending portfolios after Grameen’s success have fallen short because they failed to appreciate the mechanics of Grameen’s model and the specific social predispositions it was based on. Financial institutions in Africa clearly understand the importance of inclusive financing. Not only does it have the potential to address poverty and stimulate economic growth but it could be a key driver of revenue and profit by tapping into new client bases and markets. In order to find true success, there are several actions that nongovernmental organizations, conventional banks, other microfinance institutions and their partners can take: - First, a body of quantitative and qualitative research needs to be gathered so actors can fully grasp the psychological, societal and cultural factors behind repayment behavior across countries and regions. Partnerships between conventional banks, NGOs and academic institutions can spearhead the research. - Second, the microfinance industry needs to honestly examine its current business models and compare them to those of Grameen Bank and other similar organizations. - Finally, and most importantly, partnerships are needed to shift the mindset from maximizing profit to finding unique solutions in order to engage untapped clients and markets. Progressive thinking will lead to groundbreaking business models that would truly enable microfinance to fulfill its mission of eradicating poverty. Read more: - Distinguishing Microcredit From Microfinance - Microfinance: What You Need to Know - Wanted: Microfinance Partners in Latin America