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  • The Lending Hand


    A woodworker in Guatemala hopes to expand his small furniture-making business by acquiring electric tools. A maid in Ecuador dreams of establishing a craft stand to ensure her economic independence and her children’s future. A young woman in western Africa wants to open her own hair salon. None has a credit history, none has collateral, but all have workable ideas and a need for capital to make their business dream a reality.

    For John Choi, a 1996 accountancy graduate, these stories have a very familiar ring to them. As a managing director for World Relief in Kosovo from 2002 until 2005, Choi was responsible for the organization’s local microfinance program. Like thousands of other microfinance organizations around the world, the program’s goal is to provide small loans to help the poor establish or expand a business. And like the thousands of workers who assist these low-income entrepreneurs, Choi saw firsthand the opportunities and challenges of providing microfinance services.

    “Microfinance can open the door to economic self-sufficiency for people in poverty,” says Choi. “But it’s a challenging environment administratively because there’s so much complexity. Each country or region has unique issues. Some are cultural, others revolve around market size or average income, and still others relate to different economic systems, the political climate, or corruption. And all of these impact the approach you can take to lending, even when the loans are small.”

    And when Choi says “small,” he means it. Although in Kosovo $1,000 loans are average, globally loans of $50, $75, and $100 are more common in microfinance. While these amounts meet the needs of the low-income borrowers, managing loans of such a small size adds another level of complexity. It’s also one of the reasons why banks have not served this market—that and the lack of a credit history or any collateral.

    “Banks want to lend to people they know something about,” says Don Fullerton, visiting professor of finance at Illinois and a public policy specialist. “When they’re missing key information, there is a market failure. People who don’t fit the typical borrowing profile don’t have a chance to take advantage of the opportunities that a loan could bring them, and lenders miss the opportunities to grow their business, too.”

    This market failure has opened a door, and microfinance has put out the welcome mat.

    A Borrowing Breakthrough

    Microfinance has its roots in an experiment initiated by Muhammad Yunus in the 1970s during a famine in Bangladesh. To assist villagers living near the university where he taught economics, he started lending to them from his own pocket. When he saw the opportunities this opened up to the villagers and how reliable they were in repaying the small loans, he looked for ways to replicate the idea beyond one village.

    That was the beginning of the Grameen Bank, which expanded the practice of lending to the very poor at reasonable rates of interest without requiring collateral. In 2006, the Grameen Bank and Yunus were awarded the Nobel Peace Prize to recognize the contributions these efforts have made in alleviating poverty.

    Group lending was at the heart of the Grameen Bank’s philosophy and continues to be a model that microfinance institutions (MFIs) emulate. It works like this. The MFI offers the poorest villagers loans for their individual business projects, requiring that they form a group of three or four other villagers who seek similar loans. One of the stipulations of the loans is that if one of the borrowers in the group is unable to repay, all the members in the group lose their membership in the MFI’s bank.

    “This type of a loan contract means peers are monitoring each other— in effect, they’re co-signing for each other,” says George Pennacchi, professor of finance, who introduces microfinance concepts in his course on fixed income securities. “Group lending can be successful in a society where people have frequent contact and established ties. It creates incentives within the group that guarantee high repayment rates without constant monitoring by the MFI, and that’s another key to success because it keeps administrative costs down.”

    More Than Economics

    While microfinance certainly is an economic tool, both in terms of opportunities for borrowers and lenders, for most MFIs it has a social mission as well—to help alleviate poverty, and sometimes to change minds.

    Choi tells the story of one of his borrowers, a Serbian candymaker in Gracanica, a village in Kosovo that transformed into an enclave for minority Serbs after the war. With his recipe for Turkish Delights and a series of loans from World Relief, Sasha grew his business from a small venture in his kitchen to a manufacturing plant that sells tons of candy each year, both inside and outside his country.

    “There was a very important additional benefit beyond economic development and entrepreneurship in this case,” says Choi. “Albanians wanted to buy his product but at first did not want to do business with a Serb. His program served as a liaison between Serbian and Albanian business people until business transactions became common enough for them to comfortably interact. Economics has a way of overcoming prejudice and bringing individuals with differences together for a common goal.”

    Bringing the poor into the borrowing process also creates opportunities to teach other lessons, like improving financial literacy regarding repayment, contracts, and credit and educating borrowers about other financial services like savings and insurance.

    Raise the Roof - Housing and Microfinance

    One limitation of the microfinance industry has been what Patrick Kelley, director of international housing finance for Habitat for Humanity and a 1994 accountancy graduate, refers to as “the mono-product mentality” of only providing microbusiness loans.

    But that trend is beginning to change. “Although microenterprise loans still make up the bulk of the industry, the microfinance sector is maturing,” he explains. “Housing is an emerging product offering, especially in Latin America, as are insurance products, more sophisticated savings products, and remittance services. It’s important that these financial products be mainstreamed by microfinance service providers to expand access to the diversified financial services that the developed world takes for granted. In some poorer countries, commercial banks often serve only a minority elite of the top decile of the population or less. With such limited access, many have no financial service other than hiding away savings under their mattress.”

    A New Approach for a New Market

    The initial forays into housing microfinance have focused on working with the clientele of an existing microfinance institution (MFI). Much of the process is the same as with microenterprise loans, with the big difference being an evolution to longer-term loans.

    “To address the massive need for housing, we have to be ready to think outside the box,” Kelley says. “One way Habitat is seeking to accelerate the development of housing product offerings is by serving as a second-tier financier for those who work with the poor. That could be MFIs, other financial retailers, or even commercial banks, depending on the country. We also intervene by helping MFIs do market research and make linkages with the construction support industries to develop a successful housing product. This type of innovation can help break through some of the systemic market failures that make poverty housing so pervasive in many developing world countries.”

    And because housing loans have cash flow implications for a family that are different from microenterprise borrowing, Habitat has partnered with Citi to offer financial literacy training for borrowers. “With an increasing need to consider future cash flows and to understand budgeting, educating our clients is especially important to ensure successful outcomes,” Kelley explains.

    Joint research between Habitat and ACCION, an MFI that has been engaged in microlending for 40 years, has shown that housing finance products in Latin America are in high demand and can be profitable. It’s likely that this will be true in other areas of the world as well. “There will definitely be a learning curve here, and the initiative will require an investment in institutional structures, but that is something that Habitat is committed to.”

    Does Microfinance Deliver?

    With so many obvious economic and social benefits, what’s the downside? Some critics, like Thomas Dichter, the author of Despite Good Intentions: Why Development Assistance to the Third World Has Failed, believe microfinance hasn’t lived up to its billing—that while efforts to relieve poverty are well-intentioned, they are largely ineffective and that there is little more than anecdotal evidence to back them up.

    While hard data might have been lacking in the past, efforts by the Microfinance Information Exchange (MIX) is changing that. The MIX was established as a non-profit private company in 2002 by a group of donors, investors, and philanthropists who saw the critical need for reliable, comparable, and publicly available information on microfinance.

    According to Blaine Stephens, director of analysis for the MIX, “Until 10 years ago the data was all anecdotal, but now we have the hard numbers to speak very specifically about the trends in growth of borrowers and savers, about expected returns, and about how efficient the MFIs are.”

    He admits, however, that “it is much trickier and a much slower trek to measure social performance than financial data, but there is a great deal of work going on right now in social performance management to help us track clients and their progress. There is additional research that is attempting to assess impact. For instance, a study by Dean Karlan and Jonathan Zinman in South Africa shows that borrowers randomly assigned loans from a pool of applicants did better at keeping their jobs, were less likely to go hungry, and were 19% less likely to fall into poverty after 6 to 12 months. Studies like this need to be replicated. Assessing impact is a work in progress.”

    Another criticism is that microfinance doesn’t deliver on the promise of entrepreneurship. Pennacchi disagrees. “Just because it doesn’t create the type of entrepreneurship that we think of in the developed world doesn’t mean microfinance lacks an economic impact. You don’t have to create full-scale businesses to improve economies over time. It’s hard to measure the economic impact of improving someone’s life. When children get an education because the loans create an entrepreneurial activity that relieves the burden on the family enough to send the children to school, how can you quantify that? We might not be able to put a hard number to it, but we know education improves economies.”

    Dichter and other critics also say microfinance isn’t enough to alleviate poverty. And on that point, they’ll find lots of agreement. “It’s important that microfinance programs are not oversold as a cureall for poverty,” says Pennacchi. “They are only part of the equation.” Fullerton agrees. “There is no single way to provide for the public good,” he says. “Optimal results call for a mix of organizations and approaches.”

    Microfinance professionals know they can’t do it alone. Just ask Patrick Kelley, a 1994 accountancy graduate who worked in microfinance for six years, four in Rwanda, and is now the director of international housing finance for Habitat for Humanity.

    “There is no doubt that microfinance is no poverty panacea, but it certainly complements economic growth and development to create a more inclusive economy,” he says. “However, investments in health, education, infrastructure, and private sector development are also critical strategies for sustainable poverty alleviation and equitable growth. It’s not a matter of ‘either/or’ but of ‘both/and.’”

    What’s Ahead?

    Choi believes that the criticisms are actually helpful to microfinance because they “spur the sector to continue to evaluate how they can improve efficiencies and outcomes.” And as those improvements are made more people are paying attention.

    Where microfinance has largely been an initiative of the nonprofit sector, its success and profit-making potential is beginning to attract other players to the field, including commercial banks and even securities firms. Last May, Morgan Stanley announced it was selling collateralized loan obligations to raise $108 million to support MFIs.

    “The success of MFIs has demonstrated that there is a bankable market to the poor, which has attracted competition,” says Kelley. “This could be good for the poor, but it makes it more difficult for some of the initial demonstrators of that market to maintain their marketshare. Also, with more financial service providers entering the picture, there is the potential for clients to abuse the opportunity and that puts institutional assets at great risk, as we’ve seen in countries like Uganda and Bolivia already. The increasing professionalization of microenterprise creates opportunity, but it will also challenge the industry.”

    Sidebar: Banking on Women

    There are estimates that between 80 and 90 percent of microfinance borrowers are women. In most every country around the world, women have the highest unemployment rates and comprise the majority of the informal economic sector. Add to that their role as primary or sole caretakers in the family, and the need for assistance is obvious.

    Microfinance institutions (MFIs) are addressing that need by targeting services for women. Some, like Pro Mujer in Latin America, are even geared exclusively to providing microfinance services for women. Research indicates that this makes financial sense for the client, the MFI, and the developing country.

    Clients and their families obviously benefit from improved living conditions and opportunity, which can include a greater likelihood that children will receive an education. MFIs benefit by establishing a strong group of reliable borrowers, as women are more tied to the community and household and have higher levels of repayment. And the economies of developing countries benefit because, as research indicates, gender inequalities result in greater poverty, slower economic growth, weaker governance, and a lower standard of living for everyone.

    Sidebar: Do-It-Yourself Lending

    In the 1990s when Sonali Rammohan was an undergraduate at Illinois, she developed a passion for nonprofit management as a finance major and an active volunteer in Alpha Phi Omega, a campus service fraternity. Nearly a decade later, when she moved across the country armed with an MBA and experience in both the private and nonprofit sectors, she began volunteering with Kiva, an organization that links microentrepreneurs with potential donors via their website.

    “To me, microfinance is putting business principles to work to serve a good purpose, a purpose of social entrepreneurship” she says.“I volunteered doing public relations for Kiva, spreading the word about their model, which uses an online platform to directly connect investors with clients. I also became a lender.”

    Kiva makes the lending role simple and allows anyone with an Internet connection to be a microfinance banker.When potential lenders visit the website,, they can view profiles, photos, business proposals, and lending histories of entrepreneurs in developing countries.The information has been vetted by microfinance institutions (MFIs) in each client’s home country.Would-be lenders can choose from among the entrepreneurs featured and use their credit card to provide a loan as small as $25 by using the website. Kiva transfers the loan proceeds to the local MFI, which disburses it to the borrower.The MFI is responsible for collecting the repayment and providing updates to Kiva, which supplies them to the online lenders.When the full amount of a loan has been repaid, the funds are returned to the lender who may withdraw them or re-lend.

    Rammohan made two loans to Ugandan entrepreneurs—a barber who needed a power generator to keep his business operating during electricity shutdowns and a woman who mills and sells maize but needed to hire workers to help her carry the product to market.

    “I chose these borrowers because they were responsible for many family members and had compelling stories of working hard to improve their families’ lives,”Rammohan says.“I am hopeful that their loans will enable them to expand their businesses going forward.”

    Sidebar: Microfinance by the Numbers

    • Half of the world’s population lives on less than $2 a day.
    • Fewer than 2% of poor people have access to financial services from
    sources other than money lenders.
    • More than 2,000 MFIs serve nearly 77 million people in developing
    • Nearly 95% of microfinance borrowers repay their loans.
    • Microfinance borrowing has been growing at a rate of 30% annually.
    • The average loan amount is approximately $400, ranging from $1,000 as an
    average in the former Soviet Union and Eastern Europe to around $100 for
    borrowers in Asia.
    • Interest rates for MFIs average 30% to 31% to cover the cost of small loans
    and weekly repayments. Rates are declining due to increased competition
    and the larger loan balances associated with repeat clients and new
    financial product offerings.Moneylenders often charge double or triple the
    interest rates of MFIs.

    Sources: Unitus;World Bank,Microfinance Information Exchange; The Virtual Library on
    Microcredit;Microbanking Bulletin

    Related Information:

    Perspectives Magazine - Fall 2007 Issue (PDF file)

    Professor George Pennacchi - Faculty Profile

    UIUC College of Business Department of Accountancy