What is 2+2? More effective microloans!

Authors: Florence Harmel, Salma Debbarh, Saad Niaz

 

Currently, 836 million people (12% of the world’s population) experience extreme poverty; living with less than $1.25 a day. While the world has seen some progress over the past years in reaching the UN Millennium Development Goals, which set eradicating hunger and poverty on top of the global agenda, extreme poverty remains an imminent challenge. Poverty may have retreated, with the proportion of the world’s population living in extreme poverty dropping from 50% to 14% from 1990 to 2015, it remains a prime issue in most emerging, and several developed economies.

In the 1970s, the economist Mohammad Yunus began offering cash on credit to poor women in the village of Jobra, Bangladesh; the intention was to assist them in launching income-generating projects to help support themselves and their families. Loans started from as little as $10 and did not exceed $500. This was the birth of the microcredit system – an opportunity to extend loans to the strata of society which could not access traditional financial system.

Since then, various forms of microlending programs have been introduced in many countries, from India to the United States.  In 2017, the market for microfinance investments in micro, small and medium enterprises was projected to grow by an average of 10% to 15%. stronger growth was expected in India and the Asia-Pacific region.

Microcredit was built with the objective of lifting vulnerable people out of poverty by allowing them to benefit from financial freedom. Access to credit is supposed to enable poor people to become entrepreneurs, increase their earnings and improve their quality of life. Many lenders accompany their small loans and financial services with peer support, networking opportunities and even health care to improve their clients chance of building a successful small business. In doing so, many economists submit belief that microfinance has a powerful potential to reduce poverty.

However, evidence on the success of microloans has shown varying results. Studies examining its impact in rural Pakistan, urban Kenya and Uganda, among other developing countries, have both confirmed and contradicted the premise that microloans lift people out of poverty.

To clarify the issue with strong evidence, several research teams across the world conducted large field experiments to measure the impact of access to microcredits on borrowers’ living standards. Studies were carried out in the following countries: Bosnia and Herzegovina, Ethiopia, India, Mexico, Mongolia, Morocco, and the Philippines. The studies showed that even though households who benefited from microloans enjoyed greater financial freedom, they did not experience sustainable increase in their income, nor achieved the ability to scale their businesses. All the seven studies agreed on the fact that microloans did not lift poor households from poverty. Furthermore, access to such loans showed negligible tangible impact on the well being of the borrower and household members.

A potential explanation for this finding is that a significant part of loans is used for consumption purpose like household expenses instead of investing in business operations. Another possible explanation is that not all borrowers are good entrepreneurs. Even though, in general microcredit helped to increase business investments and expenses, on average it did not have any positive effect on the borrower’s profit. Microcredit helps a few of the more entrepreneurial poor to start up businesses, but that doesn’t translate into gains for the borrowers, as measured by indicators like income, spending, health, or education.

The strategy of microcredit organizations emphasizes rapid scalability and cost efficiency whereas launching or expanding a micro business requires a certain time to permit substantial economic change. Moreover, most of microcredit beneficiaries lack of basic business knowledge and skills that would enable them to run a business.

These findings contrast with the assumptions of microcredit system. The model assume that many poor people can become micro-entrepreneurs. Entrepreneurship skills and financial planning are assumed as innate within borrowers. Additionally, and most importantly the model assumes that if the poor can repay their loans at high interest rates, it is a good indication that they are doing well financially.

While research seemed to contradict these assumptions, financial literacy appears to be the bottleneck of microfinance institutions. Ground studies showed that capital, knowledge, and opportunity are the three key items that will help to empower the poor.

Financial literacy represents skills and knowledge that equip individuals to make prudent financial decisions. It is an essential prerequisite for MFI borrowers. It leads to better financial inclusion and better business decision and management. Even though limited research has been done on levels of financial literacy, some development banks like the Asian Development Bank consider financial literacy education to be vital and private foundations like the Citi Foundation (funded by CitiGroup) have supported several programs to increase levels of financial literacy worldwide.

To tackle this issue, it is proposed to introduce mandatory financial literacy modules in the microloan screening process. For each applicant, a mandatory training should be designed to educate on the benefits of financial planning, sound investing activities and business management. By resequencing the process flow in a microfinance institution, loans will only be extended to individuals who successfully graduate from the financial literacy program. This would allow for risk mitigation in terms of loan defaults – by educating the grassroot segment on the benefits of microloans and how to manage them, MFIs can shift the usage of their loans from personal short-term consumption to sustainable business investments.

Backed by the popular saying “teach a man to fish and you will feed him for a lifetime”, financial literacy programs will allow microloan borrowers to learn the art of business and debt management in a practical manner. Further, milestones would be set to assist in achieving financial goals against the amounts extended as credit.

Another benefit that stems from this resequencing and innovation is the repayment of loans in a timely manner and with a reduction in markup rates. Presently, the markup rates on microloans are higher than the rates on unsecured commercial banking products. Case in point – the IRR on a small-ticket microloan by Finca Microfinance Bank is an exorbitant 48%.[1] This is largely due to the high default risk in microloans. By teaching the grassroot segment on the importance of investments and sustainable financial planning, the risk level is reduced, thereby allowing room for a reduction in markup rates.

Grameen Bank – the pioneer in the microloan space claims that it achieves a 95% repayment rate. Recent studies however have shown that the repayment rates on microloans are not capturing the reality behind the programs.[2] Borrowers are frequently using repeat loans or loans from different institution to pay-off existing debt, creating a downward spiral of ever-increasing debt.

With this resequencing innovation, the aim is to ensure credits are used towards income generating investment rather than short-term consumption. The second module of the financial literacy education will be around investments in the borrowers’ respective sectors; this would increase the ability to create and scale sustainable business models. This would help to repay the debt and as the business grow providing new credits. Further, as grassroot businesses achieve growth, the investment in financial education will decrease with every loan renewal.

There is strong research proving that increasing financial literacy increases the rate of repayment of loans in developed countries for mid-sized loans; however very few long-term research has been conducted on micro credit. This is also largely due to a direct relationship between education levels and poverty levels in an economy.

The research paper from Rashmi Barua and Renuka Sane[3] is one of the few studies available for perusal. They have evaluated the impact of a mandatory financial education program on female customers of an urban micro-finance institution (MFI) headquartered in Mumbai, India. The result suggested that financial literacy led to a decline in the total number of days taken to make loan repayments as well as the number of months in which repayment is delayed. This could be a game changer for MFIs as this would increase the repayment rate and therefore reduce cost. These costs could compensate the initial cost of investment for the education.

Another result from the same research suggests that the results are driven less by the content of the mandatory program itself, and more by the program raising general awareness and encouraging individuals to seek more information from other education programs. Therefore, along with improving basic education, it also improves the awareness and individual attitudes towards making sound financial decisions. One of the key outcomes of this awareness is a reduction in the death spiral within the credit debt segment.

Assessing the risks of this innovation, it is imperative to note that growing competition within microlenders has created multiple options for grassroot borrowers. Through the choice between different institutions, if borrowers are seeking short-term loans for critical personal expenses, they might lean towards a simple institution with easy access to credit rather than to a model which mandates a literacy program prior to disbursement. Another risk is the cost of the educational training. If financial literacy doesn’t turn up to be an advantage for loans repayment, this innovation would reduce the competitiveness of the mandating microfinance lender in the long run.

Financial literacy has been a key discussion since 2010 and has been promoted by the OECD and the UN as an accelerator towards achieving the millennial goals.

Some institutions have implemented financial literacy as a prerequisite to obtain a loan, but rather for mid-sized loans as compared to microcredits. For example, the KGSA foundation, located in the slums of Namibia, provides entrepreneurial training and business courses for families and graduates who are interested in starting their own business and have trouble accessing credit. Each participant’s business idea is run through several different tests to identify its feasibility, profitability, and sustainability. If it passes, the individual is awarded the necessary start-up capital. The Urwego Opportunity Bank (UOB), a micro finance bank in Rwanda, analysed the impact of financial literacy on their loan repayment. The findings suggested that the financial literacy was critical to the success of loan repayment as it allowed the clients to use book-keeping skills, credit management skills, and budgeting skills to ensure timely repayments. It also leads to improved performance on cash flow management, the choice of interest rate, loan period, loan size, planning, running cost and internal audit. As a result, UOB is offering a program called Holistic Life Improvement giving specific advice on business management, household financial management and health management.

The Microfinance Institutions Network (MFIN) a self-regulatory organization and an industry association of microfinance, has also launched a financial literacy mobile app for microfinance clients.

However, very few are including financial literacy as a pre-requisite screening tool. The gap exists – to achieve sustainability, it is pivotal that this gap be plugged at the earliest! Training the micro-borrowers will allow for greater financial freedom and will impact the economy’s GDP and literacy levels in a positive manner.

 

[1] http://www.finca.pk/files/2015/01/Lending-Rates.pdf

[2] http://online.wsj.com/public/resources/documents/pearl112701.htm

[3] Repayment in microfinance: The role of financial literacy and caste, Rashmi Barua and Renuka Sane, May 2014