Microfinance: Part 1: little but mighty

RMA Journal, The, May, 2004 by Gail Buyske

Think of a small business loan. Then think smaller. Think of a business loan so small that a $75 million community bank might be tempted to turn its nose up at it. This two-part article evaluates the relevance of microfinance for U.S. lenders. Part 1 offers a definition of microfinance, the status of microfinance in developing economies, and the characteristics of developing countries that facilitate microfinance. Part 2 presents the keys to successful microfinance lending, other developments in the U.S. and international microfinance field, and what major international banks are already doing in microfinance.

Microfinance sometimes seems like one of those trendy topics that you notice in the popular press but that often disconnects from a banker's sense of reality. How can Financiera Compartamos in Mexico, as one example, have a $42 million microfinance loan portfolio with a past-due Joan ratio of 1.1% (1) when we know that developing economies often suffer from weak banking systems, corrupt business cultures, and imperfect property rights? It's quite a leap of faith to believe that microfinance lenders in such countries can achieve better results than many American banks can hope for in their Community Reinvestment Act (CRA) lending.

That said, there are reasons to take a closer look at microfinance:

* The extensive experience of the international microfinance market in serving low-income and poor populations provides potential lessons for the U.S. market as well, where microenterprise employment is estimated to account for 16.6% of all private (nonfarm) employment. (2) While it is important not to exaggerate the similarities between international and U.S. microfinance, it would be equally wrong to disregard the advances that are taking place internationally.

* For lenders operating in international markets, the microfinance field is important to understand as a potential means of expanding their client base, as a source of correspondent banking and capital markets business, and as a valuable vehicle for generating goodwill.

Microfinance Defined

The term microfinance as used here refers to financial services for the poor and lower-income sectors of the population. Most microfinance loans range in size from a few dollars up to several thousand dollars, with a standard loan in the $300 to $1,000 range. Loans typically are used for working capital and have maturities of under one year, although longer-term products are also sometimes available. Borrowers range in size from the self-employed to enterprises with up to five or even 10 employees.

Microfinance sometimes generates confusion for nonspecialists because there are two microfinance models. The model that will be emphasized in this article is based on lending to single borrowers using principles familiar to most lenders.

The other main microfinance model, and the one that has captured the public imagination, is the group-lending model originated by Grameen Bank of Bangladesh and its charismatic founder, Muhammad Yunus, on the basis of a $27 loan that he made to 42 basket weavers in 1976. (3) The defining characteristic of group lending is that all group members are responsible for the timely repayment of any loan made to any single member of that group. This model therefore internalizes risk diversification and monitoring into the structure of the loan. It also mitigates the difficulties of securing adequate collateral, because the group lending structure provides the secondary source of repayment if collateral fails. One of the great legacies of this model is the fact that the poor can be very reliable borrowers.

There is much debate within the microfinance field about the pros and cons of the individual-lending versus the group-lending model. In fact, the models are similar in every way except for the definition of the borrower--that is, a group or an individual.

It is important to differentiate at the outset between the microfinance markets in developing countries and the U.S. It would not be an exaggeration to say that microfinance has revolutionized the field of poverty alleviation in developing countries, as demonstrated by the fact that today there are over 68 million microfinance borrowers worldwide--an almost fivefold increase over the past six years. (4) Loans outstanding are estimated to be $16 billion with an average outstanding of $400. (5) Approximately one-third of these loans are made by commercial banks, one-third by cooperative banks and credit unions, and one-third by specialized microfinance institutions. (6) The enormous outreach indicated by this data is a clear testament to microfinance's two great advantages as a development tool: Its resources are reusable, since they are provided in the form of loans, and microfinance offers the poor an opportunity to help themselves.

The U.S. microfinance market began its development later than the international market; one of the key dates is 1991. when the Small Business Administration (SBA) Microloan Demonstration project was legislated and the first association of American microfinance intermediaries was created. The potential market for microfinance is smaller in the U.S. and, because of the higher cost of operating a business in a mature economy, the size of microfinance loans tends to be higher--the average loan extended tinder the SBA Microloan Program is $11,670. Operating a micro business is also more complicated in the U.S.; in fact, one of the important lessons learned in microfinance domestically is that training is a significant factor in success. Microfinance in the U.S. has historically been largely the province of nonprofits; the involvement of banks is typically in the form of loans or grants to these nonprofits, often for CRA purposes. The U.S. microfinance market will be discussed in more detail in Part 2.