Microfinance serves as a poverty alleviation tool, providing the poor with access to financial inclusion services. Those in poverty need such services to act as a safety net when topping up insufficient income, managing contingencies, planning for the future or trying to increase income through enterprise. Unfortunately, because of their inability to provide credit history or collateral, as well as the high transactional costs of the small loans required by those in poverty, mainstream banks are reluctant to serve this group. Chemin (2008) explains that:
Lending to a borrower [without knowing] if his project is good or bad… is the adverse selection problem. The moral hazard problem is that once you have lent the money, you still don’t know if the borrower will successfully realise the project (ex-ante moral hazard) and if he does succeed in his project, whether he will want to repay or take the money and run (ex-post moral hazard). Regular monitoring… is expensive and not practical for the small scale of loans given by a lender.
In response to such challenges, microfinance institutions (MFIs) typically target women (who have been associated with higher repayment rates than men) and promote group lending, which creates a joint liability, encouraging repayment through social capital and regular, public repayments (Yunus, 2010). Governments are responsible for general society including those in poverty, so it is in their best interests to work with MFIs, which may be in a better position to provide suitable financial services e.g. microcredit, savings, insurance and non-financial services such as education, training or healthcare. This paper will explore the way that governments work with MFIs by discussing their contributions in two capacities; as investors and as regulators of the microfinance sector.
Muhammad Yunus’s Grameen Bank serves as the poster child for MFIs. Since its inception in Bangladesh in 1976, Grameen Bank has provided loans of $9.1 billion to the poor across 37 countries. This success is partially owed to infancy subsidies from the Bangladesh Bank. Just 23% of the world’s MFIs operate without subsidies, which implies that MFIs still rely on governments to fund them against challenges such as the administrative costs of processing small loans. In addition, government funding may be viewed as a way to protect MFIs from mission drift via private investment. The expectation is that governments will maintain concerns for the poor, while for-profit investors may make financial gains a priority and ignore the needs of the poor. This concern was illustrated in the 2007 initial public offering of Mexican MFI Banco Compartamos, which enriched wealthy private investors with returns of over 50%, generated from charging interest rates of 86% to those in poverty. Grameen Bank on the other hand, received subsidies for interest rates charged to clients while obtaining commercial finance. They sold bonds guaranteed by government without delegating all costs to clients. As shown in figures 1 and 2, there was no stark difference between the gross loan portfolios of each MFI, yet Grameen’s outreach with the support of government as well as commercial finance, was almost three times the amount of Banco Compartamos’ outreach.
Figure 1 – Grameen Bank Overview
Figure 2 – Banco Compartamos Overview
Source: MIX Market
Grameen Bank still receives concessional rates from the Bangladesh Bank, despite operating at arms-length and even clashing with Bangladeshi politicians in some instances. This shows the ability of government to fund MFI’s while offering them autonomy. On the other hand, it also implies that MFIs risk crossing political boundaries. In Uganda, some politicians have been found to use Savings and Credit Cooperative Organization (SACCO) programmes to foster support for their parties. The Ministry of Microfinance channels money to the community through SACCOs so that community groups can borrow money for agricultural activities or business at interest rates of 9% and 13% respectively. The funds are targeted at all people, but political parties have been found to coerce voters by claiming that only their supporters are eligible for the funds. In Bangladesh, loans were found to subsidise well-off, politically-connected entrepreneurs rather than those in poverty. As a solution, MFIs have kept at arm’s length from government involvement, and most programs are run by NGOs, free of many of the political biases of earlier subsidised programs. This has also been the case in Uganda, where Village Savings and Loans Associations (VSLAs) have become the preference because they offer members more control and security over their contributions. However, many borrowers have been found to demand greater security of their collective funds and increased access to larger loans once the VSLAs are established. So they turn to MFIs, which until recently have operated under a liberal microfinance policy with little regard for client protection. This will be explored further in the next section on regulations.
Another concern with government investment is the potential for it to end. Rhyne (1998) explains that governments are unlikely to subsidise MFIs indefinitely and not on a major scale. This was experienced by Community Development Finance Institutions (CDFIs) in 2008, when the UK Government’s Phoenix Fund, which acted as a subsidy and enabled CDFI’s to issue enterprise loans at low interest rates, was discontinued. CDFIs then faced mission drift as their need to achieve ﬁnancial sustainability surpassed their initial social outreach priorities. Lack of subsidies affects social performance differently across regions. D’Espallier et al. (2013) found that:
- African and Asian unsubsidised MFIs charge higher interest rates (in Africa, this is by more than 50% above those charged by subsidised MFIs)
- Latin American unsubsidised MFIs serve fewer women
- Eastern European and Central Asian unsubsidised MFIs serve less poor clients
In each region, the outcome is the same; a group of potential borrowers become financially excluded due to lack of funding. This shows that despite the aforementioned risks of government funding, it plays a fundamental role in the outreach of MFIs, which makes government contributions pivotal. If MFI programs lose government funding, they will face closing down, mission drift or cross-subsidisation (Morduch, 2000).
MFIs have various organisational structures and may operate as NGOs, banks, credit cooperatives or non-bank financial institutions. This implies some challenge in creating a universal conceptual governance framework, which is needed to manage the principle-agent relationship effectively by aligning the objectives of investors with those of MFI managers. Nonetheless, a 1998 survey of the microfinance industry reported that “the objectives and performance of MFIs organised under different legal forms do not differ substantially” (Hartarska, 2005), nor do the financial, operational, compliance and strategic risks, as found by Ernst and Young (2014). Risks such as over-indebtedness are prevalent across the microfinance industry and with the increasing use of mobile banking, cyber-crime risks will appear across the different MFIs also. Ernst and Young (2014) explain the direct link between an effective governance framework and mitigation of risks:
If executed correctly, a risk management program can be a driver of growth and business performance, enabling an entity to take better recognised risks and achieve its objectives of financial inclusion.
Government regulations can provide guidance for effective policies to be produced and are best placed to encapsulate country-specific characteristics such as level of development and institutional capacities. As already mentioned, there was a liberal microfinance policy in Uganda until recently. The 4-tier system (Figure 3), aimed at sector growth and integration into the formal financial system, provided for both regulated and unregulated institutions to co-exist, as well as formal and informal institutions. Banks and credit institutions, which are highly regulated and supervised by the Bank of Uganda, occupy the first two tiers. The third tier, composed of Micro Deposit-taking Institutions (MDIs), was created by a 2003 Act to allow the largest MFIs to submit themselves to full supervision in exchange for the ability to accept and on-lend deposits from the general public. Tier 4 however, lacked regulation so practically anyone could call themselves an MFI – including loan sharks and money lenders. This led to a lack of trust in MFIs, with some informal ones stealing from borrowers and committing fraud. In 2016, the Ugandan government passed the Tier 4 Act, which will allow for all MFIs to be formally regulated and supervised, as well as distinguishing between MFIs and money lenders. This Act is expected to improve financial security, quality of service including consumer protection and socio-economic development and increase financial inclusion across the population.
Figure 3 – Uganda’s 4-Tier Microfinance System
Source – Bank of Uganda, 2014
The need for government intervention was also highlighted in Bosnia and Herzegovina, where laws governing banking and non-bank financial institutions and the oversight of these institutions, are decentralised and held by the two administrative entities, the Federation of Bosnia and Herzegovina (FBH) and the Serbian Republic of Bosnia (SRB). The autonomy to create differing regulatory frameworks between the FHB and SRB highlighted the need to create a single state-level banking regulator to protect the interests of the clientele and the legitimacy of the sector. At the turn of the century, the Bosnian microfinance sector grew rapidly from foreign investments and debt financing from local commercial banks and as a result became profitable and largely self-sustaining, though increasingly competitive. MFIs responded to increasing competitive pressure by increasing maximum loan amounts, widening loan purposes and introducing new products such as consumer loans. In the absence of a centralised credit bureau until 2008, this led to relatively high levels of cross‐ and over‐indebtedness among MFI borrowers. The economic crisis of 2008 increased the problem of indebtedness, resulting in high default rates, a decline in portfolio size and negative returns for foreign investors. Since 2008, the USAID-sponsored initiative PARE (Partnership for Advancing Reforms in the Economy) and similar initiatives such as the Microfinance Law of 2007, which enables state banking agencies to supervise micro credit and leasing companies, were established to facilitate the development of state-level banking regulations and the formation of a single state-level banking regulator in Bosnia.
Both Uganda and Bosnia and Herzegovina welcomed government regulations to ‘save’ their microfinance sectors. Such interventions however, are not always welcome. The Andhra Pradesh crisis in India was characterised by stress and even multiple suicides amongst over-indebted microfinance borrowers as a result of coercive lending and recovery methods used by loan officers, who were under immense pressure to compete with an over-supply of MFI’s in the region. The government intervened by forbidding operations to be carried out if an MFI wasn’t registered with them and in some cases politicians encouraged borrowers not to repay loans. The impact on the microfinance industry was devastating, with default rates surging and cash flow drying up, which ultimately affected borrowers by curtailing their access to credit. This is an example of the need for government to look at the bigger picture when considering client protection. For example, Morduch (2000) found that despite the regular public outcry regarding high microfinance interest rates, the poor require access to credit, not “cheap” credit. This was echoed by Kevin Cadman, CEO of Grameen UK (2016), who argues that an APR of 100% could amount to £15, so critics should assess the amount that borrowers pay in cash before accusing MFIs of extortion. It is a rarity for microfinance programs to experience significantly altered client demand for their loan products as a result of increasing interest rates (Rhyne 1998), which could be why there is no usury law in the UK and the onus is instead on nonmonetary accountability based on reputation and joint liability mechanisms.
As the social economy evolves, so does the potential for the microfinance market to grow and better meet the needs of those who are financially excluded through non-financial services, product diversification, client protection and initiatives to combat adverse selection and moral hazard. It is apparent that governments are best kept at arms-length, but measured contributions are pivotal to the success of the microfinance industry, which lacks an overseeing body to finance, regulate or endorse the various forms of MFI. As a representative of society and a source of funding, governments are best placed to provide the foundations to promote transparency, drive growth and improve legitimacy within the microfinance sector.