MICROFINANCE MATTERS - Commercial Banks and Microfinance

By Jennifer Isern, Lead Microfinance Specialist, CGAP and David Porteous, Consultant

There is a vast potential market for retail financial services among low-income clients, and a growing number of commercial banks have successfully entered this market. In 1998, CGAP described commercial banks as "new actors in the microfinance world."[1] Seven years later, it is not surprising that commercial banks are playing an increasingly important role in many financial services markets across the world. Compared with many existing providers of microfinance, commercial banks have potential competitive advantages in a number of areas, such as recognizable consumer brand names, existing infrastructure and systems, and access to capital.

The commercial opportunity in microfinance is catching the interest of mainstream banking. The February 2005 issue of The Banker carried a special feature on microfinance. The editorial of this issue stated: "Bankers are only just realizing that the poor have needs just like anyone else and that giving them the opportunity to help themselves not only works, but can open up the global financial markets to an entirely new customer market and asset class."[2]

Why Enter the Market?

In a number of countries, banks have been compelled by their governments to provide financial services, especially credit, to sectors such as small or agricultural enterprises that are considered social priorities. Using moral or legal compulsion generally has not led to sustainable models of service provision. However, increasingly, commercial banks are investigating for themselves, and some are entering the microfinance market because they see sustainable profit and growth opportunities.

Commercial banks face increasing competition in their traditional retail markets. This is causing margin squeeze. It is also leading forward-thinking banks to explore new potential markets that can generate growth in client numbers at acceptable profit margins.

CGAP estimates that there are up to 3 billion potential clients in the microfinance market.[3] Some 500 million people are currently being served by socially-oriented financial institutions, ranging from cooperatives to postal savings banks, that extend financial services beyond the traditional clients of commercial banks. Nonetheless, a significant number of potential clients remain unserved.

A recent CGAP survey identified over 225 commercial banks and other formal financial institutions that are engaged in microfinance.[4] For some, microfinance has been highly profitable. Certain microfinance-specialized banks are now more profitable than the banking sector average in their country (see figure 1).

Success is not guaranteed, however, as some banks have attempted to serve this market and failed because they did not understand the market or tried to move too quickly. Those that have succeeded offer a number of lessons to those now considering this market.

How to Enter the Market

The CGAP survey of banks in microfinance reveals that there is no single approach to entering the market for microfinance. For one thing, different banks will have different business goals, and the competitive and regulatory environment will vary. Banks have a wide range of approaches to choose from when entering the market.

Some banks enter the market directly by expanding their retail operations to reach the "micro" level by creating an internal unit or launching a separate company, such as a service company or specialized financial institution. Others take an indirect approach by working with existing microfinance providers. CGAP has identified six discrete approaches banks use to enter the microfinance market.

Choosing the approach that fits both the bank and the circumstances at the outset is an important factor in future success. Each approach has its particular rationale, risk profile, success factors, and costs. The section that follows sets out the basic model and variations in each case, together with selected examples of banks following each approach. The decision tree in figure 2 shows how different factors may give rise to a different choice of model.

Next Steps

Commercial banks that wish to take advantage of the opportunities in microfinance should carefully evaluate the considerations listed in the decision tree above, specifically their own goals, the potential market size and competition, the regulatory environment, and their current infrastructure and systems.

Given the differences between classic banking and microfinance, commercial banks need to view microfinance as a new business line and conduct the same kind of research that any company would entering a new market. For one thing, the clients and products may pose different risks from the risks of traditional banking. The different models outlined offer a range of risk levels for banks, and ways of managing them. Any bank looking to get into the market will need to take into account the bank's own interests and institutional capacity, competition, and other market factors. Secondly, banks getting involved in microfinance will need to develop new products appropriate to their target clientele. To deliver the products effectively, banks usually need to adapt their systems and procedures and provide specialized staff training and incentives on the new clients and products.

While a variety of models are evolving for commercial banks to enter the microfinance market, none is doing it successfully without board and management vision and commitment. Without this vision and commitment, it is unlikely that a bank will apply the resources-human and financial-necessary to make microfinance a profitable part of the business.

Entering this market is a long-term business proposition. No bank should expect to make a "quick buck" from microfinance. But the evolving models and profit records of successful players are encouraging more banks to see the long-term business rationale. There is a massive potential market for banks that approach these clients successfully.

Box 1 Serving the Underserved-What Makes for Success?

Commitment from board and management, strong internal champions, and alignment with the bank's core commercial strategy
Knowledge of microfinance best practices and how to serve micro-clientele
Infrastructure located conveniently for clients
Products especially adapted for low-income and informal markets
Systems and procedures adapted to the microfinance operations, e.g., systems that support immediate follow-up on missed payments
Appropriate staff training and incentives on new clients, products, and delivery systems

For further information and actual examples of the models discussed in this article, see CGAP Focus Note No.28, "Commercial Banks and Microfinance: Evolving Models of Success", by Jennifer Isern and David Porteous: www.cgap.org/docs/FocusNote_28.pdf

(1) Baydas, Graham, and Valenzuela, Commercial Banks in Microfinance: New Actors in the Microfinance World, 1998, www.cgap.org/publications/focus_notes.html.

(2) The Banker, February 2005, p. 6

(3) Christen, Rosenberg, and Jayadeva, Financial Institutions with a "Double Bottom Line," 2004

(4) Isern, Ritchie, Crenn, and Brown, "Review of Commercial Bank and Other Formal Financial Institution Participation in Microfinance," 2003.