Some realities on microfinance

The financial services grapevine in Malta is making certain sounds about some form of possible introduction - under whose aegis is not quite yet known - of microfinancing for certain economic activities in the country. It is an intriguing idea and certainly one which deserves a lot of thought and careful analysis, both of the function itself as well as, inevitably, of the contextual environment into which it is being considered to be introduced, not least economic.

Let one, right at the outset, clear out of the way some people's misconceptions about it. I have heard people talk about it in a manner that immediately suggests that they are thinking that, having failed to see venture capital financing really taking off in Malta, well, microfinancing could therefore provide them with what they didn't get via the venture capital route! The two concepts are miles away from each other and, rather than go into why and how, it is probably better to talk about the (latest kid on the block?) microfinance idea being considered.

The genus of microfinance does not essentially lie in the business or the entrepreneurial world.

This method's birthplace was in the world of philanthropy, that is making loans available to the very poor. Its birthplace in fact is what is probably the world's poorest country: Bangladesh. And it all started at around 1978, when the visionary who set it going, Muhammad Yunus (later a Nobel Prize laureate) started making loans of only a very few dollars' equivalent to very poor women who had no access to lending from financial institutions. So we're more in the world of (God bless him, aged 80 and still at it!) Mgr Victor Grech and Caritas here than in that of the country's business world. That much for starters.

When Mr Yunus set up the first microfinance bank in the world, Grameen Bank, his objective was very, very clear.

Loans would be made to poor people to help them set up small enterprises that would lift them out of poverty. But what perhaps was the major unique factor in the success of the initiative was that a full repayment rate exceeding 90 per cent of all small loans given followed. As Grameen Bank grew - precisely on this lending to the poorest basis and the excellent repayment rate - in Bangladesh, it in fact ended up becoming a behemoth among that impoverished country's financial institutions.

Mr Yunus's microfinance model was so successful it is now copied in more than 40 countries round the globe.

And it is even offering loans to the poor in the US. On purely historical basis, it would be incorrect to say that microfinance had to wait for Grameen to appear.

It may surprise some people but there are about 28 million people in the US who have no bank accounts and about 45 million have only limited access to financial institutions.

Before Grameen's arrival in the US in 2008, there already were about 750 microfinance organisations in the country, of which about 200 made loans. A notably successful one is Project Enterprise of New York, which is in fact based on Grameen principles. One of its beneficiaries was Egypt Lawson, a young Afro-American woman from Harlem who set up a wig making business with a $1,700 loan and four years later her company was registering a turnover of $3.2 million.

And, yet, the problems of relating structures like these to any environment where they may happen to be set up remain enormous. For one thing, it is often difficult to assess the real operational costs of such, in a sense, non-institutional lenders. Low standards of management and governance are often also a part of such costs.

There are then a number of economic considerations that warrant analysis. The markets where they are often brought to operate are of a type where imperfect information affects both the supply and demand sides of such an informal credit market. This situation impacts on the actual cost of lending in the first place and, secondly, in enhancing product differentiation in cases where each microfinance lender has a relatively small number of customers.

When a potential borrower approaches a microfinance institution for a loan it is often impossible from only casual observation to determine the risk involved in offering him a loan agreement. Unlike sellers in other financial markets, the lender here cannot sell loans to every buyer (borrower) who comes along because this could easily lead to an increase in the riskiness of the loan portfolio, which the lender may find unacceptable. The agreement that the lender will offer, if he does make an offer, even in microfinance will still depend crucially on his assessment of the risk of default.

This risk of default is dependent, among other things, on the borrower's credit history and the characteristics of the project he wishes to invest in or get going. To overcome this informational problem even microfinance lenders spend significant time and resources screening a loan applicant. And the extent of this will, of course, depend on the extent to which the environment there would be one where credit histories are documented and pooled. Screening costs, as is known, are often further enhanced by moral hazard - any source of information has itself to be screened for reliability.

On the demand side, microfinance borrowers are often also not well informed about the terms under which loan contracts would be available from lenders because of characteristics of informal credit markets such as lack of advertising and a time-consuming and imperfect screening process. This then often enhances product differentiation in some environments where some lenders typically package lending services with other services like trading and marketing.

There is therefore an imperative need of profiling and contextualising microfinance according to specific environments.

Not every country will have a profile identical to Bangladesh or New York's Harlem, for that matter.

Screening, loan administration costs, actual costs of lending, interest rates, market distortions, market entry, product differentiation, red tape, even a country's tax system; the list of elements can indeed be endless. All are factors that should put us on a cautious analytical and learning course before embarking on what is, to be factual, a very interesting activity.

And I say this irrespective of whatever international institution may be offering Malta funding for such a venture.

Dr Consiglio lectures in the Department of Banking and Finance of the Faculty of Economics, Management and Accountancy of the University of Malta.