Sustainability and profitability of microfinance institutions

Transcription

1 I N T E R N A T I O N A L B U S I N E S S P R O G R A M S Master Program in International Finance and Economics (MiFE) R E S E A R C H P A P E R S I N I N T E R N A T I O N A L F I N A N C E A N D E C O N O M I C S Center for Applied International Finance and Development (CAIFD) Sustainability and profitability of microfinance institutions Author: Research Paper 4/2011 ISSN

2 CONTENTS List of abbreviations... iv List of tables/figures... iv 1. Introduction Theory Definition of Microfinance History of Microfinance Microfinance models Solidarity group Village banking Grameen model Individual model Microfinance market Informal market Semiformal market Formal market Profitability of MFI Costs Revenues Interest rates ii

3 4. Sustainability of MFI Operational sustainability Financial sustainability Double bottom line principle Discussion of ethical aspects Outlook References iii

4 List of abbreviations MFIs OSS FSS NGO SHG BMT UNCDF ROE Microfinance Institutions Operating self-sufficiency Financial self-sufficiency Non-Governmental Organization Self -Help Group Biometric Teller Machine United Nations Capital Development Fund Return on Equity List of tables/figures Figure 1: Average loan size per region Figure 2: Defining the Poor.-4- Figure 3: Access to Finance -11- Figure 4: Regional Breakdown of Access to Microfinance -12- Table 1: Advantages &Disadvantages of MFIs Figure 5: Categories of costs Figure 6: Costs by Region iv

5 To give away money is an easy matter and in any man s power. But to decide to whom to give it, and how large, and when, and for what purpose and how, is neither in every man s power nor an easy matter. -Aristotle- v

6 1. Introduction It is a fact that about 4 billion people worldwide live on less than US$2 per day (Microfinance Bulletin, 2008a, 7) and poverty is one of the major problems that is still prevailing in today s world. Currently the eight Millennium Development Goals, to be reached by 2015, are a worldwide attempt that might really help to fight poverty. Surprisingly more than 3 billion poor people seek access to basic financial services worldwide (Helms, 2006, ix) and were ignored by commercial banks for a very long time. For commercial banks the poor were seen as unbankable for decades because they cannot provide collateral. Robinson estimates that about 90 percent of the people in developing countries have no access to institutional financial services (Robinson, 2001, 9). Microfinance offers financial services to those who are not served by the traditional financial sector. Therefore it was one of the most important tools to help to solve this problem and bridge the gap for the poor; even if it is not a magic solution that cures all poverty. The Nobel Prize winner in 2006, Professor Muhammad Yunus, was the one who showed with his Grameen bank that the concept of microfinance successfully works and that poor people proved to be viable customers. Since Yunus first loan issue to a group of poor rural women in Bangladesh more than 30 years ago, the microfinance market has grown with an enormous pace and has enlarged its portfolio of financial services beyond pure microcredit. As Schmidt described in 2008, microfinance is widely known and regarded as the most humane part of the international financial system, perhaps even the only humane part (Schmidt, 2008, 1). With such enormous numbers given, there is a great potential in this segment of global society and a disproportionately high demand for such financial services especially by the working poor. Therefore everybody jumped on the microfinance bandwagon with its comparatively high interest rates and repayment rates of almost 100 percent that make the poor borrowers more attractive for banks and - 1 -

7 international investors than other commercial lending in the traditional retail business. The recent trend of commercialization of microfinance institutions (MFIs) even underlines a run for profits from the business with poor customers. Opponents of the concept of profitable microfinance argue that loans should for socio-political reasons be subsidized and stress that the social mission of MFIs needs to be a higher goal and therefore be more important than profits. From an ethical point of view it is questionable whether it is acceptable to earn money on business with poor? In the following the concept of microfinance is introduced as well as the potential of profitability and sustainability of MFIs. Eventually the research question is discussed and answered. 2. Theory In the following the theoretical background necessary to understand the concept of microfinance is explained. 2.1 Definition of Microfinance Microfinance is commonly associated with small, working capital loans that are invested in microenterprises or income-generating activities (Churchill and Frankiewicz, 2006, 18). Such microenterprises are often family owned and have less than five employees, sometimes based out of the home, as for instance small retail kiosk, sewing workshops, carpentry shops and market stalls (Whole Planet Foundation, 2009). Today however microfinance is referred to more generally as the provision of financial services to those excluded from the formal financial system (UNCDF, 2002). In the beginning the credits that were given to poor were called - 2 -

8 microcredits or micro-lending, but soon it became clear that also other financial services were used and needed by the poor which enlarged the microcredits to microfinance (Felder-Kuzu, 2005). Nevertheless micro-credits remain the most important financial services out of the entire range of financial products in microfinance business. The average microfinance loan size varies geographically and has maturities of less than one year in general. Figure 1: Average loan size per region based on Swisscontact 2008 The typical users of microfinance services are traders, street vendors, small farmers, service providers (hairdressers and rickshaw drivers), artisans and small producers, such as blacksmiths and seamstresses and belong to the economically active poor population that are living close to the poverty line and are therefore self-employed, low-income entrepreneurs in both urban and rural areas. (Ledgerwood, 1999, 2). As distinguished by Robinson in 2001, (Robinson, 2001, 18) there are extremely poor and economically active poor people. Economically active poor refers to those among the poor who have some form of employment and who are not severely food-deficit or destitute

9 Figure 2: Defining the Poor based on CGAP 2003 The graphic shows most of the microfinance clients who are living close to the poverty line, defined by the Worldbank and that the extreme poor are rarely reached by microfinance. 1 Social safety net programs from international donors are often more appropriate for the destitute and extreme poor (CGAP, 2003). According to Churchill and Frankiewicz (2006, 21-22) the most common microfinance products include the following: Income-generating loans (for the aforementioned entrepreneurial activities), emergency and consumption loans (in case of natural catastrophes or family deaths), housing loans, leasing (new forms of micro leasing e.g.: cattle), savings, insurance, payment services and nonfinancial services such as social intermediation, business development, social service and consulting or technical assistance. Microfinance has, if properly applied, the ability to improve the lives of the poor in many ways. The access to the financial market enables the poor to create occupation and participation in economic cycles not only for themselves but often for others as well. Furthermore it helps them to create assets and even savings, 1 Extreme poverty is defined as living on less than US$0,75 a day by the Worldbank (World Bank, World Development Report 1990:Poverty) - 4 -

10 which reduce poverty and empower especially women. Therefore it is logic that the latter ones are the preferred clients of MFI. Women are more reliable and generally have a greater sense of responsibility. Also women make up a significant proportion of the poor who suffer more from poverty than men, since in many countries they are still discriminated and excluded from men s working world. Moreover an increase in women s income benefits the household and the community to a greater extent than an equal increase in men s income would do (Ledgerwood, 1999, 38). Robinson tellingly says that microfinance services in general can help low-income people reduce the personal risk of going default, improve management capabilities, raise productivity, obtain higher returns on investments, increase their incomes and improve the quality of their lives and those of their dependents such as children and other family members (Robinson, 2001, 9). 2.2 History of Microfinance Microfinance is not a completely new concept of finance and its roots can be found in medieval Europe, especially Ireland and Germany, instead of Bangladesh where the famous founding father of Grameen Bank, Professor Muhammad Yunus, with its own lending policy started its operations in the 1970s and who is nowadays a synonym for microfinance. In Europe in the 15 th century, the Catholic Church founded so called pawn shops in order to protect people from shady loan sharks and moneylenders who gave out loans at usurious interest rates. These pawn shops later spread throughout the continent (Helms, 2006, 2). As further described by Seibel: informal finance and self-help have been at the origin of microfinance in Europe (Seibel, 2005, 3). More formal credit and savings institutions for poor people were already established in Ireland by the Irish Loan fund system as early as 1720, using peer - 5 -

11 monitoring to enforce the repayment in weekly installments of initially interestfree loans from donated resources (Seibel, 2003, 2). In the early 1800s a financial organization based on cooperative principles was founded by Friedrich Wilhelm Raiffeisen in Germany and expanded rapidly within Germany and later also to the rest of Europe, North America and developing countries beyond. Raiffeisen created credit associations, predominantly of farmers in rural areas that were later known as Raiffeisenkassen and now Raiffeisenbanken (Seibel, 2005, 4). In 1999 Ledgerwood described the focus of these cooperative financial institutions as savings mobilization in rural areas that attempt to teach poor farmers how to save money (Ledgerwood, 1999, 2). In the early 1900s the concept of Raiffeisen began to appear with adaptations in parts of rural Latin America (Helms, 2006, 3). Besides the financial services offered, the Raiffeisen-cooperatives created a tailormade sales and trading platform for their rural members to cover their needs in agricultural products such as seeds, fertilizers etc. for production on the one hand and giving them access to subordinate markets for their products on the other, however all based on a minimum of cost and maximum for their direct profit. In case of any surpluses achieved in the cooperative its members could even additionally increase their assets. Another milestone in the history of microfinance was the opening of the Indonesian People s Credit Bank (BPRs) in 1895 that became the largest microfinance system in Indonesia (Helms, 2006, 3). In Bangladesh Professor Muhammad Yunus disbursed first loans from his own pocket to a group of rural women in Jobra in 1976 (Yunus, 1999) and successfully developed the concept of microfinance with his Grameen Bank throughout the country and later the whole world. Most of these early microcredits were based on solidarity based lending (which will be explained later). Other examples of early pioneers besides Grameen Bank are ACCION International, Self-employed Women s Association Bank in India and many more (Helms, 2006, 4)

12 Other concepts of subsidized loans given out by nongovernmental organizations (NGOs) and governments to farmers, which might be compared with pure microcredits, often failed since farmers took the low interest loans as grants and more importantly they did not reach the really poor at all, but rather the more influential and better-off farmers (Helms, 2006, 4). In the 1980s the microcredit programs improved their methodologies significantly and managed to be financially viable through cost-recovering interest rates and a very high repayment quota. Since then the activities and volumes in the field of microfinance have grown substantially. In the early 1990s the term microcredit was replaced by microfinance which included not only credits but also other financial services for poor people (Helms, 2006, 4). Today there is a strong trend towards commercialization and transformation of providers of microfinance into formal financial institutions. This stems from the motivation of profitability and sustainability of microfinance institutions. More and more institutions became independent from donor funds and raise their capital from the capital markets while increasing their outreach. The year 2005 was declared as the Year of microfinance and attracted even more private investors to invest their funds into microfinance activities (Sundaresan, 2008, 5). Surely this trend is not over yet even though it is not yet clear how the current financial crisis affects the microfinance sector and to what extent the MFIs might suffer from recessions and current mistrust among financial institutions on capital markets. Given the fact that microfinance organizations are mainly active in the lesser developed parts of the world, where neither bubbling real estate markets nor speculative cash-rich investment banking opportunities do exist, it is even conceivable that microfinance might see an impetus if commercial banks henceforth will globally refocus their business in a back to the roots trend onto basic and non-artificial financial products for retail clients

13 2.3 Microfinance models In the following the most common lending approaches and microfinance credit models are described in order to give an overview of how the actual money lending technically is accomplished Solidarity group The solidarity group model is also called peer lending group and normally consists of four to five individuals who group together to borrow a loan in solidarity. The members are self selected, based on their reputation and relationship to each other. Useful here is the self screening and group pressures imposed upon every member of the group, urging each and every one of the borrowers to contribute his part in solidarity as mutually agreed and so ensures a rather secure loan recovery for the MFI. Morally speaking, the burden of such a microcredit is spread on more shoulders than in the case of a single borrower. The same naturally also applies on the risk perspective of the lending institution spreading its potential loss likelihood. It is the responsibility of the entire group that every payment is made on time according to a predefined repayment schedule. This also implies that the whole group suffers possible consequences in case they fail to pay back the loan. Most severe consequence for the poor is the loss of reputation and creditworthiness. After a successful repayment of the loan the group has the possibility and qualified to get a larger loan for larger activities and projects if desired. In this model the MFI has less work to do since the borrowers of the groups have most of the responsibilities such as: forming the group and selecting the right members, administration and organization of repayment plan and scheduling group meetings and meetings with the loan officers from the MFI (Hazeltine and Bull, 2003, 104)

14 2.3.2 Village banking Village banking describes a community-based credit and savings association, run by a village itself. The model was founded by John Hatch, the founder of the American NGO Finca (Felder-Kuzu, 2005, 31). With this lending model, 25 to 50 low income members of a village, mostly women, join to take out a relatively large loan from a MFI and act as guarantors at the same time. After receiving the loan a self appointed village committee decides who gets smaller loans out of the group. This model further enables saving deposits. The normal payback periods range from 4 to 12 months and only after completion a new loan can be taken for the community. The role of the MFI is to assist only in administration and technical issues (Hazeltine and Bull, 2003, 104) Grameen model The Grameen model was invented in 1976 by Professor Muhammad Yunus, the founder and managing director of Grameen Bank. The model proved to be successful and today is practiced in more than 250 outlets of Grameen Bank in more than 100 countries (Yunus, 1999). The Grameen model was copied and modified many times according to the respective needs of regional markets and clients. Therefore many other models are extensions of, or derived from, the Grameen Model. Basically a new branch of the MFI is set up in a village with a field officer and some qualified workers, who have already done research on the population there in advance and made their choice according to its potential demand and its need of financial support. These employees of the MFI support then up to 15 to 20 villages in the surrounding and are strive to make the local, poor people aware of the microfinance possibilities through word of mouth and personal advisory. The lending process is similar to the solidarity group approach. Groups of five are created. However in the beginning only two members of the group receive a loan - 9 -

15 and are monitored for one month. The credibility of the group will then be based on the repayment performance of the first two individuals (Hazeltine and Bull, 2003, 105). If they are reliable and could pay back their loan, the remaining members qualify for a loan as well, since the group is jointly and severally liable for the single members. Armendáriz de Aghion and Morduch say that loans go first to two members of the group, then to another two, and then to the fifth group member. Given that loans are being correctly and timely repaid, the cycle of lending continues (Armendáriz and Morduch, 2005, 13) Individual model The individual model is the most expensive and labor-intensive model for the MFI. Here clients have to be monitored and far more and deeper field research is necessary in order to choose the right clientele, especially because these people have no tangible collateral or credit history and in most cases are illiterate. Sources of information for the field officer are the family, friends and leaders of the community (Hazeltine and Bull, 2003, 105). It is not unusual that the borrowers need to have a bailsman out of the family or community in order to receive a loan (Felder-Kuzu, 2005, 30). With this model, the loan is given directly to the borrower and it is his/her sole duty to pay back the full amount plus interest rates without financial support from a group in case he/she defaults. Technical assistance as well as payment schedules and business management training is generally provided by the MFI (Hazeltine and Bull, 2003, 105). These were however not the only microfinance models existing. There are more models that were tailored and modified according to the needs of the poor in different developing countries. The aforementioned models serve as a basis in most cases and are therefore noteworthy

16 2.4 Microfinance market The microfinance market has evolved over the past decades and has grown at a remarkable pace. It is estimated that today there are between 7,000 and 10,000 established microfinance institutions of which only a fraction reports its data to rating agencies or microfinance platforms, such as the MIX ( There are a lot more investments needed to meet the estimated US$300 billion demand for services. Currently MFIs supply an estimated US$15-25 billion in loans (Daley-Harris, 2009, 10). According to Felder-Kuzu (2005, 39) the number of outstanding loans is 40 million which amount to this US dollar amount. So the potential demand is much higher than the loans and services already provided and the market of microfinance is growing further. Microfinance can mostly be found in developing countries but was recently also adopted by developed, western countries. Figure 3: Access to Finance based on Demirgüç-Kunt et al

17 While Figure 3 shows the percentage of households with deposit or loan accounts in an institution or MFI and the resulting huge potential demand for MFIs to cover, Figure 4 is more precise, based on the Micro Credit Summit Campaign Report 2009, and shows the relationship between the number of families living in absolute poverty in each region of the world (i.e. those living on less than US$1 a day adjusted for Purchasing Power Parity) and the number of poorest families that were reached with a microloan in each region at the end of For this statistic however only 3552 MFIs worldwide contributed their information. Figure 4: Regional Breakdown of Access to Microfinance based on Daley-Harris, 2009, 36 In general the main players of the microfinance market can be divided into three groups: the informal sector, the semiformal sector and the formal sector. All of them will be explained in the following Informal market Informal financial markets have already existed for a very long time and generally speaking have contributed to the development of the formal financial markets. The informal financial market will probably always continue to exist. For microfinance this means that lending money to the poor is not a new invention but

18 has already existed since decades. Even if detailed and reliable data on informal financial markets is not easily available, several studies showed that the effective borrowing costs in such markets as well as interest rates charged are rather high, e.g. payday lending often exceeds 200 percent on an annualized basis (Sundaresan, 2008, 4). According to Robinson (2001, 13) informal commercial moneylenders such as cash-rich local traders, employers, landlords, commodity wholesalers, pawnbrokers and other moneylenders are useful or even in most cases the only way for poor people to raise their incomes and manage growth. Without those lenders many poor people would not have the possibility to get a loan at all without collateral and are therefore often more important for the creation of an economic society than formal financial institutions. The most informal source of finance is clearly the family, relations or community members as sources of lending. In general the advantages of informal financial services for the poor are the easy access to money, the minimal or no paperwork at all and the quick availability of funds. However, negative aspects for the poor include high cost, poor quality or undependable availability (Churchill and Frankiewicz, 2006, 20). Typically, informal microfinance service providers are not referred to as institutions and are neither subject to special bank laws nor to general commercial law (Ledgerwood 1999, 97). Also Sundaresan (2008, 3) affirms that informal credits usually operate outside the border of regulators and are often not subject to monitoring and supervision of governments or agencies of governments. Surprisingly enough, most of the NGOs that operate in the microfinance business are still informal institutions dependent on subsidies and donors. Nevertheless, there is a trend towards a regulated transformation of many NGOs going on which is called up scaling (Felder-Kuzu, 2005, 28) Semiformal market In the field of microfinance there are also a variety of semiformal financial organizations which are unlicensed and generally unsupervised but may operate

19 under certain general laws and regulations (Robinson, 2001, 49). These semiformal institutions are often registered entities, but not usually subject to oversight by a banking or finance authority (Churchill and Frankiewicz, 2006, 27). Most common semiformal financial institutions are financial cooperatives (such as credit unions and saving and loan cooperatives), financial NGOs, Village Banks and registered Self Help Groups (SHG). Especially in India the concept of SHG experienced a boom lately. Here groups of about 15 women come together under the guidance of NGOs, government agencies or regional rural banks to start small regular savings. These pooled savings are used to make small interest bearing loans to the group s members. After successful management of the groups, bank credits are made available to the SHG in order to increase their resources (Dichter and Harper, 2007, 73) Formal market In general formal financial institutions are subject not only to general laws, but also to specific regulation and supervision by the Central Bank, Ministry of Finance or an agency thereof (Churchill and Frankiewicz, 2006, 27). Examples of such microfinance banks are ADOPEM (Dominican Republic), BancoSol (Bolivia), Grameen Bank (Bangladesh), NovoBanco (Angola), and XacBank (Mongolia) amongst others. More and more commercial banks have discovered the potential and demand for microfinance services and are now providing a range of services for micro entrepreneurs. A common approach is branch banking where small branches are established in a decentralized way in order to serve their poor clients. This approach is often costly since administrative costs are rather high (Ledgerwood, 1999, 100). This movement is called downscaling and is further described by Felder-Kuzu (2005, 28) as regulated (governmental, agricultural, regional or private-) banks who decided to engage in microfinance. Typical downscalers are large corporate banks offering individual loans to upper-end microenterprises

20 or small businesses (Drake and Rhyne, 2002, 71). Examples for successful downscaling are Sogebank (Haiti), Equity Building Society (Kenya) and Bandesarrollo (Chile) (Churchill and Frankiewicz, 2006, 29). Furthermore the formal market of microfinance is influenced by the process in which informal MFIs convert into formalized or regulated financial institutions which was referred to as upscaling before. This usually requires fresh capital from outside investors, regulatory approval by local banking authorities and improved governance plus internal controls. The transformation process then typically allows MFIs to mobilize client deposits as an additional source of refinance and offer additional non-credit products (Frank, 2008, 2). Furthermore, with the transformation and growth of their assets, MFIs get improved access to new sources of funding in the international capital markets and also product diversification which allows them then to broaden their outreach and serve more clients. Overall, the microfinance market currently faces a trend towards commercialization which is a broad term used to refer to the application of market-based business principles to microfinance. This is usually associated with a MFI s development away from donor or subsidized funding towards commercial borrowing of debt and equity (Frank, 2008, 2). It can be concluded that there are three ways a MFI can become part of the formal microfinance market: either by downscaling, where regulated banks adopt microfinance as a particular business segment on its own, or by transformation (upscaling), where NGOs transform into regulated financial institutions. A third way would be a new establishment or start up of a microfinance bank under regulations of the relevant local supervising authorities and laws. On the next page a general overview of the advantages and disadvantages of the various market players is shown

21 Formal market Semiformal market Informal market Players Rural Banks, Commercial banks (downscalers), Upscalers (former NGOs), Microfinance Banks Financial cooperatives, Microfinance (or financial-) NGOs, Village Banks and registered SHG Local traders, employers, landlords, commodity wholesalers, pawnbrokers and other moneylenders Advantages Regulated status ensures better quality of services Access to commercial funding Potential to serve more people and offer greater loans Disadvantages Interest rate ceilings may impose constraint to sustainability Formal requirements may increase costs Potential mission drift towards less poor clients Focus more on poorer markets Not constrained by regulations Subsidy assistance No access to commercial funding may restrict outreach Usually not allowed to offer savings accounts Possible inefficiency and lack of transparency Potential to reach remote areas Free of observation/ regulation Greater potential to experiment with new innovative services Strong dependence on donor funds and subsidies Restricted potential for outreach Table 1: Advantages &Disadvantages of MFIs based on Churchill and Frankiewicz, 2006, Profitability of MFI It is widely known today that providing loans to micro-entrepreneurs has a relatively attractive potential to generate profits and growth. In some areas, like Asia, Africa and Latin America the profitability of MFIs is already squeezed by greater competition in the industry (Lascelles, 2008). In the following chapter it is explained how and what kind of costs, revenues and interest rates MFIs generate. 3.1 Costs MFIs that provide multiple microfinance services face various costs. In general it can be distinguished between costs related to financial services and functionally

22 separate costs (direct and indirect costs). Sometimes it is not possible to separate or segment costs of MFIs easily because non-financial services, such as consultancy, training and technical assistance, are necessary to ensure a good credit behavior and risk minimizing. Costs that occur due to non-financial services are often cross-subsidized by financial service earnings. Costs directly attributable to the micro-financial services include for instance personnel expenses (e.g. salary for loan officers), refunding of staff transportation and training for loan officers, loan loss provision, and interest expense on borrowings that refinance the loan portfolio (Helms, 1998). Further the costs of MFIs can be generally categorized in fixed (e.g. office rent) and variable costs (e.g. travel expenses to meet clients) (Churchill and Frankiewicz, 2006, 338). In general MFIs gain relatively little from economies of scale because microcredit is rather labor intensive: salaries make up the majority of most MFIs operating expenses and fixed costs are relatively low compared with variable costs (Rosenberg, et al., 2009). Operating expenses of MFIs include most often personnel and administrative costs and represent a major part of charges to borrowers. The handling of cost allocation differs from institution to institution and is sometimes not even practiced by every MFI. MFIs often have the following categories of costs in their chart of accounts: Figure 5: Categories of costs based on Helms, CGAP

23 The next figure shows that administrative costs of MFIs are a major cost component across all regions worldwide. Considering how much effort it is to record the frequent meetings with borrowers, the loan application procedures for mostly illiterate clients, to document every microloan and repayment amount etc. this cost structure becomes even clearer. Figure 6: Costs by Region based on Helms 2008 Since the loan portfolio represents the biggest asset of a MFI, the nonpayment of a loan is not only the biggest risk a MFI might face, but also a cost center that is often underestimated (CGAP, 2001, 10). Also here the accounting for loan delinquency varies enormously among MFIs, but practically there are only two alternatives. Some of the institutions reschedule unpaid or non-performing loans with the borrower immediately while others write them off after it is sure that the loan cannot be paid back after a certain time period of default. The liquidation of collaterals like in a commercial bank is not an option since the business-model as such does not require them as a prerequisite of lending to a client. In general every MFI has a certain percentage of loan loss provision in its profit and loss account that needs to be considered as major costs from the outset. In order to give a practical example of how this might look like, the practices of

24 Grameen Bank are briefly showed. Grameen Bank has a 1 percent loan provision on regular loans and a 100 percent loan provision on overdue loans (overdue means 10 consecutive installments were not paid). The overall repayment rate of Grameen Bank in 2007 was 98,02 percent (Grameen Bank, 2009). It is very common that MFIs face similar high repayment rates. However it needs to be considered that MFIs will monitor closely and report on their borrower s loan servicing behavior which means a timely controlling of collection or repayment rates as indicators of the relevant portfolio quality. These repayment rates are based on cash flows for a given period and as such, they do not report cumulative arrears in the portfolio. In most cases, a consistent repayment rate of 98 percent is not equivalent to a 2 percent loan loss rate. Repayment rates only measure the cash flow of the period and do not account for accumulated loss or increased future risk tied to those delinquent loans (UNCDF, 2009). So it is in any case important to undertake precautious measures and provide sufficient loan loss provision in advance in order to measure the costs of loans correctly. Another important cost factor is the debt funding and refinance of the MFI. Often MFIs can receive debt funding at below-market interest rates due to subsidies and support from governments encourage the socio-political aspect of MFIs lending. This kind of funding is referred to as soft loan, which is a loan, typically from a donor or government, with a lower interest rate than a MFI could have obtained from commercial sources (CGAP, 2001, 23). This sort of subsidy is calculated by subtracting the amount of interest and fees paid on soft loans from the amount the institution would have paid if the loans had been priced at commercial rates (UNCDF, 2009). Therefore the current trend away from subsidies towards a commercial approach of microfinance adds to the costs of MFIs and narrows their gross margin on loans directly. Funds generated from MFIs own customers savings deposits is naturally not affected by this trend and so becomes an even more attractive refinancing alternative in a mixed overall calculation and perspective

25 It is also worth mentioning the cost to clients which include not only the interest rates and fees, but also transaction cost directly arising for a loan processing. Transaction costs of borrowers include both opportunity costs, for example the time spent for group meetings and meetings with the loan officer, and indirect expenses for notarized documents, transportation/travel expenses to the bank etc. Such transaction costs borne by clients as out-of-pocket expenses are not revenue for the microfinance organization and are often neglected when calculating the total cost of a microfinance service (Schreiner, 1999). Sometimes even psychological costs occur to the borrowers when they have to enter a formal institution where they do not feel comfortable and even inferior. However it is impossible to measure these costs in terms of material figures. The poor borrower s pure transaction costs are in general higher if they borrow from a financial institution instead of from informal moneylenders who would have more of an all inclusive calculation of interest. Nevertheless total borrowing costs are much lower at financial institutions (Robinson, 2001, ). One of the major goals of MFIs is to reduce the distance from its administration to its target market which allows users to access these services at a lower cost. Also, keeping the number of formal and costly steps in processing a loan application to a minimum means a less expensive service to a borrower. Group meetings and time spent away from his own business represent lost income to a client, indirectly increasing the cost of the service. Additional costs borne by the client and not part of the MFI s income do not benefit to the institution, and make the service more costly for the client (UNCDF 2009, Churchill et al. 2006). Steps to reduce costs from the side of the institution are for example the group lending model that allows the MFI to shift certain costs of administration and lending risk to the members of the group. Furthermore biometric teller machines (BTMs) reduce the administrative costs of extending small loans to communities where the literacy levels are low (Sundaresan, 2008, 13). On the whole J.D. Von Pischke, one of the leading experts on development finance, suggested as a goal and benchmark which in the beginning of microfinance seemed unrealistic: the sum of administrative and risk costs of good

26 MFIs should not amount to more than 20 percent of its loan portfolio. At this level, costs would be low enough to be passed on to the customers, consequently allowing the MFIs to cover their costs and enabling them to expand the scope of their activities in accordance with their dual goals of sustainability and increasing outreach (Schmidt, 2008, 10). 3.2 Revenues Financial revenue from the loan portfolio is by nature of this business the main source of revenue for MFIs and has two components: interest charges and fees and commissions. Besides that, MFIs also obtain revenues from other sources beyond lending. The average MFI allocates only three-quarters of its assets as loan portfolio which creates the need to maximize the return of almost one-quarter of its assets in alternative activities beyond lending (Microfinance Bulletin, 2008b, 22-29). These returns in general represent interest on investments, net gains on financial assets and income from non-lending related services e.g. in rural areas: from trading seeds with the cooperative clients financed by their loans. Other operating revenue stems from the provision of services, including revenue from insurance or transfer services or non-financial revenue from the provision of financial services, such as the sale of passbooks or SmartCards 2 ; including net exchange gains (Microfinance Bulletin, 2008b, 43). Another important cash inflow for the MFI is the often mandatory savings account of a client. These saving accounts are frequently a requirement for getting a loan. Grameen Bank for example requires all borrowers with loans above US$138 to contribute at least US$0.86 each month to a pension savings account, which will be paid out after 10 years with double the amount that was paid in (Yunus, 1999, 240). In case of providing saving products in the product portfolio this would however also 2 Smartcards are cards with embedded microchips that provide information on customer accounts

27 contribute largely to the costs of MFIs since they have to provide savers with interest as well. The overall financial revenue can be summarized in the following formula: Financial Revenue = Revenue from Loan Portfolio + Revenue from Other Financial Assets + Revenue from Other Financial Services (Microfinance Bulletin, 2008b, 32) For the revenue from loan portfolio the formula is: Revenue from Loan Portfolio = Interest on Loan Portfolio + Fees and Commissions on Loan Portfolio (Microfinance Bulletin, 2008b, 32) In these formulas the interest on loan portfolio is the interest earned on outstanding loans. Fees and commissions might represent penalties for delayed payments, commissions for loan officers and other fees like handling of credit application. Donations are typically shown separately in order to present pure and real income from microfinance operations. Larger loans as well as higher interest rates would of course result in more income for MFIs and make them more profitable due to cost and some scale effects. On the other side this might create large disadvantages for the poor target clients who are dependent on the loan and might have difficulties in paying back larger amounts. 3.3 Interest rates Since interest rates on micro-loans represent the major costs for the clients and at the same time the main income for MFIs it is now worth taking a closer and systematic look at it. Very often the seemingly high interest rates compared to normal commercial lending rates are the strongest point of criticism for opponents of profitable

28 microfinance business. In 2006, the average worldwide microfinance lending rate stood at 24.8 percent (CGAP, 2009, 7). But also rates above 50 percent up to 80 percent and even 100 percent are not uncommon. In relation to the amounts borrowed, they mostly reflect the high all in costs rather than high profits of MFIs (Sundaresan, 2008, 87). As administrative costs for individually tailored microloans are much greater than for normal standardized loans, it is usually inevitably to do micro-lending on a financially sustainable basis without charging interest rates that are substantially higher than what banks normally charge in order to cover the costs. Interest rates should also cover the operating expenses besides refinancing expenditure and consider provisions for potential portfolio risk and inflation. Furthermore higher interest rates for microloans are justified by the complex and labor-intensive structuring, documentation and provision of the credit, the often remote location of the clients and the frequent meetings with MFI s staff during approval and repayment process. To give an example: lending US$10,000 in 100 loans of US$100 is obviously more expensive concerning staff salaries etc. than giving out one single loan of US$10,000 at once (Rosenberg et al., 2009). On the other side, it is argued that high interest rates made it possible to grow the industry of microfinance und expand the outreach in breadth and depth because many MFIs were able to cover their costs und use profits to give out more loans to an even larger number of people in areas otherwise unattractive. As a consequence, interest rates ceilings, imposed by governments, would inversely affect the outreach of MFIs because they are not able to meet their cost und cannot operate efficiently. This results in a restriction to further expand the lending operations to a larger number of poor people. Often MFIs get donations or subsidies that are passed on to its clients through a lower final and so practically subsidized rate of interest. This adjustment may result in an operating loss for the institutions (Microfinance Bulletin, 2008a, 70) because with the remaining spread on top of interest rate subsidies, they might not be able to cover their costs efficiently and are dependent on the support and availability of such funds from then on. The same applies to interest rate ceilings imposed by governments. Such

29 ceilings rather create an artificial and not compliant barrier to the business in terms of free market mechanism and so hurt poor people even more since it restricts MFIs to fully cover their costs by the income from interest rates. At the end and in consequence this might force them to give loans to better-off and richer people only, who tend to ask for larger loans. In the Philippines for example credit subsidies by low interest rates had worsen income distribution because only a few, typically well-off farmers, receive the bulk of the cheap credit. When interest rates are not allowed to reflect costs of financial intermediation, wealth and political power replace profitability as the basis of allocating credit (Armendáriz and Morduch, 2005, 9). In general it is far less expensive to borrow from commercial MFIs than from local money lenders (Robinson, 2001, 7) who typically charge nominal effective interest rates of 10 percent to more than 100 percent a month whereas sustainable microfinance institutions usually charge nominal effective interest rates of 2 to 5 percent a month (Robinson, 2001, 16-17). Moreover, the access to finance as such is often more important than the costs since microfinance represents the only opportunity to get money to start a business and improve the living condition for many of the poorest people. Armendáriz de Aghion and Morduch (2005, 17) even argue that typical poor borrowers may be able to routinely pay interest rates above 100 percent and still have surplus left over. This is true because of the high turnover activities of the poor entrepreneurs. An example that prompted a lot of discussion was the case of the for-profit MFI Compartamos in Mexico, who went public in 2007, as first microfinance bank. At that time Compartamos listed shares for over US$1 billion and earned huge profits by charging their customers interest rates of at least 79 percent per year (Economist, 2008). It argued that they could reach more people by making such profits and were criticized as loan sharks for their usurious rates. This is however not a typical example of the industry but more of an exception

30 As a general rule, income to lenders and cost to borrowers can both be increased by charging additional commissions and fees to the interest rates, but as competition among MFIs grows the pressure to offer competitive and marketable interest rates increases as well. Furthermore clients become more knowledgeable in financial issues with the development of the microfinance industry and might choose an institution with lower interest rates. The ultimate goal therefore is to reduce costs of MFIs which allow interest rates to go down as well. It is suggested that interest rates should generate revenue equal to or more than the cost per unit of principal lent. Therefore the interest rate that creates financial efficiency is: r (i+α+p) (1-p) Here r is the interest rate charged per unit of principal, i is the cost of raising resources per unit of principal, α is the expected cost of administering and supervising a loan per unit of principal lent and p is the percentage of principal and interest payments due that cannot be recovered (Khandker, and Khalily, 1995, 39). A more precise formula for the proposed annualized effective yield (R) 3 is: R = AE + CF+LL+K- II 1-LL It cannot be said at which point interest rates are abusively high since there is no agreed standard worldwide. It is very dependent on the particular regional market environment and the cost and organizational structures of MFIs and whether the institution is in general for-profit or statutory non-profit with different shareholder expectations and donor contributions respectively. Also the structure 3 AE=Administrative expense; CF=Cost of Funds; LL=Loans losses; K= desired capitalization rate; II=Investment income ; all expressed as average percentage of loan portfolio (Ledgerwood, 1999, 149)

31 and business model of MFIs lending portfolio or for example its client s repayment schedule contributes to this and interest rates vary according to the yearly, monthly or weekly payment of interest. 4. Sustainability of MFI As the concept of microfinance came into focus, the question of whether donor support is necessary in the long term and the issue of sustainability of such institutions came up as well. It could be argued that the long term sustainability of MFIs is not important as long as money was given to micro entrepreneurs and a start up help was given. This would imply that sustainability of the micro enterprises is more important than the long term existence of the financial institution that stood behind the start up. In this paper however, only the sustainability of MFIs is going to be examined further. As MFIs seek to reach as many poor people as possible in the long run to fulfill their goal to fight against the worldwide poverty, it became clear that this outreach is only possible on a sustainable and efficient basis. Some opponents of this argument state that sustainability is not possible by reaching the poorest people on the planet. They furthermore argue that there exists a tradeoff between outreach and sustainability. This however is going to be discussed later. One might assume that sustainable MFIs are typically for-profit commercial companies, but this is not true. Actually, almost two-thirds of the sustainable MFIs are NGOs, cooperatives, public banks, or other not-for-profit organizations (Rosenberg et al., 2009). Sustainability in general means the ability of a program to continuously carry out activities and services in pursuit of its statutory objectives. For an ideal MFI this would mean the ability to continue operating as a development financial institution for the rural poor (Khandker and Khalily, 1995, 36). Since MFIs are more and more viewing their financial services as profitable businesses, it is of importance to constantly look for possible cost reductions or

32 reallocations in order to operate profitable and economically viable. For a better understanding of the profitability and sustainability, ratio analyses are often used. In the following part different forms of sustainability and ratio analyses are examined and the principle of double bottom line of MFIs is discussed. 4.1 Operational sustainability Operational sustainability accompanies the concept of operational self-sufficiency (OSS) which measures operating revenue as a percentage of operating and financial expenses, including loan loss provision expense and the like. If this ratio is greater than 100 percent, the MFI is covering all of its costs through own operations and is not relying on contributions or subsidies from donors to survive (Churchill and Frankiewicz, 2006, 367). OSS in general includes all the cash costs of running a MFI, depreciation and the loan loss reserve. Sometimes donors will exclude the cash costs of funds from their analysis because those MFIs that begin to access the commercial financial markets and pay the cost of capital would look relatively worse than other institutions with the same costs and outreach, but who have remained reliant on donor capital to fund their portfolio (UNCDF, 2002, 20). This applies due to the fact that some donor fund dependent institutions do not have the same financing cost as commercial MFIs. OSS is calculated as: Financial Revenue (Total) (Financial Expense + Loan Loss Provision Expense + Operating Expense) (Microfinance Bulletin 2008a, 13) The United Nations Capital Development Fund (UNCDF) in 2009 defines OSS simply as: Operating income Total operating expenses (UNCDF, 2009)

33 Operational sustainability actually refers to the future maintainability of the MFI s OSS. For MFIs it is one of the major goals to achieve OSS in order to maintain viable and further grow in their operations. 4.2 Financial sustainability In general financial sustainability describes the ability to cover all costs on adjusted basis and indicates the institution s ability to operate without ongoing subsidy (i.e. including soft loans and grants) or losses. Here UNCDF distinguishes financial self-sufficiency (FSS) from OSS only by the fact of an adjusted basis. 4 The FSS indicator measures the extent to which a MFI covers adjusted operating expenses with operational income. This ratio is calculated by using: Adjusted operating income Adjusted operating expense (UNCDF, 2009) Ledgerwood additionally states that the FSS indicator should show whether enough revenue has been earned to cover direct costs, (including financing costs, provision for loan losses and operating expenses) and indirect costs (including adjusted cost of capital) (Ledgerwood, 1999, 217). Due to the fact that donor support is not unlimited in reality, financial viability of microfinance services is crucial for expanding outreach to large numbers of the world s poor. Moreover the retention of profits of microfinance operations is important to capitalize growth (CGAP, 1998). 4 Adjusted means showing how MFIs would look like on an unsubsidized basis with funds raised on the commercial market; plus inflation adjustments

34 This also indicates that financial services are priced so that their costs are covered and they do not disappear when donors or governments are no longer willing or capable to subsidize them (Christen, et al. 2004, 12). It is obvious that MFIs need to cover both their operational as well as their financial costs in order to maintain their position in the market in the long run. Especially by covering the financial costs they get access to the capital markets and to commercial capital which then allow MFIs to increase and grow their loan portfolio and clientele outreach. MFIs can as a rule serve their poor customers best by operating sustainably, rather than by generating losses that require constant infusions of undependable subsidies (Rosenberg et al. 2009). Armendáriz de Aghion and Morduch (2005, 16) describe the issue of donor support like this: The hope for many is that microfinance programs will use the subsidies in their early start-up phases only, and, as scale economies and experience drive costs down, programs will eventually be able to operate without subsidy. Once free of subsidy, it is argued, the programs can grow without the tether of donor support (be it from governments or donors). To do this ( ) programs will need to mobilize capital by taking savings deposits or by issuing bonds, or institutions must become so profitable that they can obtain funds from commercial sources, competing in the marketplace with computer makers, auto manufacturers, and large, established banks. However it is not always guaranteed to obtain commercial debt because microfinance services and the unsecured lending to the poorest are still often seen as too risky by traditional banks (UNCDF, 2002, 21). Out of the approximately 10,000 MFIs worldwide, it is estimated that only 3 to 5 percent have achieved full financial sustainability (Dichter and Harper, 2007, 49). Moreover there is still a huge gap between supply and demand of micro financial services which cannot be filled with unsustainable MFIs in the long run. As a rule of thumb, MFIs with annual losses of about 5 percent tend to become unsustainable (Rosenberg et al. 2009, 12). A very important aspect that needs to be considered when looking at the rather small number of sustainable MFIs is the

35 size of these institutions. On average, sustainable MFIs are much larger than unsustainable ones and to get a clear picture one should weight and consider the number of borrowers or the portfolio size instead (Rosenberg, 2008). Of course operating sustainable depends on many factors inside and outside the MFI. Inside the institution transparency, good governance, cost allocation/savings and at least reaching break even are major factors of success. At the same time MFIs have to operate under favorable outside market conditions such as easy, low-cost access to a large number of economically active poor clients, a favorable legal environment without regulative interest rate ceilings and demand of rather large average loan sizes (Dichter and Harper, 2007). Two best practice examples of sustainable MFIs are Bank Rakyat Indonesia and BancoSol in Bolivia. Both have a large commercial outreach to poor people while being consistently profitable in their business operations (Robinson 2002, 3). Summarized, the viability-outreach relationship can be described as follows. If a MFI operates viably by making profits and providing its investors with reasonable economic returns, combined with a capacity to grow, it needs several prerequisites for that. These are cost recovering interest rates, commitment of the management, constantly low cost levels and a good methodology. The next step then allows MFIs to leverage funds in the commercial market based on availability-andmarket price or offer-and-demand principle. They are then able to borrow from commercial sources and mobilize deposits. Finally this leads to an increased outreach with a larger number of clients (Asian Development Bank, 2000). 4.3 Double bottom line principle Financial performance or so to speak the economic bottom line as described above, like operational self-sufficiency, financial self-sufficiency and the overall viability of a MFI, are most often seen as the indicator of success in the

36 microfinance market. Yet for more and more MFIs there is another goal to be reached, namely a second social bottom line measured at the positive impact of a business model for the poor. Both financial and social (and developmental) goals together are building the so called double bottom line for MFIs (Microfinance Bulletin, 2008b, 12). The social or developmental objective stems from the very roots of microfinance as a tool of development aid and was already well practiced by the traditional notfor profit MFIs. The double bottom line principle is what currently sets most transformed MFIs apart from those traditional financial institutions (Ledgerwood et al. 2006, 166). Obviously it is more difficult to measure social performance and the impact on poor than financial performance which is represented by hard facts and naked figures only. Plus there are no existing indicators yet that would fulfill this task in an acceptable manner and so social performance is measured in a variety of ways. Attempts for expressing the social bottom line are for example qualitative reporting on performance, quantified statistics, management devices, monetized results and indices (Tulchin, 2003). It is said that a strong financial performance paves the way for the social mission to be successful as well (Microfinance Bulletin, 2008b). Such tendencies can also be observed in commercial banks in the same way. Many of these disclose their charity activities in a prominent position of their annual reports nowadays. The reverse conclusion is therefore that the social objectives cannot be achieved if the MFI does not reach its financial objectives or at least operate efficiently. With the trend of MFIs towards commercialization and the thereof stemming criticism of profits from the business with poor, the question what MFIs actually do for the poor in terms of social improvement become louder. Transformed MFIs are nowadays trying to work on their double bottom line and communicate their social mission again publicly. Lately there was also an emergence of a new, non juridical form of Social Enterprises with its success measured by social and financial terms (Microfinance Bulletin, 2008a). For example Grameen Bank claims to be a social enterprise with profitable financial returns while

37 consequently and sustainably keeping focused on their social mission to alleviate poverty. Grameen Bank operates about 30 social businesses such as a hospital for the poor or a joint venture with the French Group Danone, which provides poor children with nourishing yogurts at low prices (Yunus 1999). The distinction between social purpose of activities in this context and humanitarian undertaking in terms of caring is very narrow. Moreover as indicators for the social improvement of their clients (meaning if they moved out of poverty), Grameen Bank developed ten decisions. These include inter alia the access to clear drinking water, primary education of children and three meals a day for each member of the family. The concept of double bottom line even goes one step further. The international development community has largely moved beyond the double bottom line concept to embrace triple bottom line objectives (Microfinance Bulletin, 2008a). Here the environmental impact and evaluation of all projects and activities to this extend is considered as a third objective in business practices. 5. Discussion of ethical aspects In the beginning of this paper it was challenged whether it is acceptable to earn money on business with poor people. During the progress it became clear in which way and to what extend MFIs are able to earn money with microfinance services extended to this group of society. The income from interest rates on microloans represents the main source of revenue for most MFIs. Consequently there is an ongoing debate, whether these comparatively high interest rates are usurious and should be subsidized and whether a commercial aspiration for profits is in line with widespread ethical standards, when the clients are the poorest of the poor and still they are forced to pay surpassing interest rates for loans. In the following the pro and contra of this debate is discussed more deeply. It could also

38 be described as the poverty lending approach vs. the financial system approach (Robinson, 2001). First of all, proponents of the poverty lending approach perceive the social mission of MFIs to be an absolute and superior goal to reach above all others. They are uncomfortable with the notion of private parties generating any profit from microlending, which they view as a non-profit oriented service to poor people or humanity, and not as a business opportunity driven by and following purely economic market rules. From their point of view the poverty alleviation and development aid is prior-ranking to the financial performance terms of commercial activities with the poor class of society. Their point of view further implies that in the hands of donors, NGOs and a government, the micro lending is more concerned with the poorest people and represents a true development aid. From a moral perspective, taking a debt in general can be unfavorably for people, especially already poor ones. It is well known that already in the Bible, money lending was restricted to and practiced by a small group of people, who did not enjoy a high social acceptance despite their enormous influence on the, at that time, still less complex economy. For micro borrowers the pressure to repay the loans is very high as soon as they want to escape a destiny-oriented thinking and as soon as they strive to improve their economic and social situation. Depending on the cultural environment these poor people live in, they would not even start such improvement on their own initiative and so it is little surprising that the mostly used borrowing model is the group lending model which reinforces the undertaking of paying back the loan in due time by group pressures and the fear to lose face in the community. It is also reported that this often leads to suicides and violence from group members against a non-paying debtor in order to keep the entire group s credibility and creditworthiness intact (Dichter and Harper 2007). This leads to another argument why it might not be acceptable to earn money on business with poor. The charging of interest itself represents money taken out of clients pockets when they actually are just about to earn money and increase their income. Plus it is unreasonable if it exceeds the basic costs of lending i.e. cost of

39 refinance, but also deposits excessive profits into the pockets of a MFI s private owners. Even interest rates that only cover costs and include no profit can still be unfair if the costs are extremely high because of avoidable inefficiencies (Rosenberg et al., 2009). Often it is not straightforward to a MFI s client, from the start of their borrowing for a new commercial project, that they as micro borrowers are able to create their own business with favorable results. Impacts beyond their knowledge and control may occur due to saturated undeveloped markets, no demand for their products, economic shocks or other circumstances beyond their responsibility. Moreover a lack of skills and basic understanding of doing business often leads to difficulties in paying back the loans and operating their own small business. The fact that micro credits are often taken in order to buy food or medicine instead of using it for income generating activities promotes again the poverty lending approach with subsidized loans or even grants as a developmental aid for the poorest (Dichter and Harper, 2007). Another argument by the critics of profitable microfinance is the high borrowing costs besides interest as such for the poorest. Borrowers with loans less than US$150 are the ones who face the highest relative cost of obtaining financial services. Costs range from 35 to 38 percent which raises the question whether this really contributes to poverty alleviation and should be subsidized by donor contributions or not (Sundaresan, 2008, 7). Not only are the poorest borrowers facing the highest cost but also MFIs are facing disadvantageous cost for the smallest loans to those clients. In general the larger the loan size is, the higher the profits for the MFI are, because administrative costs do not increase proportionately with loan size. This relation leads to the threat that MFIs abandon their low-income clients with small loan amounts as they progress upstream (Sundaresan, 2008, 42) which is also known as so called mission drift. Mission drift in the field of microfinance means that MFIs move away from their traditional mission of serving low-income clients with micro credits to alleviate poverty, in favor of generating profits for private and outside investors by serving higher income clients with larger loans or maintaining high-interest rates on micro

40 loans despite their good performance and achieving highest profitability in this segment. For many mission drift comes automatically with commercialization and transformation of MFIs (Frank, 2008). Finally the example of Compartamos in Mexico (already shortly mentioned earlier on page 24) shall show why it might not be acceptable to make money on business with poor. At the time of Compartamos public offering of its shares on the stock market in 2007, its clients were charged almost 100 percent of interest rate (including value added tax etc.) already and the institution was operating very profitable. Little surprisingly the sale was oversubscribed by 13 times. The IPO netted some US$450 million for its initial investors and valued the company at about US$1.4 billion (Daley-Harris, 2009, 16). Later in 2005, nearly one quarter of the bank s interest revenue contributed to the bank s total published annual profit which furthermore reconfirmed the success of the public offering. Compartamos consistently increased its profitability to satisfy shareholders by practically charging its client such high interest rates and managed to create returns on equity (ROE) of above 50 percent a year. Proponents of the poverty lending approach argued that such earnings were unconscionable and the unethical profits were earned from poor Mexicans (Cull et al., 2008). It is questionable whether Compartamos could have substantially reduced its interest charges and could have provided a less expensive service for the poor people. Instead the profits for outside and inside investors were more important than the original strategic goal. Nowadays such a strategy is called increasing shareholder value above all. The MFI itself justified its practices by the large outreach of clients that can be afforded only by the profitability achieved and by the inflow of fresh capital from economically satisfied investors. Having seen that the poverty lending approach promotes the subsidized loan for the poorest of the poor, it is now important to take a look at the other side. The financial system approach argues that microfinance should be practiced in commercial terms like in the conventional financial and banking system. Moreover subsidies and welfare practices should additionally and especially be used for alleviation of extreme poverty only and be disbursed to the advantage of

41 this social group directly. This implies that MFIs should operate profitable and sustainable in order to serve the economically active poor people in a proper way. So in the following, arguments that support generating profits on business with poor are examined closer. At first the term profit does, from a commercial point of view, not necessarily mean greed of gain but technically it stands for covering total costs while having a surplus left over. In fact high profits in the early stages of MFIs are by experience positive, because high returns will attract more investment in terms of funding and more rapid outreach of services to people who need them. Such basic understanding creates a confidence that competition will eventually moderate those profits (Rosenberg et al., 2009). So cost coverage and profit implies sustainable operations of a MFI and enables a greater outreach. This outreach can be translated in a greater effect for the original goal of poverty alleviation. From the point of view of the proponents of the financial system approach it is in general not a question of what is more important, poor people or profits, but more how can poor people be helped. Also Robinson (2001, 11), describes that microfinance demand can be met on a global scale only through the provision of financial services by self-sufficient institutions. This once again implies that sustainability and outreach are complementary. For others the transformation process and profitability of MFIs is a must-do in order to maintain the mission rather than facing a mission drift. Instead of thinking that profit maximization is the prevailing objective, it must be assumed that the service to the poor people is at least equally important. A further issue of usurious interest rates was already mentioned earlier. Commonly people think high interest rates must be disadvantageous for the poor because in most cases they are erroneously compared to commercial interest rates. Such people do misunderstand the main issue of interest rates of MFIs. We saw in former sections why interest rates need to be higher in order to cover the proportionately higher costs, related with minor amounts of micro credits, and so create a very high percentage of effective overall cost in relation to the small loan

42 From the commercial point of view it only makes sense to charge interest rates that at least cover the expenses related to the bigger material effort in dealing with borrowers without collateral. Moreover in general donor funding is of limited quantity in most countries and will never be sufficient to reach more than a tiny fraction of those poor families who could benefit from quality financial services. Therefore more of these poor can be helped only if MFIs can mobilize relatively large amounts of commercial finance at market rates satisfying ROE expectations of investors. This however cannot be done unless they charge interest rates that cover their total costs (Rosenberg, 1996). Besides that, there is evidence that a comparatively larger number of borrowers than prima vista expected is able to pay interest rates at such high levels. We have found out earlier that the basic concept and mechanism of microfinance is not new but has already existed for a long time in almost every country of the world and mainly in the informal financial sector (e.g. money lenders and loan sharks). In all eras and all social systems in history, certain people were able and willing to pay even higher interest rates, too. MFIs provide their customers with more service and value added for lower interest rates compared to money lenders rates. In most cases they provide their borrowers with consulting, management training, and continuous support and back up during their loan periods. So it is obvious that the poor benefit more from organized and often regulated micro-financial services than from bare informal lending. In addition, the mere access to financial means is valued higher by the poor than the effective costs for the loan. One could also assess the fairness of interest rates by evaluating the client s costs in the absence of the lending institution (Hudon, 2007); meaning whether the poor people would be better off without the MFIs. This however can be denied when taking a look at the success of microfinance in the last 30 years and their positive effect on poverty alleviation so far. If one furthermore considers the general principle of demand and supply, it is clear that the demand for loans is much higher than actual supply of microfinancial services at the moment. In other words, the gap of funding is

43 evident and immanent. It is a general rule of the markets that as long as demand is higher than supply the providers of the products in this case money is the single product demanded without any differentiator - or services regulate, or better say dominate the market and determine the prices. This is another argument that favors the ability of MFIs to earn money on their supply of microcredits. Using one more general principle of economics that speaks in favor of profitability is the concept of diminishing returns that poor families face due to micro credits. This concept implies that poor people with a lower level of capital are able to earn higher returns more quickly. In fact micro borrowers are able to earn much faster high margins by the mere fact of getting the capital to do so. This is why they are able to pay the relatively high cost for the provision of capital more easily. Why should MFIs not benefit from these higher returns as well? Seen from the other perspective would it be acceptable if poor people are able to double or triple their income because of micro credits while MFIs are not able to cover their costs and go bankrupt in the long run? Once again Professor Yunus Grameen Bank serves as a best practice example in this context because it operates profitable and ethically correct at the same time. Grameen Bank charges its poor clients around 20 percent interest for income generating loans (Grameen Bank, 2009). It manages to reduce its costs by using the Grameen group lending approach which spreads the risk of default and many costs among the members of the group of borrowers. As already mentioned earlier Grameen Bank keeps its focus on the mission to alleviate poverty and claims to be a social enterprise. A final argument for the sustainability of MFIs and the profits on business with poor is clearly that microfinance investors would like to invest in projects that meet the commercial standards, too. Well performing MFIs are therefore able to attract even more investors which then promote growth and more outreach of these institutions. Commercial investment is an integral part for the long term existence of microfinance. Nevertheless many MFIs cannot cover their costs completely and people might still think this is suitable because of their social

44 mission and the self-evident and constant support of donors. However it must be considered for how long donor support can be ensured and whether continuing financial support from donors is realistic in the long run. Summing up it is actually not an either/or discussion on whether MFIs should be profitable and earning money on business with poor is acceptable or not. It is more a question of how much they should earn. This means that unproportional high profits in microfinance business must be examined carefully, especially when cost reductions would be possible. It is also not a fact that microfinance is a new way to earn profits from the poor because as said it happened for a very long time. It is even more desirable that investors should invest their money into microfinance in order to do something ethically good besides the bare profit and loss calculation and if it is done in a morally proper, calculable and sustainable business way it is even better for all participants. Therefore keeping in mind the principle of double bottom line helps MFIs to work in an ethically correct way with the poor. Also not the goal of profit maximization but client protection should be a guideline for MFIs. Poor clients can be protected besides others by transparency in interest rate pricing (which means disclosure of annual reports) and the usage of reporting standards at the lender s side. In the end it is obvious that if MFIs do not operate profitable and go bankrupt in the long term, neither the investors nor the poor are helped. 6. Outlook It has been elaborated in this paper that the strict choice between profit hunting and pure social MFIs is false. In the future there will be a need of ethically oriented investors plus profitable and sustainable MFIs in order to fund outreach and development of microfinance. Microcredit techniques and the institutions that employ them are still relatively new and having sprung up over the last years with an immense boom after the Nobel peace prize for Yunus and the Grameen Bank in 2005 and the official Year of Microfinance in

45 However the industry is still in a nascent state in most countries and has a long way to go and develop further in order to saturate the great potential demand for loans from the unbanked poor. Besides the loads of new start-ups, already established MFIs are facing a current trend of commercialization of microfinance business. Those rise to the challenge of how to develop new innovations to reach much poorer people and more of them than they currently do while sustaining their profit levels (Cull et al., 2008, 24). Such new innovations include a noticeable new focus on savings products and insurances which represent a brand new niche. For example the two market leading German commercial insurers Allianz and Munich Re Group are already exploring the business opportunities in the micro insurance niche market. Other innovations in microfinance are for example online platforms like Kiva ( that operate as an intermediary for private investors who would like to lend to poor entrepreneurs in a developing country. The platform creates the possibility to do so in an easy online procedure. Technical innovations allow MFIs to improve their performance, reduce costs and facilitate the life of the poor by simplifying the credit application, repayment and usage of the loan. Examples for this are the SmartCards and BTMs already mentioned earlier. Micro financial services even in combination with modern mobile communication represent new windows of opportunity for MFIs (e.g. payments/transfers via mobile phones etc.). MFIs will hopefully continue to consistently improve performance, transparency, and reporting by implementing industry s best practices, upgrading management information systems, and using third-party evaluators (Tulchin, 2003). Microfinance has already provided billions of dollars to poor people. Now with the global credit crunch lending money became more difficult and expensive. This might to some extent also affect the poor borrowers since funding for MFIs becomes scarcer. Surprisingly, there are however many investors willing to invest into microfinance products when the institutions operate profitable. The high interest rates and repayment rates are quite attractive for investment bankers who currently face only downwards trends at the stock exchange. The failure rate of

46 most MFIs is despite the current financial crisis at a minimum level and returns better than those of conventional banks (Hauschild, 2009). A reason for that might be that behind microfinance, there exists a real (even if small) economy and no imaginary artificial investment vehicles. Those who borrow, work on small, local projects unaffected by large-scale global banking projects. On the other side many MFIs, who have not built a deposit base by themselves, depend on financing from international banks and capital markets. In order to prevent bottlenecks in financing for MFIs, the German Development Bank Kreditanstalt für Wiederaufbau (KfW) and the International Finance Corporation (IFC, Worldbank) raised a fund of targeted 500 million US dollar for the support of MFIs in difficult times (KfW Entwicklungsbank, 2009) and tried to pave the way for a hopefully successful future of the concept of microfinance. In the end the concept of microfinance with its potential to generate profits surprised many. The huge number of poor people, completely forgotten by the formal financial market for such a long time, turned out to be viable customers of micro financial services and changed the paradigm of western countries. Microfinance will continue to provide attractive investment opportunities in the future if people from developed countries keep being on the lookout for new markets, products and investment opportunities in this field

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53 Contact International Business Programs Master Program in International Finance and Economics (MiFE) Center for Applied International Finance and Development (CAIFD) Prof. Dr. Klaus Stocker Prof. Dr. Uwe Mummert Prof. Dr. Birgit Eitel Bahnhofstr Nürnberg Tel Fax IB hochschule.de university.de/ib