Readers – This post is an eclectic set of thoughts and facts on Microfinance. I am writing it primarily to share my knowledge (and wisdom?) on this industry, which I have acquired over the past 3 months or so at Juhudi, but also partly to find some inspiration and excitement for starting out my own Microfinance Institution in Pakistan, which turned 64 yesterday (Happy Independence Day). It’s a tough decision. It is enormously exciting on a professional level and gets me closer to long-term goals of doing my part to turn around 64 years of mismanagement and malaise. The idea of going out to deep rural areas in Pakistan, building relationships and managing people in Punjabi, building something that is high quality right from the start, and which I can call my own, and having tremendous social impact doing all this, gives me a serious kick. It does, however, carry huge risk, and comes at significant personal cost. No more hot showers, cool nights and Western friends of Nairobi (not implying that I don’t have any Eastern friends in Nairobi). I will be swimming with buffalos in the village pond, in 45 degree heat, and socializing with the village mulla (priest). I have done it before – It’s always fun for a few days, but a bit too much for an entire year, which is the minimum commitment required to build something successful (watch the Indian reality TV show – Desi Girl – http://en.wikipedia.org/wiki/Dil_Jeetegi_Desi_Girl).
You really need to start following the news and current affairs, if you do not already know that Microfinance is huge – absolutely massive. I will be a bit late to enter the game. 20 years too late, to be precise – almost an entire generation. At the world micro-credit summit in 1997, when I was only 11 years old, industry bigwigs had set the goal of reaching 100 million poor families by 2005. They set high aspirations, and have largely met them. Mixmarket.org which is a database of Microfinance institutions around the world shows 92.5 million borrowers at the end of 2009. It seems to be fairly comprehensive in its coverage so the number is probably quite accurate, barring perhaps a little bit of double counting due to borrowers who have taken multiple loans from different institutions (need to build those micro-credit bureaus along with biometric National ID systems in each country to solve this problem). If we assume a “family multiplier” of five (on average, each borrower supports five individuals), microfinance is already reaching around half a billion people, or almost 20% of the world’s poor. In Pakistan, however, a country with 70 to 80 million poor people, there are only 1.3 million borrowers. With the same family multiplier, penetration in Pakistan is at half of the global level. And the penetration in Pakistan is one-tenth of that in Bangladesh for example, which is the birthplace of microfinance, and by far the leader in terms of penetration. In fact, I think it might be fully saturated, but I do not know nearly enough to make that claim.
So there is definitely a need for me to throw my hat in the ring. Also, most microfinance institutions take an approach which focuses on ideas, or marketing to impact investors rather than rigorous operational execution. And often even the idea generation and execution is piecemeal, haphazard or trial and error like. This is the very nature of entrepreneurship, especially social entrepreneurship, but this should no longer be the case in a well-established space like microfinance. We should be able to get this right now. Yet, across the board in microfinance, we continue to see to poor or sub-optimal outcomes, even in recently established Greenfield institutions. Most of the institutions listed on databases such as Mixmarket.org seem to be losing money, or to use a more acceptable industry term, not operating at “100% sustainability”. Industry colleagues tell me that systems and processes are almost universally inefficient if not altogether broken. With a bit of my current knowledge and experience, and with some rigorous planning and foresight, I can build something which is sustainable and pristine right from the outset. My efforts may not win me an Ashoka award (Ashoka.org is an institution which provides recognition to innovators in the social enterprise space) but I can still have tremendous social impact, building high quality structures based on old or existing ideas, rather than generating new ideas, per se. Speaking of existing ideas, I have secretly been taking notes on the Juhudi model of agricultural asset backed financing, which I can copy cat, and which seems to be safer and more sustainable than traditional urban micro-enterprise finance, and perhaps more beneficial to the borrower.
In fact, what we do at Juhudi is absolutely brilliant. Instead of financing cash or working capital, which is often lacking, even in existing high return generating micro-enterprises, because of people’s poor saving habits (living hand to mouth), or due to frequent financial shocks e.g. medical costs associated with illnesses, or dowry for weddings, Juhudi adds an incremental hard asset. The asset sits illiquid on the farmers’ balance sheet and along with the loan repayment process, acts as a highly effective mechanism for farmers to save incrementally i.e. over and above what they were already generating. One illiquid asset or cow becomes two, then three and eventually four. The asset base builds up, and due to the scarcity of capital often generates an annual return exceeding 100%. Soon enough the farmer has a large and steady source of income driven by a healthy illiquid asset base. If cash was sitting there, or added to either meet the needs of an existing enterprise or on an incremental basis, it can still earn a pretty decent return, completely free of risk, (7 to 10% for a fixed deposit in Kenya), but it would probably not survive in its purest state for very long, likely spent on consumption or replacing something which should have been saved in the first place through better financial discipline. Rarely does cash provided by urban Microfinance institutions get spent on incremental investment – the real impact of urban microfinance is often overstated. This Juhudi model does, however, come at a social cost in the utilitarian sense of things. This is the classic equity versus efficiency paradigm in economic policy. Or what some also call a “Second best” outcome – still good but not the best.
So what is the best outcome? Dairy cows are at their most productive in large commercial farms, where concentrated expertise, capital equipment and good access to working capital can help extract the most out of them – most milk and meat, that is. Also, value chains are most efficient and hold most value when they are set up in a cluster (the value chain from start to end includes breeders, vets, feed providers, artificial insemination service providers, farmers, transporters, chilling plants, processing plants and end product distributors). My classic example of this is Bhains Colony (literally translating to Buffalo Colony) in Landhi, a slum in Karachi, where by some estimates there are more cows than people (think hundreds of thousands of cattle). The area produces so much cow dung, that it was a huge community health issue for many years. The dung was just being dumped into the sea – causing eutrophication, and destroying endangered mangroves, rich in bio-diversity and useful coastal protection against the rough Arabian Sea. Where there were only problems and no one saw value, the Electric Power Utility stepped in. They are investing in distribution networks to take the dung away, creating another income source for the residents, and are building a power plant where it can be turned to energy, solving Karachi’s energy crisis in a cheap and efficient manner. There is literally a market now for dung in Karachi. One kilogram sells for 3 rupees or so, according to a friend working at the Electric Power Utility.
The same, of course, cannot be done in deep rural areas of Kenya for Juhudi farmers, because the cost of building out deep rural distribution networks will be prohibitive. Dung is used locally, for other purposes, but not perhaps the most economically efficient ones in the grander urban scheme of things. And at Juhudi, we might be taking cows from efficient urban or sub-urban clusters and putting them in deep rural areas (remember – Juhudi has not added any cows to the system; it has simply taken them from one place and put them in another). Anecdotally, their productivity is lower, and their mortality rates are higher, although no one has quantified exactly how large or significant this impact is. And I believe very strongly, that if we are to create enough food to feed our growing population, we will have to take people off the land, and build larger more efficient farms with clustered value chains. I am so late on the communist central planning game as well – oh how I lack imagination and just recycle old ideas. Farmers can use the payout from the sale of their rural land and assets to acquire urban assets, acquire skills to provide urban services or build urban enterprises. There will be more food, more services and more enterprises – Utilitarian bliss – and without any serious distribution issues; a first best outcome.
This is already happening naturally or spontaneously. Or may be the invisible hand is doing it – my favorite character in Economics after the middle man, that old chap doing a thankless but darn good job. You might have heard about this, even with your skimpy news reading. The process is called urbanization or rural to urban migration. But this process comes with its own sets of issues even perils. Strong existing social networks are breaking down, there is pressure on already poor urban infrastructure and people are getting exposed to dangerous ideas or rather ideologies. But it’s not happening at the rate it should be (“should” here is not my a principled stand that it ought to be happening, but rather my expectation given the economic dynamics of the situation – the fact that the invisible hand is always hard at work). This comes back to the original problem of saving, or having illiquid assets on farmers’ balance sheets, the only way it seems that they can lead financially sustainable lives. Liquid assets e.g. cash just don’t seem to stay around for very long, often spent on consumption rather than investment, so liquidating the land can be dangerous – the same way Golden Hand Shake or severance schemes are often dangerous for urban service or industrial workers. These issues fall within the realm of behavioral economics, and I am sure someone somewhere is digging into them. In the meantime, farmers will stay on the land, our food will continue to get more and more expensive (same supply – growing demand), and ironically enough the farmers will be the ones rioting about it.
Getting away from Juhudi and my controversial and confusing ideas mixing micro-behavioral-economics with macroeconomics – one thing that most people don’t seem to understand is why Microfinance Institutions charge such a high interest rate. “We” are often thrown in the same bucket as loan sharks, or that notorious village money lender – another one of my favorite characters in Development Economics. The line is indeed fine and blurry. Compartamos, a large and highly successful consumer finance company or Microfinance institution in Mexico is often cited as a wolf, not even trying to hide in sheep clothing. They charge 70% plus to their borrowers. Grameen and SKS on the other hand, based in Bangladesh and India respectively, are clearly driven by strong social values, having passed on the efficiencies of scale to their borrowers, and charging rates in the mid-twenties, having initially started out in the early thirties. This blurriness is often opportunistically used by self-serving politicians to create a raucous and self-serve. SKS was very badly hit by a political uproar over a string of suicides which were casually linked to its lending practices. These two types of organizations show that the difference between a Microfinance Institution and a loan shark is only that of core values, and in my humble opinion, neither is right or wrong, good or bad. And high interest rates, such as those charged by Compartamos will eventually be competed out of the market, with the process only accelerated by the presence of social entrepreneurs willing to give away even more value, so the question of values might just be an irrelevant one. The loan shark might after all be an endangered species.
But often the difference between loan sharks and Microfinance institutions is cited as the “recipe” of group lending or group guarantee, which is an effective way of leveraging social networks and peer pressure to lend to those who have no collateral to offer. This is not true, because loan sharks have started using group structures as well – because they work just as well for profiteers. It’s also not the difference between McDonald’s and the corner doner kebab shop. We have scale, we have systems, we have technology, and we have standardized processes, which the “individual” money lender might not, but we also have Compartamos, an institutional version of that old individual loan shark. The individual village money lender has very clearly been elbowed out of the mainstream market, the same way now that KFC has come to Kenya, quite a few mom and pop Swahili food joints will likely move into more and more obscure areas. It’s creative destruction, but just like Compartamos or SKS, it can be either used to make a fair consensual profit (nothing wrong with the profit motive), or be passed on as social value (nothing wrong with charity, especially where it retains the dignity of the beneficiary). So – no difference, except in core values. But as I mentioned earlier, our saving grace is that the likes of Compartamos will likely not be able to charge “usurious” rates forever, because if the market is too profitable, other players will enter and compete away the profit. Let all discussion or debate on the values of Microfinance be buried forever (after we build out those micro-credit bureaus and ensure that individual borrowers do not get over indebted).
Allow me to end by illustrating why a Microfinance institution charges 30% to 35% on average where as a commercial bank will charge an average customer less than 10%. Please refer to Exhibit A, a breakdown of the economics of a typical Bank vs. Microfinance Institution.
The short answer is that they both typically make around the same returns, Microfinance making a slightly higher return because it is perceived to be more risky, and thus able to hold or attract less leverage – borrowed money. Because the cost of Microfinance is much higher and has to be passed onto customers, Microfinance ends up charging a higher rate. Basic industrial economics teaches us that the costs just about cover the interest rate, leaving behind a “fair” return – as one would expect in a well-functioning and healthy competitive industry (the same way the loan shark will not survive). But what are these cost drivers, and why are they so different? For any financial institution, there are fundamentally four drivers, shown in Exhibit A, and banks are able to keep each one of these lower than Microfinance institutions.
The largest difference is driven by driver III, which is the distribution or service cost base. Banks typically have a fixed sales and service network, and customers typically walk in to buy products or to get served. In fact, the average bank customer does not make in-person contact with their bank that often. I learnt in some of my consulting work serving financial institutions that for the average banking customer, face-to-face contact only happens around twice a year after the initial sale. The brick and mortar model is coming to an end. The rest of the contact is through highly efficient call centers, where service providers can be packed in, both across space and time (please wait for future blog post on Physonomics) and customers can be made to wait. Other efficient channels are ATMs, self-service machines and now online. By contrast, walk-in Microfinance is unthinkable. There are people who are trying it out, and from what I know, failing miserably. Our model will not work if our loan officers do not visit loan groups at least once a month. They have to make the group dynamic function well, build strong relationships with our clients, and ensure that they know and understand that we are still around to recover our money. In fact, at Juhudi, with our deep rural model, some of our loan officers can spend up to 5 or 6 hours a day just travelling to a remote loan group meeting, unlike a bank call center employee, who is kept busy as a bee all day long.
Also, there is the classic “Base of the Pyramid” issue of small ticket size. Our loans are much smaller than those of the average bank, in fact typically just a fraction of the size, so driver III works against us, even if we were servicing our “tickets” in the same way as a bank. In fact, I strongly support partnerships between Microfinance institutions, telecom operators, mobile payments service providers, non-governmental organizations and fast moving consumer goods companies, at the Base of the Pyramid, because they help consolidate distribution, allowing for greater volume along the same channel. Some of us are very uncomfortable with the notion of a loan officer providing loans, deworming kits and shampoo sachets in the same visit. But if it is all legal and well-meaning, with clients really pulling on the shampoo rather than loan officers pushing them down their throats, large volumes of tiny ticket sizes of various items, need to absolutely be combined to make the distribution channel profitable and efficient. The Base of the Pyramid consumer eventually wins. This is what Vikram Akulla of SKS calls “Google territory”, Google making a tiny pinch of money for each ad-click, but across a very high volume of users.
The other levers are largely self-explanatory. Muhammad Yunus, Nobel Laureate and founder of Grameen, will be serious angry at me for my quantitative assumptions on I and IV. He maintains that uncollateralized loans are just as safe as collateralized ones if not safer (lever I). The data which I have seen does not seem to prove his point. Also, Microfinance loan losses are comparably low enough, so the impact on the overall economics is marginal, even if we were to use his assumptions instead of mine. He also maintains that Microfinance institutions can tap into more customer deposits, and have just as good access to savings as commercial banks (lever IV). Again, I disagree. Commercial banks with their urban foot-print, attract affluent customers who are less price sensitive. They will always be able to tap into more savings at cheaper rates. What is really helping support Microfinance though, is the presence of so many impact and social investors, such as Acumen Fund, Soros Economic Development Fund, Rockefeller Foundation, Ford Foundation, etc. which helps keep the cost of funding in the 5% to 10% range. Without these investors interest rates for end borrowers would be even higher. These guys are also helping keep the likes of Compartamos out of the game, or at least accelerating their downfall.
So has this post provided me with enough opportunity to reflect and make up my mind? Confusion (no further comment).
