MICROFINANCE MATTERS - Creating a Virtuous Triangle

There has been some debate in this International Year of Microcredit on the need to encourage collaboration between governments, development agencies and the commercial banks in strengthening the microfinance sector. As a former commercial banker myself I am addressing this from the private sector viewpoint as I perceive this is where the greatest challenges to developing an inclusive approach lie.

To bring the commercial banks into the partnership - for 'partnership' is what it must be - requires a wholesale change in their mindset. In particular the banks need to be persuaded that microfinance represents a business opportunity which can not only contribute to their bottom lines but also develop local economies (and therefore their markets), broaden their market penetration and create future sales demand for additional services. In short, they need to discover 'the fortune at the bottom of the pyramid[2]'.

The banks may take a direct role where they already have an operational capability in country or, if lacking such a presence, provide indirect support by working through other institutions already established on the ground. The two are not, of course, mutually exclusive as a bank can be both a direct provider as well as a wholesaler, although care needs to be taken to avoid possible conflicts of interest.

Apart from the widely prevalent misconception that it is 'charity' (which in some cases it is) or that it is somehow linked to other non-commercial agendas that might undermine its financial sustainability (which in some cases it does!), perhaps the three most significant inhibitions to commercial banks' embracing microfinance are:

Of the three, i) is the most critical as this more than any other determines whether or not microfinance can be run as a sustainable (i.e., 'profitable') business thus attracting the necessary investment in both funding and expertise from the financial markets. In the most extreme cases interest ceilings are fixed through 'usury laws' which require an act of government to amend or repeal. A more common situation, however, is where authority is delegated to the central bank or ministry of finance to set interest rate limits as it deems necessary. In either case government must be persuaded to liberalise the interest rate regime and allow the market to set its own level. This, however, is never easy as not only is it necessary to create the political will for change (particularly difficult in those countries with a legacy of statism) but change itself may be seen as a threat to entrenched interests - which might even include the banks and other MFIs themselves - especially where there is government subsidisation of the financial system.

To overcome this there needs to be commitment to a consultative process in which the three pillars will work together to support microfinance sector development. In particular the development agencies and banks have a vital role to play in representing to sometimes reluctant governments the advantages of the market system. The development agencies would take the lead position in this due to their institutional power and being perceived as more disinterested, while the banks can help in the education process by demonstrating by their own experience that liberalisation stimulates economic growth and innovation and opens up segments of society previously without access to financial services. This joint approach can be very effective and there are a number of international banks who have been very successful in lobbying governments on behalf of their corporate interests.

Nevertheless, with few exceptions the bigger commercial banks have largely ignored microfinance and those few that have shown interest have generally regarded it as 'corporate social responsibility' or charity work rather than a serious business opportunity. However, as the likes of Bank Rakyat Indonesia, BancoSol (Bolivia) and, of course, ACLEDA Bank in Cambodia have shown, it is possible to run a microfinance bank on commercial lines and produce sustainable returns every bit as good as the best commercial banks. This message needs to be spread across a far broader spectrum of the financial community and I propose some ideas to get the discussion going.

OPPORTUNITIES

DIRECT DELIVERY (Bank has operational presence)	INDIRECT DELIVERY (Bank has no/limited operational presence - operates through agents/intermediaries)
*deepen market penetration* by tapping into upwardly mobile socio-economic levels.	*deepen market penetration* by accessing new territories and expanding 'global' coverage.
*diversify market spread* by introduction of new products and services.	*diversify market spread* by introduction of new products and services.
*expand market potential* by promoting economic growth through the provision of credit to previously disregarded economic segments, e.g., micro-to-small enterprises ('MSEs').	*expand market potential for future direct access* by promoting economic growth through the provision of credit to previously disregarded economic sectors e.g., micro to small enterprises ('MSEs') and assisting potential customers to move up the wealth ladder creating future demand for other products/services and establishing corporate brand.
*build future market share* by assisting customers to move up the wealth ladder creating future demand for other products/ services and creating long term brand loyalty.
*good risk/reward equation.* Experience has shown that with properly managed microfinance credit risk is no higher (and in many cases less) than other forms of credit particularly Consumer Lending - and the returns are higher!	*good risk/reward equation.* Experience has shown that with properly managed microfinance credit risk is no higher (and in many cases less) than other forms of credit particularly Consumer Lending - and the returns are higher!
*economies of scale* inherent in a microfinance portfolio allowing commercial banks to leverage their systems through hubbed networks as well as migrating products and skills cross-border.	*economies of scale* inherent in a microfinance portfolio allowing commercial banks to leverage their systems through hubbed networks providing outsource processing to agent(s)/intermediary(ies) as well as migrating products and skills cross-border.
*cross-selling* of other appropriate products (e.g., 'bancassurance', cash management, family remittances).	*cross-selling* of other appropriate products (e.g., 'bancassurance', cash management, family remittances).
*....and 'early bird' status.* Big competitive advantage for the first comers due to high entry costs and lower returns for later arrivals.	*....and 'early bird' status.* Big competitive advantage for the first comers due to ability to 'cherry pick' the best agent(s)/intermediary(ies) setting higher entry costs and lower returns for later arrivals.

CONSTRAINTS

DIRECT DELIVERY (Bank has operational presence)	INDIRECT DELIVERY (Bank has no/limited operational presence - operates through agents/intermediaries)
*political risk.* Microfinance seen as politically loaded, especially in emerging democracies, as politicians may try to use it for their own ends.	*finding the right partner* and developing the necessary trust, working relationships and technical cooperation (always the fear that the foreign partner will 'take over' when the business achieves critical mass).
*legal and regulatory infrastructure.* 'Usury Laws'; restrictions on foreign banks; lack of protection for lenders.
*negative perceptions.* 'Microfinance is too risky'. 'Does not fit our core business/strategy'. 'Too labour intensive/high volume of small value loans will not produce sufficient returns to justify investment'.	*lack of management control.* Quality control, brand confusion and reputational risks. Need for constant monitoring.
*accessing the market. Perceived need for expensive delivery* systems e.g. rural branch network, mobile banks/credit officers, use of local agents in the community.	*revenue sharing issues.*

STRATEGIES

DIRECT DELIVERY (Bank has operational presence)	INDIRECT DELIVERY (Bank has no/limited operational presence - operates through agents/intermediaries)
*develop strategic partnerships* with government and development agencies. Assist officials to understand the benefits of a market economy and the need to liberalise the financial environment. Provide professional advice to development agencies to assist their sector advocacy role.	*develop strategic partnerships* with government and development agencies. Assist officials to understand the benefits of a market economy and the need to liberalise the financial environment. Provide professional advice to development agencies to assist their sector advocacy role.
*use agents/intermediaries where appropriate* especial at local levels - reduces need for expensive office network and brings in local knowledge and connections. Use of mobile offices to be considered.	*operate through local agent(s) /intermediary(ies)* to obtain delivery network, technical skills and local knowledge. Right choice and preliminary relationship preparation critical to success.
*leverage MIS.* Microfinance is a high volume low value business: it is essential to homogenise and simplify loan and other products to reduce processing costs and obtain economies of scale. *manage microfinance portfolio as a separate business* at least initially. Commercial bankers do not as a rule translate well into microfinance lenders and it is better to bring in the skills and allow them to operate in their own space (where it is also easier to monitor performance).	*provide wholesale funding to local agent(s) /intermediary(ies) at favourable rates but look to ancillaries to leverage returns:* e.g. providing outsourced IT processing for agents; use of agent to sell other products and services; use local network to market correspondent banking services to international clients and other FIs.
*use microfinance to build future retail and MSE business.* (Can later be managed as one function - see above)	*use experience gained through working with intermediary to develop long term strategy for direct entry i.e. establishing own wholesale/retail operation.*
*monitor microfinance customers to pick future 'winners'.* Emerging markets provide fertile ground for entrepreneurs who may become future major relationships for the bank (the example of Hong Kong).	*monitor microfinance customers to pick future 'winners'.* Emerging markets provide fertile ground for entrepreneurs who may become future major relationships for the bank (the example of Hong Kong).

It is obvious that full participation of the commercial banks is vital to the future development of the microfinance sector. Moreover, there is a unique opportunity to demonstrate that government, the development agencies and the private sector banks can reinforce each other to achieve their individual aspirations. Their key roles and contributions can be graphically illustrated as follows:

Through the process of this 'virtuous triangle' I believe that the international commercial banks will recognise the commercial opportunities in bringing microfinance into the mainstream of financial services and will play a key role in driving it in the twenty-first century.

1 The author is a former senior executive with Standard Chartered Bank.

2 An article as brief as this can only barely touch the surface of the subject: for further argument see Prof. C.K. Prahalad's brilliant and provocative book "The Fortune at the Bottom of the Pyramid. Eradicating Poverty Through Profits" (Wharton School Publishing, 2004).