The Economist, Tom Easton, 3 November 2005
In rich countries, financial services on the whole work remarkably well, despite the exotic salaries, the crackpot deals and the occasional bust. The vast majority of people have access to interest-bearing savings accounts, mortgages at reasonable rates, abundant consumer credit, insurance at premiums that reflect the risk of losses, cheap ways of transferring money, and innumerable sources of capital for funding a business.
By contrast, financial services for poor people in developing countries—a business known as “microfinance”—have mostly been awful or absent. With no safe place to store whatever money they have, the poor bury it, or buy livestock that may die, or invest in jewellery that may be stolen and can be hard to sell. Basic life and property insurance is rarely available. Home loans are costly, if indeed they can be found at all. For many people, the only source of credit is a pawnshop or a moneylender who may charge staggeringly high interest and beat up clients who fail to pay on time. In the Philippines, lenders who zip from town to town on motorcycles expect six pesos back for every five they lend. That translates into an annual interest rate of over 1,000% on a loan for a month.
For workers from poor countries who venture abroad to earn a better living, sending money home to relatives can be hugely expensive. Such remittances have become an important source of income in many developing countries, dwarfing other inflows of capital from overseas such as foreign direct investment and multilateral aid. But if the money is being sent, say, from America to Venezuela, charges can amount to as much as 34% of the sum involved, according to Dilip Ratha of the World Bank.
Why are the poor so badly served? The easy answer, that people who have little money do not make suitable clients for sophisticated financial services, is at most a half-truth. A better explanation, this survey will argue, is that the poor have been hurt by massive market and regulatory failure. Fortunately that failure can be, and increasingly is being, remedied.
In most developing countries, the barriers to providing financial services for the masses are all too clear. Inflation tends to be high and volatile; government is often incompetent; and the necessary legal framework for financial services is often missing. Property laws can make it impossible for poor borrowers to use assets such as their home as collateral for loans.
In the past, many countries have outlawed “usury”, and today many Islamic countries prohibit the charging of interest. Governments in developing countries often impose caps on the interest rates charged on loans for the poor. Despite their popular appeal, such caps undermine the profitability of lending and thus reduce the supply of loans.
Incomplete and erratic regulation of financial institutions has also undermined the confidence of the poor in the financial services that are available. When they can find an institution that will accept their tiny deposits, it often lacks the sort of government deposit insurance that is routine in rich countries, so when a bank goes under, savers suffer. For example, Indonesia's PT Bank Dagang Bali, once known for its work with poor clients, was closed by regulators last year after it was discovered to be insolvent and riddled with fraud. Many savers did not get their money back.
Corruption is also commonplace in many developing countries. A recent study by the World Bank found that in two poor states in India where the financial system is largely controlled by the government, borrowers paid bribes to officials amounting to between 8% and 42% of the value of their loans. Corruption raises the cost of every financial transaction, allows undesirable transactions to take place and undermines consumer confidence in the financial system. This, and the related curse of cronyism, explains why access to financial services in countries where the state has control over the financial sector is poorer than where it does not.
Inadequate basic public services add to the burden on financial firms. SKS, a fast-growing microfinance institution in India, has had to build back-office systems that can work on two hours of power a day; it closely monitors voltage when its computers are running and keeps a diesel generator on hand. Many others simply give up on the idea of modern technology and continue to use paper instead. This makes them vulnerable. The tsunami in December 2004 wiped out financial records at many small Indonesian banks.
But not all the blame goes to poor-country governments. Financial-services firms too have failed to do enough to deal with the lack of the sort of data (for example, about a client's financial history) that are taken for granted in rich-country financial systems, and to find ways of reaping economies of scale. Many have simply dismissed the possibility that serving the poor might be a viable business.
The start of something big
In recent years, at least in some parts of the world, this bleak picture has begun to change, first in credit, then in savings and more recently in remittances. Even insurance—not only the basic life sort but also more sophisticated forms for things like cattle and weather risk—is gradually being introduced.
These changes have recently received a lot of attention in policymaking circles. Grand claims have been made that credit can end poverty. A World Bank report by Thorsten Beck, Asli Demirguc-Kunt and Soledad Martinez published last month shows a strong correlation between lack of financial access and low incomes (see chart 1). Earlier research by the first two authors and Ross Levine concluded that a sound financial system boosts economic growth and particularly benefits people at the bottom end of the income league. A long-term study in Thailand by Robert Townsend of the University of Chicago and Joe Kaboski of Ohio State University showed that families with access to credit invested more, consumed more and saved less than those without such access.
What makes microfinance such an appealing idea is that it offers “hope to many poor people of improving their own situations through their own efforts,” says Stanley Fischer, former chief economist of the World Bank and now governor of the Bank of Israel. That marks it out from other anti-poverty policies, such as international aid and debt forgiveness, which are essentially top-down rather than bottom-up and have a decidedly mixed record.
Studies by Stuart Rutherford, who runs an experimental bank that provides loans and takes deposits in the slums of Bangladesh, show that the poor attach great value to having a safe place to keep money and some means of providing for life's risks, either through savings or, better still, through insurance. When financial services are available to them, the poor, just like the rich, snap them up.
In one sense, microfinance has been around for a long time. What is now generating so much hope and excitement is less the discovery of some entirely new way to deliver financial services to the poor than the effect of the rapid innovation that has taken place in the past three decades.
From pawnshop to Citigroup
The oldest financial institution in the Americas is a pawnshop on Mexico City's central square. Set up in 1775 under an edict by the Spanish crown to assist people in financial trouble, it is called Monte de Piedad, variously translated as the mountain of mercy or the mountain of pity. Pity or mercy come in the form of cash in return for valuables. Unclaimed items end up for sale in a series of glittering rooms near the main banking hall.
By transforming trinkets into capital, pawnshops perform an important (if under-appreciated) service, but they have three limitations. They advance cash only to people with assets. Their loans are based on the value of collateral, not of a business venture. And the valuables held as collateral cannot be used to fund businesses, as banks' cash deposits can.
There have been two notable attempts to find alternatives. One has been the creation by developing-country governments of state banks, particularly to finance the rural poor. These have mostly been a disaster. The other, much more successful one involved a number of organisations extending uncollateralised loans to very poor borrowers. In 1971, Opportunity International, a not-for-profit organisation with Christian roots, began lending in Colombia. ACCION International, also not-for-profit, made the first of what it called “micro” loans in 1973. Grameen Bank started in 1976 and soon became extraordinarily famous for offering “microcredit” to women in small groups.
To qualify, Grameen's customers had to be extremely poor, probably earning less than a dollar a day. To overcome the lack of collateral or data about creditworthiness, group members were required to monitor each other at weekly meetings, applying varying degrees of pressure to ensure repayment. As loans were repaid, people were allowed to borrow more. The group replaced the security that pawnshops gained from collateral. The model is not perfect, but it does have real virtues and has since spread around the world.
Why did these organisations start with providing credit? They assumed that poor people were unable to save, and that their sole need was for capital. But that was not the whole story. When BRI, a failing state-controlled rural lender in Indonesia, was transformed into a bank for the poor in 1984, it offered not only the usual loan products but also a government-guaranteed savings account with no minimum deposit. This has been an extraordinary success: BRI now has 30m savings accounts.
Nobody knows how many institutions are providing microfinance in some form, but the number is certainly huge (see article). They are growing fast and serving a vast number of people in absolute terms, although still only a small proportion of the billions who earn only a few cents a day. Local banking giants that used to ignore the poor, such as Ecuador's Bank Pichincha and India's ICICI, are now entering the market. Even more strikingly, some of the world's biggest and wealthiest banks, including Citigroup, Deutsche Bank, Commerzbank, HSBC, ING and ABN Amro, are dipping their toes into the water.
The downsides
Not everyone has been pleased with the prospect of better financial services for the poor. Islamic fundamentalists have bombed branches of Grameen in Bangladesh and attacked loan officers of other institutions in India. Maoists have looted microfinance offices in Nepal. The head of a microfinance effort in Afghanistan was murdered, possibly by drug traders.
To drug lords in Afghanistan, the availability of credit is unwelcome because it gives a choice to farmers who were previously forced to grow poppies for want of other ways to finance their crops. For the elites in closed markets running inefficient monopolies, credit raises the prospect of future challenges from entrepreneurs. For radical Muslims, it means that women (who in many countries make up the bulk of microfinance borrowers) are able to run viable businesses and become independent. And for everyone in poor countries, credit can mean social upheaval as merit and enterprise replace inheritance, family ties and position.
Nor does microlending always have a happy outcome. The clients of K-Rep, an excellent Kenyan microfinance bank in a small town on the fringes of Nairobi, are a pretty resourceful lot, but when the government stopped repairing roads, picking up rubbish and spraying for malaria, some were at their wits' end. Drainage in the marketplace was plugged by uncollected garbage and customers stopped coming. Maria Njambi, a single mother with a ten-year-old child, used to have a viable business selling fruit and vegetables she bought with credit from K-Rep, but she had to watch her inventory rot and has stopped repaying her loan. She is not alone in her misfortune. A report in 2002 by CARD, a microfinance organisation in the Philippines, offers the following explanation for borrower attrition: “It is a tragic fact that over time, husbands will fall sick, sari-sari [variety] stores will be robbed, harvests will be poor and children will die.”
Yet microfinance institutions typically claim extraordinarily low loan losses of 1-3%, a bit better than the rate for big banks in rich countries and much better than for the big credit-card companies. Given the difficulties facing businesses in poor areas, some critics question the accuracy of these figures. Many of the banks lending to the poor are not-for-profit organisations whose accounts are rarely scrutinised by outsiders. Much of their capital has been provided by governments or philanthropists, and often does not have to be repaid, so perhaps microfinance institutions are being quietly lenient with their customers. Indeed, large-scale defaults in microfinance may go unreported. The Townsend-Kaboski research project in Thailand informally tracked hundreds of microfinance institutions and found that in the five years before the Asian financial crises, 10% failed and a quarter stopped lending.
So there is room for scepticism, but also plenty of reason for hope. The biggest of these is just how much progress the industry has made in the past 30 years.
In rich countries, financial services on the whole work remarkably well, despite the exotic salaries, the crackpot deals and the occasional bust. The vast majority of people have access to interest-bearing savings accounts, mortgages at reasonable rates, abundant consumer credit, insurance at premiums that reflect the risk of losses, cheap ways of transferring money, and innumerable sources of capital for funding a business.
By contrast, financial services for poor people in developing countries—a business known as “microfinance”—have mostly been awful or absent. With no safe place to store whatever money they have, the poor bury it, or buy livestock that may die, or invest in jewellery that may be stolen and can be hard to sell. Basic life and property insurance is rarely available. Home loans are costly, if indeed they can be found at all. For many people, the only source of credit is a pawnshop or a moneylender who may charge staggeringly high interest and beat up clients who fail to pay on time. In the Philippines, lenders who zip from town to town on motorcycles expect six pesos back for every five they lend. That translates into an annual interest rate of over 1,000% on a loan for a month.
For workers from poor countries who venture abroad to earn a better living, sending money home to relatives can be hugely expensive. Such remittances have become an important source of income in many developing countries, dwarfing other inflows of capital from overseas such as foreign direct investment and multilateral aid. But if the money is being sent, say, from America to Venezuela, charges can amount to as much as 34% of the sum involved, according to Dilip Ratha of the World Bank.
Why are the poor so badly served? The easy answer, that people who have little money do not make suitable clients for sophisticated financial services, is at most a half-truth. A better explanation, this survey will argue, is that the poor have been hurt by massive market and regulatory failure. Fortunately that failure can be, and increasingly is being, remedied.
In most developing countries, the barriers to providing financial services for the masses are all too clear. Inflation tends to be high and volatile; government is often incompetent; and the necessary legal framework for financial services is often missing. Property laws can make it impossible for poor borrowers to use assets such as their home as collateral for loans.
In the past, many countries have outlawed “usury”, and today many Islamic countries prohibit the charging of interest. Governments in developing countries often impose caps on the interest rates charged on loans for the poor. Despite their popular appeal, such caps undermine the profitability of lending and thus reduce the supply of loans.
Incomplete and erratic regulation of financial institutions has also undermined the confidence of the poor in the financial services that are available. When they can find an institution that will accept their tiny deposits, it often lacks the sort of government deposit insurance that is routine in rich countries, so when a bank goes under, savers suffer. For example, Indonesia's PT Bank Dagang Bali, once known for its work with poor clients, was closed by regulators last year after it was discovered to be insolvent and riddled with fraud. Many savers did not get their money back.
Corruption is also commonplace in many developing countries. A recent study by the World Bank found that in two poor states in India where the financial system is largely controlled by the government, borrowers paid bribes to officials amounting to between 8% and 42% of the value of their loans. Corruption raises the cost of every financial transaction, allows undesirable transactions to take place and undermines consumer confidence in the financial system. This, and the related curse of cronyism, explains why access to financial services in countries where the state has control over the financial sector is poorer than where it does not.
Inadequate basic public services add to the burden on financial firms. SKS, a fast-growing microfinance institution in India, has had to build back-office systems that can work on two hours of power a day; it closely monitors voltage when its computers are running and keeps a diesel generator on hand. Many others simply give up on the idea of modern technology and continue to use paper instead. This makes them vulnerable. The tsunami in December 2004 wiped out financial records at many small Indonesian banks.
But not all the blame goes to poor-country governments. Financial-services firms too have failed to do enough to deal with the lack of the sort of data (for example, about a client's financial history) that are taken for granted in rich-country financial systems, and to find ways of reaping economies of scale. Many have simply dismissed the possibility that serving the poor might be a viable business.
The start of something big
In recent years, at least in some parts of the world, this bleak picture has begun to change, first in credit, then in savings and more recently in remittances. Even insurance—not only the basic life sort but also more sophisticated forms for things like cattle and weather risk—is gradually being introduced.
These changes have recently received a lot of attention in policymaking circles. Grand claims have been made that credit can end poverty. A World Bank report by Thorsten Beck, Asli Demirguc-Kunt and Soledad Martinez published last month shows a strong correlation between lack of financial access and low incomes (see chart 1). Earlier research by the first two authors and Ross Levine concluded that a sound financial system boosts economic growth and particularly benefits people at the bottom end of the income league. A long-term study in Thailand by Robert Townsend of the University of Chicago and Joe Kaboski of Ohio State University showed that families with access to credit invested more, consumed more and saved less than those without such access.
What makes microfinance such an appealing idea is that it offers “hope to many poor people of improving their own situations through their own efforts,” says Stanley Fischer, former chief economist of the World Bank and now governor of the Bank of Israel. That marks it out from other anti-poverty policies, such as international aid and debt forgiveness, which are essentially top-down rather than bottom-up and have a decidedly mixed record.
Studies by Stuart Rutherford, who runs an experimental bank that provides loans and takes deposits in the slums of Bangladesh, show that the poor attach great value to having a safe place to keep money and some means of providing for life's risks, either through savings or, better still, through insurance. When financial services are available to them, the poor, just like the rich, snap them up.
In one sense, microfinance has been around for a long time. What is now generating so much hope and excitement is less the discovery of some entirely new way to deliver financial services to the poor than the effect of the rapid innovation that has taken place in the past three decades.
From pawnshop to Citigroup
The oldest financial institution in the Americas is a pawnshop on Mexico City's central square. Set up in 1775 under an edict by the Spanish crown to assist people in financial trouble, it is called Monte de Piedad, variously translated as the mountain of mercy or the mountain of pity. Pity or mercy come in the form of cash in return for valuables. Unclaimed items end up for sale in a series of glittering rooms near the main banking hall.
By transforming trinkets into capital, pawnshops perform an important (if under-appreciated) service, but they have three limitations. They advance cash only to people with assets. Their loans are based on the value of collateral, not of a business venture. And the valuables held as collateral cannot be used to fund businesses, as banks' cash deposits can.
There have been two notable attempts to find alternatives. One has been the creation by developing-country governments of state banks, particularly to finance the rural poor. These have mostly been a disaster. The other, much more successful one involved a number of organisations extending uncollateralised loans to very poor borrowers. In 1971, Opportunity International, a not-for-profit organisation with Christian roots, began lending in Colombia. ACCION International, also not-for-profit, made the first of what it called “micro” loans in 1973. Grameen Bank started in 1976 and soon became extraordinarily famous for offering “microcredit” to women in small groups.
To qualify, Grameen's customers had to be extremely poor, probably earning less than a dollar a day. To overcome the lack of collateral or data about creditworthiness, group members were required to monitor each other at weekly meetings, applying varying degrees of pressure to ensure repayment. As loans were repaid, people were allowed to borrow more. The group replaced the security that pawnshops gained from collateral. The model is not perfect, but it does have real virtues and has since spread around the world.
Why did these organisations start with providing credit? They assumed that poor people were unable to save, and that their sole need was for capital. But that was not the whole story. When BRI, a failing state-controlled rural lender in Indonesia, was transformed into a bank for the poor in 1984, it offered not only the usual loan products but also a government-guaranteed savings account with no minimum deposit. This has been an extraordinary success: BRI now has 30m savings accounts.
Nobody knows how many institutions are providing microfinance in some form, but the number is certainly huge (see article). They are growing fast and serving a vast number of people in absolute terms, although still only a small proportion of the billions who earn only a few cents a day. Local banking giants that used to ignore the poor, such as Ecuador's Bank Pichincha and India's ICICI, are now entering the market. Even more strikingly, some of the world's biggest and wealthiest banks, including Citigroup, Deutsche Bank, Commerzbank, HSBC, ING and ABN Amro, are dipping their toes into the water.
The downsides
Not everyone has been pleased with the prospect of better financial services for the poor. Islamic fundamentalists have bombed branches of Grameen in Bangladesh and attacked loan officers of other institutions in India. Maoists have looted microfinance offices in Nepal. The head of a microfinance effort in Afghanistan was murdered, possibly by drug traders.
To drug lords in Afghanistan, the availability of credit is unwelcome because it gives a choice to farmers who were previously forced to grow poppies for want of other ways to finance their crops. For the elites in closed markets running inefficient monopolies, credit raises the prospect of future challenges from entrepreneurs. For radical Muslims, it means that women (who in many countries make up the bulk of microfinance borrowers) are able to run viable businesses and become independent. And for everyone in poor countries, credit can mean social upheaval as merit and enterprise replace inheritance, family ties and position.
Nor does microlending always have a happy outcome. The clients of K-Rep, an excellent Kenyan microfinance bank in a small town on the fringes of Nairobi, are a pretty resourceful lot, but when the government stopped repairing roads, picking up rubbish and spraying for malaria, some were at their wits' end. Drainage in the marketplace was plugged by uncollected garbage and customers stopped coming. Maria Njambi, a single mother with a ten-year-old child, used to have a viable business selling fruit and vegetables she bought with credit from K-Rep, but she had to watch her inventory rot and has stopped repaying her loan. She is not alone in her misfortune. A report in 2002 by CARD, a microfinance organisation in the Philippines, offers the following explanation for borrower attrition: “It is a tragic fact that over time, husbands will fall sick, sari-sari [variety] stores will be robbed, harvests will be poor and children will die.”
Yet microfinance institutions typically claim extraordinarily low loan losses of 1-3%, a bit better than the rate for big banks in rich countries and much better than for the big credit-card companies. Given the difficulties facing businesses in poor areas, some critics question the accuracy of these figures. Many of the banks lending to the poor are not-for-profit organisations whose accounts are rarely scrutinised by outsiders. Much of their capital has been provided by governments or philanthropists, and often does not have to be repaid, so perhaps microfinance institutions are being quietly lenient with their customers. Indeed, large-scale defaults in microfinance may go unreported. The Townsend-Kaboski research project in Thailand informally tracked hundreds of microfinance institutions and found that in the five years before the Asian financial crises, 10% failed and a quarter stopped lending.
So there is room for scepticism, but also plenty of reason for hope. The biggest of these is just how much progress the industry has made in the past 30 years.
