Moving Beyond Storytelling: Emerging Research in Microfinance (Contemporary Studies in Economic & Financial Analysis)

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MOVING BEYOND STORYTELLING: EMERGING RESEARCH IN MICROFINANCE

CONTEMPORARY STUDIES IN ECONOMIC AND FINANCIAL ANALYSIS Series Editors: Robert J. Thornton and J. Richard Aronson Recent Volumes: Volume 83: Volume 84:

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CONTEMPORARY STUDIES IN ECONOMIC AND FINANCIAL ANALYSIS VOLUME 92

MOVING BEYOND STORYTELLING: EMERGING RESEARCH IN MICROFINANCE EDITED BY

TODD A. WATKINS Lehigh University, Bethlehem, PA, USA

KAREN HICKS Lehigh University, Bethlehem, PA, USA

United Kingdom – North America – Japan India – Malaysia – China

Emerald Group Publishing Limited Howard House, Wagon Lane, Bingley BD16 1WA, UK First edition 2009 Copyright r 2009 Emerald Group Publishing Limited Reprints and permission service Contact: [email protected] No part of this book may be reproduced, stored in a retrieval system, transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without either the prior written permission of the publisher or a licence permitting restricted copying issued in the UK by The Copyright Licensing Agency and in the USA by The Copyright Clearance Center. No responsibility is accepted for the accuracy of information contained in the text, illustrations or advertisements. The opinions expressed in these chapters are not necessarily those of the Editor or the publisher. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN: 978-1-84950-681-6 ISSN: 1569-3759 (Series)

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CONTENTS ACKNOWLEDGMENTS

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INTRODUCTION

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MICROFINANCE MEETS THE MARKET Robert Cull, Asli Demirgu¨c- -Kunt and Jonathan Morduch MICROFINANCE AND CAPITAL MARKETS: THE INITIAL LISTING/PUBLIC OFFERING OF FOUR LEADING INSTITUTIONS Ira W. Lieberman, Anne Anderson, Zach Grafe, Bruce Campbell and Daniel Kopf

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ROLE REVERSAL: PUBLIC AND PRIVATE FUNDERS IN MICROFINANCE Julie Abrams and Damian von Stauffenberg

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THE GREAT DIVIDE IN MICROFINANCE: POLITICAL ECONOMY IN MICROCOSM Bruce E. Moon

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THE NEW MONEYLENDERS: ARE THE POOR BEING EXPLOITED BY HIGH MICROCREDIT INTEREST RATES? Richard Rosenberg, Adrian Gonzalez and Sushma Narain MICROFINANCE DURING CONFLICT: IRAQ, 2003–2007 Frank R. Gunter v

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CONTENTS

EVALUATING MICROFINANCE PROGRAM INNOVATION WITH RANDOMIZED CONTROLLED TRIALS: EXAMPLES FROM BUSINESS TRAINING AND GROUP VERSUS INDIVIDUAL LIABILITY Dean Karlan, Tomoko Harigaya and Sara Nadel

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A FRAMEWORK FOR INNOVATION ROADMAPPING IN MICROFINANCE INFORMATION SYSTEMS Todd A. Watkins

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DOES ONE SIZE FIT ALL IN MICROFINANCE? NEW DIRECTIONS FOR ACADEMIC RESEARCH Joshua K. Ault and Andrew Spicer

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ABOUT THE AUTHORS

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ACKNOWLEDGMENTS This volume has been made possible through the support and guidance of the Martindale Center for the Study of Private Enterprise, College of Business and Economics, Lehigh University. Professor J. R. Aronson, Director, provided encouragement and advice throughout the process. We also thank Dr. Andrea Wuerth, who was instrumental in coordinating the initial phases of this book.

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INTRODUCTION OUTLINING A MULTIDISCIPLINARY MICROFINANCE RESEARCH AGENDA The microfinance industry (MFI) has crossed the threshold into a period of tremendous growth. This growth was significantly accelerated by media attention to the industry during the United Nations Year of Microcredit in 2005 and the awarding of the 2006 Nobel Peace Prize to Grameen Bank founder Mohammed Yunus, as well as the interest of high-profile donors and investors, including eBay founder Pierre Omidyar and Microsoft founder Bill Gates. Despite the promise for international development, despite the proven track record of exceptional loan repayment rates, and despite the development of competitive markets in countries like Bolivia, Peru and Bangladesh or the global expansion of microfinance access to tens of millions of new clients, little research has explored the impact this expansion has had on global poverty and economic and social development, in general. To address this gap, this volume brings together leaders in the microfinance industry and researchers representing a range of academic disciplines, many of whom have contributed to Lehigh University Martindale Center’s Microfinance Program. Our goal is to outline a multidisciplinary research agenda for the field. The topics addressed in this volume and the questions posed can serve to guide social scientists, technology experts, development specialists, investors, microfinance practitioners, policymakers, and students. So far, the question of whether or not microfinance actually helps alleviate poverty has been answered largely by the ad hoc but compelling, often emotional stories of individual clients and institutions. Experts in this volume take readers beyond the promising rhetoric of the microfinance industry to address some of the most pressing questions facing the industry today. For example:  Can large scale for-profit commercial investment contribute to both enhancing the sustainability of the microfinance industry and deepening its social impact? ix

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 How are MFIs addressing the problem of institutional sustainability and can improved financial sustainability occurs without mission drift away from the poorest clients?  Are government subsidies to MFIs helping or hurting private investors pursuing the most attractive microfinance investment opportunities?  How do we determine the impact MFIs are having on poverty?  To what extent is microfinance useful or viable in unstable and war-torn regions?  In what ways can technology help the industry better reach the millions still without access to basic financial services?  Which different microfinance business models and product designs are likely to be most successful? In which social, cultural, and economic environments?

THE VOLUME’S CONTRIBUTIONS In the first chapter, Robert Cull and colleagues (Microfinance Meets the Market) discuss the controversy over the growing role of fully commercial, profit-seeking institutions in microfinance. The increasing investor interest in profit-maximizing operations has been challenged by sometimes quite vocal socially oriented microfinance institutions that focus on the poorest customers and women. The success and growth of ACCION, Bank Rakyat Indonesia (BRI), FINCA, and Grameen Bank led the way in being able to offer financial services to the poor. However, the problem of institutional sustainability raises the issue of that sustainability without ‘‘mission drift’’ away from targeting the poorest. Morduch et al. draw on a data set that includes most of the world’s leading microfinance institutions. The evidence suggests that investors seeking pure profits would have little interest in most of the institutions that in practice actually serve the poorest customer, and that the future of microfinance is unlikely to follow a single path. Next in the second chapter, founding CEO of CGAP Ira W. Lieberman et al. (Microfinance and Capital Markets: The Initial Listing/Public Offering of Four Leading Institutions) examine the history of the first four MFIs that went public on stock markets: BRI on the Jakarta exchange, BRAC Bank on the Dakha and Chittagong exchanges in Bangladesh, Banco Compartamos in Mexico and Equity Bank, which trades on the Nairobi exchange in Kenya. As public companies and regulated banks, their financial performance is now being benchmarked against traditional banking sectors

Introduction

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and other corporations in their respective countries. Their robust growth and performance are signals to capital markets that microfinance is a potential profitable investment. Each ranks among the best-performing banks and financial institutions in their respective markets. The authors also suggest that these cases highlight the potential MFIs have for achieving management excellence, good governance and ownership incentives, massive scale, strong brand image, and high product quality. In the third chapter, Julie Abrams, Principal of Microfinance Analytics and MicroRate founder Damian von Stauffenberg (Role Reversal: Public and Private Funders in Microfinance) explore direct retail lending to microfinance institutions. Both authors run firms that analyze microfinance institutional performance. They posit a surprising reversal of roles between governmentowned development agencies and private lenders. Backed by a grant from Calmeadow, a Canadian foundation with a distinguished record in microfinance, this study of overall funding patterns in microfinance confirmed what the analysts had sensed while undertaking individual performance ratings: public international development financing institutions are not complementing private lenders; they are crowding them out of the most attractive MFI investments. In the fourth chapter in our collection, International Political Economy (IPE) scholar Bruce E. Moon (The Great Divide in Microfinance: Political Economy in Microcosm) draws parallels between, on the one hand, the recent contentious divide between proponents of microfinance commercialization and those who prefer concentration more exclusively on social mission and on the other hand, a generation-earlier ideological schism among IPE scholars. Aiming to help shed light on today’s heated argument, Moon discusses commonalities with IPE’s historic grand chasm between neo-liberal ‘‘market’’ and pluralist social contract ‘‘state’’ perspectives. Several issues central to the microfinance literature were anticipated by the IPE literature, based on which Moon suggests components of a microfinance research agenda appropriate for IPE and development scholars. The volume then turns to a rare look at the development of microfinance programs in conflict zones. Professor and Colonel (Ret.) Frank R. Gunter (Microfinance during Conflict: Iraq, 2003–2007) served as the chief economic advisor to the US-led multinational coalition in Iraq for several terms of duty. Iraqis have a short history with microfinance and the industry operates in an extremely challenging environment, including an Islamic culture that views loans very differently than in the West. Gunter gives an historical overview of the lessons learned in conflict finance, the differing military and civilian views of the role of microfinance, and the major issues that have

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impact on MFIs in Iraq, including the macroeconomy, violence, corruption, culture of credit, the banking system, and the regulatory environment. He also describes the seven MFIs that had begun operating there by the end of 2007, with financial help from the coalition and government of Iraq as part of the counter-insurgency campaign. Though none of the seven are yet selfsustaining, remarkably there are notable successes. The sixth installment herein is from Yale experimental Economist Dean Karlan and colleagues (Evaluating Microfinance Program Innovation with Randomized Controlled Trials: Examples from Business Training and Group versus Individual Liability). Laying a methodological path for future research, they argue for applying empirical scientific methods to evaluating microfinance innovations and outcomes through experimental, randomized controlled trial research. Their goal is to enhance the prospects for learning which innovations will truly benefit clients and MFIs as they evolve and grow. The authors highlight problems of non-experimental approaches usually used and discuss their research on the MFI program design problem of choosing among alternative lending methodologies to illustrate the benefits of rigorous controlled trials for measuring impact and improving MFI sustainability and growth. The seventh chapter moves from guidelines for research methods to guidelines for microfinance technology development. The inability to reach large numbers of clients efficiently remains one of the principal challenges, and MFIs increasingly look to technological innovation to better track operations, reach new customers and lower transaction costs. Pointing to successful precedents in other industries, innovation management and policy scholar and Director of Lehigh University’s Microfinance Program Todd A. Watkins (A Framework for Innovation Roadmapping in Microfinance Information Systems) argues that the microfinance industry would benefit from an ongoing industry-wide technology roadmapping program that collaboratively guides innovation investments and strategies. Based on a series of facilitated workshop discussions among leading microfinance information technology experts from around the globe, the chapter outlines their consensus innovation needs and priorities in microfinance information systems. In the volume’s final chapter, international business scholars Joshua K. Ault and Andrew Spicer (Does One Size Fit All in Microfinance? New Directions for Academic Research) suggest that existing research in the field of international business provides important theoretical perspectives for framing microfinance research. In particular, they explore how countries’ social norms and institutions influence the commercial success and failure of microfinance business models. They report on an initial test of their hypothesis by modeling

Introduction

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the growth in the numbers of commercial microfinance clients across 178 countries using existing indices of political stability and informality of business contracts as proxies for institutional similarity or dissimilarity. Based on their encouraging results, they suggest a future research agenda in microfinance of tailoring theories of institutional distance to the specifics of the industry, looking at what types of microfinance models are likely to work under what types of institutional conditions. In summary, we hope the conclusions and recommendations of the contributions in the volume will help guide a broad multidisciplinary agenda for future research and in turn improve both policymaking and the evolution of organizational and business models in microfinance that can be sustainable, socially aware, and that will accelerate the expansion of financial access and the alleviation of poverty around the globe. Todd A. Watkins Karen Hicks Editors

MICROFINANCE MEETS THE MARKET$ Robert Cull, Asli Demirgu¨c- -Kunt and Jonathan Morduch 1. INTRODUCTION In April 2007, Banco Compartamos of Mexico held a public offering of its stock in which insiders sold 30 percent of their holdings. The sale was oversubscribed by 13 times, and Compartamos was soon worth $1.6 billion (for details of the story, see Rosenberg, 2007; Malkin, 2008; Accion International, 2007). A month before the offering, the Economist (2007) had written: ‘‘Compartamos may not be the biggest bank in Mexico, but it could be the most important.’’ Compartamos’ claim to importance stems from its clients – not from their elite status, but from the opposite. The bank describes them as low-income women, taking loans to support tiny enterprises like neighborhood shops or tortilla-making businesses. The loans the women seek are small – typically hundreds of dollars rather than many thousands – and the bank requires no collateral. It is a version of ‘‘microfinance,’’ the idea associated with Muhammad Yunus and Grameen Bank of Bangladesh, winners of the 2006 Nobel Peace Prize. For Yunus, microfinance can unleash the productivity of cash-starved entrepreneurs and $

This chapter previously appeared in the Journal of Economic Perspectives 23(1), 2009. Reproduced by kind permission of American Economic Association.

Moving Beyond Storytelling: Emerging Research in Microfinance Contemporary Studies in Economic and Financial Analysis, Volume 92, 1–30 Copyright r 2009 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1569-3759/doi:10.1108/S1569-3759(2009)0000092004

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ROBERT CULL ET AL.

raise their incomes above poverty lines. It is a vision of poverty reduction that centers on self-help rather than direct income redistribution. For the supporters of Compartamos, its public offering heralds a future in which microfinance routinely attracts investment from the private sector, freeing it from the ghetto of high-minded, donor-supported initiatives. As testimony to the power of profit, Compartamos’ supporters point to the institution’s aggressive expansion, fueled largely by retained earnings: between 2000 and 2007, Compartamos grew from 60,000 customers to over 800,000, quickly making it one of the largest ‘‘microlenders’’ in Latin America. Microlenders can and should compete shoulder-to-shoulder with mainstream commercial banks, supporters say, vying for billions of dollars on global capital markets (Funk, 2007). But Muhammad Yunus (2007) was not among those rejoicing: ‘‘I am shocked by the news about the Compartamos IPO,’’ he announced. ‘‘When socially responsible investors and the general public learn what is going on at Compartamos, there will very likely be a backlash against microfinance.’’ Yunus’s reaction was prompted by Compartamos’ very high interest rates. At the time of the IPO, Compartamos’ customers were paying interest rates of 94 percent per year on loans (once 15 percent value added taxes are included). In 2005, nearly one-quarter of the bank’s interest revenue went to profit, which in turn propelled the success of the public offering.1 For Yunus, the high interest rates and large profits were unconscionable, extracted from Mexico’s poorest citizens. A leader of one non-government organization (NGO) in Latin America argued that Compartamos’ strategy is ‘‘socially, economically, and politically dangerous and should be morally condemned’’ (Velasco, 2007). The competing reactions reveal diverging of views around the possibilities and limits of microfinance, a polarization captured colorfully by Connie Bruck (2006) in The New Yorker.2 Yet there are also areas of shared vision. Most important, all agree that the demand for reliable financial services is huge. We estimate that roughly 40 to 80 percent of the populations in most developing economies lack access to formal sector banking services (Beck, Demirgu¨c- -Kunt, & Martinez Peria, 2007; World Bank, 2007). All sides agree that access to reliable financial services might help hundreds of millions, perhaps billions, of low-income people currently without access to banks, or at the mercy of exploitative moneylenders. Muhammad Yunus and Grameen Bank led the way by showing that with donor support a wide range of poor and very poor customers are bankable – they can borrow and save steadily and pay substantial fees.

Microfinance Meets the Market

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But the role of fully commercial, profit-seeking institutions in providing such microfinance loans is controversial. In Yunus’ (2007) depiction, Compartamos is nothing but a brute moneylender, the very beast that Grameen Bank was built to root out. For Yunus, microfinance institutions should be ‘‘social businesses’’ driven by social missions (Malkin, 2008). After all, like most other microfinance institutions, Compartamos could have instead substantially reduced interest rates (and profit rates) and nonetheless expanded, but at a somewhat slower pace (Rosenberg, 2007). For Compartamos’ supporters, though, the high profits allowed Compartamos to serve hundreds of thousands of poor customers who otherwise would have had even worse financial options. They ask: Would not serving them be a better moral outcome? The Compartamos initial public offering makes it possible to imagine investors funding microfinance globally at $30 billion per year (Funk, 2007), rather than the current $4 billion (as estimated by the donor consortium Consultative Group to Assist the Poor, 2008). This hope makes it possible to imagine serving over 1 billion low-income customers, rather than the 133 million counted in 2006 or the 175 million projected for 2015 (Daley-Harris, 2007). Microfinance ‘‘has lost its innocence,’’ a Compartamos-supporter declared. ‘‘To mourn this loss of innocence would be wrong y To attract the money they need, [micro-lenders] have to play by the rules of the market. Those rules often have messy results’’ (von Stauffenberg, 2007). In the next section, we offer an overview of the economic logic behind microfinance institutions, describe how the movement from socially oriented non-profit microfinance institutions to for-profit microfinance has occurred, and lay out some of the unanswered questions about the role of commercialization in microfinance. We then seek answers to some of these questions by drawing on a data set that includes most of the world’s leading microfinance institutions. The evidence suggests that investors seeking pure profits would have little interest in most of the institutions we see that are now serving poorer customers. This evidence, and other points in our discussion, will suggest that the future of microfinance is unlikely to follow a single path. The clash between the profit-driven Banco Compartamos and the ‘‘social business’’ model of Grameen Bank offers a false choice. Commercial investment is necessary to fund the continued expansion of microfinance, but institutions with strong social missions, many taking advantage of subsidies, remain best placed to reach and serve the poorest customers and some are doing so at massive scale. The market is a powerful force, but it cannot fill all gaps.

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2. THE EVOLUTION OF MICROFINANCE The greatest triumph of microfinance is the demonstration that poor households can be reliable bank customers. The received wisdom at the start of the 1970s held that substantial subsidies were required to run financial institutions serving poor households in low-income countries. Government banks often shouldered the task of serving the poor, usually with a focus on farmers. However, most state-run banks were driven by political imperatives, and so they charged interest rates well below market rates and even then collected loan repayments only half-heartedly. The risks inherent in agricultural lending together with the misaligned incentives led to institutions that were costly, inefficient, and not particularly effective in reaching the poor (Conning & Udry, 2007). Beginning in the 1980s, microfinance pioneers started shifting the focus. Instead of farmers, they turned to people in villages and towns running ‘‘non-farm enterprises’’ – like making handicrafts, livestock-raising, and running small stores. The shift brought advantages: non-farm businesses tend to be less vulnerable to the vagaries of weather and crop prices, and they can generate income on a fairly steady basis. The top microlenders boast repayment rates of 98 percent and higher, achieved without requiring that loans be secured with collateral. The experiences – taking place in cities and villages in Latin America, Africa, and Asia – refute decades of assertions that the way to serve the poor is with massive subsidies. The high loan repayment rates for microfinance institutions were credited to new lending practices, especially ‘‘group lending’’ (also called ‘‘joint liability’’ lending), and economic theorists took note.3 In the original models, customers were typically formed into small groups and required to guarantee each others’ loan repayments, aligning their incentives with those of the bank. Today a broader set of mechanisms is recognized as also contributing to microfinance successes – especially the credible threat to deny defaulters’ access to future loans, with or without group contracts. These banking successes should be celebrated. They pave the way for broadening access to finance for hundreds of millions, perhaps even billions, of low-income people who today lack ready access to formal financial services. Such access on its own is not yet proven to increase economic growth or to reduce poverty on a large-scale level – and, as a general proposition, we doubt that it will on its own. However, such access can do something more modest but critical: it can expand households’ abilities to cope with emergencies, manage cash flows, and invest for the future – basic

Microfinance Meets the Market

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financial capabilities that most of us take for granted but that are especially critical for low-income households operating on tight margins. In addition, microfinance institutions have proven particularly able to reach poor women, providing the hope of breaking gender-based barriers. In most places men dominate farming decisions, but women play larger roles in running household side-businesses, and women have quickly become the main microfinance clients, even in countries where gender equality is far from the norm. By 2000, 95 percent of Grameen Bank’s customers were women, and we show below that women have become a focus of microfinance worldwide, though the average share of women served is substantially lower for commercial microfinance institutions than for NGOs.

2.1. The Big Leap: Profit-Making Poverty Reduction In the 1980s and 1990s, policymakers took a big leap, arguing that the new microfinance institutions should be profitable – or in the prevailing code language, they should be ‘‘financially sustainable.’’ The argument for emphasizing profit-making microfinance institutions proceeds in three steps. First, it holds that small loans are costly for banks to administer but that poor households can pay high interest rates. Moneylenders, it is often pointed out, routinely charge (annualized) interest rates of over 100 percent per year, so, it is reasoned, charging anything lower must be a benefit; CGAP (1996) articulates this argument sharply. Within reason, this argument holds, access to finance is more important than its price. The second part of the argument holds that subsidies were at the root of problems in state banks, and that, even in non-governmental institutions, ongoing subsidization can weaken incentives for innovation and costcutting. The third part of the argument holds that subsidies are not available in the quantities necessary to fuel the growing sector, so that if the goal is to spread microfinance widely, no practical alternative exists in pursuing profitability and, ultimately, full commercial status. In this spirit, donors encouraged both non-profit and for-profit microfinance institutions to raise interest rates. Use subsidies sparingly, donors argued, and only in the start-up phase: earn ample profits, and expand as rapidly as profits allow. Commercialize. Attract private investors. This argument that microfinance institutions should seek profits has an appealing ‘‘win–win’’ resonance, admitting little trade-off between social and commercial objectives. The idea that commercial businesses can be part of the solution to eliminating poverty has been celebrated in business

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best-sellers like C. K. Prahalad’s (2004) The Fortune at the Bottom of the Pyramid: Eradicating Poverty through Profits, and is spawning interest in microfinance at top business schools. However, the argument rests on empirical assertions that might or might not be true. For example, take the claim that many poor households will pay high interest rates without flinching, and the related claim that the existence of moneylenders implies the insensitivity of most borrowers to interest rates. Moneylender loans are often taken for short periods of less than a month, however, and are often used as a short-term patch to meet pressing consumption needs – whereas microfinance loans are typically held for several months at minimum and are targeted at business investment. The standard Grameen Bank loan, for example, had a one-year term. The most typical informal-sector loan is in fact not an expensive loan from a moneylender, but rather a loan from a neighbor or relative, typically without interest at all. Moreover, it is not obvious that using subsidies surely cripples incentives in non-profit institutions. Nor that subsidized funds are sharply limited or will soon dry up. Nor that private investors will reliably evince interest in microfinance over the long-term relative to their other options. Nor that for-profit institutions have the greatest possibility for reaching the greatest numbers of very poor people, relative to non-profits that take such outreach as their explicit mission. The billions of dollars of foreign investment so far comes from donor agencies and ‘‘social investors,’’ not investors seeking maximum financial returns (CGAP, 2008). The data presented in this chapter do not speak to all of these empirical assertions, especially the broader issues about the ability of microfinance institutions to increase overall rates of economic growth, but they do help to illuminate key issues around commercialization and the place of non-profit organizations in the microfinance industry. We show that poor households can and do pay relatively high interest rates on micro-loans; that modest subsidies can be used without notable efficiency losses (e.g., repayment rates remain high); that non-profits generally target poorer households than for-profits, and that many of those non-profits are fully covering costs. We do not find that the typical commercial banks replicate the outreach of the typical non-profits, and the data thus suggest strong reservations about embracing commercialization as the single way of the future. Still, we expect that the private sector will be a growing part of microfinance: the gaps in access are large and the private sector has proven to be innovative, fast-growing, and especially ready to adopt new technology. The challenge is to embrace the opportunities of the market while recognizing the potential trade-offs.

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3. A PORTRAIT OF THE MICROFINANCE INDUSTRY Data on the microfinance industry is available from several sources, each with strengths and weaknesses. We use data from the Microfinance Information Exchange (the MIX), a not-for-profit organization that aims to promote information exchange in the microfinance industry and collects data on microfinance institutions. Some data is publicly available at ohttp://www.mixmarket.orgW, including basic financial measures for a large number of participating organizations. The organization also publishes the MicroBanking Bulletin, which reports more detailed financial information, adjusted in certain ways for comparability, but while group and subgroup averages are available, it is not possible to identify data for specific organizations. The Bulletin is available at ohttp://www.mixmbb. org/en/index.htmlW. Another source, the Microcredit Summit Database, contains information on the largest number of microfinance institutions, but provides to the public only limited information about them, including summary information, the number of all borrowers, female borrowers, and ‘‘poorest’’ borrowers. Annual reports for this data are available at ohttp://www.microcreditsummit.orgW. For the analysis in this chapter, we use a more detailed version of the data from the MIX that is not publicly available, but to which the World Bank Research Department has access through a negotiated agreement. These data include outreach and impact data, financial data, audited financial statements, and general information on specific microfinance institutions. The data set is relatively large, covering 346 institutions with nearly 18 million active microfinance borrowers and a combined total of $25.3 billion in assets (in purchasing power parity terms). Most of the borrowers – about 10 million – are in the top 20 largest institutions, which shows how the microfinance world has segmented into some very large organizations alongside many smaller, community-based organizations with membership in the thousands.4 We look at the most recent data during the period from 2002 to 2004. A critical strength of the data set is that the numbers are adjusted to show the roles of both explicit and implicit subsidies – and, to the extent possible, to bring them into conformity with international accounting standards. (There are no international standards now, and Grameen Bank, for example, has claimed profitability even in years when its earnings from business have not fully covered its costs. For an anatomy of Grameen’s accounting from the 1990s, see Morduch, 1999.) The adjustments in our data include an inflation adjustment, a reclassification of some long-term

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liabilities as equity, an adjustment for the cost of subsidized funding, an adjustment for current-year cash donations to cover operating expenses, an in-kind subsidy adjustment for donated goods and services, loan loss reserve and provisioning adjustments, some adjustments for write-offs, and the reversal of any interest income accrued on non-performing loans. One strength of the sample is that the microfinance institutions have been selected based in large part on their ability to deliver quality data. A disadvantage is that participation in the database is voluntary. (Grameen Bank, for example, chose not to participate during our sample period.) The data set is thus not representative of all microfinance institutions, and the sample is skewed toward institutions that have stressed financial objectives and profitability. However, the institutions collectively serve a large fraction of microfinance customers worldwide, and the set favors the institutions best-positioned to meet the promise of microfinance – that is, to both reduce poverty and create sustainable financial institutions. Although the data set lacks direct measures of outreach to the poor, it includes proxies that include average loan size, the fraction of borrowers who are women, and the fraction living in rural areas. These indicators are correlated with each other, and also with self-reported measures of household poverty. Thus, at a broad level, these measures of outreach help to distinguish between institutions serving the poorest customers versus those that focus on individuals with low-incomes (but who are substantially better off than the poorest). The limits of the data set are addressed in part through comparisons with the parallel work of Gonzalez and Rosenberg (2006). They also analyze the Mix Market data, but they merge it with two larger data sets – the Microcredit Summit Database and a broader, unadjusted database from the MIX. The two other data sets have information on a wider range of institutions, forming a total of 2,600 institutions world-wide and serving 94 million borrowers, but the data are largely self-reported and unadjusted. For the most part, the comparison reinforces our conclusions.

4. EIGHT QUESTIONS The data allow us to focus on eight basic questions about the microfinance ‘‘industry’’: Who are the lenders? How widespread is profitability? Are loans in fact repaid at the high rates advertised? Who are the customers? Why are interest rates so high? Are profits high enough to attract profit-maximizing investors? How important are subsidies? How robust are the financial data?

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The answers then take us back to reconsider the initial questions of subsidy, profit, and social impact in microfinance.

4.1. Who Are the Lenders? The clash between Grameen Bank and Banco Compartamos described at the start relects the variety of institutions huddled under the microfinance umbrella. The first column of Table 1 shows the composition of our sample of leading institutions. Three-quarters of the institutions are either NGOs or ‘‘non-bank financial institutions.’’ Just 10 percent are microfinance banks. (The ‘‘rural banks’’ are state-run banks, and since there are only a handful, they are not the focus here.) The groups turn out to be quite distinct. Microfinance banks, and to a lesser extent credit unions, are likely to have for-profit status. NGOs have non-profit status. Non-bank financial institutions are in a broad category that includes both for- and non-profits such as NGOs that are specially regulated in return for being allowed to assume additional roles, including, for some, taking deposits. From the economics standpoint, the main difference between for- and non-profit status is the ability to distribute profits (Hansmann, 1980; Glaeser & Shleifer, 2001). If non-profits earn revenues greater than costs, they have to plough them back in to the Table 1.

Distribution of Microfinance Institutions by Institutional Type in the MicroBanking Bulletin Sample, 2002–2004.

Bank (%) Non-government organizations (NGOs) Non-bank financial institution (NBFI) Credit union Rural bank Total Total value across institutions

Institutions

Assets

Borrowers

Female Borrowers

Subsidized Funds

10 45

55 21

25 51

6 73

18 61

30

19

17

16

18

10 5

4 1

6 1

4 1

3 0

100 100 315 Institutions $25.3 Billion

100 100 100 18 Million 12 Million $2.6 Billion

Notes: The sample includes 346 institutions. Data on assets are available for 276 institutions; on borrowers for 346; on female borrowers for 290; and on subsidized funds for 281.

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business to further social missions. For-profit institutions, in contrast, can do what they wish with after-tax profits. But, as we show below, important differences emerge in the outreach and scale of the institutions. The second column shows that while the microfinance banks made up just 10 percent of the institutions in the sample, they are relatively large, accounting for over half of all the assets of the institutions in the sample (converted into purchasing power equivalents to yield $25.3 billion in total assets). NGOs, in contrast, make up 45 percent of the institutions but can claim just 21 percent of the total assets. For all institutions, the loan portfolio is their most important asset; the result implies that banks lend in much higher volume than others. NGOs, though, reach more borrowers in total. The third column shows that NGOs can claim about one-half of the 18 million customers in this data set, with banks claiming one-quarter. Donors at large aid agencies have pushed hard to encourage the commercialization of microfinance, but the evidence here suggests that non-profit microfinance agencies still matter in a big way. That impression is reinforced in the data of Gonzalez and Rosenberg (2006), which shows that NGOs served one-quarter of the 94 million borrowers seen in 2004, with self-help groups serving another 29 percent. (Self-help groups are a variant of microfinance commonly seen in India and are typically organized by NGOs linked to banks.) Microfinance banks and licensed non-bank financial institutions served just 17 percent of all borrowers. Government institutions – often inefficient and substantiallysubsidized – over-shadowed the banks by serving 30 percent of all coverage. In terms of borrowers, the greatest scale of outreach at this juncture is thus not from commercial institutions but from others. Trends in outreach will likely shift toward private sector banks as they grow and spread, but today NGOs and other non-profits maintain a large and distinct niche. The last two columns in Table 1 show that non-profits also serve more women than banks, and they use more subsidies. Although NGOs serve half of all borrowers in the sample, they serve three-quarters of the female borrowers. Banks, in contrast, serve a quarter of all borrowers but just 6 percent of the female borrowers. (Note that only 290 of the 346 institutions report on their coverage of women, and NGOs are more likely to report, which is telling in itself.) The final column of Table 1 shows the reliance on subsidized funds. We count $2.6 billion in subsidized funds (in purchasing power parity-adjusted dollars) fueling the institutions. Of this, the microfinance NGOs take a share that is disproportionate in terms of the number of customers reached and, especially, in terms of their assets. Banks absorb subsidies too, but in much smaller quantities.

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11

4.2. How Widespread is Profitability? The data on profitability start with an important finding: earning profits does not imply being a ‘‘for-profit’’ bank. Most microfinance institutions in our sample that have total revenues exceeding total costs in fact have ‘‘non-profit’’ status. They are earning profits in an accounting sense, but as non-profits they cannot distribute those profits to investors. The distinction is important, as it means that the microfinance industry’s drive toward profitability does not necessarily imply a drive toward ‘‘commercialization,’’ where the latter status reflects institutions that operate as legal for-profit entities with the possibility of profit-sharing by investors. If anything, the profit data here signal the strength and growth of NGOs. Fig. 1 sets the scene with a plot-relating profitability and the extent of non-commercial funding. The measure of profitability on the vertical axis is the ‘‘financial self-sufficiency ratio,’’ a measure of an institution’s ability to generate sufficient revenue to cover its costs. The financial self-sufficiency ratio is adjusted financial revenue divided by the sum of adjusted financial expenses, adjusted net loan loss provision expenses, and adjusted operating expenses (MicroBanking Bulletin, 2005, p. 57). It indicates the institution’s ability to operate without ongoing subsidy, including soft loans and grants. Values below one indicate that it is not doing so. The horizontal axis gives the ‘‘non-commercial funding ratio,’’ which is defined as the sum of donations plus non-commercial borrowing plus equity, divided by total funds. The ratio is zero if all funds come from either commercial borrowing or deposit-taking. The ratio is one if the institution draws funds from neither source, instead relying on donations, borrowing at below-market interest rates nor equity.5 The gently downward sloping line shows a weak link between lower profitability and greater reliance on non-commercial funding. This result makes sense since institutions pursuing social goals are wellpositioned to use subsidies, whereas profit-seeking institutions are most likely to pursue commercial capital. More important is the scatter plot of data points, each representing a microfinance institution. Many points are above the threshold for profitability, and many are on the left of the graph, indicating low reliance on soft (subsidized) funds. This is the hope of commercial microfinance. But note too that an ample number of institutions are above the threshold and to the right, funded by social investors of various stripes. The solid circles represent institutions with for-profit status, whereas the empty circles are non-profits. Although the for-profits tend to cluster to the northwest in the figure, the non-profits are spread broadly – and many are in the profitable

ROBERT CULL ET AL.

1 .5

Financial Self - Sufficiency

1.5

12

0

.2

.4

.6

.8

1

Non-Commercial Funding Ratio Quadratic Fit

For-Profit Organizations

Non-Profit Organizations

Fig. 1. Profitability versus Non-Commercial Funding. Notes: Profitability is measured by the financial sustainability ratio. The financial self-sufficiency ratio is adjusted financial revenue divided by the sum of adjusted financial expenses, adjusted net loan loss provision expenses, and adjusted operating expenses. It indicates the institution’s ability to operate without ongoing subsidy, including soft loans and grants. The definition is from MicroBanking Bulletin (2005, p. 57).

range. These distinctions would persist even after using regressions to control for age, location, and financial structure. The success of non-profits stems from the support of social investors, whether individuals or institutions, who have turned to microfinance in a big way: in 2007, such investors put $4 billion into microfinance (CGAP, 2008), a total that has been rising fast. Social investors range from international financial institutions like the World Bank’s International Finance Corporation to major mutual fund families like TIAA-CREF, in addition to individuals investing $100 or so (at zero financial return) through internetbased sites like Kiva.org. But even if called ‘‘investors,’’ ultimately they also provide subsidies (equal to the size of the investment multiplied by the difference between the microlenders’ cost of capital if obtained through the

13

Microfinance Meets the Market

market and the financial return, if any, taken by the social investor). For microfinance to continue expanding on these terms, institutions will need to maintain access to a stream of subsidized funds – and that will depend on the ability to prove the institutions’ social worth relative to other social interventions. The evidence below shows that subsidized institutions look different from others (in ways that are consistent with their having greater outreach to the poor), but better evidence is needed to strongly make the case. Table 2 shows the profitability of different types of institutions and borrowers in a different way. The bottom row of Table 2 shows that, of the 315 institutions with data on profits, 57 percent were profitable according to the adjusted MIX data. Moreover, since profitable institutions tend to serve more customers, 87 percent of all borrowers were served by profit-making institutions. Given that our data set is a self-selected sample of leading institutions, we also look to evidence from the larger data set of Gonzalez and Rosenberg (2006). There, profit-making institutions are again much larger than others. But they find that only 44 percent of borrowers from microfinance institutions are served by profit-making institutions (in their data, profits are self-reported, so this estimate is likely an upper bound). The average is dragged down by some large and very unprofitable government Table 2.

Profitability of Microfinance Institutions. Institutions

Institution type Bank Credit union NBFI NGO Lending method Individual Solidarity group Village bank Total

Active Borrowers

Number in sample

Percent profitable

Number (millions)

Percent served by profitable institutions

30 30 94 148

73 53 60 54

4.1 0.5 2.6 8.9

92 57 75 91

105 157 53

68 55 43

7.2 7.4 1.6

95 85 67

315

57

16.1

87

Source: MicroBanking Bulletin data set. Notes: Profitability is defined by a financial sustainability ratio above 1. NBFI, non-bank financial institution; NGO, non-governmental organization. Credit unions include credit cooperatives. The table covers 315 institutions with complete data on profitability.

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banks. When focusing on private institutions and non-government institutions, about 60 percent of borrowers are served by (self-described) profitable institutions. Most borrowers from profit-making institutions are customers of NGOs. As Table 2 shows, not surprisingly, banks are more likely to be profitable than others (73 percent of institutions are profitable), and non-governmental institutions less profitable (54 percent). But because non-government institutions are numerous and some are very large, 8 million of the customers in the sample served by profit-making institutions are served by NGOs (i.e., 91 percent of 8.9 million). Banks serve under four million customers in the sample (92 percent of 4.1 million). Not all NGOs aim for profitability, and some that are profitable prefer to keep non-profit status since it often reduces the weight of regulation and taxes. But we will show that when it comes to serving poorer households and women, profit-making NGOs look much more like subsidy-dependent NGOs than they look like commercial banks. The bottom line so far is that, among these leading institutions, NGOs are far from peripheral: they serve more borrowers overall and more borrowers on a profit-making basis.

4.3. Are Loans Repaid? Much has been made of the fact that microcredit innovations allow lenders to get their money back, even in the absence of collateral. The second panel of Table 2 divides the sample by lending method. Individual lending refers to traditional lending relationships between the bank and individual customers. Solidarity group lending refers to the group contracts that were made famous by Grameen Bank, and the ‘‘village bank’’ approach captures a participatory lending method also based around group responsibility for loan repayments. The group-lending contracts (i.e., ‘‘solidarity group lending’’) are the best-known microfinance innovations, but Table 2 shows that microfinance and group lending are far from synonymous. This is another place in which we see a split between types of institutions. In our data, two-thirds of microfinance banks lend through individual methods. In contrast, three-quarters of NGOs lend through one of the two groupbased methods. Lending approaches correlate with broader social missions. The village banks generally aim to reach the most costly-to-reach and poorest customers; the solidarity group lenders also pursue poorer households, and the individual lending approach is better-suited to going ‘‘up market’’ and

Microfinance Meets the Market

15

making larger loans. The profitability figures in the bottom panel of Table 2 echo this pattern, with the village banks being least profitable (43 percent of institutions), the solidarity group lenders slightly more profitable (55 percent), and the individual lenders most profitable (68 percent). But while there are differences in profitability and target markets, there are not big differences in loan portfolio quality. The top row of Table 3 reports on the quality of loan portfolios for different kinds of institutions, and we show that all in fact do quite well. We focus on NGOs, non-bank financial institutions, and banks. For each group, the range of experience is captured with data at the 25th percentile, median, and 75th percentile. ‘‘Portfolio at risk’’ gives the outstanding balance of loans for which installments are more than 30 days overdue, expressed as a percentage of the total value of loans outstanding. The measure provides an alert that loans may not be repaid in full, but is not itself a measure of default. Alarm bells ring loudly when the measure tops 10 percent. The median figures here show that loan payments are not perfect, but risk appears to be held in check. The lending method does not appear to drive the results: patterns of portfolio strength are similar across types of institutions. (Admittedly, though, we are comparing apples with oranges and the data cannot reveal what would happen to loan repayment rates if solidarity group lenders, say, suddenly switched to individual-lending contracts. One recent randomized experiment, though, found that little changed when a Philippine lender did just that; see Gine & Karlan, 2008.)

4.4. Who Are the Customers? Table 1 showed that microfinance banks lend in greater volume than others but serve substantially fewer customers. The two facts combine to yield that banks are on average making much larger loans per borrower than NGOs. This pattern has two main implications. First, if we take loan size as a proxy for the poverty of customers (smaller loans roughly imply poorer customers), microfinance banks appear to serve many customers who are substantially better-off than the customers of NGOs. Second, banks will have an easier time earning profits (assuming that a large fraction of the cost of making loans is due to fixed costs). When both large and small loans require similar outlays for screening, monitoring, and processing loans, the small loans will be far less profitable unless interest rates and fees can be raised substantially. We return to this in the next section.

Non-Bank Financial Institutions

Banks

37 1.17 13.8 4.7 659

7.4

85

26

156

25 1.03

3.4 0.7 233

0.74

3.1

63

15

84

15 0.78

10.5 6.0 72

0.31

0.53

11.4 4.1 199

26 1.14

157

21

86

11.1

60

0.81

0.16

7.9 2.7 0

12 0.86

135

13

47

4.1

71

0.91

0.46

3.6 0.9 32

20 1.04

234

17

66

9.9

160

2.06

0.83

17.8 4.3 747

26 1.22

491

24

94

23.0

247

6.91

0.41

14.4 3.5 8

20 1.16

278

16

67

9.4

164

1.20

0.00

1.6 0.1 0

9 0.99

118

7

23

1.9

110

0.39

0.11

10.0 1.4 0

13 1.04

299

12

52

20.3

224

2.43

0.22

22.9 3.2 136

19 1.15

515

21

58

60.7

510

5.23

0.03

15.1 2.1 0

14 1.10

299

11

49

10.4

294

4.42

Notes: Return on equity is the adjusted net income divided by the total equity. Subsidy per borrower numbers are donations from prior years plus donations to subsidize financial services plus an in-kind subsidy adjustment plus an adjustment for subsidies to the cost of funds. The columns give the distributions of each variable on its own: the institution at the 25th percentile for a given variable, for example, is thus unlikely to be the same institution that is at the 25th percentile of another. Based on fewer than 10 observations.

1.00

309

38

100

23.0

135

48

27

7.59

3.54

0.74

Median 75th Median if 25th Median 75th Median if 25th Median 75th Median if 25th percentile profitable percentile percentile profitable percentile percentile profitable percentile (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12)

Non-Governmental Organizations

Non-Governmental Organizations versus Non-Bank Financial Institutions and Banks.

Portfolio at risk, 30 days (%) (2) Average loan size/ income at 20th percentile (%) (3) Active borrowers (thousands) (4) Women as a share of all borrowers (%) (5) Operating cost/loan value (%) (6) Operating cost/active borrower (PPP$) (7) Real portfolio yield (%) (8) Financial selfsufficiency ratio (9) Return on equity (%) (10) Return on assets (%) (11) Subsidy/borrower (PPP$) (12) Non-commercial funding ratio

(1)

Table 3.

16 ROBERT CULL ET AL.

Microfinance Meets the Market

17

Here, we focus on the first implication, and Gonzalez and Rosenberg (2006) again provide helpful corroborating evidence. In their data, institutions are asked to self-report on the percentage of poor borrowers among customers. Lenders are also asked to self-report on the percentage of small loans they make (specified as loans under $300). In their data, a 10 percentage point increase in the fraction of small loans is associated on average with a 9 percentage point increase in the self-reported fraction of poor borrowers served. Self-reporting bias could explain some of the correlation, but the link between smaller loans and greater outreach to the poor appears to be fairly tight when comparing across institutions. The second row of Table 3 shows how loan sizes vary across types of institutions. For comparability across countries, we divided average loan sizes by the income of households at the 20th percentile of the income distribution in the given country. One fact jumps out: the loan size/income ratio is 48 percent for the median NGO, but over four times that for the median bank. As the fourth column shows, even profitable NGOs are much closer to other NGOs than to banks. At the 75th percentile of the bank sample, average loan size reaches 510 percent of per capita household income at the 20th percentile, suggesting that the customers of those banks are very unlikely to include a large share of customers among the poor and very poor. (As in most rows of Table 3, the averages for non-bank financial institutions are in the middle of those of NGOs and banks.) The fourth row of Table 3 indicates that for over half of NGOs at least 85 percent of borrowers are female. At least a quarter of NGOs serve women exclusively. Banks serve many women, but in lower numbers; for slightly less than half of institutions, men make up the majority of borrowers. Column 4 breaks out the median only for profitable non-government microfinance organizations, and their data on women as a share of all borrowers are much closer to that of other NGOs than that of banks. The lack of sharper data on the poverty levels of customers limits the broad conclusions that can be drawn with confidence, and the evidence lags far behind some of the rhetoric on the potential for microfinance to reduce poverty. In particular, debate persists about whether, outside of Asia, microfinance can make a major dent in populations living on under $1 per person per day, the ‘‘international poverty line’’ used by the World Bank and United Nations. Debate also persists on the extent to which tradeoffs exist between pursuing profit and reaching the poorest customers. The data here suggests that this trade-off is very real, but the evidence admittedly comes from proxy indicators of customer income rather than direct evidence.

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4.5. Why Are Interest Rates so High? A common response for NGOs facing high costs is to raise interest rates – not necessarily to the high double digits charged by Compartamos, but at least to levels much higher than banks charge. The real portfolio yield in the seventh row of Table 3 is an average interest rate charged by institutions, adjusted for inflation. At the median, NGOs charge their borrowers 25 percent per year, whereas the top quarter charge 37 percent per year or more. Banks, at the median, charge just 13 percent per year at the median, and 19 percent or more for the top quartile. When compared with Compartamos’ 90þ percent average interest rate in 2007, these kinds of charges seem eminently reasonable, though they are apt to surprise newcomers to the field. Our data show the logic for why the highest fees for borrowing in microfinance are not typically being charged by the banks, the institutions most focused on profits. The highest fees are being charged by the institutions most focused on social missions, whereas the commercial microfinance institutions offer relatively cheap credit. Their cost structures explain the relationships. Some institutions, like BRAC and ASA of Bangladesh, grew to serve millions of customers while constituted as NGOs, but they are exceptions. The third row shows that the typical bank in fact has many more borrowers per institution. A comparison of the median NGO versus median bank yields a ratio of roughly 1:3 in the number of active borrowers. Scale, though, proves to be a limited route to cost reduction. The sense among microfinance experts is that returns to scale through expanding the customer base have been hard to find; a regression study of 1,000 institutions, for example, finds that scale economies disappear after about 2,000 customers (Gonzalez, 2007). After that, gains must be found by pursuing the intensive margin through serving existing customers with larger loans and more services. This is where the action is. The larger loans made by banks translate into lower costs per dollar lent, as seen in the sixth column. The median bank spends 12 cents on operating costs per dollar of loans outstanding, whereas the median NGO spends 26 cents. The result holds despite the fact that the average operating cost per borrower for the median NGOs versus banks is $156 versus $299 for the median microfinance bank (as elsewhere in the table, the dollar figures are in purchasing power parity adjusted dollars to approximate their value in local currency). The NGOs are keeping costs down, in part by giving lower quality services, but it is not enough to compensate for the diseconomies of transacting small loans.

19

Microfinance Meets the Market

Bank

Credit Union/Cooperative

Non Governmental Organization (NGO)

Non-Bank Financial Intermediary

Rural Bank

0

.1

.2

% Operating Expense % Loan Loss Provisions

.3

.4

% Cost of Funds

All variables are means

Fig. 2. The Composition of Costs as a Share of the Average Gross Loan Portfolio. Notes: Data on costs are not disaggregated by activity, so the analysis includes only those institutions whose revenue from lending (interest, fees, and commissions) is greater than or equal to 80 percent of the total revenues. In restricting ourselves to the subset of microfinance institutions that are most focused on lending, we have greater confidence in ascribing all of their costs to lending.

These relationships are shown in three figures. Fig. 2 shows that it is operating costs, rather than capital costs or loan loss provisions, that drive the differences in total costs between different kinds of microfinance institutions. Fig. 3 shows that the institutions that make the smallest loans on average are also the institutions that face the highest costs per unit lent (a result that holds up in regressions after controlling for institutions’ age, inflation, country-level governance, GDP growth, region, and lending method). Fig. 4 shows that the institutions with the highest costs per unit also charge the most to their customers. The figures come together to yield a very weak correlation between profitability and average loan size (our proxy for the income level of customers). The correlation between the financial sustainability ratio and average loan size (relative to the per capita income of the bottom 20 percent) is positive but very small (0.07 with a standard deviation of 0.06; 293 observations).

ROBERT CULL ET AL.

.6 .4 .2 0

Operating Expenses / Gross Loan Portfolio

.8

20

0

2

4 6 Avg. Loan Size/Income(20th pctile)

8

10

Fig. 3. Average Costs per Dollar Lent Fall as Loans Get Larger. Note: Horizontal axis gives the average loan size as a fraction of the average income of households at the 20th percentile of the national income distribution.

In criticizing the Compartamos stock offering, Muhammad Yunus (2007) declared: ‘‘A true microcredit organization must keep its interest rate as close to the cost-of-funds as possible y My own experience has convinced me that microcredit interest rates can be comfortably under the cost of funds plus ten percent, or plus fifteen percent at the most.’’ The evidence presented in Table 3 shows that most non-government finance organizations in our sample in fact charge more than Yunus’ desired upper range. More important, the cost data suggest that, if most non-government microfinance organizations charged much less, they would require larger subsidies to continue operating along current lines. 4.6. Are Profits High Enough to Attract Profit-Maximizing Investors? It is one thing to earn profits, and quite another to earn profits that are high enough to attract investors who have no concern with social missions. Banco Compartamos took this idea to heart in creating the high-profit

21

Premium

-.2

0

.2

.4

.6

.8

Microfinance Meets the Market

0

.2

.4

.6

.8

1

Adj.Operating Expenses / Gross Loan Portfolio

Fig. 4. Interest Rates Rise with Costs. Note: The ‘‘premium’’ is the excess of the microlender’s average interest rate charged to borrowers over the International Monetary Fund’s inter-bank ‘‘lending interest rate’’ that banks in the given countries charge to prime customers (from IMF International Financial Statistics).

strategy behind their IPO. To them, below-average profit rates would have been a ‘‘non-event’’ and would have failed to bring competitors into the sector. We find that the median NGO does earns profits, thanks to the relatively high interest rates they charge (bear in mind, once more, that this data is a selected sample of leading institutions). Profitability is measured as having a financial sustainability ratio above one (row eight of Table 3). Profits are actually rather remarkable, given that the presumption had long been that meaningfully serving the poor can only be done with subsidy, a presumption consistent with mainstream economic theory (Stiglitz & Weiss, 1981). Still, the profit levels are modest in a comparative sense; indeed, at the 25th percentile, the financial self-sufficiency ratio for non-government microfinance organizations falls all the way to 0.78. In addition, the financial bottom line for most non-government microfinance organizations is improved by the fact that they are subject only to light regulation.

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We started by noting Compartamos’ outsize return on equity above 50 percent in 2004. The return compares very favorably with Citigroup’s 2004 return on equity of 16 percent, for example. Table 3 shows that the median return on equity for non-government microfinance organizations is 3 percent and, for microfinance banks, 10 percent. The figures are impressive, but well below returns for either Citigroup or Compartamos in 2004. The numbers are larger, though, when we condition on profitability (columns 4, 8, and 12; here the returns to equity are 11.4 and 15.1). The data show the promise of microfinance as a financial proposition. Clearly the profit rates at the top end of microfinance institutions have started to be at levels likely to appeal to profit-maximizing investors. But those profit rates are far from the norm. The hope for the rest of the sector is that returns remain large enough to tempt social investors. 4.7. How Important Are Subsidies? The final section of Table 3 shows how subsidies enter the funding equation. They are sizeable: subsidy per borrower (in purchasing power parity equivalents) was $233 for the median non-government microfinance lender, reaching $659 for those at the 75th percentile. (Note that the 25th, 50th, and 75th percentiles of the subsidy variable pertain to different institutions than those at the same percentiles for the profit variables.) The median bank, however, received no subsidy, and non-bank financial institutions are, as usual, in a middle range. As with the costs, the purchasing power parity adjusted data approximate the value in local currency rather than their costs to foreign donors. In keeping with this picture, the final row of Table 3 shows that the median microfinance bank relied mainly on commercial funding and deposits. The median NGO, in contrast, turned to non-commercial borrowing and donations with far greater frequency. A more detailed breakdown of the data, given in Table 4, shows that for the 134 NGOs in our sample, 39 percent of funding came from donations, with another 16 percent coming from non-commercial (soft) loans. For the 24 banks in the first row, the two categories contributed just 3 percent to total funding. In contrast, commercial borrowing and deposits combined to give 84 percent of total funds. 4.8. How Robust Are the Financial Data? Rather than taking an institution’s statement of profitability at face value, these data have been adjusted to account for hidden subsidies; this is what

23

Microfinance Meets the Market

Table 4. Institution Type

Shares of Total Funding by Institutional Type. Shares of Total Funding

Median NonCommercial Donations Non-commercial Equity Commercial Deposits Funding borrowing borrowing Ratio

Bank (24 observations) Credit union (30 observations) NBFI (88 observations) NGO (134 observations)

0.02 [0.09] 0.11 [0.22] 0.23 [0.30] 0.39 [0.34]

0.01 [0.037] 0.03 [0.11] 0.11 [0.20] 0.16 [0.25]

0.13 [0.16] 0.16 [0.15] 0.18 [0.24] 0.08 [0.20]

0.13 [0.19] 0.06 [0.10] 0.28 [0.30] 0.26 [0.29]

0.71 [0.30] 0.64 [0.29] 0.21 [0.29] 0.10 [0.18]

0.11

Total (289 observations)

0.26 [0.33]

0.11 [0.21]

0.13 [0.20]

0.23 [0.27]

0.27 [0.34]

0.43

0.21 0.45 0.74

Notes: Means [standard deviations in brackets] rural banks omitted.

makes these data especially valuable. But the devil, as is often the case, is in the details. If a socially motivated lender obtains foreign capital from a social investor at a concessional interest rate of, say, 2 percent a year, the adjustments here account for the fact that the institution would have instead paid a higher interest rate in the capital market (were it instead a fully commercial bank). The difference in interest rates is part of an implicit subsidy. The same holds true for equity shares in the microfinance banks that are held by social investors who do not seek full financial returns. The idea behind the correction is simple, but implementing it is not. The adjustments made by the MIX organization rest on estimates of the alternative cost of capital that the micro-lender would have had to pay if it had instead obtained the capital in the market. Is that rate 6 percent? 10 percent? 14 percent? The estimate ought to account for the perceived risks of investing in microfinance institutions, which include the risk that the quality of the loan portfolio might deteriorate (especially given that the portfolio is not backed by collateral), as well as any political risk or exchange rate risk that may affect net returns (investors might also be concerned with liquidity and the possibility that the ability to withdraw funds or sell shares may be limited). The adjustments implemented by the MIX, the source of the data, use a country’s deposit rate (taken from the International Monetary Fund’s database) as the assumed cost of capital that institutions would have to pay in the absence of subsidized funding. It’s a relatively low cost of capital, and it makes most sense for institutions with the option of raising capital by

24

ROBERT CULL ET AL.

collecting savings deposits. With regard to equity, the only adjustment is an adjustment for inflation. We could go one step further by adding a few percentage points to the country’s deposit rate to account for the transaction costs entailed in collecting deposits. As a test of robustness, we instead consider the prime interest rate, the price for capital between banks and their most trustworthy customers, also taken from the International Monetary Fund database. To account for the perceived risk of lending to microfinance institutions, we conservatively added 2 percentage points to the prime rate and then re-ran the profit calculations. Not surprisingly, this higher estimate of the price of capital diminishes the appearance of profits and increases the value of implicit subsidies used by the institutions. The adjustment means that the median NGO is no longer profit-making, though it remains that they do not lean too heavily on subsidies. Banks are much less affected by the adjustment. Much more needs to be done here; these first steps reinforce the broad arguments we made earlier using the benchmark MIX data: the financial performance of most of these leading microfinance institutions is remarkable from a historical perspective, but the bulk of institutions rely on subsidies and post returns that will be of interest mainly to social investors. We leave this section with one final thought. The analysis here is ‘‘static’’ in a way that is somewhat unfair to the institutions. We have no way of adjusting for the fact that the institutions would likely shift strategies and re-allocate resources if their access to concessional funds and grants dries up. This is the hope of the believers in commercial microfinance: that, when pushed, institutions will be able to reduce their dependence on subsidy by economizing and becoming more efficient – i.e., that they are not as dependent on subsidies as the tables here suggest. This is only speculation, of course, and others fear that instead institutions will sacrifice part of their social missions if subsidies are reduced sharply. We frame these views in the next section.

5. THE LOGIC OF SUBSIDIZING MICROFINANCE The big question for policymakers and social investors is: Do the costs of subsidizing microfinance generate large, important social benefits? This question implies others. Does microfinance reach the poor in large numbers? Does it create meaningful changes in customers’ lives? Does it compare well to alternative interventions? In terms of scale, the track record of microfinance is encouraging. At the beginning of the essay, we noted a recent count of 133 million microfinance customers at the end of 2006 (Daley-Harris, 2007). Multiply that by five to

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get a rough total of the number of people affected through family members’ access to credit, and we find that microfinance reaches on the order of over half a billion poor and low-income people worldwide. When those who were previously unable to receive credit become able to receive it through microfinance, there is ample reason to expect substantial economic and social effects. This presumption is backed up by success stories and systematic evidence of high returns to capital for businesses run by the poor. McKenzie and Woodruff (2006), for example, show high returns to capital for male-owned ‘‘micro’’ businesses in Mexico. But rigorous empirical evidence based on credible control-treatment evaluations remains scant for microfinance, and the same researchers find much weaker, near-zero evidence on returns to capital for female micro-entrepreneurs in a randomized controlled trial in Sri Lanka. With the institutional data that is the focus of this chapter, we cannot add to the debate on whether subsidies to microfinance are welfareenhancing. For that, we would need data on net social and economic benefits. As summarized in Armenda´riz and Morduch (2005) and the World Bank (2007), the existing studies of the effects of microfinance yield inconclusive results, ranging from the assertion of substantial reductions in poverty among microfinance borrowers in Bangladesh to zero effects in Northern Thailand. At a first pass, the mere fact that customers continue borrowing from year to year and maintain high loan repayment rates is a sign that they value the microfinance services offered, but even that evidence in itself offers only modest reassurance. After all, continued borrowing from year to year is also consistent with being trapped in the debt. The evidence also gives no sense of net benefits; and it ignores places, like sub-Saharan Africa, in which customer drop-out rates can be high. The sharpest study so far investigates customers of a very atypical microlender in South Africa that specializes in high-interest consumer loans. Karlan and Zinman (2006) focus on a group of loan applicants that had initially been rejected. The researchers convinced the lender to reconsider the marginally rejected applicants and to reverse the loan decision for some, using a randomized algorithm. Two years later, those with the luck to be granted access to loans were in better shape than a control group that remained without loans: the intervention increased employment, reduced hunger, and reduced poverty. More studies like this are needed, particularly focused on more typical microfinance providers. The good news from Table 3 is that there is no clear evidence that subsidy necessarily reduces the efficiency of microfinance institutions, but the non-government microfinance organizations do tend to have higher

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operating costs. An important next step will be to distinguish between possible explanations. How much is due to focusing on smaller loans that drive up average costs? To working with particularly hard-to-reach households? To subsidies that breed inefficiency? In the end, social investors need to ask whether investing in microfinance is likely to yield larger impacts than allocating resources elsewhere – to clinics or schools, perhaps, or to finance for larger businesses with greater growth potential. Microfinance has, on many levels, been a remarkable success, and the time is right for establishing its social and economic impacts more strongly.

6. THE FUTURE OF FINANCIAL ACCESS FOR LOW-INCOME HOUSEHOLDS Microfinance will no doubt continue to expand and become a tighter part of the financial mainstream. Experience so far, though, suggests that the profile of commercial banks that offer microfinance in low-income communities looks different from that of non-profit microfinance institutions run by NGOs. Commercial microfinance banks are more likely to have for-profit status and to involve an individual-lending method, larger loans, fewer women customers, lower costs per dollar lent, higher costs per borrowers, and greater profitability. Non-government microfinance organizations are more likely to be a non-profit employing a group-lending method, giving smaller loans, serving more women, employing subsidies more heavily, facing higher costs per dollar lent, and being less profitable. The looming exceptions come from South Asia, where high population densities reduce transactions costs and where the cost of hiring staff of requisite quality tends to be lower than elsewhere, thus allowing more favorable pricing and profitability while making small-sized loans. Still, commercial financial institutions are apt to play increasingly large roles in serving those with low-incomes, if not the poorest. The expansion represents a potentially large gain given barriers to financial access that span well beyond just the poorest households. The focus here has been largely on lending, but banks are also in the deposit-taking business, and they are increasingly providers of insurance as well. Deposits can offer a source of lendable funds at a reasonable cost, as well as giving customers secure ways to accumulate. The challenge for microfinance institutions is that the transactions costs of handling small deposits can also be high (in part due to the need for prudential regulation

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to protect depositors), and without innovation to lower those costs, banks are unlikely to seek the business of poorer potential depositors. Of course, the problem of high transaction costs was also an issue in lending – and it holds for insurance too. Reducing costs of financial transactions thus becomes a major goal broadly. New technologies may help. Banking through mobile telephones is taking off in the Philippines, South Africa, and Kenya. Mobile banking, as it is called, can reduce costs and increase the quality of services, even in poor communities (Kapoor, Ravi, & Morduch, 2007). New combinations of automated teller machines and debit cards are also being developed and implemented. As these technologies spread, the concept of microfinance will likely expand, too. As the microfinance industry develops, both for-profit and non-profit institutions face unanswered questions. For the for-profit microfinance sector, the frontier question is: Can they develop innovations to reach much poorer households than they currently do while sustaining their profit levels? One hope is that emerging technological innovations (like banking through mobile telephones) will reduce costs and increase the quality of services (though some fear that the technology could jeopardize some of the benefits to customers that come from banking with a human touch). There will also be important continuing roles for non-profits that earn only modest profits or rely on subsidies and are often supported by social investors. For the non-profit microfinance sector, the frontier question is: Are the social and economic impacts apt to be large enough to justify and ensure continuing support? To the extent that non-profit microfinance institutions seek continuing subsidies, they will have to start taking rigorous evaluations more seriously, a process which is only now picking up steam and which so far has yielded mixed results. In the course of rethinking the boundaries of microfinance services for the poor around the world, it will surely be helpful to return to the roots of microfinance lending. The original idea of microcredit focused on funding small, capital-starved businesses. Several decades of experience has shown that the demand for loans extends well beyond customers running businesses. Even customers with small businesses often seek loans for other needs, like paying for school fees or coping with health emergencies. Johnston and Morduch (2008), for example, find that half of the recent loans taken by poor households in Indonesia were used for purposes unrelated to business. Similar findings were found by Rutherford (2006) for a sample of Grameen Bank borrowers, even though the loans were labeled as business loans.

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The future will likely see a movement toward new loan products for general purposes, new savings products, and better ways to reduce risks. Poor and low-income households typically devote much energy to juggling complicated financial lives, and improving their basic financial capabilities can be greatly beneficial to them, even if it does not lead to wide-scale poverty reduction or national-level economic growth. We have focused here on the supply side; an unvarnished appraisal is critical, and there is further to go. The history of microfinance shows that innovations will stem from supply side insights together with fresh understandings of the financial lives of poor households.

NOTES 1. The Banco Compartamos initial public offering also netted the two founders of Compartamos tens of millions of dollars each in paper profits, though it is unclear how much will ultimately be realized (interview with Carlos Danel, co-founder of Banco Compartamos, April 22, 2008, Tarrytown, New York). 2. http://www.newyorker.com/archive/2006/10/30/061030fa_fact1. 3. There is now a rich literature following Stiglitz (1990). Subsequent contributions include Conning (1999) and Rai and Sjo¨stro¨m (2004). See also the references in Cull, Demirgu¨c- -Kunt, and Morduch (2007) and Armenda´riz and Morduch (2005, chapters 2, 3, and 4). Gine, Jakiela, Karlan, and Morduch (2007) analyze simulated microfinance scenarios in Peru as a way to disentangle the overlapping mechanisms through which microfinance lending practices work to hold down default rates. 4. In the larger data set of Gonzalez and Rosenberg (2006), which includes the data from the Microcredit Summit Database, 91 percent of the 1,565 institutions they analyze in 2003–2004 are small, collectively serving just a quarter of the borrowers. The other three-quarters are served by just 145 institutions. 5. Here, donations are defined as: donated equity from prior years þ donations to subsidize financial services þ an in-kind subsidy adjustment. Equity is the sum of paid-in capital, reserves, and other equity accounts; it does not include retained earnings or net income. Commercial borrowing refers to borrowing at commercial interest rates (though in practice it can be hard to determine where the market would set those rates). Non-commercial borrowing, in parallel, is borrowing at concessional interest rates (with the same caveat as the earlier). Total funds are the sum of donations, equity, deposits (both savings and time deposits), commercial borrowing, and non-commercial borrowing.

ACKNOWLEDGMENTS The views are those of the authors and not necessarily those of the World Bank or its affiliate institutions. Morduch is grateful for funding from the Bill and Melinda Gates Foundation through the Financial Access Initiative.

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The MIX Market provided data through an agreement between the World Bank Research Department and the Consultative Group to Assist the Poor. Confidentiality of institution-level data has been maintained. We thank Isabelle Barres, Joao Fonseca, and Peter Wall of the MIX for their substantial efforts in assembling both the adjusted data and the qualitative information on microfinance institutions. We have benefited greatly from conversations with Richard Rosenberg and Adrian Gonzalez, and comments from the journal editors, Jonathan Conning, Daryl Collins, Carlos Danel, David Porteous, and seminar participants at the University of Western Ontario and National Council of Applied Economic Research, Delhi. Varun Kshirsagar and Mircea Trandafir provided expert data analysis; Aparna Dalal provided additional assistance.

REFERENCES Accion International. (2007). Following up: Replies to remaining Compartamos IPO webcast questions. Available at ohttp://www.accion.org/NETCOMMUNITY/Page.aspx?pid ¼ 713&srcid ¼ 612W. Accessed on December 13. Armenda´riz, B., & Morduch, J. (2005). The economics of microfinance. Cambridge, MA: MIT Press. Beck, T., Demirgu¨c- -Kunt, A., & Martinez Peria, M. S. (2007). Reaching out: Access to and use of banking services across countries. Journal of Financial Economics, 85(1), 234–266. Bruck, C. (2006). Millions for Millions. The New Yorker, October 30. Conning, J. (1999). Outreach, sustainability and leverage in monitored and peer-monitored lending. Journal of Development Economics, 60, 51–77. Conning, J., & Udry, C. (2007). Rural financial markets in developing countries. In: R. Evenson, P. Pingali & T. P. Schultz (Eds), Handbook of agricultural economics (Chapter 15, Vol. 3). Amsterdam: Elsevier. Consultative Group to Assist the Poor [CGAP]. (1996). Microcredit Interest Rates, Occasional Paper No. 1. Consultative Group to Assist the Poor [CGAP]. (2008). Foreign Capital Investment in Microfinance: Balancing Social and Financial Returns. Focus Note 44. Cull, R., Demirgu¨c- -Kunt, A., & Morduch, J. (2007). Financial performance and outreach: A global analysis of leading microbanks. Economic Journal, 117(February), F107–F133. Daley-Harris, S. (2007). State of the microcredit summit campaign report 2006. Washington, DC: Microcredit Summit Campaign. Funk, S. (2007). Remarks by Steven Funk, founder and member of the dignity fund board. Microcredit Summit E-News, 5(1). Gine, X., Jakiela, P., Karlan, D., & Morduch, J. (2007). Microfinance Games, World Bank. Unpublished working paper. Available at ohttp://econpapers.repec.org/paper/egcwpaper/ 936.htmW Gine, X., & Karlan, D. (2008). Peer monitoring and enforcement: Long term evidence from microcredit lending groups with and without group liability. Working Paper. Yale

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University Department of Economics, January. Available at ohttp://research.yale.edu/ karlan/downloads/bulak.pdfW Glaeser, E., & Shleifer, A. (2001). Not-for-profit enterpreneurs. Journal of Public Economics, 81(1), 99–115. Gonzalez, A. (2007). Efficiency drivers of Microfinance Institutions (MFIs): The case of operating costs. MicroBanking Bulletin, 15(Autumn), 37–42. Gonzalez, A., & Rosenberg, R. (2006). The State of Microfinance – Outreach, profitability, and poverty (Findings from a database of 2600 microfinance institutions). Presentation at World Bank Conference on Access to Finance, May 30. Hansmann, H. (1980). The role of nonprofit enterprise. Yale Law Journal, 89(5), 835–902. Johnston, D., & Morduch, J. (2008). The Unbanked: Evidence from Indonesia. Presentation at World Bank Economic Review Symposium, March 15–16. Kapoor, M., Ravi, S., & Morduch, J. (2007). From microfinance to m-finance. Innovations: Technology, Governance, Globalization, 2(1–2), 82–90. Karlan, D., & Zinman, J. (2006). Expanding Credit Access: Using Randomized Credit Supply Decisions to Estimate the Impacts, Yale University and Dartmouth College, draft. Malkin, E. (2008). Microfinance’s success sets off a debate in Mexico. New York Times, April 5, p. C1. McKenzie, D., & Woodruff, C. (2006). Do entry costs provide an empirical basis for poverty traps? Evidence from Mexican microenterprises. Economic Development and Cultural Change, 55(1), 3–42. Microbanking Bulletin. (2005). Trend Lines, Issue 10, March, pp. 1–17. Available at http:// microfinancegateway.org/files/26919_file_MBB_10.pdf. Morduch, J. (1999). The role of subsidies in microfinance: Evidence from The Grameen Bank. Journal of Development Economics, 60, 229–248. Prahalad, C. K. (2004). The fortune at the bottom of the pyramid: Eradicating poverty through profits. Philadelphia: Wharton School Press. Rai, A., & Sjo¨stro¨m, T. (2004). Is Grameen lending effcient? Repayment incentives and insurance in village economies. Review of Economic Studies, 71(1), 217–234. Rosenberg, R. (2007). CGAP reflections on the compartamos inital public offering: A case study on Microfinance interest rates and profits. CGAP Focus Note 42. Washington, DC: Consultative Group to Assist the Poor. Rutherford, S. (2006). Uses and users of MFI loans in Bangladesh. MicroSave Briefing Notes on Grameen II, No. 7. Stiglitz, J. (1990). Peer monitoring and credit markets. World Bank Economic Review, 4(3), 351–366. Stiglitz, J., & Weiss, A. (1981). Credit markets in credit with imperfect information. American Economic Review, 71, 393–410. The Economist. (2007). Economics focus: Small loans and big ambitions. The Economist, March 17, p. 84. Velasco, C. (2007). Remarks by Carmen Velasco, Co-founder and Co-executive Director, Pro Mujer, Inc. Microcredit Summit E-News, 5(1). von Stauffenberg, D. (2007). Remarks by Damian von Stauffenberg, Executive Director, MicroRate. Microcredit Summit E-News, 5(1). World Bank. (2007). Finance for all? Policies and pitfalls in expanding access. World Bank Policy Research Report, August. World Bank, Washington, DC. Yunus, M. (2007). Remarks by Muhammad Yunus, Managing Director, Grameen Bank. Microcredit Summit E-News, 5(1).

MICROFINANCE AND CAPITAL MARKETS: THE INITIAL LISTING/PUBLIC OFFERING OF FOUR LEADING INSTITUTIONS Ira W. Lieberman, Anne Anderson, Zach Grafe, Bruce Campbell and Daniel Kopf 1. INTRODUCTION Within the past few years, a new phenomenon has taken place among the world’s leading microfinance institutions (MFIs) – entry into new capital markets through initial public offerings (IPOs). ‘‘Going public’’ launches MFIs into a new frontier, not only presenting challenges but also providing new opportunities for the institutions and the clients they serve. This chapter discusses the history and IPOs/listings of the four leading MFIs who have carried out such transactions – Bank Rakyat Indonesia (BRI), BRAC Bank in Bangladesh, Banco Compartamos in Mexico, and Equity Bank in Kenya. The four institutions are well known throughout the microfinance industry for their exceptional growth, robust financial performance and their ability to scale-up their outreach to the working poor. They are now listed on national stock exchanges and, in two cases, sold internationally.

Moving Beyond Storytelling: Emerging Research in Microfinance Contemporary Studies in Economic and Financial Analysis, Volume 92, 31–80 Copyright r 2009 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1569-3759/doi:10.1108/S1569-3759(2009)0000092005

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As with any business going public, the IPOs and listings have allowed the four institutions to tap into the mainstream investor community and to take advantage of a myriad of new opportunities. The success of the IPOs signals to the microfinance community that their business can approach the mainstream capital markets successfully for funding. To the capital markets, they signal that the microfinance sector is a potential source of profitable investment. The offerings have increased liquidity for investors by creating opportunities for equity investors to exit, a critical step in attracting private capital. And, through the disclosure requirements the institutions now face, as well as overall heightened scrutiny, the offerings have created strong incentives for improved and transparent governance. These offerings resulted in another highly important step forward – MFI ‘‘value’’ information. Without adequate price and performance information with which MFIs could be evaluated, it was previously very difficult to attract private investors. The IPOs and listings have now established information about the value of MFIs in the market as well as increased transparency through the required filing documents. Going forward, these will prove to be important benchmarks for similar institutions looking to access capital markets as well as for potential investors. The market valuations affect all equity transactions for MFIs, even private placements of non-listed MFIs. Given their profitability, strong management and social missions, it is not surprising that these four companies were able to list their stock successfully, and that all four have shown remarkable growth since going public, both in share price and in overall organizational growth. As public companies and regulated banks, they are now being benchmarked against the banking sectors and other corporations in their respective countries. Each of these institutions, however, had very different structures and purposes for their actions. One of the largest MFIs in the world, BRI became the first bank with a predominate focus on microfinance to go public, in October 2003. Its offering was part of a larger process in which the Indonesian government was slowly divesting its holdings in the banking industry. BRI’s IPO was only a partial privatization, with the state retaining a majority interest in the bank. Of the $489 million1 raised by the IPO, 61% went to buy shares held by the government, while BRI retained the remainder as fresh capital. In the first three years following the IPO, BRI’s stock price increased 561%. Although it is the offspring of one of the largest NGOs in the world, BRAC Bank’s offering in July 2006 was on a far smaller scale than BRI or Compartamos. The company sold 50% of its share capital to the public, doubling the number of shares outstanding and raising $13 million to be

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used for the expansion of the bank’s operations throughout Bangladesh. BRAC’s stock price increased by 619% in the first year after the IPO. In contrast to BRI and BRAC Bank, none of the shares sold by Banco Compartamos in April 2007 were offered by the firm itself. Rather, the 30% of shares outstanding sold were part of a secondary offering, providing liquidity to existing investors. The firm received none of the proceeds. The offering opened at 12.8 times the book value and, within six months, saw a 48% increase over the initial price. Unlike the others, Equity Bank, a top-performing MFI in Africa, did not actually have an IPO, but rather a listing of stock that was already held by many of their clients and employees. Its listing was made in order to offer these shareholders the benefits of the stock market. The primary benefit was the development of a market for Equity Bank stock, both allowing existing shareholders to buy and sell at will and opening the opportunity to buy to any new investor. Despite their differences, however, the four institutions share similar characteristics that suggest only a few top MFIs will be able to step into the public realm. For example, each institution has long-serving senior management who have guided their organizations profitably as well as committed boards of directors and good-governance practices. The institutions have also achieved massive scale within their respective markets, translating into a strong capital base and profits as well as positive market recognition. Moreover, their potential for future growth is quite high. In addition, the four have sought to anticipate and address their clients’ needs through an increasing number of quality products and services, and they, for now, are respecting the components of the double bottom line. A more detailed discussion of the qualifications necessary for a successful capital-market listing can be found in the summary and conclusions of Section 2. In addition to these qualifications, however, a sophisticated or semisophisticated domestic capital market appears necessary for an institution to perform well through an offering. It is no coincidence that three of the IPOs are listed on relatively active stock markets: Jakarta, Mexico, and Nairobi. Even though BRAC Bank’s stock has shown phenomenal growth, the overall amount raised was significantly lower than that of the other three companies due in part to the limited Bangladeshi market. MFIs in similar capital markets should adjust their expectations accordingly. Although each of the institutions has performed well, it is still too early to predict a trend. Companies that have a social mission and are profitable, as well as the microfinance industry in general, have a certain cachet at the moment. Additionally, there has been a controversial but important

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discussion triggered by the Compartamos IPO regarding fair interest rates and the use of profits from businesses serving the poor. Nevertheless, the initial success of these institutions has opened the door for the industry. The four firms are succeeding due to their initial profitability, past growth, and bright future growth prospects. In each case the listings have been structured to preserve governance control among existing boards and to maintain the social mission. This chapter is divided into four sections: the first provides background on the microfinance industry; the second discusses the history of each institution and its financial performance leading up to its IPO/listing; the third examines the listings from a capital-market perspective, the key features of each listing from a technical perspective and how the institutions have performed to date; the final section provides some tentative conclusions about the meaning of these listings for the microfinance industry more broadly. Basic financial ratio-analysis data for each of the MFIs is presented in Table A1.

2. BACKGROUND In 1994 U.S. AID commissioned a team to prepare an assessment of leading MFIs in the microfinance industry. The resulting report was a seminal work on microfinance that examined eleven leading MFIs at the time, including BRI, one of the institutions that is part of this study. The 1994 study asked a series of questions about microfinance, several of which continue to be examined by the industry as it increasingly focuses on commercialization and which are highly relevant to our study (Christen, Rhyne, & Vogel, 1994, p. 2):  How are outreach and financial viability related? Does serving the poor preclude achievement of financial self-sufficiency?  If we wish to ensure that microenterprise finance reaches even the very poor, must we expect to support institutions that cannot become financially independent of donor subsidies?  How financially viable can microenterprise finance institutions be? Can they reach commercial standards? Consistently or only in limited settings?  What factors are necessary for the achievement of strong outreach and financial viability?  What are the challenges facing frontier institutions, as well as the challenges facing institutions that have not yet reached the frontier?

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The study went on to indicate that the best programs had made large advances in outreach and financial viability over five years (1990–994). Many of the institutions had sustained very high growth rates over three years. Ten of the eleven were fully self-sufficient operationally and five had crossed the hurdle of full self-sufficiency, generating returns that reflect banking standards. It is important to note that this study reached these conclusions when outside observers, if they knew anything about the industry, generally knew only a little about Grameen Bank and insiders would talk about the big three – BRI, Banco Sol, and Grameen Bank. Six years later, in 2001, Marguerite Robinson produced her seminal book on microfinance, The Microfinance Revolution: Sustainable Finance for the Poor, in which she defined the microfinance revolution in terms of commercial microfinance: The microfinance revolution is a commercial revolution based on new financial technology and greatly accelerated by the information revolution that developed concurrently. It began in the 1970s, developed in the 1980s, and took off in the 1990s y . These combinations enabled institutional profitability and long-term viability, making possible large-scale formal-sector financial outreach to low income segments of the population. (Robinson, 2001, pp. 28–29)

Dr. Robinson’s (2002) second volume on the microfinance revolution focused on Indonesia and provided exquisite detail on the growth of BRI’s unit desa system, which shows that MFIs could be viable, self-sufficient, and profitable. BRI also proved how important savings were to poor people, as BRI mobilized massive amounts of small savers in some 3,000 or more villages throughout Indonesia. However, the unit desa system was housed in a large bank owned by the Government of Indonesia, whose infrastructure was created by the government through a program dedicated to financing the expansion of the rice crop in Indonesia. As such, BRI was an anomaly; it was one of the few state-owned financial institutions in the world successfully to build a meaningful microfinance operation. A number of state-owned banks, especially postal banks, have been successful in mobilizing deposits from the poor. Moreover, in West Africa the large cooperatives are primarily savings cooperatives modeled after their French equivalent. But the BRI unit desas are somewhat unique in successfully mobilizing both savings and offering loans to microfinance clients. BRI has now been partially privatized through its IPO discussed in this chapter. In 2005, with the commercialization of microfinance well advanced, Beatriz Marulanda and Maria Otero examined the future of microfinance in

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Latin America. Their study concludes that: The ability of some of the leading microfinance institutions in the region to sell bonds successfully on their local capital markets is leading the way to the ever increasing availability of private capital funding. With such funding, microfinance in the region will see the elimination of what in past years was the key constraint to growth of the industry, that of access to sufficient capital. (Marulanda & Otero, 2005, p. B)

Two papers published in 2006, the first by Elizabeth Rhyne and Brian Busch and the second by Elizabeth Rhyne and Maria Otero, gave further confirmation of the exponential growth of commercial microfinance. In the CMEF sponsored study by Rhyne and Busch (2006), the authors compared growth of commercial microfinance as of 2006 with an earlier CMEF sponsored study in 2004. Of 120 institutions, the study found sufficient comparable data on 71 commercial MFIs. The loan portfolios of these institutions grew 231% over the three years in question or an average of 77% per year, reaching almost $5 billion from $1.5 billion three years earlier. The number of borrowers had increased by 73% or some 24% a year to some 4.1 million borrowers up from 1.7 million borrowers in 2004. Moreover, this growth was widespread globally with portfolio growth at 119% in Africa, 249% in Asia, 396% in Eastern Europe, and 169% in Latin America over this same period. The authors concluded that the 199 MFIs in the study provided a snapshot of shareholder (commercial) microfinance throughout the world in 2006. Together they accounted for a combined portfolio of 11.5 million borrowers and $8.7 billion in portfolio assets. Their combined equity was $1.5 billion with assets of some $13.7 billion. Large MFIs – portfolios over $100 million and clients in excess of 100,000 – also increased in numbers: 20 institutions had over 100,000 borrowers and 20 had assets over $100 million, with the ProCredit Banks, operating as both microfinance and full service banks focused on small and medium enterprises (SMEs), dominating that list. Six MFIs met both criteria – TEBA, ACLEDA, BRI, Banco Solidario, Compartamos, and MiBanco (Rhyne & Busch, 2006). Rhyne and Busch focus on commercial institutions and do not address the large NGOs in Asia, particularly BRAC Bangladesh, Grameen, and ASA as examples. However, although BRAC’s microfinance operations have remained under the wings of its NGO, BRAC Bank, one of the institutions that has gone public and is a subject of our study, focuses on small- and medium-size businesses (SMEs), an important niche in the highly competitive Bangladeshi market. BRAC’s microfinance NGO and its SME bank cover a very large number of borrowers and have an asset base which meets the criteria of the largest institutions.

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The Rhyne and Busch paper does not address institutions that mobilize a large amount of savings. In our study BRI, Equity Bank, and most recently BRAC Bank, are highly successful in their ability to capture a large amount of savings, with BRI and Equity Bank doing so through a large number of very small or micro savings accounts. The Rhyne and Otero (2006) study looks at what the drivers are of success in microfinance. One of the drivers identified is commercial entry. The authors note The entry of commercially oriented providers will substantially change the microfinance field y . The right conditions for rapid entry by new commercial players are now present in the marketplace: demonstrated profitability, business models that can be copied, and competencies for working with low income populations. The history of financial innovation suggests that once such conditions are present, spread can be very rapid. (Rhyne & Otero, 2006, pp. 17–18)

In this study we see further confirmation of the rapid progress made by commercial microfinance and the potential for the industry to reach a new stage in terms of its growth and outreach to the poor, while maintaining the profits, return on assets (ROA) and return on equity (ROE) necessary to attract private equity investors on a substantial scale. This new stage of development in the industry will not necessarily come from the ability of institutions to do IPOs, but rather by the signals these successful IPOs send to commercial investors, such as private equity investors or venture capitalists, and their ability to eventually exit investments they make in MFIs or microfinance equity funds.

3. THE INSTITUTIONS As we noted in the introduction, each of the four institutions has approached the capital markets somewhat uniquely, partly a result of different political and economic conditions within each institution’s respective country (Table A2). In this section, we will briefly discuss the nature of these four MFIs, their histories as financial institutions, their growth and financial performance, and their ability to reach scale and impact those without access to formal financial services. 3.1. Bank Rakyat Indonesia Established in 1895, BRI is among the oldest banks in Indonesia. Its unit desa system was established in 1984, and it is currently one of the largest

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MFIs in the world.2 The unit desa system is essentially a network of village banks that provide microfinance and savings to poor rural farmers. The system emerged from efforts by the Indonesian government in the early 1970s to increase the size of the rice crop substantially by subsidizing the financing of inputs such as fertilizer and seeds. BRI administered the financing by establishing some 3,600 unit desas at its peak under the BIMAS (Mass Guidance) credit program. The unit desas were also responsible for providing rural, non-agricultural loans. Employment levels at the unit desas grew rapidly to some 14,000 employees. Although the effort succeeded in terms of increasing the rice crop, it was clear by the early 1980s that the program of subsidized financing was very costly to the government. A nonpayment culture developed rapidly, and the program became clearly unsustainable in the long run (Charitonenko, Patten, & Yaron, 1998). In 1984, utilizing the infrastructure of the BIMAS program along with the technical assistance and advice of a Harvard Institute of Development team, the government and BRI developed the unit desa system. The key was the development of the KUPEDES loan product as well as a number of savingsdeposit products introduced after the KUPEDES (Charitonenko et al., 1998). Although the products have been somewhat modified over the past several years, the unit desa system remains much as it was designed in 1984. By 1986 the program reached its breakeven point and took off on a remarkable period of growth. From 1984 to 1996, BRI generated 18.5 million KUPEDES loans and during 1996 the unit desas were extending some 160,000 loans per month, averaging $1,007 (approximately at GNP per capita) with some 70% of loans below this average. By the end of 1996, the loan portfolio was about $1.7 billion (Charitonenko et al., 1998).3 Perhaps even more impressive was the growth in savings during this same period. Before the transformation of the village units from 1973 to 1983, savings mobilized through the national savings system totaled $30 million. As of the end of 1996, total unit desa savings were about $3.0 billion, or nearly $800,000 per unit desa, in 16.2 million savings accounts. Equally impressive is that the average size of these deposits in the primary savings products was US$184. This represented some 30% of the total number of savings accounts in Indonesia, serving 10% of Indonesia’s population (Charitonenko et al., 1998). The BRI unit desa system broke even after just 18 months in operation, in part due to the advantage of inheriting the BIMAS Program unit desa infrastructure. Profits of just $6 million in 1986 rose to $177 million by 1996. Return on average equity (ROE), which was 63% from 1990 to 1993, more

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than doubled to 134% in 1996.4 ROA averaged 4.6% over the seven years from 1990 to 1996. The long-term loan loss ratio of the program averaged 2.15% over this period of time, with the 12-month loan loss rate at 1.59% in 1996 (Charitonenko et al., 1998).5 These high growth years for the unit desas ran parallel to the growth of the overall Indonesian economy, which experienced more than a decade of uninterrupted growth. In 1970 about 60% of Indonesians lived below the poverty line; by 1996 just 11% of the population lived below the poverty line (Robinson, 2002). This is a remarkable achievement for any developing economy. The unit desas benefited from this period of stable and strong economic growth. In turn the working poor in rural villages benefited from the extensive village network of BRI, the opportunity to save safely while earning a decent return and the loans offered under KUPEDES. However, 1996 was a watershed year for the Indonesian economy. By 1997, the economy was deeply enmeshed in the East Asian crisis that spread rapidly throughout the region from its origins in Thailand.6 Indonesia’s GDP, which had expanded by some 8.0% a year for more than a decade, plunged by 13% in 1998 (Robinson, 2002). In the aftermath of the East Asian crisis, BRI was listed as part of a package of three banks who were majority owned by the Indonesian government. The crisis adversely affected the banking sector in Indonesia, forcing the government to intervene and recapitalize many of the state-owned banks, especially large commercial banks such as BRI. In all, the government closed 16 banks and transferred 54 distressed banks to IBRA, the Indonesian Bank Restructuring Agency (Kawai, Lieberman, & Mako, 2000). Although BRI had been reorganized in 1997 as a commercial bank prior to the crisis, the government still owned all of its shares. With high financial returns from the unit desas and a savings base in excess of the lending base, the larger bank was able to drain funds from the rural areas and intermediate these as corporate loans, often through politically tied lending. During the East Asian crisis, this resulted in large-scale defaults. More than half of BRI’s capital was impaired as a result, and it accumulated large-scale losses. The government was forced to recapitalize the bank in 2000 (Holloh, 2001, p. 47). Although the unit desas’ loan portfolio, savings balances, and profits were reduced substantially in dollar terms between 1997 and 2000, in Rupiah terms the system continued to grow and all measures of financial soundness remained solid, actually improving after 1998 when the crisis was at its deepest (refer to Table 1). As Robinson (2002, p. 397) has noted, ‘‘By examining the unit desas’ performance from 1996–2001 it would be impossible to learn that the country had been in deep crisis.’’

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Table 1.

Unit Desa Savings and Lending.

Value of outstanding loans Billions of Rupiah Millions of U.S. dollars Number of outstanding loans (thousands) Long-term loss ratioa Portfolio statusb Value of savings Billions of Rupiah Millions of U.S. dollars Number of savings account (thousands)

1996

1997

1998

1999

2000

4,076 1,711 2,488 2.15% 3.65%

4,685 1,008 2,616 2.17% 4.73%

4,697 585 2,458 2.13% 5.65%

5,957 841 2,474 2.06% 3.05%

7,827 816 2,716 1.90% 2.51%

7,092 2,976 16,147

8,837 1,900 18,143

16,146 2,012 21,699

17,061 2,408 24,236

19,115 1,992 25,823

Source: BRI monthly unit desa reports. a The long-term loss ratio measures the cumulative amount due but unpaid since the opening of the unit compared with the total amount due. b Portfolio status measures the aggregate amount of overdue principal installments compared with total principal outstanding.

Yet, BRI as a corporate bank, 100% owned by the state, did not do as well during the crisis. The government had to intervene and recapitalize it with an injection of government bonds into the bank’s capital. The focus starting in 2000 would be on micro, retail, and SME loans (Holloh, 2001; Robinson, 2002). It is clear from the data on BRI’s outreach data that the average size of the unit desa’s loans has been reduced and that the institution is reaching further down scale, with respect to average loan size as compared to per capita GNP. The average loan size was $878, or some 55% of GNI per capita, at the end of 2006. Savings balances continue to reflect the enormous core group of poor savers, with the average savings balance at $158, or some 9% of GNI per capita, at the end of 2006.7 BRI first listed on the Jakarta Stock Exchange on October 31, 2003. The IPO brought with it a new strategic focus for the institution; it would be a full-service commercial bank heavily focused on micro and small business (retail) lending. In fact, as part of a memo of understanding with the International Monetary Fund (IMF), the Ministry of Finance enjoined BRI from making corporate loans to new customers. The agreement with the IMF was to sell off the bank’s corporate loans, but that aspect of the agreement was not fully implemented at the time of the IPO. The bank was instead required to develop a strategy that would build on its strengths – the unit desa system, retail or small-business lending and consumer lending (Bank Rakyat Indonesia, 2003).

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For the past few years, growth has been modest but steady, reflecting the maturity of the unit desa system and the need for the bank to regenerate its capital. Growth in borrowers has averaged 3.7% a year reaching a total of 3.5 million borrowers at the end of 2006. The loan portfolio has grown to $3.0 billion. Savings accounts have somewhat peaked, growing at 1.23% per year over the past three years and in fact declining by 4.1% in 2006. However, the unit desas had 31 million savings accounts, with a total deposit balance of $4.9 billion at year-end 2006 (mixmarket.org). Financial performance remained very strong at the end of 2006, with ROA of 6.88% and ROE at 129.96%.8 The profit margin was 31.17%, and operating expenses to loan portfolio were 8.26%. Portfolio at risk was 5.07%, and the write-off ratio was less than one percent, at 0.83% (mixmarket.org). See Table 2 for a summary of BRI’s microfinance operations. Despite its great success to-date, the unit desa system still faces a number of challenges and risks. These are discussed by Robinson (2002) in her seminal work on Indonesia, Microfinance Revolution Volume 2: Lessons from Indonesia,9 and are as follows:  Political instability – There exist threats from outside BRI with respect to the stability of Indonesia and its potential for radicalization as well as from the political direction of the government with respect to BRI’s policies and lending activities.  Inappropriate regulatory environment – The unit desas are required to comply with banking regulations that are inappropriate to its microfinance business, a problem faced by a number of microfinance banks and regulated finance institutions.  Mission drift – There is a danger that, having been recapitalized and existing within a large commercial bank, BRI will stray from its mandate and resume corporate lending on a large scale. BRI’s achievements in microfinance to-date are remarkable. The institutional infrastructure, systems, and products are in place, allowing it to continue performing as one of the giants of the industry. Also, in its earlier development BRI’s management and the unit desas’ management, for example, Kamady Arief and Sugianto, were totally devoted to the development of microfinance and maintaining the integrity of the unit desas, separate from the bank. A long-serving Minister of Finance, Ali Wardana, also supported them. It is not certain that the present leadership and future leadership of the bank, appointed after the crisis, will share this same vision for the future.

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Table 2.

Bank Rakyat Indonesia (BRI).

Year of establishment Country Number of branches Mission

1895 Indonesia 324 and over 3,900 unit desas ‘‘To perform the best banking activities by delivering services mainly to small and medium enterprises in order to support economic development. To provide excellent services to its customers through a widely distributed network supported by professional human resources and to conduct good corporate governance practices. To provide optimal profit and benefit to its stakeholders.’’

Number of borrowers (year over year growth %)

2004 2005 2006

Average loan balance per borrower

2006

Gross loan portfolio (year over year growth %)

2004 2005 2006

Average loan balance per borrower/ GNI per capita (%)a

2005

Number of savings accounts (year over year growth %)

2004 2005 2006

Average saving balance per saver

2006

Saving balance (year over year growth %)

2004 2005 2006

Average savings balance per borrower/GNI per capita (%)a ROA (%) ROE (%) Profit Margin (%) Borrowers per staff member Operating expenses/loan portfolio (%) Portfolio risk (%) Write off ratio (%)

2005 2006 2006 2006 2006 2006 2006 2006

Source: All data are taken from The Mix Market website. a 2006 data unavailable.

3,210,678 3,313,532 3,455,894

3.6 3.2 4.3

$878 $2,044,532,205 $2,321,540,457 $3,035,685,400

18.9 13.5 30.8

54.74

31,271,523 32,252,741 30,907,566

4.7 3.1 (4.1)

$158 $3,503,488,748 $3,748,591,984 $4,869,688,137 9.08 6.88 129.96 31.17 90 8.26 5.07 0.83

8.0 7.0 3.0

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3.2. Bangladesh Rural Advancement Committee – BRAC Bank BRAC is a non-governmental organization (NGO) begun in 1972 as a relief and rehabilitation effort after the Bangladesh War of Liberation. Over the years, BRAC has evolved into the largest national NGO in the world. It is involved in myriad social support services, financial services, business entities and training programs, all with the twin objectives of poverty alleviation and empowerment of the poor, especially women. BRAC is present in some 62,000 villages throughout rural Bangladesh. Its social services include health services, diagnostic laboratories, community nutrition centers, schools, libraries, reading centers, and handicraft production centers. BRAC also operates BRAC University, providing tertiary education.10 In short, BRAC is a highly successful social conglomerate. It has achieved its size and excellence under highly dedicated management led for more than 35 years by Fazle Abed and his tight knit team. BRAC manages a very extensive microfinance program – BRAC Economic Development Program. By the end of 2006, the program had reached some 4.6 million poor, mostly women. BRAC’s microfinance operations were conducted through 1,205 service offices. Its loan portfolio was $350 million with an average loan balance per borrower of $77, or some 14% of GNI per capita in 2006. Savings mobilization was more modest, with 45,000 accounts totaling $538,000. The average savings balance is $11 or 2.86% of per capita income. It is clear that BRAC reaches very poor clients. Moreover, BRAC continuously tries to reach further down the scale to the poorest of the poor, largely through grant programs that prepare their clients economically, until they are able to borrow.11 Despite its effort to reach as far down the scale as is economically feasible, BRAC’s microfinance operations have operated profitably with a ROA of 6.9%, ROE of 23%, operating costs of 13% and portfolio write-offs at 0.63% as of the end of 2006 (mixmarket.org). BRAC’s microfinance operations have extended to Sri Lanka, Afghanistan, and subSaharan Africa, making BRAC a multinational MFI. See Tables 3 and 4 for a summary of BRAC’s microfinance and SME operations, respectively. In addition to its microfinance operations, BRAC has been involved in operating a number of businesses – a poultry farm, cold storage facilities, internet service provider, land and housing operations, hospitality services, and housing finance. BRAC also runs a number of programs that build employment skills and educate young people throughout Bangladesh. However, BRAC did not choose to commercialize its microfinance operations; it remains with the NGO. Instead, BRAC’s management chose

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Table 3.

Bangladesh Rural Advancement Committee (BRAC)Microfinance NGO.

Year of establishment Country Number of branches Mission

1972 Bangladesh 1205 (referred to as team offices) ‘‘BRAC works with people whose lives are dominated by extreme poverty, illiteracy, disease and handicaps. With multifaceted development interventions, BRAC strives to bring about change in the quality of life of poor people in Bangladesh.’’

Number of borrowers (year over year growth %)

2004 2005 2006

Average loan balance per borrower

2006

Gross loan portfolio (year over year growth %)

2004 2005 2006

Average loan balance per borrower/ GNI per capita (%)a

2005

Number of savings accounts (year over year growth %)

2004 2005 2006

Average saving balance per saver

2006

Saving balance (year over year growth %)

2004 2005 2006

Average savings balance/GNI per capita (%)a ROA (%) ROE (%) Profit margin (%) Borrowers per staff member Operating Expenses/loan portfolio (%) Portfolio risk (%) Write off ratio (%)

2005

2.86

2006 2006 2006 2006 2006 2006 2006

6.90 23.27 26.94 186 12.91 3.76 .63

Source: All data are taken from The Mix Market website. 2006 data unavailable.

a

3,993,525 4,159,793 4,550,855

14.3 4.2 9.4

$77 $243,146,287 $268,859,260 $350,160,812

20.6 10.6 30.2

13.75

27,208 32,548 45,234

0.7 19.6 39.0

$11 $538,405 $437,523 $515,572

(2.7) (18.7) 17.8

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Microfinance and Capital Markets

Table 4. BRAC Bank – SME Bank. Number of borrowers (year over year growth %)

2004 2005 2006

– 37,584 61,526

Average loan balance per borrower

2006

Gross loan portfolio (year over year growth %)

2004 2005 2006

Average loan balance per borrower/GNI per capita (%)

2006

Number of savings accounts (year over year growth %)

2004 2005 2006

Average saving balance per saver

2006

Saving balance (year over year growth %)

2004 2005 2006

$140,343,076 $202,610,141 $344,798,781

Average savings balance/GNI per capita (%) ROA (%) ROE (%) Profit margin (%) Borrowers per staff member Operating expenses/loan portfolio (%) Portfolio risk (%) Write off ratio (%)

2006 2006 2006 2006 2006 2006 2006 2006

283.69 1.42 23.0 16.09 20.2 6.54 3.76 0.63

– – 63.7

$4,761.09 $99,975,273 $178,133,580 $292,930,698

98.6 78.2 64.4

1,013 – 124,289 258,601

– – 108.1

$1,333.32 128.8 44.4 70.2

Source: All data are taken from 2006 Annual Report and Prospectus.

to float BRAC Bank, a commercial bank servicing SMEs in Bangladesh – largely the ‘‘missing middle’’ with respect to financial services in many developing countries. BRAC perceived an important economic and social opportunity in serving this ‘‘missing middle’’ and floated BRAC Bank through an IPO on the Dakha and Chittagong Stock Exchanges on December 11, 2006. BRAC Bank raised some $13 million through the IPO, all of which will be utilized to expand the bank’s operations throughout Bangladesh (BRAC Bank Limited, 2006). By the end of 2006, BRAC Bank operated some 280 unit offices, had approximately 3,000 staff and 61,000 borrowers, with a gross loan portfolio of $293 million. During 2006, monthly loan volume averaged $5.8 million

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dollars and average loan size was $4,761 dollars. Savings deposits totaled $344 million dollars coming from 259,000 savings accounts. During 2006 net profits were $5 million, up from $530,000 in 2003. ROA was 1.42% and ROE was 23% in 2006. Although BRAC is considered one of the most successful MFIs, its unique structure and development present several challenges that the organization will have to address:  A non-profit structure – Currently BRAC’s microfinance strategy operates under an NGO structure that does not allow for the mobilization of savings or the ability to raise funds commercially. This strategy differs markedly from the approach taken by BRI and Equity Bank, for example, which provide microfinance and SME services through full-scale commercial banks. Compartamos also operates as a commercial bank, but is focused on microfinance and has not yet mobilized savings in a significant way. Although BRAC’s strategy reflects its personal development and there is no single best model to be prescribed, there are certain advantages to operating as a commercial entity. These include the ability to:  offer clients a range of savings products and deposit insurance as allowed by the government,  use savings mobilization as a primary funding source for the bank,  offer a range of loan products and other financial services, and  access the branch infrastructure and technology of a bank (i.e., ATMs, MIS, and back office operations). One long-term possibility for BRAC is to merge its microfinance operations into the bank. Not having sufficient inside knowledge of BRAC, nor of the regulatory issues and political/economic and social considerations in Bangladesh, we are not making such a recommendation. We are simply speculating about whether such a change will make sense in time.  Succession – One of the major factors of BRAC’s success has been the commitment and savvy of its founding management team. Now the team is beginning to grow older together, and BRAC has begun to address the question of succession.12 Management succession will be a key issue of the success of the institution as well as for the industry as a whole going forward. 3.3. Banco Compartamos, S.A. (Compartamos) Compartamos is one of the largest MFIs in all of Latin America.13 It originated in a Mexican youth organization developed to improve the life of

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poor Mexicans living in marginalized communities. Compartamos was launched with a village banking pilot program in 1990 as an NGO titled Asociacion Programa Compartamos (Banco Compartamos, 2007b; Rhyne & Guimon, 2007). Compartamos operated as an NGO until 2000. In 2000, with a client base of 64,000 borrowers, it became a regulated financial institution in the form of a SOFOL (Sociedad Financiera de Objecto Limitado – a financial institution with limited objectives). Finally, in June 2006, the institution became a licensed commercial bank (Rosenberg, 2007). Compartamos was started by three young and highly talented social entrepreneurs, who have since remained as senior managers (Banco Compartamos, 2007b). Carlos Labarthe serves as managing director and board director, Carlos Danel serves as co-managing director and board director, and Ivan Mancillas serves as vice president of business development and alternate board director. The team’s talent, passion, commitment to the mission, and willingness to draw on external expertise has been a critical factor in success. Additionally, from the beginning Compartamos has had a committed board of directors, including representatives of the Harp family, Mexican business leaders and, in recent years, representatives of outside equity investors, such as the World Bank Group’s International Finance Corporation (IFC), ProFund, and ACCION International. Compartamos’ early financing was somewhat typical for MFIs at that time. In the initial years, management secured funding in increasing amounts from various donors. Then in 1996, it received a grant of $2 million from Consultative Group to Assist the Poor (CGAP) to support its expansion and capacity building efforts (Rosenberg, 2007).14 With this financing, Compartamos was able to reach the take-off stage. By 1996 growth was robust and remained so until the institution went public. From 1996 to 2000, Compartamos expanded its client base at a rate of 24% a year as an NGO. As a regulated financial company from 2000 to 2006, growth averaged 46% a year. By the end of 2006, Compartamos reached 600,000 clients with a loan portfolio at $271 million. All profit measures were exceptionally strong as a result of high real-interest rates and exceptionally low loan-loss rates. At the end of 2006, ROE was 57.53% and ROA was 23%. Portfolio at risk was 0.62%, and loan write-offs were 0.57%. See Table 5 for a summary of Compartamos’ microfinance operations. Yet Compartamos continues to reach down the scale to some of the poorest populations in Mexico, with an average loan size of $440 (5.45% of GNI per capita) at the end of 2006. Compartamos operates 187 branches in 28 states of Mexico. Loans are focused toward rural villages and women

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Table 5.

Banco Compartamos, S.A. (Compartamos).

Year of establishment Country Number of branches Mission

1990 Mexico 187 (located in 28 different states) ‘‘Compartamos is a social company committed to the people. We generate development opportunities within the lower economic segment, based on innovative and efficient models on a wide scale as well as transcending values that create external and internal culture, fulfilling permanent trusting relationships and contributing to a better world’’

Number of borrowers (year over year growth %)

2004 2005 2006

309,637 453,131 616,528

Average loan balance per borrower

2006

Gross loan portfolio (year over year growth %)

2004 2005 2006

Average loan balance per borrower/ GNI per capita (%)a ROA (%) ROE (%) Profit margin (%) Borrowers per staff member Operating expenses/loan portfolio (%) Portfolio risk (%) Write off ratio (%)

2005

5.45

2006 2006 2006 2006 2006 2006 2006

23.18 57.35 44.82 192 33.45 0.62 0.57

43.8 46.3 36.1

$440 $101,023,790 $180,630,956 $271,098,542

59.4 78.8 50.1

Source: All data are taken from The Mix Market website. 2006 data unavailable.

a

entrepreneurs (98% of its clients) who lack adequate access to finance (Rhyne & Guimon, 2007). The client base is widely diversified across Mexico’s regions, but the largest concentration of clients is in the poorest, indigenous states, such as Chiapas, Guerrero, Oaxaca, and Veracruz. Although Compartamos has diversified its products over the years, 87.4% of its total loans belong to its income generator (IG) for women. This program places women in groups of 15 and together they provide a solidarity guarantee (Banco Compartamos, 2007b; Rhyne & Guimon, 2007). Also, all clients of the IG Loans are provided with basic life insurance

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coverage at no extra cost to the borrower due to an alliance established with Seguros Banamex. (Banco Compartamos, 2007b). Unable to mobilize deposits as a SOFOL, Compartamos financed this expansion through a combination of retained earnings from strong profit performance and an injection of $6 million in equity investments from international investors focused on microfinance. The international investors included ACCION International, ProFund, and IFC (Rhyne & Guimon, 2007; Rosenberg, 2007).15 However, it was Compartamos’ ability to tap both the inter-bank market and the capital markets that made a substantial difference in its ability to expand its client base. That early entry into the capital markets in turn conditioned the institution and the market for its IPO. In July 2002, Compartamos issued $20 million of bonds, with a three-year maturity rated by Standard & Poor’s as MxAþ, and in February 2004, with a 34% guarantee from IFC, Compartamos raised five-year bonds in an amount of $50 million, rated by Standard & Poor’s and Fitch Mexico as mxAA.16 In June 2006, Compartamos received a commercial banking license from the Mexican Ministry of Finance and Public Credit and changed its name to Banco Compartamos S.A., Institucio´n de Banca Multiple. Commercial bank status allows Compartamos to continue diversifying its sources of funding and its product offerings, especially the mobilization of savings deposits. On April 20, 2007, Compartamos went public through an IPO that listed it on the Mexican Stock Exchange and also offered shares to international institutional investors under U.S. Securities and Exchange Commission (SEC) Rule 144A. The offering was unusual for an IPO in that the bank received none of the proceeds from the sale. It was a 100% secondary offering that raised some $474 million and allowed the principal shareholders – ACCION, IFC, Compartamos (the original NGO) – as well as the individual Mexican shareholders – managers and directors, who had founded and run Compartamos since 1990 – to recoup their investment and, as it turned out, very substantial profits (Banco Compartamos, 2007a). The Compartamos IPO focused attention on its profitability and robust ROA and ROE performance, in large part due to its substantially high interest rates. The IPO also generated controversy in the microfinance industry and the business press17 due to the large returns to Compartamos’ investors. Setting aside the external controversy over high interest rates and excessive profits from the public offering, Compartamos has a number of internal issues to deal with:  Cash mobilization and handling – At present, Compartamos’ regional offices do not handle cash. Instead, clients use other commercial banks

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throughout Mexico based on agreements Compartamos has negotiated with these banks. Compartamos has the dual task of cash management – of converting the present offices/branches to real banking branches able to handle cash securely – and the need to develop systems to move that cash to regional and/or central depository facilities. This has to happen if Compartamos intends to mobilize deposits in the future.  Savings mobilization – How should Compartamos approach the costly and very intensive effort of mobilizing savings from its clients? Compartamos needs to design savings products that are both economically viable for the bank and appealing to its clients. Savings are an important potential service for Compartamos’ poor clients, but they can be a costly alternative way to fund the bank if not handled properly. Also, the branch offices will need to be able to physically handle the increased inflows of clients once savings products are available. This will require significant investments in the present offices to convert them to full branches or the build-out of new branches in some cases that can mobilize savings with adequate security and the ability to handle the traffic flow.  Diversification of product offering – Compartamos will need to diversify its product base to become a full service bank for its clients. Currently, village-group loans dominate the product offerings; individual loans, housing rehabilitation loans, money transfers and remittances, and insurance products could add fee income and provide Compartamos’ clients with a wider range of services (Banco Compartamos, 2007a).  Competition – Finally, given its very high profitability, high real rates of interest to its clients and overall strong financial performance, its seems reasonable that Compartamos will face strong competition in the future from other banks or non-traditional financial institutions in Mexico, such as Banco Azteca and the recently licensed Banco Wal-Mart. Compartamos will need to decide how to step down the pricing curve (i.e. reduce its interest and fees) while still remaining profitable and competitive for the long term and continuing to serve the needs of its traditional client base.

3.4. Equity Bank Limited Equity Bank was founded in Nairobi in 1984 as the registered Equity Building Society (EBS). It focused initially on providing term loans and in mobilizing deposits. The bank opened several branches in nearby Central Province during its initial years of operation. Less than a decade after its inception, the high risk of term loans, a stagnant deposit base, lack of

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capital, poor management and a difficult macroeconomic and political environment led the bank to the brink of collapse. Despite its license as a mortgage lender, its initial portfolio consisted primarily of unsecured equipment loans to coffee and tea farmers. The Central Bank of Kenya declared EBS insolvent in 1993, when more than 50% of its loan portfolio was at risk of default and deposits were being used to cover operating expenses (Coetzee, Kabbucho, & Mnjama, 2002; Pearce & Rensch, 2005). Realizing that the bank needed help, in 1994 the chairman recruited James Mwangi, the current Equity Bank CEO, and began a major restructuring effort. The effort focused on the economically active poor – micro and small, salaried employees, small commercial farmers, and medium-sized enterprises in both urban and rural areas. In addition, the bank began a major marketing effort to mobilize savings deposits. The vision evolved over the years, but ultimately the goal was to become the leading retail bank in East Africa by providing the full range of financial services to the economically active poor (Coetzee et al., 2002; Pearce & Rensch, 2005). The new management team placed significant emphasis on training and recruiting quality staff and developed a culture of service to the clients above all. James Mwangi currently serves as the managing director of Equity Bank and is highly regarded in Kenya and throughout the microfinance industry for his managerial excellence and his commitment to growth while also serving the poor. He has begun to assemble a management team in the bank to focus on its long-term growth. Like Abed at BRAC, and Labarthe and Danel at Compartamos, Mwangi has a unique capacity as a social entrepreneur and manager to build Equity Bank for the future (Equity Bank, 2006a). He has also created incentives for his management team by providing them with share ownership in the bank. The listing on the Nairobi Stock Exchange and the increase in the value of Equity Bank’s shares provides an important compensation incentive to attract talent to the bank that other non-public banks and MFIs will find hard to match (Equity Bank, 2006b). During its restructuring, EBS reached out selectively to the international microfinance community for assistance. In 1999, funding from MicroSaveAfrica and Swiss Contact, followed soon after by assistance from the British Department of International Development (DFID), made a major difference in Equity Bank’s turnaround. For example, a DFID grant of $411,000 allowed EBS to upgrade the technology and increase the scale of its mobile banking units that reach clients in remote rural areas. The mobile units began operating in 2000 with $262,000 of EBS’ own capital. Technical assistance from MicroSave and Swiss Contact, based on market research in Kenya, resulted in a new focus for EBS – on the development of

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a product design that would be appropriate for the microfinance and small business market. Just as BRI was able to implement a massive savings program through carefully researched product design, EBS developed a range of savings products that met its clients’ needs. Savings provided a source of low cost capital, allowing the bank to rapidly expand its branch footprint throughout the country while also enabling it to validate clients’ creditworthiness before lending. To receive a loan, a client had to open an account and save with EBS for a minimum of six months. Commenting on Equity’s business model, AfriCap Microfinance Company, Ltd., a Mauritian-based microfinance investment fund, noted: The company attracts savings by providing comparatively high rates, flexible products and outstanding customer service. As an example, the savings account offers a very low minimum balance, no fixed fees and no restrictions on withdrawals and deposits. Loyal savers are progressively converted into borrowers on the basis of their savings patterns. As a result the company incurs little additional marketing costs while building its loan portfolio. (AfriCap, 2003, p. 10)

The bank also offered a full range of loan products; however, until recently the bank’s strength has been in its savings products (Coetzee et al., 2002). Portfolio at risk has remained high by microfinance standards, even though the bank has performed as well or better than many of its banking competitors in Kenya. EBS needed to invest a significant amount of funds and effort in management information system (MIS) software and creditrisk management systems to comply with changing banking regulations in Kenya, and perhaps more importantly, to tighten its control over its portfolio performance. However, EBS also needed more equity capital to support its large deposit base and rapid expansion. In April, 2003, AfriCap focused on equity investments in emerging MFIs throughout Africa, investing $1.5 million in EBS and becoming its first external strategic investor. Moreover, AfriCap also provided technical services funding and support through its Technical Services Facility (TSF) and two members of its management team joined EBS’ board of directors as EBS also sought to strengthen its governance as part of the bank’s overall reorganization and restructuring effort (AfriCap, 2006). In 2000, EBS was being compared to other MFIs. For example, it was compared to Kenya Rural Enterprises (K-Rep), the first MFI to convert to a fully licensed bank in Africa that, at the time, had 15,451 clients, 369 million Ksh in loans and a market share of only 2%. Equity Bank was also compared to FALU, a limited liability company that had 15,000 clients, 231 million Ksh in loans and a market share of 1% as well as the Kenya

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Women’s Finance Trust (KWFT), an NGO with 19,618 clients, 265 million Ksh in loans and a market share of 1%. It was the rural cooperatives serving small farmers, SACOs, which controlled the market, with over a million active clients, 23 billion Ksh in loans and 94% market share (Coetzee et al., 2002). However, as member-based cooperatives, the SACOs were largely unregulated and many proved unstable with poor governance and concentrated lending to farmers with a narrow range of crops. In 2004, EBS was given a full banking license and following its turnaround and initial take-off phase, the bank began to grow dramatically. By 2006, the year the bank decided to go public, there were few that continued to benchmark EBS as an MFI. Equity Bank Limited, as the bank was renamed, was now benchmarked against the Kenyan banks. Equity Bank Limited’s growth has been meteoric. From 2003 to 2006 the number of borrowers increased from 59,000 to 240,000 at an annual average of 66%. The portfolio grew from $15 million in 2002 to $158 million at year end of 2006, an annual average growth rate of 82%. The number of savings accounts during this same period grew from 156,000 to just over a million, an 61% average growth rate, while deposit balances grew from $28 million to $236 million, a 72% average growth rate. At the end of 2006, the bank’s ROA was 4.85% and its ROE was 40.36%. The profit margin was 31.53%. Capital adequacy was 11% and the debt-toequity ratio was 8.10%. Operating expenses increased rapidly as well to keep pace with expansion, at 77% on average per year from 2003 to 2006; however, at 42.38%, operating expenses as a percentage of loan portfolio were high. Also, portfolio at risk stayed stubbornly high at 12.19% (Equity Bank, 2007a; mixmarket.org). See Table 6 for a summary of Equity Bank’s microfinance operations, and Table 7 for related performance indicators and rankings from the Market Intelligence Banking Survey. Equity Bank Limited, just as the other institutions, faces a number of issues (Equity Bank, 2006a):  Risk management – Equity Bank’s portfolio at risk, risk management systems, and control over its very diverse portfolio of lending products remain the area that most needs attention. CGAP is currently providing Equity Bank with technical assistance in this area. In addition, a major investment and effort by the bank’s management to upgrade its MIS is designed to address these areas.  Competition – Equity Bank’s expansion has led it to bump up against the large corporate banks in Kenya. Competition among these banks is really heating up and there is a question as to whether or not these banks will

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Table 6. Year of establishment Country Number of branches Mission

Equity Bank. 1984 Kenya 36 ‘‘Mobilize resources to maximize value and economically empower the microfinance clients and other stakeholders by offering customerfocused quality financial services and solutions’’

Number of borrowers (year over year growth %)

2004 2005 2006

Average loan balance per borrower

2006

Gross loan portfolio (year over year growth %)

2004 2005 2006

Average loan balance per borrower/ GNI per capita (%)a

2005

Number of savings accounts (year over year growth %)

2004 2005 2006

Average saving balance per saver

2006

Saving balance (year over year growth %)

2004 2005 2006

Average savings balance per borrower/GNI per capita (%)a ROA (%) ROE (%) Profit margin (%) Borrowers per staff member Operating expenses/loan portfolio (%) Portfolio risk (%) Write off ratio (%)a

2005

36.73

2006 2006 2006 2006 2006 2006 2005

4.85 40.36 31.53 172 42.38 12.19 1.92

Source: All data are taken from The Mix Market website. a 2006 data unavailable.

59,306 110,112 239,541

(9.0) 85.7 117.5 $444

$40,088,984 $38,303,996 $106,374,014

81.7 (4.5) 177.7

65.64

413,095 556,000 1,014,474

63.8 34.6 82.5 $165

$57,932,010 $108,240,431 $167,645,004

30.3 86.8 54.9

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Table 7.

Market Intelligence 2006: Selected Indicators for Equity Bank (2005 Data).

Performance Indicator

MIBS 2006 Ranking

Cost of funds (0.91%) Return on capital employed (31.40%) Total income/total assets (16.45%) Number of branches (36) Number of employees (884) ROA (4.37%) Before-tax profit (501 million Kshs) Total net operating income (1,803 M Kshs) Total income (1,885 Kshs) Net interest income (866 million Kshs) Total assets (11,457 million Kshs) Total liabilities (9,863 million Kshs)

1 3 4 4 5 5 8 9 11 12 13 13

Comparison to Prior Year 1.25% in 2004 17.17% in 2004 16.39% in 2004 89% increase over 2004 53% increase over 2004 3.25% in 2004 129% increase over 2004 74% increase over 2004 71% increase over 2004 119% increase over 2004 71% increase over 2004 81% increase over 2004

Source: Market Intelligence Banking Survey 2006. Note: Prepared by Marguerite Robinson for a note on Equity Bank, November 2006.

begin to reach down the scale with respect to loans and savings mobilization and compete with Equity Bank directly.  Growth management – Equity Bank has high costs as a result of its expansion and has had to absorb a very larger number of personnel in a short period of time. Although the bank grows exponentially, it is hard to also attack issues such as productivity and efficiency, but that will become a necessity at some point in time.  Expansion opportunities – Equity Bank has ambitions to expand throughout East Africa. Interestingly, the bank is likely to bump against BRAC who has its own ambitions to enter 10 countries in Africa. BRAC is a formidable competitor and is already having significant success at an early stage in Uganda. Will Equity Bank go it alone in East Africa? Will it meet nationalistic and political resistance? Does it have the management capacity to expand internationally? These are but a few of the questions that will need to be answered before the bank moves forward on an international strategy. 3.5. Institutions Summary and Conclusions What is it about these four institutions that have qualified them for capital market listings and IPOs? What lessons can other large MFIs considering this step take from the success of these institutions?

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3.5.1. Management Excellence Each of the institutions in question has long serving senior management, who are outstanding social entrepreneurs and managers. Their respective institutions have consistently generated profits. The exception is BRI, which had very dedicated heads of the unit desa program and the bank, including former managing director of the unit desa system Sugianto, former president of BRI Kamardy Arief and former Indonesian Minister of Finance (1968–1983) Ali Wardhana, whose current leadership is concentrated in the larger bank and less known in the microfinance industry.18 Also, when BRAC Bank was established, BRAC’s senior management hired highly experienced bankers to run the bank rather than using the NGO management directing the microfinance operations. Any decision to take an institution public, particularly an institution such as Compartamos or BRI that wishes to raise funds from international institutional investors, requires significant reflection on the quality of the current management, noting whether they can manage the institution profitably in the future while also providing returns to investors. 3.5.2. Good Governance A second condition precedent for an IPO is the existence of a committed board as well as well-instituted good governance practices. For international institutional investors financing under U.S. SEC Rule 144a, that would include practices that comply closely with the U.S. Sarbanes Oxley Act guidelines respecting such matters as independent and qualified audit committees and MIS and accounting systems that provide high standards of internal controls. They will also look to the independence of and qualifications of directors. The four institutions we have examined have all made a serious effort to recruit qualified boards of directors and to implement good governance practices. Becoming regulated financial institutions has certainly been an important factor in these institutions’ improving their governance and going public. Best governance practices remain a very under-examined issue in the microfinance sector and more attention will need to be spent on it as MFIs seek to attract significant amounts of external capital or, as in this case, go public (Lieberman & Rhyne, 2005; also see Equity Bank, 2006a). 3.5.3. Ownership Incentives In two of the institutions that listed – Equity Bank and Compartamos – management and director ownership has become an important issue. It stands to reason that long-serving management and directors should have

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incentives tied closely to the long-range success of their institution. The fact that these individuals have been rewarded for their success is a good signal to the industry and should also enable the industry to attract first-class talent as the very critical issue of management succession is addressed in a number of MFIs. In both these cases, management acquired their shares through investment. However, as public entities they will be able to use options or stock grants as incentives for existing management and employees and, as appropriate, to attract new management into the company. Many MFIs have operated with the same senior management team over the last 15–20 years or more, from the early emergence of microfinance in the developing world. Incentive compensation could play an important role in an orderly succession both out of and into these institutions. That is the normal case in for-profit institutions, both financial and industrial. BRI, with majority ownership by the Indonesian government, could presumably not offer such incentives. In the case of BRAC Bank, the very small ownership stake of the senior management of the NGO speaks highly of their individual commitments to the Bangladeshi poor. Despite these two examples, incentives have an important role to play as MFIs structure themselves on commercial terms and become shareholderowned institutions. We would expect to see stock options as an important form of incentive compensation for management recruitment and employee stock plans as more MFIs go public in the future. 3.5.4. Scale Each of these institutions has achieved massive scale within its respective market, translating into a strong capital base and profits. As banks by any international measure, the four are quite small, but within their markets BRI and Equity Bank are important. BRAC has also reached substantial scale, especially if we look at the combined microfinance and SME operations (the latter within BRAC Bank). Compartamos is a niche bank in Mexico, but it is among the largest MFIs in the country and Latin America. The profitability, ROA, ROE, and low loan loss-ratios of these institutions rank them among the best performing banks and financial institutions in their respective markets. Clearly these four institutions are among the best of the MFIs. As such they were able to list and issue their shares to both domestic and international investors. The performance to date of their postIPO stocks is a reflection of their long-term growth potential. Even if we assume that their growth rate will slow by 50% by the end of 2011, collectively their scale or outreach to the working poor will be very significant – projected at some 11 million borrowers and 41 million savers.19

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3.5.5. Brand Image and Market Recognition When an investment advisor looks toward taking these institutions public, there is a convincing story that can be told. Simply, the four institutions have performed exceptionally well, and they benchmark well within the industry and within their respective financial sectors. In marketing terms, they carry a very strong brand image that is recognized favorably by the investing public in their countries and increasingly by knowledgeable investors in international markets. 3.5.6. Quality of Products and Services20 It seems clear that each of the institutions have figured out what it takes to meet and anticipate client needs. MFIs operating within a bank are better able to offer a full range of products and services to their clients, including a diversity of savings products, insurance, money transfers, remittances, e-banking, and mobile banking as circumstances warrant. Although to date the four institutions have not expanded to offer a full suite of financial products and services. However, BRI does offer a range of savings products, and Equity Bank offers products for both savings and loans. Compartamos serves as an agent for insurance product offerings. Moreover, as these banks add small-business finance on a sound basis, they are able to improve their economics – for example, through larger average loan and deposit size – without abandoning their social mission. For the moment, BRAC has chosen to keep the microfinance and SME operations separate. Compartamos is strictly a microfinance bank and has yet to mobilize savings in a meaningful way. However, BRI and Equity Bank combine these offerings. The quality of services and products is not only reflected in high profits, low loan-loss ratios and low portfolio at risk (Equity Bank is something of an outlier with respect to portfolio at risk), but also, in the case of BRI and Equity Bank, in savings that provide low cost of funds to these institutions. Not only can these banks reach a critical mass of clients, but in the future we expect that they will reach them with various products and services that allow these banks to add to fees and earn income as well as providing for their clients’ needs. BRAC Bank, Equity Bank, and ProCredit Bank have seen the advantage of serving the ‘‘missing middle’’ – small business in addition to micro-entrepreneurs – but BRAC does this by separating the two sets of target clients between its NGO offering microfinance and its

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bank offering SMEs finance, whereas the other two offer a range of financial services through their commercial banks. Again, these actions serve to add to the quality and branding of each bank. 3.5.7. Technology and Infrastructure Each of the four institutions discussed have had to build an extensive infrastructure of branches or service offices to reach their clients. For example, Equity Bank in its prospectus discusses moving from 31 branches in 2005 to 61 branches by 2009. Since its founding in 2001, BRAC Bank has grown to 18 branches and 313 regional marketing/field offices. BRI has an extensive village network that exceeded 3,900 unit desas at its peak, and Compartamos now faces the task of converting a very extensive serviceoffice network to full bank branches if they are going to intermediate savings. Along with this growth, however, comes a need to continuously invest in technology such as ATMs, credit and debit cards, and MIS systems. BRI and Equity Bank have discussed the extensive investments required in MIS systems, the former as a use of proceeds and the latter before listing. It seems clear that MFIs that want to go public will need to be up-to-date technologically and demonstrate their ability to compete in the banking sector with the latest in technological products and systems. 3.5.8. The Social Bottom Line Microfinance has received a great deal of positive publicity in the past few years. There seems to be an important market segment of individual investors and institutions that will invest a portion of their funds in institutions that support a double bottom line. Initially, debt funds that could guarantee their investors a minimum social return were uniquely placed to tap into this market segment. We have seen this in the development of microfinance funds such as Blue Orchard, the Responsibility Fund, Deutsche Bank’s Microfinance Fund, the Calvert Social Funds, and the Calvert Foundation, which also makes loans and invests in MFIs. Sound MFIs with the qualifications to go public are perfectly placed to tap into this positive market sentiment and growing segment of investors keen to invest in socially responsible institutions. The question then is whether IPOs and the entry of commercially funded equity investments make it harder for MFIs to focus on a social bottom line. The evidence from the four IPOs/listings discussed in this chapter seems to

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suggest that for the moment these institutions are respecting the financial and social components of the double bottom line. Will market pressure to maintain the stock price force these institutions into mission drift over time? That remains to be seen and is certainly one of the risks. 3.5.9. Outside Strategic Investors With the exception of BRI, these institutions had participating internationally recognized external investors take equity stakes prior to the IPO. In addition to the capital they provided, strategic investors such as IFC, ACCION, AfriCap, ShoreCap International, or their respective equity funds served as an important measure of confidence in the institution before the IPO/listing. In addition, each of these institutions, with the possible exception of BRAC, has received significant technical assistance from the donor community and microfinance experts in order to ensure that their product lines, lending methodologies, credit management systems, MIS, management structures and governance processes, among other areas, met or exceeded industry standards. 3.5.10. Benchmarking As a result of their profitability and growth, the institutions that have listed or gone through an IPO are increasingly being benchmarked or measured in terms of performance against regulated financial institutions. They are supervised by the respective banking regulation and supervisory authority in their countries and are increasingly being rated by international rating agencies such as Fitch and Moody.21 Also, market research on these institutions from investment banks and brokerage firms will rate them against banks rather than other MFIs. 3.5.11. Accounting and Management Information Systems Each of the institutions was audited by internationally recognized accountants. Without adequate investment in software, accounting systems and MIS, it is difficult to prepare the years of audited financial statements, disclose financial information and reconcile the documents with U.S. GAAP or international accounting standards. Each of the institutions that listed or went through the IPO was able to meet the disclosure requirements. Tables 2–6 provide a summary of key performance data for each of the MFIs discussed earlier for the years 2004–2006.

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4. THE CAPITAL MARKET LISTINGS/OFFERINGS22 The previous section of this chapter analyzed each of the four MFIs that have conducted IPOs or listed and demonstrated that these MFIs are strong performers with opportunities for future growth. Given their profitability, strong management and social missions, it is not surprising that all four companies were able to successfully list their stock, generally with great demand. It is also important to note that all four companies’ stocks showed remarkable growth in the initial period following their IPO/ listing. Yet, each of these institutions had different structures and purposes for their action. In fact, unlike the other three MFIs, Equity Bank did not actually have an IPO, but rather a listing of stock that was held by many of their clients and employees. This section is intended to describe the individual nature and reasons for each IPO or listing. We will explain the reasons each of these companies believed there was an advantage to going public, as well as the performance of each company’s stock following the IPO/listing.23

4.1. BRI Offering On October 31, 2003, BRI became the first bank with a predominant focus on microfinance to go public. By the time of its IPO, BRI had already passed its stage of dramatic growth and was a mature institution. The BRI IPO was part of a larger process where the government was slowly trying to divest its holding in the banking industry. In part, this was a way to raise funds for the Indonesian Treasury as well as to allow the government to follow through with its IMF commitments after the East Asian crisis (Business Week, 2005). BRI was listed on the Jakarta Stock Exchange, but shares were also offered, under U.S. SEC Rule 144A, to international institutional investors without a listing on any of the U.S. or other major stock exchanges. Some 41% of BRI’s capital stock was sold, and therefore, it was only a partial privatization, with the state retaining a majority interest in the bank. The IPO raised close to $489 million, of which 61% of the proceeds went to reimburse the Government of Indonesia. The rest of the proceeds were retained by BRI, with the intent to ‘‘fund future growth [and] investment in technology,’’ according to the BRI Offering Circular (Bank Rakyat Indonesia, 2003). BRI’s stock performed exceptionally since the IPO, with a 561% increase on the original price in just three years. The lock-up period for the offering

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was twelve months and expired on November 10, 2004. The price increased 143% from the time of the offering to the date the lock-up period expired. From July 7, 2004, the monthly return has varied from 19.5% (August 2005) to 24.4% (November 2004) with an average monthly return of 4.12%. As of September 10, 2007, BRI’s shares were trading at some 4.4 times book value and at a price earnings multiple of 16.5.

4.2. BRAC Bank Offering In July 2006, before the IPO of BRAC Bank, BRAC’s microfinance division approached the capital markets to securitize its microfinance portfolio. This allowed it to raise BDT 12.6 BN (US $180 million equivalent). The securitization was structured by RSA Capital, Citigroup, FMO, and KFW (Citibank, 2006; also see Rahman & Mohammed, 2007). On December 11, 2006, BRAC Bank was floated on the Dhaka and Chittagong Stock Exchanges. BRAC Bank raised some $13 million through the IPO, all of which will be used to expand the bank’s operations throughout Bangladesh. The company sold 50% of its share capital to the public (this doubled the number of shares outstanding), and all proceeds were received as paid in capital by the bank. None of the existing shareholders sold at the time of offering; however, the IFC did receive an exemption from the lock-up period, allowing it to sell immediately if it chose to.24 The distribution of the IPO allowed for one-third of the company to be owned by the Bangladeshi public, with another 8% split between nonresident Bangladeshis and mutual funds. The lock-up for BRAC will last for three years, an exceptionally long holding period to the usual 90 days to six months that are required by international markets. BRAC’s stock showed phenomenal growth in its first year with an increase of 619% over the initial price. As of September 10, 2007, BRAC Bank’s shares traded at a multiple of 6.86 times book value and at a price earnings ratio of 19.1 times. The BRAC IPO provided several benefits to the bank and shareholders. First, by raising funds, it allowed the bank to expand its operations into new markets. It will also allow institutional investors such as ShoreCap and the IFC to exit some of their investment. Investors gained market advantages, including greater liquidity and price discovery. BRAC can presumably go back to the market or to international markets to raise more capital if it so chooses, assuming its performance remains strong.

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4.3. Compartamos’ Listing Banco Compartamos went public on April 20, 2007. The company sold 29.9% of the shares outstanding (Burnhill, 2007). In contrast to the other IPOs discussed here, in this case none of the shares sold were offered by the firm itself. Rather, all the shares offered were part of a secondary offering so the firm received none of the proceeds from the sale. This IPO received substantial press because of its huge success and the very substantial returns to its investors. ACCION International, for example, had invested $1 million in Compartamos and earned some $143 million as a result of the IPO. The proceeds of the sale went mainly to four groups: the ACCION Gateway Fund ($143 million), the Compartamos NGO ($93 million), the IFC ($42 million), and individual shareholders, namely the management and directors of the bank ($136 million). Compartamos NGO plans to use their proceeds to continue its work on improving health and nutrition for poor Mexicans, whereas ACCION and the IFC will use their proceeds toward furthering their development objectives (Rosenberg, 2007). Of the shares sold, 18% were offered to the general public in Mexico and 82% were offered to international, Qualified Institutional Buyers (the U.S. SEC has both an asset test and a qualitative test to ensure that investors are ‘‘financially sophisticated’’ to purchase securities sold under Rule 144(A). Some 158 institutional buyers purchased shares. Of these institutional buyers, 58% were hedge funds and 42% more traditional financial institutions. The opening price of the stock was MXN 40.00 or $3.65. The offering opened at 12.8 times book value or at a market cap of $1.56 billion for Compartamos. The offering was oversubscribed 13 times. As of August 13, 2007 the price was $5.4 per share, which implies a premium of 48% over the issue price and a market valuation for Compartamos of $1.9 billion (Burnhill, 2007). As of September 10, 2007, Compartamos’ shares traded at 4.73 times book value and at a price earnings multiple of 11.85 times earnings. According to the detailed report on the Compartamos IPO done by ACCION International, ‘‘The initial impetus behind the Compartamos IPO came from a normal process of ownership evolution. A sale of a portion of total shares held would allow the shareholders to redeploy capital that was otherwise tied up.’’ The report goes on to explain that another advantage of an IPO is that diversification of the ownership base prevents ‘‘major disruptions in governance, management, and strategic direction that abrupt ownership can bring.’’

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Why was the Compartamos IPO so successful? What were the factors leading to its success? According to the report by ACCION International, the following factors were in play (Rhyne & Guimon, 2007):  Local financial market – the Mexican Bolsa (stock exchange) is well developed and liquid with a sound regulatory environment.25 There had been few recent IPOs, and there had been a lack of banking IPOs. In fact, the acquisition by foreign banks of Mexican banks such as Banamex had taken a number of important bank stocks off the Mexican Bolsa.  Compartamos’ structure – Compartamos had demonstrated sustainable growth, strong growth potential, superior management, socially valuable operations, good client relationships and strong governance.  Global factors – at the time of the IPO, high liquidity in global markets combined with a global recovery of IPOs, a strong financial sector and the emerging recognition of microfinance helped boost the success of Compartamos.  IPO process – Compartamos benefited from the excellent commitment of underwriters, who were able to tap into both domestic and international markets.  Economic/political factors – at the time of the IPO, the macroeconomic situation was very stable. This was because of a low-risk spread for Mexican paper, a general interest in Mexico as an emerging investment market and a stabilized political environment following the elections.  Microfinance sector in Mexico – at the time of the IPO, competition was not yet too strong. Investors could expect Compartamos to maintain profitability for some time.

The Mexican market of small-scale lending is becoming increasingly crowded. Compartamos may face competition from Banco Azteca, a large consumer lender tied to Group Elektra that provides consumer loans to the poor directly from Elektra’s retail outlets. Banco Wal-Mart has recently announced that it is also interested in becoming a large-scale lender for consumer goods, adding further competition (Epstein & Smith, 2007b, 2007c). Interestingly, Mexico’s microfinance lender, Financiera Independencia, went public on November 1, 2007, listing some 20% of the company (136 million shares) on the Mexican Bolsa and the international markets. HSBC’s ownership in Financiera Independencia was reduced from 20% to 18.7% by the offering.

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4.4. Equity Bank’s Listing As previously mentioned, unlike the three other banks, Equity Bank did not execute an IPO. Instead the firm went from being traded over-the-counter (OTC) to being listed on the Kenyan Stock Exchange on August 7, 2006. According to the board’s objectives, as provided in the Equity Bank Investor Briefing 2006 (p. 2), the purpose of the listing was ‘‘to offer shareholders and the Bank the benefits of the stock market, liquidity, and price discovery.’’ Other objectives included the need to consolidate and cement effective corporate governance, the attempt to position Equity strategically in the capital markets, and the desire to allow Kenyan’s to own and be a part of the success of the bank. Before the IPO, there was an agreement made that current shareholders would not divest of their shares for two years following the listing as a way of locking in large shareholders and aligning their interests with new owners (Robinson, 2006). On April 23, 2007, after its initial listing, Equity Bank issued 181,129,100 new shares by allotting two ordinary shares to owners for every one ordinary share registered in their name. This allocation led to a large increase in the volume of trading. Equity’s stock showed excellent growth, with a 96% increase on the initial price. A publication of the African Alliance (2007), an investment banking group located in Africa, described the excellent prospects for expansion for Equity. They write (p. 1) that by ‘‘providing banking services to the masses and generally expanding its distribution channels and services, Equity Bank Limited will be a star performer.’’ In addition, a second event occurred after the listing that gives credibility to this view that Equity Bank will be a star performer. On November 14, 2007, Equity Bank and Helios EB Investors, LP, (‘‘Helios’’) subscribed for 90.5 million new ordinary shares in the bank at KES 122 (US$1.95 per share, where 63 KES equals US$1, versus the original listing price at US$0.96 per share) per new ordinary share. The purchase price equated to EBL’s weighted trading average, as traded on the Nairobi Stock Exchange for the three months ending October 22, 2007. The investment will substantially increase EBL’s capital, and Helios will become the largest shareholder in EBL at 24.99%. The transaction awaits regulatory approval from the Kenyan Central Bank and the Capital Markets Authority; moreover, the Nairobi Stock Exchange will be asked to approve the listing of Helios’ shares. The share sale is not only important for the liquidity it brings to Equity Bank but also because Helios is a prestigious investor making equity investments in Africa. Helios’ principals are Africans with a strong record in equity investing, backed by capital from such investors as the U.S. Overseas

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Private Investment Corporation (OPIC), the Commonwealth Development Corporation (CDC), the IFC and the Soros Fund Management (Equity Bank, 2007b).

4.5. Capital Market Summary and Conclusions The stock market offers benefits and opportunities to these four companies that they did not have prior to going public. Most of these benefits are similar to the advantages that going public creates for any business: the ability to raise funds from capital markets, liquidity, price discovery, improvements in governance, greater transparency in accounting and information provision and the ability to invest in new technology or branch expansion as well as a means to provide incentives to management and employees and to address succession and recruit future management. Going public also provides an opportunity for equity investors to exit, critical in attracting private capital. We would expect to see some MFIs in the future use the fact that they have tradable shares for acquisitions and mergers. There are some concerns that going public may affect the ability of these companies to maintain their social purpose, but each of these companies has been diligent in maintaining an ownership structure that will not allow large changes in their mission. One important externality of the IPO is transparency. Through the information memorandum and other filing documents, the public can gather detailed information on the MFIs that go public. In one case, the Compartamos offering generated a controversial debate regarding the commercial model of microfinance. Closer observation of the business operations of a company like Equity Bank or Compartamos is proof of the commercial viability of microfinance. As ACCION’s report states, ‘‘The Banco Compartamos IPO is a powerful validation of the commercial model of microfinancey’’ (Rhyne and Guimon, 2007, p. 15).26 However, others have argued that the closer observation of business operations that accompanies all commercial transactions and especially IPOs can cause MFIs to focus disproportionately more on investor needs rather than client needs, resulting in interest rates that are too high. Although various solutions have been proposed, including profit limits for MFIs and ‘‘truth in lending’’ policies to ensure that customers clearly understand effective interest rates, we suggest that in time natural market competition will bring down both interest rates and profits. It is certainly too early to come to any conclusions about the stock performance of these four banks, but it is difficult not to notice that all four

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have shown good to excellent growth. Although it is premature to call it a trend, it would be of value to continue following these stocks to see if there are some common factors driving their performance. The following reasons for the strong performance of their stocks post listing are, at present, primarily conjecture on our part:  Growing popularity of microfinance – There may be an ‘‘irrational exuberance’’ for microfinance stocks. The double bottom line and social appeal of these banks may cause this rise. Microfinance is part of the zeitgeist of socially responsible investment. In fact, there are relatively few choices for investors who want to take an equity stake in microfinance, and the decision by these MFIs to list really enhances the appeal for those institutional investors interested in this niche market.  Undervaluation – Some of these banks may have been underpriced at the time of the IPO to ensure a highly successful offering. Since there was little comparable history in offering MFIs to the market, the tendency of the advisors would be to underprice to demonstrate success. Also, for local investors, there may be only a few offering in their domestic market that matches the quality of these institutions. For example, if we take the case of Mexico, some of the large Mexican banks were taken private after the Tequila Crisis in 1995, when they were acquired by international banks – Banamex by Citicorp and Bancomer by BBVA.  Brand premium – There may be a brand premium for these MFIs. Each of these companies is well known and generally well respected in their country, and investors may desire their stock for this reason rather than standard performance measures. Also, where the institution, as is the case for BRI, Equity Bank and Compartamos, has competitive dominance over its market niche, there are expectations that they will continue to generate profits for some time into the future.  External factors – We may be experiencing a unique convergence of factors:  huge liquidity in international capital markets in part due to the very large U.S trade deficits and large Eurodollar holdings held abroad (however, the recent financial crisis over mortgage-backed securities may in fact sap liquidity from the market for some time);  surpluses in exporting powers such as China, and oil and gas exporting countries;  professional investors keenly interested in emerging market opportunities; in this respect, perception of country risk would make it relatively easy to market the Compartamos, Mexico offering to

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international investors, while the offering of BRAC Bank in Bangladesh or Equity Bank in Kenya would have been correspondingly more difficult;  the dearth of good product offerings in microfinance that offer investors a quality institution and also an exit opportunity, made the offering of these institutions uniquely attractive;  the rapid growth of emerging-market stock exchanges all seeking good listings again made these institutions attractive as a niche market in the emerging-markets sector. These factors may have created the ideal scenario for a quality MFI to have an IPO with an attractive valuation. How long this will last is anyone’s best guess as markets continue to evolve and conditions in the international economy change. This leads to an overall conclusion that there is an emerging-market opportunity for a number of other MFIs to go public in the future. Each institution will need to assess its own reasons for doing so, as the cost of an IPO is quite high, not only in professional fees and other expenses, but in management and staff time spent preparing the offering and participating in a ‘‘road show’’ for interested institutional investors. It is not a spur of the moment decision; rather it takes substantial time and funds to execute an IPO. In discussion with microfinance equity fund managers and investors in the microfinance industry, the views of the IPOs were mixed.27 Many of the fund managers recognized that this would provide additional validation for microfinance as a subset of the formal financial sector and perhaps more important, a new investment opportunity in emerging-markets. Fund managers indicated that the IPOs would make it easier to raise funds from private investors. However, that also means more competition, as larger financial groups already in the business – Citicorp, Credit Suisse, Deutsche Bank – are seeking to expand their investments in the sector, while groups such as JP Morgan are said to be planning entry soon. Also, deep concern has been expressed over the high price-earnings and book-value multiples at which the shares of the four institutions were trading. The concern is that this irrational exuberance might produce a microfinance ‘‘bubble,’’ and it would be much more difficult for the fund managers to invest at ‘‘acceptable’’ or reasonable prices. However, it seems clear that these are among the best of the MFIs throughout the world and it is doubtful that the next-in-line MFIs would command such multiples.

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69

5. OVERALL CONCLUSIONS Our conclusions are straightforward and simple: four excellent MFIs decided for their own reasons to list/IPO on their domestic capital markets and, in two cases, to also raise funds from institutional investors internationally. The industry has been moving in this direction for some time. We have tried to demonstrate in the first section of this chapter how excellent these institutions are. It is that excellence in management, governance, systems and technology, methodology, and product line that has allowed these institutions to achieve massive outreach to the lower-income segments and yet remain highly profitable at levels that most banks would envy. As public institutions and regulated banks, these institutions are now being benchmarked against the banking sector in their respective countries. As successful as they have been, rapid growth brings problems. Each of these institutions will need to face a series of issues to continue to be among the best. However, given the quality of their management, we assume they will address those concerns. Going public is not a spur of the moment decision; it is very costly. Preparing the information, data, audited financial statements required for due diligence by an advisor, prospectus and a package for institutional investors is a time absorbing and costly event. The ‘‘road shows’’ to visit with potential investors are also demanding and costly as are the legal, audit and financial advisory fees. An MFI has to think carefully through the decision to go public. However, there are clear advantages – the ability to raise capital from an alternative source, to provide incentives for management and staff, to allow partial or complete exits by initial equity investors in these firms, to raise capital for technology investments and branch expansion, and eventually, but not yet a use of proceeds, to acquire or merge with other MFIs. Interestingly, three of the MFIs that have gone public have had strategic equity investors and several have had extensive external technical assistance to reach their present level of excellence. Equity Bank has recently concluded a deal, subject to regulatory approval, to sell a 25% interest in the bank to a private equity firm, post its listing, at a price reflecting its recent trading price, considerably in excess of the listing price. The best structure and sequencing seems to be the combination of the two – a strategic investor followed by a listing/IPO, though Equity Bank attracted strategic investors both before and after its listing. One thing is clear – the strategic international investor gives the market an added measure of confidence, which is important for an IPO in a sector that up to now has

70

IRA W. LIEBERMAN ET AL.

little comparable experience for the institutional investors in the market to analyze. Each institution’s shares have performed well initially in their respective capital markets; we could perhaps call it a bit of ‘‘irrational exuberance.’’ However, it is still early, and we will see how the shares perform over time. Companies that have a social mission and are profitable have a certain cachet as does the microfinance sector for the moment. We would expect that trend perhaps to strengthen in time. The initial success of the IPOs has opened the door for the industry. It has also generated a controversial but important discussion on consumer protection and fair interest rates. There are a number of MFIs or groups that could go public over the next few years. Some are already deep into their preparation, and one in Mexico was formally announced. We believe this will increase competition, allowing for a natural decrease in interest rates and an increase in attention focused on customer needs. MFIs interested in going public should learn from the experiences of these four institutions. Finally, it is clear that these institutions are also poised to achieve massive outreach to their potential client base – the working poor without formal access to finance. BRAC is an interesting case as it has now become a multinational NGO in microfinance in Asia and Africa. We could see BRAC and Equity Bank either collaborating or competing throughout East Africa within the next five or more years.28 We have projected conservatively that if these four institutions that went public continue to grow, but at a declining rate over the next five years (2007–2011), they could together reach some 16 million borrowers and have 41 million savings accounts, without projecting savings from BRAC and Compartamos. We fully expect Compartamos to mobilize savings starting in 2009. Interestingly, with the exception of Compartamos, these institutions are also reaching a large number of SMEs. Perhaps even more important is the quality of their products and services. We expect these four institutions to become more diverse and fully meet the financial needs of their clients going forward.

NOTES 1. Please note that all amounts, unless otherwise indicated, are stated in U.S. dollars. 2. For a comparative discussion of microfinance in Indonesia, in particular BRI’s unit desa system, see Robinson (2002). 3. See also BRI Unit Products, Bank Rakyat Indonesia and USAID, International Visitor Program.

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4. It is not clear how much equity was allocated to the unit desa system; therefore, its real equity base might be understated, and these very high returns on equity misleading. 5. See also BRI Unit Products, Bank Rakyat Indonesia and USAID, International Visitor Program, as well as Robinson (2002) for the loan loss percentage data. 6. For an excellent discussion of the crisis, see Robinson (2002, pp. 46–58). 7. Metrics from The Mix Market, http://www.mixmarket.org. 8. See Note 4 on the potentially exaggerated returns on equity for the unit desa system. 9. See also Bank Rakyat Indonesia, Offering Circular, 18–33, ‘‘Risk Factors.’’ 10. See BRAC Bank Limited’s annual reports for 2003 to 2006, http://www.brac.net. 11. Ibid. 12. BRAC Bank Limited, Prospectus, 35-38 (see ‘‘Officers and Directors’’). 13. For a comparison of Compartamos with other large LAC MFIs, see Marulanda and Otero (2005). 14. Richard Rosenberg and Robert Christen initially evaluated Compartamos and recommended that CGAP fund its expansion. Ira Lieberman was the CEO of CGAP at the time and brought that proposal to CGAP’s Credit Committee as one of CGAP’s earliest and largest grants. Rosenberg and Christen continued to provide advice to CGAP’s management in its early years. 15. ACCION’s investment of $2 million in Compartamos was funded by USAID and CGAP funding for ACCION’s Gateway Fund that was intended for equity investments in unspecified MFIs. USAID also provided Compartamos with an additional $2 million through ACCION in 2000 that went partially to the NGO for technical assistance and primarily to the for-profit institution as a loan. 16. Banco Compartamos (2007b). Also listed in IFC documents. 17. For example, BusinessWeek online, December 13, 2007: ‘‘The Nobel Prizewinning microfinance pioneer refuses to mention the words ‘Compartamos’ and ‘microfinance’ in the same breath.’’ Also see Epstein and Smith (2007a and 2007b). 18. Ali Wardhana became Coordinating Minister of Economics, Finance, and Industry and continued to serve as an economic advisor to the government. Although he remained in the background, Wardhana has been a vital supporter to the unit desa system. See also Robinson, Microfinance Revolution Volume 2, p. xvvi. 19. Projections prepared by Bruce Campbell take the historical growth rate of each of the institutions compared to the number of borrowers and then reduce their rate of growth stepwise between 2007 and 2011, so that by the end of 2011 the growth rate has been reduced by 50%. For savings, the projections focus only on Equity Bank and BRI. At present BRI dominates these numbers. However, Compartamos is beginning to experiment with savings, and BRAC is mobilizing a large amount of savings in its SME bank. If both these two institutions succeed as we expect, then the four might well reach 45 million savers in the next five years. 20. For an interesting discussion of this issue, see Rhyne and Otero (2006). 21. Equity Bank was rated by MicroRate and Planet Rating, both specialized microfinance rating agencies. 22. Unless otherwise noted, the information in this section of the chapter comes from the offering memorandum or prospectus the MFI published before its IPO. 23. All stock price data are as of September 10, 2007. All numbers are converted at the time of the transaction. For example, if BRI went public on November 10,

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IRA W. LIEBERMAN ET AL.

2003, we have converted November 10, 2003 Indonesian Rupiah to November 10, 2003 US Dollars. Currency exchange fluctuation will affect data. 24. Paul Christensen (bank director, BRAC Bank), personal communication. 25. As a result of the Tequila Crisis, the regulatory environment for banks and the stock exchange had improved significantly. 26. A positive outcome of this debate on the Compartamos IPO is a code of conduct now being adopted by many MFIs on increasing transparency in interest rate and fee disclosure so that the client understands the effective cost of his or her loan. 27. Meeting, Council of Microfinance Equity Funds, Amsterdam, October 10–11, 2007. 28. Joining them in seeking expansion in Africa is AfriCap, which recently recapitalized at $50 million on October 25, 2007. Ira Lieberman led an advisory team that assisted in this effort. AfriCap was the first strategic investor in Equity Bank, and it could collaborate in the future expansion of Equity Bank or of BRAC. Alternatively, all three could compete. Any of these options should give a boost to the growth of microfinance in Africa.

ACKNOWLEDGMENTS We appreciate the generosity of Calmeadow in providing funding for this chapter. We also acknowledge the support provided by Deborah Drake and ACCION International in allowing Zach Grafe to work on this chapter, while working at ACCION as an intern. We also appreciate the support of Professor Richard Aronson and the Martindale Center at Lehigh University for this work. We thank the individuals who agreed to serve as reviewers for this chapter and who also provided us a number of valuable comments and insights – Alex Silva, Paul Christensen, Jennifer Isern, Marguerite Robinson, Richard Rosenberg, and Jose Ruisanchez. Last, we thank Anita Gardeva and Kelley Mesa from ACCION for editing this chapter in preparation for the CMEF Conference in May 2008.

REFERENCES AfriCap. (2003). Investment report. January. AfriCap. (2006). Business plan, portfolio summary. Banco Compartamos. (2007a). Estados financieros dictaminados. Mexico: Mexico City. Banco Compartamos. (2007b). Offering circular. Mexico: S.A. Mexico City. Bank Rakyat Indonesia. (2003). Offering circular. Jakarta, Indonesia. BRAC Bank Limited. (2006). Prospectus. Dhaka, Bangladesh. Burnhill, L. (2007). Bringing Microfinance to Scale, Power Point presentation. ACCION. August 24.

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BusinessWeek. (2005). Jakarta puts its banks on the block. BusinessWeek October 31. Available at http://www.businessweek.com/magazine/content/05_44/b3957084.htm. Charitonenko, S., Patten, R., & Yaron, J. (1998). Indonesia: Bank Rakyat Indonesia-Unit Desa, 1970–1996, sustainable banking with the poor (May). Washington, DC: World Bank. Christen, R.P., Rhyne, E., & Vogel, R. (1994). Maximizing the outreach of microenterprise finance: The emerging lessons of successful programs. IMCC, September. Citibank. (2006). Bangladesh: Citigroup supports world’s first AAA-rated microcredit security. July. Available at http://www.citigroup.com/citgroup/press/2006/060706b.htm. Coetzee, G., Kabbucho, L., & Mnjama, A. (2002). Understanding the rebirth of equity building society in Kenya. MicroSave-Africa. August. Epstein, K., & Smith G. (2007a). Online extra: Microlending is no cure-all. BusinessWeek. December 13. Available at http://www.businessweek.com/magazine/content/07_52/ b4064045922248.htm. Epstein, K., & Smith G. (2007b). The ugly side of microlending. BusinessWeek. December 13. Available at http://www.businessweek.com/magazine/content/07_52/b4064038915009.htm. Epstein, K., & Smith G. (2007c). Wal-mart banks on the ‘Unbanked’. BusinessWeek. December 13. Available at http://www.businessweek.com/magazine/content/07_52/b4064042918153.htm. Equity Bank. (2006a). Information memorandum. Nairobi, Kenya. Equity Bank. (2006b). Investor briefing 2006, Nairobi, Kenya. Equity Bank. (2007a). Annual report and financial statements 2006. Nairobi, Kenya. Equity Bank. (2007b). Press release. November 14. Holloh, D. (2001). ProFI microfinance institutions study. Bank Indonesia and German agency for technical cooperation (GTZ), Denpasar. March. Kawai, M., Lieberman, I., & Mako, W. (2000). Financial stabilization and initial restructuring of East Asian corporations: Approaches, results and lessons. In: L. Adams & X. Pomerleano (Eds), Managing financial and corporate distress: Lessons from Asia. Washington, DC: Brookings Institution Press. Lieberman , I., & Rhyne, E. (2005). The practice of corporate governance in shareholder-owned microfinance institutions, consensus statement of the Council of Microfinance Equity Funds (CMEF). May. Marulanda, B., & Otero, M. (2005). The profile of microfinance in Latin America in 10 years: Visions and characteristics. ACCION. Pearce, D., Rensch, M. (2005). Equity building society reaches rural markets. CGAP case study, agricultural microfinance. August. Rahman, R., & Mohammed, S. S. (2007). BRAC micro credit securitization series I: Lessons from the world’s first micro-credit backed security (MCBS) (March). Boston: Analytics Ltd. Rhyne, E., & Busch, B. (2006). The growth of commercial microfinance. Council of microfinance equity funds (CMEF). September. Rhyne, E., & Guimon, A. (2007). The Banco Compartamos initial public offering. InSight 23. June. Rhyne, E., & Otero, M. (2006). Microfinance through the next decade: Visioning the who, what, where, when and how. ACCION. November. Robinson, M. (2001). The microfinance revolution: Sustainable finance for the poor. Washington, DC: World Bank and the Open Society Institute. Robinson, M. (2002). The microfinance revolution, Volume 2: Lessons from Indonesia. Washington, DC: World Bank and the Open Society Institute. Robinson, M. (2006). Note on Equity Bank. Unpublished. November.

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Rosenberg, R. (2007). CGAP reflections on the Compartamos initial public offering: A case study on microfinance interest rates and profits. Focus Note 42. CGAP, Washington, DC. June. The MIX Market. BRAC (Bangladesh Rural Advancement Committee). Available at http:// www.mixmarket.org. The MIX Market. BRI (Bank Rakyat Indonesia). Available at http://www.mixmarket.org. The MIX Market. Compartamos (Banco Compartamos, S.A., Institucio´n de Banca Mu´ltiple). Available at http://www.mixmarket.org. The MIX Market. Equity Bank (Equity Bank). Available at http://www.mixmarket.org.

2006 2005 2004 2003 2002

2006 2005 2004 2003 2002

2006 2005 2004 2003 2002

2006 2005 2004 2003 2002

Debt/Assets

Capital/assets

ROE

23.00% 26.50% 19.97% – –

7.05% 4.64% 5.89% 8.72% –

92.95% 95.36% 94.11% 91.28% –

40.46% 24.74% 15.48% 24.01% –

10.99% 13.91% 18.95% 12.18% 12.93%

89.01% 86.09% 81.05% 87.82% 87.07%

8.10 6.19 4.28 7.21 6.73

Financial reports

Financial reports 13.18 20.55 15.97 10.47 –

Equity Bank

BRAC

56.12% 53.54% 47.51% 53.82% –

42.39% 37.66% 39.27% 35.31% 33.54%

57.61% 62.34% 60.73% 64.69% 66.46%

1.36 1.66 1.55 1.83 1.98

Financial reports

Compartamos

29.28% 28.75% 33.40% 37.02% –

10.91% 10.88% 11.63% 8.93% 6.71%

89.09% 89.12% 88.37% 91.07% 93.29%

8.17 8.19 7.60 10.20 13.90

Financial reports

BRI

Basic Ratio Analysis for BRAC Bank, Equity Bank, Compartamos, and BRI.

Debt/equity

Table A1.

APPENDIX

143.26% 111.32% 116.08% 106.70%

4.89% 5.79% 5.76% 5.29% 6.13%

95.11% 94.21% 94.24% 94.71% 93.87%

19.46 16.28 16.37 17.89 15.30

MIX Data

Microfinance and Capital Markets 75

2006 2005 2004 2003 2002

2006 2005 2004 2003 2002

2006 2005 2004 2003 2002

2006 2005 2004 2003 2002

ROA

Profit margin

Deposits/loans

Deposits/assets

76.64% 79.46% 81.56% 77.00% –

117.71% 113.74% 140.38% 121.85% –

16.09% 16.42% 14.61% 12.98% –

81.58% 78.97% 75.76% 85.78% 83.17%

149.47% 163.78% 176.83% 201.56% 184.46%

22.35% 19.12% 13.14% – –

4.86% 3.88% 2.54% 3.00% –

Financial reports

Financial reports

1.42% 1.36% 1.36% – –

Equity Bank

0.00% 0.00% 0.00% 0.00% 0.00%

0.00% 0.00% 0.00% 0.00% 0.00%

31.06% 27.30% 26.49% 28.17% 26.37%

22.66% 20.47% 17.86% 18.65% –

Financial reports

Compartamos

(Continued ).

BRAC

Table A1.

80.44% 79.04% 76.98% 80.58% 80.64%

137.86% 128.48% 132.12% 160.33% 176.84%

20.21% 22.08% 23.39% 17.11% 11.33%

3.19% 3.23% 3.44% 2.92% –

Financial reports

BRI

88.57% 83.61% 84.02% 83.92% 82.47%

160.41% 161.47% 171.36% 188.65% 195.49%

7.58% 6.42% 6.42% 6.05%

MIX Data

76 IRA W. LIEBERMAN ET AL.

2006 2005 2004 2003 2002

2006 2005 2004 2003 2002

2006 2005 2004 2003 2002

2006 2005 2004 2003 2002

2006 2005 2004 2003 2002

Loans/assets

Borrowers/employee

Depositors/employee

Cost per borrower

Operating expense/ loan portfolio

6.54% 6.44% 8.20% – –

$310.67 – – – –

84.9 75.3 – – –

20.2 22.8 – – –

65.11% 69.86% 58.10% 63.19% –

27.99% 31.69% 35.72% – –

$180.98 $212.30 $170.13 $104.00 –

727.7 629.0 779.4 712.4 742.3

180.9 124.6 111.9 184.0 195.4

54.58% 48.22% 42.84% 42.56% 45.09%

45.83% 54.81% 52.93% 49.47% –

$190.78 $200.00 $164.46 $145.53 –

0.0 0.0 0.0 0.0 0.0

192.5 197.4 198.4 212.7 194.6

89.08% 81.95% 78.24% 71.22% 74.69%

9.62% 10.89% 10.61% 13.24% –

$252.31 $240.29 $207.44 $215.83 –

801.9 859.0 857.7 1,075.7 1,328.7

89.7 88.3 88.1 111.7 143.7

58.35% 61.52% 58.27% 50.26% 45.60%

31.88% 35.91% 34.77% 43.37%

55.21% 51.78% 49.03% 44.48% 42.19%

Microfinance and Capital Markets 77

2006 2005 2004 2003 2002

2006 2005 2004 2003 2002

2006 2005 2004 2003 2002

2006 2005 2004 2003 2002

Capital adequacy ratio as calculated (capital/assets)

Savers/borrower

Average deposit size

Average loan balance

$4,761.09 $4,739.61 – – –

$1,333.32 $1,630.15 – – –

4.20 3.31 – – –

$626.35 $692.85 $627.50 $338.65 $368.28

$232.70 $224.73 $159.30 $176.32 $178.79

4.02 5.05 6.97 3.87 3.80

10.99% 13.91% 18.95% 12.18% 12.93%

Financial reports

Financial reports

7.05% 4.64% 5.89% 8.72% –

Equity Bank

$429.70 $398.04 $316.35 $302.58 $281.69

– – – – –

0.00 0.00 0.00 0.00 0.00

42.39% 37.66% 39.27% 35.31% 33.54%

Financial reports

Compartamos

(Continued ).

BRAC

Table A1.

$2,910.25 $2,320.56 $2,088.21 $1,816.23 $1,441.65

$448.62 $306.31 $283.26 $302.26 $275.68

8.94 9.73 9.74 9.63 9.25

10.91% 10.88% 11.63% 8.93% 6.71%

Financial reports

BRI

$878.41 $700.62 $636.79 $554.80 $439.78

$157.56 $116.23 $112.03 $108.64 $92.97

4.89% 5.79% 5.76% 5.29% 6.13%

MIX Data

78 IRA W. LIEBERMAN ET AL.

2006 2005 2004 2003 2002

Capital adequacy ratio as reported in financial statements

Loan Savings

2006 2005 2004 2003 2002

Loan write-off ratio as reported by The MIX

Pct of GNI

2006 2005 2004 2003 2002

Portfolio at risk W30 days as reported by The MIX

1013.00% 283.69%

13.53% 9.39% 10.15% 14.29% 23.27%

0.63% 1.69% 2.78% 2.59%

3.76% 5.92% 8.33% 5.98% 5.97%

118.18% 43.91%

1.92% 0.40% 1.87% 3.35%

12.19% 51.54% 22.21% 28.76% 8.29%

5.88% –

0.57% 0.51% 0.24% 0.31% 0.18%

1.13% 1.24% 0.56% 0.70% 1.11%

227.36% 35.05%

18.82% 15.29% 16.19% 19.64% 12.62%

0.83% 1.43% 1.59% 0.79% 2.61%

5.07% 4.76% 4.78% 6.04% 4.37%

68.63% 12.31%

Microfinance and Capital Markets 79

63.9 3 54

470 NA

61.5

3.2

66

390

34.2

33.42 (2000) 137 (medium development)

141.8 1.9

128.9 2

2005

90.4

1280

28

2.3

67.8

220.6 1.4

2005

34.3 (2002) 108 (medium development)

79.5

590

36

2.4

65.8

206.3 1.3

2000

73.6

540

79

5

49

34.3 2.3

2005

42.5 (1997) 152 (low development)

70.8

430

77

5

48.4

30.7 2.2

2000

Kenya

Mexico

91

7310

22

2.1

75.4

103.1 1

2005

46.05 (2004) 53 (medium development)

87.3

5110

25

2.4

74

98.0 1.4

2000

Sources: All data except the UN HDR rank and GINI are from WDI database: http://publications.worldbank.org/WDI/ a Atlas method; bamong 177 countries.

Population (million) Population growth % (annual) Life expectancy at birth, total (years) Fertility rate, total (births per woman) Mortality rate, infant (per 1,000 live births) GNI per capitaa (current US$) Adult literacy rate (% ages 15 and older) GINI coefficient UN human development rankb

2000

Indonesia

Poverty Data for Locations of the Four MFIs.

Bangladesh

Table A2.

80 IRA W. LIEBERMAN ET AL.

ROLE REVERSAL: PUBLIC AND PRIVATE FUNDERS IN MICROFINANCE$ Julie Abrams and Damian von Stauffenberg 1. INTRODUCTION The rapid growth of foreign private lending to microfinance institutions (MFIs) in the past several years has led to a surprising reversal of roles between government-owned development agencies and private lenders. Development institutions [International Financial Institutions (IFIs)] are concentrating their loans in the strongest MFIs, leaving private lenders to look for opportunities among smaller, riskier borrowers. Development institutions are ‘‘crowding’’ private lenders out of the best MFIs. But first, a brief word about how this report came to be. MicroRate analyzes MFIs. Hundreds of MFI ratings over 10 years have allowed MicroRate to observe funding patterns. One of those patterns is the growing willingness of foreign private lenders to invest in MFIs. In the past three years, the volume of international private lending has exploded: in 2005 alone, outstanding loans doubled to nearly $1 billion. It was surprising to

$ This article previously appeared in MicroRate’s MFInsights, February, 2007, and focuses on direct retail lending to microfinance institutions. Equity and guarantees are not addressed, nor are lending via apexes, or debt or equity investments in microfinance investment vehicles.

Moving Beyond Storytelling: Emerging Research in Microfinance Contemporary Studies in Economic and Financial Analysis, Volume 92, 81–107 Copyright r 2009 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1569-3759/doi:10.1108/S1569-3759(2009)0000092006

81

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JULIE ABRAMS AND DAMIAN VON STAUFFENBERG

see that official development institutions, far from supporting this strong private commitment, as their policies require them to do, are often undermining it. IFIs publicly claim to take risks the private sector is unwilling to take. One would therefore have expected government-owned development institutions to shift their lending to more risky MFIs as soon as private lenders entered the field. The opposite is happening. Development agencies are today heavily concentrating their funding in the largest and most successful MFIs, exactly the target investment market of private investors. IFIs covered by this chapter include the large international and regional development banks and institutions [International Finance Corporation (IFC), European Bank for Reconstruction and Development (EBRD), Banco Centroamericano de Integracio´n Econo´mica (BCIE), Corporacio´n Andina de Fomento (CAF), etc.]. But they also include national development finance institutions such as KfW (Germany), at present the largest source of loans for MFIs, and Agence Franc- aise du De´veloppement (AFD) (France). Finally, there is AECI, a part of the Spanish foreign ministry, which is not a development bank but a window through which budget allocations are channeled to microfinance. In terms of amounts lent to MFIs, KfW leads, with AECI and IFC, in second and third place. Also, included in the analysis are IFIs that are majority owned by their governments, such as FMO (Netherlands) and BIO (Belgium). The appendix contains a description of IFIs included in this analysis. How did this counterintuitive funding approach happen? We decided to investigate. Backed by a grant from Calmeadow, a Canadian foundation with a distinguished record in microfinance, MicroRate commissioned a study of funding patterns in microfinance. Research confirmed what we had observed in our ratings: IFIs are not complementing private lenders; they are crowding them out of the most attractive parts of the MFI market. This report documents what we found. IFIs nearly doubled (88% increase) their direct funding to alpha-rated MFIs in 2005 (see Section 3). In the largest and most successful MFIs, IFIs are the dominant and growing foreign funding source. Microfinance Information eXchange (MIX) data on over 160 MFIs confirm this trend. A number of the largest MFIs in the MIX database have received all of their foreign loans from IFIs. Section 4 cites examples of cases, where private lenders wanted to provide funding to an MFI but were unable to do so because they were unable to match terms offered by IFIs. Which leads to the question: why are development institutions concentrating on MFIs that can attract private lenders? The answer has to do with the nature of IFIs. Their official mission is to go where the private sector does not yet dare to tread, to assume risks that private capital would

83

Role Reversal: Public and Private Funders in Microfinance

$1,200

60

$1,000

50

$800

40

$600

30

$400

20

$200

10

$0

Number of Funds

USD M

find unacceptable. For example, FMO (Netherlands) puts it succinctly, stating that, ‘‘thanks in part to its relationship with the Dutch government, FMO is able to take risks which commercial financiers are not-or not yet-prepared to take’’ FMO (2006c). The policy statements of many IFIs contain such language. Often, IFIs have adhered to these principles. As described in Section 6, some IFIs have been very effective as catalysts that mobilize private funding. Indeed, IFIs have been instrumental in some innovative transactions, including creation of some of the private vehicles that now lend to MFIs. So why has the risk-based division of labor between IFIs and private capital broken down in recent years? One answer could be that the rapid emergence of private lending to MFIs has taken IFIs by surprise. The number and size of so-called Microfinance Investment Vehicles (MIVs) has recently mushroomed, as can be seen in Fig. 1. In the past two years, available private and public foreign funding has grown much faster than the capacity of top-rated MFIs to absorb these funds. The loan portfolio of Latin American MFIs tracked by MicroRate has grown by about 40% annually since 2001. MicroBanking Bulletin data published by the MIX, which cover over 300 MFIs, show a similar growth rate of 36% (MicroBanking Bulletin, 2006). Forty percent compound annual growth is extremely fast growth. But private lending nearly doubled in 2005 from $513 million to $981 million (MicroRate, 2006), while IFI

0 2003/2004 Portfolio

2005 Number of Funds

Fig. 1. MIV Portfolio and Number of Funds, 2003/2004 and 2005. Note: 2003/2004 Portfolio: $511 million, 2005 Portfolio: $981 million; 2003/2004 Number of Funds: 45, 2005 Number of Funds: 54.

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microfinance exposure jumped from over $1 billion to $2.4 billion from 2003 to 2005, with an additional $750 million in IFI funding to be invested in 2006. By the end of 2005, IFIs had invested $1.5 billion directly in MFIs (Reille, Seidek, & Pasricha, 2006). Capital markets instruments have been an important element in the accelerating flow of private funding for microfinance. Bond issues, securitizations, collateralized debt obligations (CDOs), and many varieties of funds are all channeling private foreign funding to MFIs, as seen in Table 1. The number of transactions is growing, and at the same time, average deal size is getting significantly larger, with just three transactions accounting for over $300 million in 2006. Because the situation is changing so quickly, top IFI decision-makers may not be aware of the extent to which their loans are displacing private

Table 1. Year

2001 2002

Examples of Recent Microfinance Transactions (Amounts in $, Some Issued in Local Currency, Denoted ‘‘LC’’). Bond Issue

2004

Fin America Mibanco Compartamos Mibanco Compartamos Compartamos

$2 million, LC $6 million, LC $15 million, LC $9 million, LC $5 million, LC $17 million, LC

2005

Compartamos

$29 million, LC

WWB Colombia

$52 million, LC

2003

Faulu Kenya $7 million, LC ProCredit Ukraine $10 million, LC

2006

ProCredit Kosovo WWB Colombia

$9.5 million, LC $20 million, LC

Securitizations, Collateralized Debt Obligations and Initial Public Offerings (IPOs)

BlueOrchard Microfinance Securities I BlueOrchard Microfinance Securities II Global Commercial Microfinance Consortium European Investment Fund Global Partnership Microfinance Fund BlueOrchard Loans for Development (BOLD) with Morgan Stanley XXEB BRAC MicroVest/Calvert/Dignity Fund Equity Bank IPO

$40 million $47 million $75 million $25 million $2 million

$99 million partially LC $60 million $180 million, LC $2 million $28 million, LC

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funding. A look at official IFI announcements of loans to MFIs supports this impression. IFIs tend to emphasize the unique role they play and imply, or even sometimes assert outright, that private funds are not available at suitable conditions, such as in the case of KfW lending to Compartamos, described in Box 1. Whether top decision-makers are aware of it or not, there are powerful incentives for IFIs to maximize their microfinance exposure, and to do so by concentrating on the largest and safest borrowers. A strong reason is the need for IFIs to demonstrate their development engagement. Microfinance has acquired such a positive image, that a sizeable exposure in this sector has become a sign of an IFI’s commitment to development. This is reinforced by an IFI’s need to disburse its microfinance budget each year, leading to a ‘‘built-in conflict between volume and quality targets’’ (Berglo¨f, 2006, p. 21). IFIs are not primarily profit-driven; thus, success is often defined by the amounts that have been lent. Volume becomes a proxy for development impact. If a budget has been allocated to microfinance, that budget must be spent – and spending it on a few large loans to top MFIs is far quicker, cheaper, and less risky than lending to, and nurturing immature institutions. The tendency of IFIs to bulk up their budgets with microfinance operations has given rise to what some call ‘‘trophy lending,’’ where IFIs make MFI loans not where they are most needed but where they can be placed with less expense and risk. As CGAP described in a recent aid effectiveness study, ‘‘development agencies always face pressure to defend their budget and staff levels by disbursing high funding volumes y the problem is widely recognized and deplored’’ (Rosenberg, 2006, pp. 7–8). AECI, the Spanish aid agency, is an example of a public funder that is disbursing large loans to top MFIs. It receives a large annual budget allocation for microfinance (currently h100 million). Clearly, it is easier to make a few large loans to top-rated MFIs – to go for the low-hanging fruit – than to fund smaller, risky institutions. AECI is an extreme case, because it is a political agency. But this tendency is present to a greater or lesser extent in a number of IFIs. The rapid emergence of a large number of private lenders is one of the most encouraging aspects of microfinance. If all of those among the poor who can use credit productively are to be reached, then vast amounts of private funding will be needed in the future. IFIs, large as they are, cannot come close to meeting the future funding needs of MFIs, a fact most IFIs willingly acknowledge. Only private capital can provide that kind of money. By forcing private lenders out of the most lucrative segment of microfinance, IFIs are hampering the development of the very institutions on which the sector will depend in the long run.

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Box 1. IFIs still funding Mexican superstar MFI Compartamos In 2005, CGAP issued a report announcing the demise of subsidized funding to the Mexican MFI, entitled, Donors Succeed by Making Themselves Obsolete: Compartamos Taps Financial Markets in Mexico (Dugan & Goodwin-Groen, 2005). By all accounts, Compartamos is one of the most successful MFIs in the world. According to IFC, ‘‘Compartamos is well managed, sufficiently capitalized, has an excellent portfolio, and is remarkably profitable’’ (IFC Structured Finance, 2004). It holds an Aþ rating from mainstream rater Fitch. Standard & Poor rated its bonds AA. Compartamos’ portfolio was $180 million as of 2005 and had grown at a compound annual rate of 76% per year over the past five years. Its RoE averaged 50% (!) over the past five years. Compartamos has issued $66 million in local currency bonds in the Mexican market since 2002. Since starting out as an NGO, it transformed into an NBFI and, as of June 2006, has converted into a commercial bank. Compartamos has clearly shown itself very capable of funding itself through the local capital markets, through local bank funding, private foreign funding, and soon will add deposits to its funding base. Nonetheless, IFIs continue to fund Compartamos:  KfW issued a $6 million equivalent local currency loan to Compartamos in late 2005. Its rationale for the loan was that ‘‘KfW granted the FC promotional loan in local currency and with a term that is not available from the national banks’’ (KfW, 2006). Yet, the three-year loan tenor was the same as a larger loan for $8 million equivalent in local currency that Compartamos received from Banco Nacional de Mexico (Compartamos, 2006, p. 16).  Inter-American Investment Corporation (IIC) approved a $20 million renewable medium term local currency loan to Compartamos in June 2006. Given Compartamos’ record of successful capital market operations, and easy access to private lenders, it is difficult to see why an IIC loan was needed.  IFC approved a $10 million, 7-year local currency loan to Compartamos in 2006.9

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2. IFIS PLAYED AN EARLY CATALYTIC ROLE IN ATTRACTING PRIVATE FUNDING TO MICROFINANCE In the past, IFIs have often been on target in their efforts to promote microfinance. The microfinance sector would not have advanced to where it is today had it not been for the essential role played by IFIs in the late 1990s and the early years of this decade. At a recent microfinance investors’ meeting, Steve Hardgrave, formerly of Omidyar Network, noted that IFIs ‘‘have been instrumental in getting the industry to where it is today.’’1 IFIs were ideally placed to actively promote unproven MFIs. Institutions such as the Inter-American Development Bank (through local apex institutions), the European Investment Bank (EIB), CAF, the International Fund for Agricultural Development (IFAD), and others were early lenders to today’s leading MFIs long before they became household names. The Inter-American Investment Corporation was one of the early funders of pioneer microfinance bank BancoSol. Some, such as IFC, supported about 20 greenfield MFIs, including what have become some of the highly successful ProCredit Banks.2 The Andean Development Bank (CAF) had a significant development impact by funding what have since become 30 of Latin America’s largest and most successful MFIs. But, like many other IFIs, CAF has found it hard to recognize when it is no longer needed. At the end of 2005, CAF had $53 million invested in 30 MFIs that now boast impressive statistics that would fit nicely in any private investor’s investment portfolio: average MFI portfolio size of $76 million, aggregate deposits of $1.2 billion, past due portfolio of a mere 1.4%, and average return on equity (RoE) of 21% (Soriano & Padro´n, 2006). Yet, some IFIs do know when to step back and let private funds take their place, such as the Inter-American Development Bank’s Multilateral Investment Fund (MIF), which has a good track record in this regard. Aware that private lenders are entering the market, the MIF has insisted on selling assets and not renewing loans to strong MFIs, and it has shifted its attention to new and underfunded MFIs to ensure that it does not crowd out private investors. IFIs justly deserve credit for assuming the risk of funding young MFIs at a time when microfinance was much less proven as a sector, and local and foreign private investors were less eager to lend to MFIs. From this perspective, IFIs can count as successes both the MFIs and the private investors that are now flocking to fund microfinance. The success of MFIs that IFIs helped to fund has also motivated some commercial banks to

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provide microfinance in domestic markets, known as downscaling. Clearly, IFIs played an important role in early funding of MFIs. But are they still funding these same MFIs even though by now they have become the industry’s success stories? Are they crowding out private investment in the process? This question is addressed Section 3.

3. TOP MFIS RECEIVE DISPROPORTIONATE AMOUNT OF IFI FUNDING To check whether complaints about IFIs ‘‘crowding out’’ private funders are based on facts, we analyzed IFI debt as a percentage of MicroRate clients’ foreign debt for 2004 and 2005 to see how predominant IFI funding was. Any MFIs with no foreign debt at all were excluded from the review. The analysis was limited to the last two complete calendar years so as to capture only recent trends. The results are summarized in Table 2, which indicates that IFIs are directing nearly all of their new loans to MicroRate’s most creditworthy, alpha-rated clients.3 IFIs are concentrating their funding on the largest, most commercially successful MFIs, as measured by size (gross portfolio), profitability (RoE), efficiency (operating expenses/gross portfolio), and portfolio quality (portfolio at risk greater than 30 days – PAR 30). Remarkably, IFI exposure in alphas nearly doubled, increasing by Table 2.

Average IFI Debt Concentrations in MicroRate Clients by Rating Type, 2005.

Rating

Alpha

Number of MFIs in sample 12 Average 2005 portfolio ($ million) $50 million Average 2005 saving ($ million) $77 million (3 MFIs) Average 2005 Return on Equity 28% Average 2005 operating expenses/ 17% loan portfolio Average 2005 PAR 30 2% Average amount of IFI debt 2004 $1.1 million Average amount of IFI debt 2005 $2.1 million Average % increase in IFI debt 88% 2005 Source: Analysis of MicroRate data.

Beta Plus

Beta

Beta Minus

11 $14 million $12 million (4 MFIs) 22% 20%

6 $9 million $0

5 $11 million $0

13% 18%

15% 21%

3% $1.1 million $1.3 million 12%

6% $0.6 million $0.6 million 0%

5% $0.2 million $0.1 million –25%

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88% in 2005. IFI lending to the beta-plus-rated MFIs increased by 12%; exposure in the betas remained unchanged, and actually dropped by 25% in MFIs rated beta-minus – precisely the kind of up-and-coming institutions where IFI funding is most needed today. Since the average portfolio of alpha-rated MicroRate clients is more than three times greater than the beta-rated institutions, this implies not only an increasing percentage but also a far higher volume of IFI investment going to alpha-rated MFIs. As Table 2 indicates, among MicroRate clients, IFIs continue to invest heavily in the most commercially successful MFIs. To determine if this trend was widespread beyond MicroRate clients, we analyzed all MFIs with portfolios of $5 million or more included in the MIX database (http://mixmarket.org) that disclosed performance data. The findings were striking. Table 3 indicates that as recently as 2004 and 2005, MFIs with IFI funding had double the portfolio, deposits, and triple to as much as 14 times the profitability of MFIs without IFI funding. And the amount of IFI debt continued to increase in the largest MFIs into 2005, increasing an average of 75% among MFIs with any IFI funding. In this Table 3.

Comparison of MFIs with no IFI Debt versus any IFI Debt, 2004 and 2005. 2004

Number of MFIs Average portfolio ($ million) Average savings ($ million) Average Return on Equity Average operating expenses/loan portfolio Average PAR 30 Average 2004 IFI debt/ total foreign debt Average 2005 IFI debt/ total foreign debt Average % increase in IFI debt 2004–2005

2005 No IFI debt

Multiple of IFI debt vs. no IFI debt

No IFI debt

105 $50 million

57 $23 million

2X

117 45 $46 million $26 million 2X

$48 million

$28 million

2X

$47 million $29 million 2X

17%

6%

3X

18%

1%

14X

19%

24%

0.8X

19%

25%

0.8X

3% 68%

4% –

0.7X –

3% 60%

4% –

0.7X –

62%

10%

0.2X

61%

–

–

71%

–

–

75%

–

–

Source: Analysis of MIX data.

Multiple of IFI debt vs. no IFI debt

Any IFI debt

Any IFI debt

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Table 4.

Average IFI Debt Concentrations in MIX MFIs (Portfolios W$5 million), 2004–2005. W75% IFI Debt

Number of MFIs Average portfolio ($ million) Average savings ($ million) Average Average Average Average Average Average

Return on Equity operating expenses/loan portfolio PAR 30 2004 IFI debt/total foreign debt 2005 IFI debt/total foreign debt % increase in IFI debt 2004–2005

49 $58 million $57 million (27 MFIs) 16% 17% 3% 90% 93% 62%

W50% IFI Debt 68 $55 million $51 million (35 MFIs) 15% 18% 3% 81% 85% 67%

0–50% IFI Debt 48 $35 million $43 million (16 MFIs) 22% 19% 3% 31% 28% 91%

Source: Analysis of MIX data.

larger pool of MFIs, IFIs also tended to fund better performing MFIs, while MFIs with no IFI debt had lower performance results using these same metrics. As we drilled down into the data, as can be seen in Table 4, it was clear that MFIs with both larger portfolios and greater deposit mobilization tended to have a higher percentage of IFI debt in their foreign funding. Thirty MFIs with gross portfolio above $50 million received 90% more IFI funding in 2005 than in 2004. Thirteen MFIs with RoE of over 15% received fully 100% of their foreign funding from IFIs in 2005. It is clear from looking at MicroRate clients and at the MIX database: IFIs heavily fund and continue to increase concentration of funding in top-tier MFIs. Section 4 provides examples of what this intensive IFI funding looks like on the ground, as it bumps up against the growing number of private investors actively seeking out microfinance investment opportunities.

4. EXAMPLES OF CROWDING OUT BY IFIS If not applied properly, grants, subsidized loans, and excessive guarantees to financial service providers can undermine or crowd out national or international commercial capital markets and/or domestic savers. (CGAP, Good Practice Guidelines for Funders of Microfinance)4

Private lenders have increasingly complained about being ‘‘crowded out’’ by IFIs. What exactly is ‘‘crowding out?’’ It can mean IFIs supplying MFIs with any combination of below-market loans: below-market interest rates, larger loans whose size is a multiple of a private investor’s largest loan size,

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longer tenors, and extended grace periods not offered by a private investor. Crowding out also occurs when IFIs flood an MFI or even a local microfinance market with capital, preempting the need for further private capital. In extreme cases, below-market IFI loans have led MFIs to prepay a private loan and then take out a new IFI loan, often at a lower interest rate, and for a larger amount. In some instances, MFIs will not renew a private loan, replacing it with cheaper IFI debt. Some IFIs are lending to MFIs with successful deposit programs that presumably could source new capital by promoting savings; other IFIs offer free technical assistance that comes with a loan to the MFI. To be clear: from the demand side, an MFI is completely justified in accepting IFI loans. MFIs will always shop for the best terms they can get. This is what any savvy financial manager should do. However, from the supply side, it is inappropriate for IFIs to undersell private domestic or foreign sources of funding and thus make loans to MFIs that could and should fund themselves commercially. Below are some examples of crowding out. There are many more instances that have taken place. Virtually every private lender to MFIs can cite a list of examples. The ones mentioned here are intended to give a sense of what is occurring. Any of the following leads to crowding out: 1. Pricing loans at lower interest rates and offering higher volumes than private foreign investors;  In four West African countries, an IFI crowded out a private investor by offering 6%, four-year loans. The private investor, who would typically charge 8–9%, was unable to place the funds with a number of MFIs due to the underpricing by 200–300 basis point below market. Another private investor sought to lend to an MFI in Benin but could not match the IFI rates there either.  In Eastern Europe, an IFI crowded out a private foreign investor by making a 5.8% fixed rate, four-year loan to an MFI.  AECI provided 5%, 10-year euro funding to two Eastern European MFIs in 2005 and 2006: Partner (6 million euros) and Altermodus (2.5 million euros), underpricing a private foreign lender by 250–400 basis points, and crowding out its lending to the MFIs in 2006.  A private investor found that one IFI has underpriced it by about 50–200 basis points and that IFIs in general are underpricing by as much as 200–300 basis points.

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Some IFIs are offering dollar loans of 5–6% fixed with 5- to 10-year tenors. A prototypical private investor would need to charge at least LIBOR5 plus 5% to cover the cost of processing the loan and funding costs, or about 10.5%, as of early 2007. 2. Flooding an MFI or even a country market with large loans, which preempt MFIs’ needs for additional foreign capital for the time being;  As seen in Table 5, EBRD lent to several Eastern European MFIs in 2006 for amounts that were 20–30% of the MFI’s gross portfolio value, and 25–68% the MFI’s liabilities.  Similarly, FMO invested in three Cambodian MFIs for amounts also comprising a significant stake of each MFI’s gross portfolio and total liabilities (Table 6).  Not all IFIs are willing to take on such large exposures as a percentage of an MFI’s balance sheet. For instance, IFC will typically not lend more than 10–15% of an MFI’s total liabilities. EBRD notes that its covenants limit its exposure in an MFI at any point in time to 50% of equity. FMO officially states that it does not typically finance greater than 10% of an MFI’s assets or 20% of the balance sheet, although exceptions are made for institutions with limited funding alternatives; loan tranches are dispersed accordingly. 3. Offering below-market loans so that MFIs do not renew or in some cases prepay an outstanding loan to a private investor and take a new cheaper loan from an IFI;  An Eastern European MFI prepaid its loan to a private investor and replaced it with an IFI euro loan at 5% fixed rate for a five-year term.  A Latin American MFI that had a private loan for $500,000 at a 9% interest rate due in mid-2006 prepaid in 2005, then received a $2.5 million loan from an IFI at a fixed dollar rate of 7.99%. The new IFI loan was five times the size of the prior private loan and 101 basis points cheaper. 4. Lending to MFIs that already have large local deposit bases.  IFC issued a $29 million local- and foreign-currency loan to Mibanco (Peru) in 2006. Mibanco has a $207 million portfolio, $148 million in savings, completed three oversubscribed local bond issues for a total of $15 million, and has a 34% RoE.6 Mibanco has financed an increasing proportion of its portfolio through savings it captures. At the time of the IFC loan, Mibanco had on its books loans from one domestic bank, one international bank, three international private investment funds, and four IFIs (including an earlier loan from IFC), as well as

h 6 million (issued in tranches) h 8 million (including h 4 million convertible loana) h .23 million (issued in three tranches) $2 million (USD equivalent, issued in local currency)

Amount of EBRD Loan

1/2006

5/2006

9/2006 8/2006

Date of Loan

h 9.5 million

h 0.8 million

h 27 million h 30 million

2005 MFI’s Gross Portfolio

21

29

22 27

2005 EBRD Loan as % of MFI’s Gross Portfolio (%)

h 8 million

h 0.3 million

h 22 million h 22 million

2005 MFI’s Total Liabilities

Examples of 2006 EBRD Loans to Eastern European MFIs.

a

Sources: EBRD (2006a, 2006b), European Union (2006a, 2006b), ‘‘MIX’’. According to EBRD, 4 million euros of this may be converted into equity, and it is EBRD’s first convertible loan.

Kazakhstan Loan Fund, Kazakhstan

Microinvest, Tajikistan

EKI, Bosnia Mikrofin, Bosnia

MFI

Table 5.

25

68

27 36

2005 EBRD Loan as % of MFI’s Total Liabilities (%)

Role Reversal: Public and Private Funders in Microfinance 93

$3 million $3 million $2.5 million

Prasac, Cambodia AMRET, Cambodia CEB, Cambodia

7/2006 7/2006 4/2006

Date of Loan

$11 million $12 million $6 million

2005 MFI’s Gross Portfolio

26 26 40

2005 FMO Loan as % of MFI’s Gross Portfolio (%) $4 million $11 million $5 million

2005 MFI’s Total Liabilities

Sources: FMO (2006a, 2006b); ‘‘MIX’’. a According to FMO, these loans were issued in Cambodian riels, or a combination of riels and US dollars.

Amount of FMOa Loan

Examples of 2006 FMO Loans to Cambodian MFIs.

MFI

Table 6.

80 28 46

2005 FMO Loan as % of MFI’s Total Liabilities (%)

94 JULIE ABRAMS AND DAMIAN VON STAUFFENBERG

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95

from two domestic apex funds. IFC has justified the loan on the basis that it was the first time any foreign creditor provided local currency funding to MFIs using domestic swap markets.  In September 2006, EBRD approved a $5 million loan to Xac Bank in Mongolia, an MFI whose deposits funded 84% of its portfolio. At the time, MicroVest and other private investors were seeking to lend to Xac Bank and were crowded out by this new loan. Xac Bank already had international private investor loans from Dexia, Calvert, MicroVest (coming due), ASN-Novib, Deutsche Bank, Oikocredit, ShoreCap, Triodos-Doen, and Triodos-Fair Share Fund, in addition to IFC, and two domestic banks. EBRD pointed out this was its first loan in Mongolia, which had just become a member country. IFIs also offer MFIs technical assistance to accompany their loans, hardly a level playing field with which private investors can compete. Technical assistance funding can be significant: IFIs reported to CGAP that they expected to place $750 million in new technical assistance funding in 2006 alone (Reille et al., 2006). While good IFI technical assistance can be of great value to an MFI, offering it as an additional benefit of an IFI loan that a private lender could have provided is certainly not best practice. In addition to specific instances of crowding out private capital described in this section, many IFIs are generally funding the top tier of MFIs, described in Section 5.

5. A FEW EXAMPLES OF RECENT IFI LENDING TO TOP-TIER MFIS The Spanish Government gives below-market loans to top MFIs with nonmarket tenors and grace periods. The Spanish Government agency AECI7 issues loans directly to MFIs. Table 7 summarizes publicly announced AECI loans to MFIs from January through October 2006. All loans are significantly below market in interest rate charged, loan tenor, and grace period of loan. The typical loan is at a maximum of 5–5.5% fixed interest rate in euros, with a 10- to 12-year tenor, and frequently providing a fiveyear grace period. In no respect are these commercial terms. As a point of comparison, a private fund would typically need to charge about twice as much to deliver a return to its clients. As indicated in Table 7, AECI lent four million euros to PSHM (Albania) in 2006, when the MFI already

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Table 7. MFI (Country)

Examples of AECI (2006) Approved Loans (January–October 2006). Funding Amount

MFI’s Other Funding Sources Already in Place as of End of 2005

FinComu´n (Mexico)

h 2 million

 $13 million deposits  Four Mexican banks  Deutsche Bank Microcredit Development Fund

Prestanic (Nicaragua)

h 1 million

 Eight local sources  Foreign funding from ADA, Alterfin, BCIE, BlueOrchard, Cresud, Etimos, Incofin, Oikocredit

Caja Municipal Trujillo (CMAC Trujillo) (Peru)

h 8 million

 $84 million deposits  Eight sources of local funding  Foreign funding from BlueOrchard, CAF, Dexia, KfW, LA-CIF

Edyficar (Peru)

h 3 million

   

PSHM (Albania)

h 5 million

 Two local banks  Three other local funding sources  Foreign funding from Symbiotics Microfinance Loan Obligation, Dexia Fund (BlueOrchard), Deutsche Bank, Etimos, Feu Vert, Land O’ Lakes, Oikocredit, responsAbility Fund, Swiss Microfinance Fund, Triodos

Prizma (Bosnia and Herzegovina)

h 4 million

 Foreign funding from ASN-Novib, Dexia (BlueOrchard), Cordaid, Credit Suisse, IFAD, KfW, Oikocredit, Triodos-Doen, USAID

Mi-Bospo (Bosnia and Herzegovina)

h 3 million

 Four local banks  One other local source of funding  Foreign funding from Deutsche Bank, GMF, Hivos-Triodos, IFC, Microfinance Securities XXEB, MicroVest, KfW, Oikocredit

Alter Modus (Serbia and Montenegro)

h 2.5 million

(MFI does not report to MIX, so information is limited)  Foreign funding from EBRD, Triodos-Doen

Five local banks Four other local funding sources h 3 million in prior funding from AECI (via ICO) Foreign funding from BIO, BlueOrchard, CARE, IADB, ICO, IFC, LA-CIF, MicroVest, Oikocredit

Sources: AECI, MFI audited financial statements.

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97

had 10 other private foreign investors and five local funding sources. In this instance, PSHM had already received a loan from the Symbiotics Microfinance Loan Obligation at the euro 4.5 year swap rate þ5.17%. The MFI also already had a loan from BlueOrchard at 6-month Euribor þ7% in place at the time of the new AECI loan. In Bosnia, AECI lent four million euros to Prizma in 2006, while BlueOrchard had previously issued a loan to the same MFI at the end of 2005 for 500,000 euros at an 8.5% interest rate. This kind of duplication of IFI funding following private funding is quite common by AECI and other IFIs. AECI loans are all issued in hard currency, primarily the euro, requiring the MFI to incur foreign exchange risk. Even euro loans to MFIs in dollarized economies incur foreign exchange risk of the euro against the dollar. There are no foreign exchange hedge products for long tenors in the local capital markets of the MFIs’ countries. If currency devalues in any of the 10 years of these loans, an MFI faces a potentially significant loss.

5.1. New IFI-Funded Eastern European Fund Pursues a Strategy of Funding the Region’s Top MFIS The European Fund for Southeast Europe (EFSE) was created in 2005, primarily with funding from KfW, IFC, EBRD, and FMO. Launched with h 65 million, the fund had grown by September 2006 to 235 million euros, nearly all of it provided by IFIs and governments (EFSE, 2006). EBRD explained its funding, noting the intent of the fund is ‘‘Demonstration effect: Commercial financing is rarely available to local institutions due to perceived high risks. Successful lending will attract other foreign investors to the region and the sector’’ (EBRD, 2006). IFC describes the fund’s purpose, that it ‘‘will contribute to building public confidence in financial institutions and encourage more intermediaries, such as commercial banks, to extend financial services to this sector y Non-profit institutions (NGOs) that are dependent on continued donor funding have traditionally dominated the microfinance sector. This project, through technical assistance, will contribute to their organizational strengthening’’ (IFC, 2006). Yet thus far, EFSE has used its IFI funding to finance MFIs that already access local and foreign private funding. As of September 2006, EFSE invested nearly one-quarter (23%) of its microfinance portfolio in only three ProCredit Banks, whose average portfolio is $241 million, and whose average savings are $269 million.8 EFSE lends to some of the bestknown and most successful Eastern European MFIs, including Bosnian

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MFIs Mikrofin, EKI, Sunrise, Prizma, Partner, and Mi- Bospo; ProCredit Banks of Serbia, Romania, and Moldova; Albanian MFI PSHM; and Montenegran MFI AgroInvest. Some of these MFIs were already sourcing funding from multiple local banks. For example, in a 2005 report, PlanetFinance rated Bosnian Mikrofin ‘‘A,’’ impressed that ‘‘The story of the past three years is that of Mikrofin’s remarkable ability to obtain loans from commercial funders and of their growing presence in its capital structure y Most remarkably, Mikrofin has managed to get conservative local commercial banks (3 thus far) to commit increasing credit exposure’’ (Planet Rating, 2005, p. 24). Why is an IFI funding this type of MFI? One year after its creation, EFSE had not yet mobilized significant amounts of private funding. It is still early to pass judgment on EFSE. But so far, it has primarily been a channel of distribution of IFI funding to finance some of the strongest MFIs in the region. It is hard to see how a pool of official funding of such size best furthers the cause of private foreign lending for microfinance in Southeast Europe or how it is helping to nurture up-and-coming MFIs in the region. 5.2. IFI that Promotes Going Downmarket Stays Upmarket BIO, the Belgian development institution, seemed determined to resist the temptation to concentrate its money in top MFIs. A 2004 BIO publication states, ‘‘In the microfinance industry, BIO will consider stimulating investments in smaller and less mature institutions but with the skills and capacity to become first-rank ones’’ (BIO highlights 2004). Yet in 2005, BIO made new microfinance loans to five MFIs: Banco ProCredit, Nicaragua; Banco ProCredit, Bolivia; CEB, Cambodia; PADME, Benin; and Findesa, Nicaragua. MicroRate has rated all of these institutions except CEB, and by no definition would they be called ‘‘smaller and less mature’’ MFIs. Their average portfolio size is $42 million, and two had deposits of $20–25 million. Each is either the top, or the number two MFI in its respective country. 5.3. Regional Development Bank Provides Extensive Subsidized Loans in Central America BCIE has been the largest source of subsidized microfinance credit in Nicaragua and had a portfolio of below-market loans of $20 million in Nicaragua alone as of 2005 (Flaming et al., 2005). BCIE provides large

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Box 2. Moroccan microfinance market still heavily funded by IFIs; MIVs mostly absent IFIs have largely preempted private lenders from entering the rapidly growing Moroccan MFI market by offering terms that private lenders cannot match:  The European Investment Bank (EIB), using funds provided by the European Union, doubled its investment in Al Amana, an alpharated institution and the largest Moroccan MFI, to h 10.5 million, in 2005 (Al Amana, 2006). These loans were at below market rates with concessionary tenors and grace periods: EIB lent h 3 million at 4.85% with a two-year grace period and h 2 million at 4.74% with a three-year grace period (Al Amana, 2006). EIB also issued a h 2.5 million loan to FONDEP in November 2005, repayable in 10 years (FONDEP, 2006). These loans occurred in the same year that EIB President Philippe Maystadt announced a strategic decision to refocus its microfinance resources in 2005 to strengthen equity of several regional investment funds rather than to individual MFIs, noting, ‘‘We believe in a market-oriented banking approach y EIB is not allowed to grant subsidies’’ (Microfinance Matters, 2005).  AECI also doubled its loans to Al Amana in 2005, to h 6.2 million, charging only 2.45% with a five-year grace period.  In February 2006, French IFI AFD lent h 1 million to Al Amana and h 0.5 million to AMSSF.  CGAP found that just three Moroccan MFIs – Al Amana, Zakoura, and FONDEP – received $66.4 million in IFI funding as of 2005.10

and underpriced loans throughout Central America. For example, BCIE funds FINCA Honduras, among other Honduran MFIs, for an amount equivalent to 31% of its total liabilities, at an interest rate lower than the Inter-American Development Bank, local foundations, and local banks (Finca Honduras, 2006). As can be seen in Box 2, several IFIs pursued funding strategies in Morocco which preempted private lenders. These are just a few examples of IFI lending to top MFIs that could and should have been funded by private lenders. To balance out the picture, IFIs have also been investing in a number of innovative and groundbreaking transactions, described in Section 6.

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6. BEST IN CLASS: INNOVATIVE IFI TRANSACTIONS The IFIs’ tendency to fund low-risk, large MFI loans is a recent phenomenon. In the past, they often fulfilled their development role. Below are some recent examples in which IFIs have played a catalytic role to leverage and attract private capital in very successful ways in a number of groundbreaking transactions. 1. Taking first loss positions in CDOs and securitizations IFIs have successfully used their public funding to absorb the higher risk position of some recent innovative microfinance capital markets transactions  In 2004, the US Government–owned Overseas Private Investment Corporation (OPIC) made possible the first microfinance CDO: the Blue Orchard Microfinance Securities I (BOMFS I). It did so by purchasing the subordinated tranche and guaranteeing 75% of the operation. This allowed BlueOrchard to mobilize private funding and to conclude a pioneering issue that has served as a model for others. The second-ever microfinance CDO also involved OPIC and Blue Orchard. In that issue, OPIC was able to reduce its guarantee to 35% of the $47 million issue.  In the largest dollar-denominated capital markets operation to date, the 2006 BlueOrchard Loans for Development (BOLD) $99 million issue with Morgan Stanley, Dutch IFI FMO played a similar role, taking a 28% first loss position. Commercial investors purchased the remaining $72 million. FMO has since resold $3 million of its first loss position to private investor Grey Ghost, freeing up some of FMO’s capital to be redeployed, and can sell more to other private investors.  FMO and KfW played a key role in the world’s first true microfinance securitization. In 2006, Bangladeshi MFI BRAC securitized $180 million equivalent of its portfolio. FMO purchased one-third of the certificates, which are denominated in local currency. Citibank bought another third backed by an FMO guarantee and a counter guarantee from KfW. (Citibank Bangladesh and two local banks purchased the remaining one-third of the certificates.) 2. Guaranteeing bonds and local bank loans IFIs are also well positioned to provide guarantees for capital markets transactions such as bonds  In a transaction ahead of its time, USAID (not an IFI, but a development agency) guaranteed 50% of a $5 million bond issued by

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BancoSol (Bolivia) in 1996. More recently, USAID guaranteed the first tranche of Mibanco’s (Peru) first bond issue in 2002, while CAF guaranteed half of Mibanco’s second bond issue in 2003. Significantly, Mibanco’s third issue had no guarantee, yet the issue was oversubscribed. Here, the public guarantee truly catalyzed the MFI’s ability to show its creditworthiness in the local Peruvian marketplace.  IFC provided a 34% guarantee on $46 million of local bonds issued by Mexican MFI Compartamos in 2004 and 2005, allowing the MFI to lead in global MFI bond volume.  French IFI AFD provided a 75% guarantee on Faulu Kenya’s fiveyear bond issue in 2004, the first issue by an African MFI. 3. Helping to launch MIVs The first microfinance fund, ProFund, was launched in 1995 with equity investments from the IADB, IFC, and CAF, among others. The second, the Latin American Challenge Investment Fund (LA-CIF) involved the MIF (an affiliate of the IADB), Scandinavian IFIs and KfW. Since then, IFIs have regularly provided seed funding for MIVs. All of the transactions described above share the common feature of leveraging IFI funds to attract additional private capital to the sector.

7. RECOMMENDATIONS: WHAT ROLE SHOULD IFIS PLAY? IFIs, with their low-cost public money, should move away from the same regulated MFIs they have funded over the past several years and encourage them to develop their own links to domestic capital markets. This means focusing more on the next generation of strong institutions, offering seed capital and support for the development or transformation of this new crop of stars. (From CGAP’s ‘‘Access to All: Building Inclusive Financial Systems’’ Helms, 2006, p. 103).

How can IFIs best leverage their microfinance capital going forward? What roles can they play given the rapidly changing landscape of microfinance drawing in ever-increasing amounts of private capital? How does an IFI know when it has accomplished its mission and ought to move on? Their best role is to strengthen the overall capacity and transparency of the industry and to act as a catalyst for private capital that would not otherwise invest in microfinance. Examples are described below.

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1. Make IFI funding transparent IFI investment data are not easy to track down. Those interested in tracking and measuring IFI investment must hunt through multiple sources, only to find limited disclosure and dated information. The IFI with the largest direct exposure to microfinance, KfW of Germany, is also the least transparent. KfW discloses partial information but it does not tell the public which MFIs it has lent to or how much. IFC and EBRD disclose the date and total amount of MFI transactions and sometimes the tenor but never the terms such as interest rate charged or grace period. As public development institutions, IFIs should be held to high standards of transparency. They should disclose to what institutions they have lent, as well as the amount, interest rate charged, currency, grace period, tenor, and repayment terms. 2. Maximize commercial participation in innovative capital markets transactions IFIs are well placed to provide credit enhancements such as first loss positions, wraps, insurance, and guarantees. IFIs are ideally positioned to provide guarantees for capital markets transactions such as bonds, particularly in markets where a guarantor with a well-known name, reputation, and public backing is needed to reassure private investors. IFIs can also leverage their funds by providing MFIs with guarantees for local banks to issue local currency loans to MFIs. 3. Seed the next generation of MFIs IFIs should once again shift their focus to MFIs that are not yet able to attract commercial funding. IFIs could seed and nurture the next generation of successful MFIs. For example, IFC and KfW are currently funding up to seven greenfield MFIs in Africa through the Microfinance Initiative for Sub-Saharan Africa (MIFFSA). 4. Help develop mechanisms to cover foreign exchange risk The rapid increase in foreign currency lending exposes MFIs to foreign exchange risk, although some IFIs and MIVs are now offering local currency loans. In most developing countries, it is still difficult and expensive to obtain foreign exchange risk cover. IFIs can play a role in providing a collar to cover risk on local currency loans issued by commercial lenders and identify other mechanisms for MFIs to cover their foreign exchange risk efficiently, particularly in countries where such cover is not commercially available. 5. Promote further private sector channels for microfinance and fund industry infrastructure

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IFIs can help expand microfinance capacity in a number of ways. IFIs can promote local distribution channels for microfinance, such as bank downscaling, and SME lending for MFIs to head upmarket. IFIs can also support MFIs’ initiatives to increase mobilization of deposits. They can help MFIs expand horizontally into additional product lines such as leasing and insurance. Lastly, IFIs can use their risk capital to fund industry infrastructure such as credit bureaus and better use of technology.

8. CONCLUSIONS IFIs provided key early funding to MFIs. Yet, in the past few years, as microfinance has become increasingly popular, IFIs have all too often given in to the temptation to go for the low-hanging fruit. Top-rated MFIs are receiving large IFI loans, often at below-market conditions, forcing private lenders to shift to higher risk MFIs. If IFIs have any doubts as to whether their funding is crowding out private investors, a quick inquiry to several private investors would suffice to remove any uncertainty. IFIs have naturally gravitated toward funding the largest and least risky MFIs. Senior decision-makers, be they members of the Board of Directors or top managers, have not prevented IFIs from opting for volume and low risk at the expense of development impact. This must change. What is happening in IFIs today has its roots in the governance of the microfinance operations of those institutions. An effective governance structure is necessary to compel public development institutions to counter this tendency and act as catalysts for – not substitutes to – private lending. Reform of IFI lending behavior would be made easier if their microfinance operations were more open to public scrutiny with full and timely disclosure of the details of loans to MFIs. As far as we know, none of the IFIs reveal planned loans in advance, to find out whether private lenders would be willing to step in. To dampen the appetite of IFIs for funding top-tier MFIs, it would help if private lenders were able to monitor IFI lending. It is difficult for individual lenders to do this, but as a group, perhaps through the proposed Microfinance Investor Association, they could evaluate IFI loans as they are being approved and draw attention to those that displace private funding. Microfinance is a dynamic industry where the pace of change seems to be accelerating daily. In this environment, IFIs urgently need to refocus on

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how to complement and attract the private sector instead of preempting it and competing with it as they are now often doing. ‘‘AFD constantly assesses itself to ensure it is not crowding out other players, and that it is adding value,’’ says Martha Stein Sochas, Head of Bank and Financial Market Division, AFD (Collet, 2006). Let that be the goal and practice of all IFIs funding microfinance.

NOTES 1. Comment at Omidyar Network at Microfinance Investor’s Roundtable, Washington, D.C., October 2006. 2. ProCredit Holding AG is the main shareholder of 19 ProCredit banks in Africa, Latin America, and Eastern Europe, providing credit to micro and small enterprises, with nearly h2 billion in outstanding portfolio. 3. Alpha-rated clients are well-functioning, fully creditworthy MFIs. Beta-rated MFIs are viable institutions, but they present issues and risks that need to be mitigated. These range from moderate (beta-plus) to major (beta-minus). 4. CGAP (2006b, p. 11). Revised ‘‘Pink Book.’’ 5. In February 2007, LIBOR was at about 5.4%. 6. Data from MIX Market (http://mixmarket.org). 7. Loans are issued through AECI’s Fondo de Concesio´n de Microcre´ditos (FCM) and issued through the Instituto de Cre´dito Oficial del Reino de Espan˜a (ICO). 8. From MIX data as of June 30, 2006. 9. Loan was part of a $50 million overall funding package for Compartamos. 10. $45.1 million to Al Amana, $13.1 million to Zakoura, and $8.2 million to FONDEP (CGAP, 2006a, p. 37).

REFERENCES Agencia Espan˜ola de Cooperacio´n Internacional – AECI. (2006). Fondo para la Concesio´n de Microcre´ditos (FCM). Madrid, Spain: AECI. Available at http://www.aeci.es Al Amana. (2006). Rapport sur la mission de Commissariat aux comptes, exercise areˆte au de´cembre 2005. Rabat: Al Amana. Available at http://www.mixmarket.org/en/demand/ demand.show.profile.asp?ett ¼ 304# Berglo¨f, E. (2006). Results measurement at EBRD: Current practices, lessons learned. PSD Forum 2006. London: EBRD. Available at http://rru.worldbank.org/Documents/ PSDForum/2006/erik_berglof.pdf BIO. (2004). Highlights 2004. Brussels: BIO. Available at http://www.b-i-o.be CGAP. (2006a). CGAP IFI survey 2006. Washington, DC: CGAP.

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CGAP. (2006b). Good practice guidelines funders of microfinance (2nd ed.). Washington, DC: CGAP. October. Available at http://www.cgap.org/portal/binary/com.epicentric.contentmanagement.servlet.ContentDeliveryServlet/Documents/donorguidelines.pdf Collet, E. (2006). Microfinance: Macro impact. Manila: ADB. adrmagaazine.com. Available at http://cgap.org/press/press_coverage16.pdf Compartamos. (2006). Estados Financieros Dictaminados. Mexico City: Compartamos. Available at http://www.mixmarket.org/en/demand/demand.show.profile.asp?ett ¼ 237# Dugan, M., & Goodwin-Groen, R. (2005). Donors make themselves obsolete: Compartamos taps financial markets in Mexico. CGAP Direct Case Study No. 19. Washington, DC: CGAP. Available at http://cgap.org/direct/docs/case_studies/cs_19.pdf EBRD. (2005). Project summary document. London: EBRD. Available at http://www.ebrd.com/ projects/psd/psd2005/36415.htm EBRD. (2006a). EBRD loan boosts Kazakh MSEs. London: EBRD. January. Available at http:// 209.85.165.104/search?q ¼ cache:NX1hi0c2mxcJ:www.ebrd.com/new/pressrel/2006/4jan24. htmþkazakhstanþloanþfundþandþEBRD&hl ¼ en&gl ¼ us&ct ¼ clnk&cd ¼ 1 EBRD. (2006b). EBRD NGO Newsletter. London: EBRD. Available at http://www.ebrd.com/ oppor/ngo/new/news/news0906.pdf EFSE. (2006). Investment portfolio and quarterly funding fact sheet, September. Available at http://www.efse.lu/docs/EFSE%20Fact%20Sheet%20-%20Investment%20Portfolio% 203rd%20Quarter%202006.pdf European Union. (2006a). Bulletin of the European commission: International organisations and conferences: EBRD funding. Brussels: European Union. January–February. Available at http://209.85.165.104/search?q ¼ cache:ef-aSvM9EEMJ:europa.eu/bulletin/en/200601/ p126001.htmþEBRDþandþKazakhstanþLoanþFund&hl ¼ en&gl ¼ us&ct ¼ clnk&cd ¼ 4 European Union. (2006b). Bulletin of the European Commission: International organisations and conferences: EBRD Funding. Brussels: European Union. June. Available at http:// 209.85.165.104/search?q ¼ cache:OA3gHGyj4j4J:europa.eu/bulletin/en/200606/p127001. htmþmicroinvestþtajikistanþandþEBRD&hl ¼ en&gl ¼ us&ct ¼ clnk&cd ¼ 4 Finca Honduras. (2006). 2005 audited financial statements. Tegucigalpa: Finca Honduras. Available at http://www.mixmarket.org/en/demand/demand.show.profile.asp?ett ¼ 1923# Flaming, M., Duflos, E., Helms, B., Siedek, H., Summerlin, R., & Duarte, S. (2005). Country-level effectiveness and accountability review: Nicaragua. CLEAR Reports. Washington, D.C.: CGAP. Available at http://www.cgap.org/docs/clear_nicaragua_ report.pdf FMO. (2006a). Changing the face of Cambodian microfinance. The Hague: FMO. Available at http://www.fmo.nl/en/recent/newsitem.php?id ¼ 95&archive ¼ 1&PHPSESSID ¼ 49e7d5fc3fa9c94cc5c84c5ded27bbce FMO. (2006b). FMO boosts microfinance in Cambodia with unique financing. The Hague: FMO. Available at http://www.fmo.nl/en/recent/pressitem.php?id ¼ 94&archive ¼ 1& PHPSESSID ¼ a1ab2b640fecde97a9045bc0327f89d1 FMO. (2006c). Program description. The Hague: FMO. Available at http://www.citigroup.com/ citigroup/press/2007/070116b.htm FONDEP. (2006). MicroCredit rapport des auditeurs independants, etats financiers selon les directives du CGAP exercise 2005. Rabat: FONDEP. Helms, B. (2006). Access for all: Building inclusive financial systems. Washington, DC: CGAP. Available at http://www.cgap.org/portal/site/CGAP/menuitem.23fd010a5265 8d4367808010591010a0

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IFC. (2005). Summary of project information. Available at http://www.ifc.org/ifcext/ spiwebsite1.nsf/2bc34f011b50ff6e85256a550073ff1c/93293156041ddc83852570ae006343 c3?opendocument IFC Structured Finance. (2004). Financiera compartamos. Washington, DC: IFC. Available at http://www.ifc.org/ifcext/treasury.nsf/AttachmentsByTitle/SF_Compartamos/$FILE/ Compartamos.pdf KfW. (2006). Credit line for financiera compartamos. Frankfurt: KfW. Available at http://www.kfwentwicklungsbank.de/EN_Home/Laender_und_Projekte/Lateinamer74/ Mexico36/EPKD_21865_202091684_EN_Compartamos_e.pdf MicroBanking Bulletin. (2006). Trendlines 2001–2004 benchmarks. Washington: MBB. Available at http://www.mixmbb.org/en/mbb_issues/12/Online%20Tables/Trend%20 Lines%202001-04%20Benchmarks.xls#OutreachAvg Microfinance Matters. (2005). Interview with European investment bank (EIB) president, Mr. Philippe Maystadt: On microfinance at the EIB. New York: UNCDF Year of Microcredit. Issue 17, October. Available at http://www.uncdf.org/english/microfinance/ pubs/newsletter/pages/2005_10/news_Maystadt.php MicroRate. (2006). Microfinance investment vehicles: An emerging asset class. Arlington, VA: MicroRate. November. Planet Rating. (2005). Mikrofin Bosnia and Herzegovina. Paris: Planet Rating. Reille, X., Seidek, H., & Pasricha, N. (2006). CGAP IFI survey 2006. Washington, DC: CGAP. Rosenberg, R. (2006). Aid effectiveness in microfinance: Evaluating microcredit projects of the World Bank and the United Nations development programme. Focus Note No. 35. Washington, DC: CGAP. Available at http://www.cgap.org Soriano, A., & Padro´n, A. J. E. (2006). Analysis of microfinance institutions, 2005. Caracas: CAF. Available at http://www.caf.com

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APPENDIX Table A1.

International Financial Institutions (IFIs) Included in this Chapter.

International Financial Institution

Agencia Espan˜ola de Cooperacio´n Internacional (AECI) BIO

Corporacio´n Andina de Fomento (CAF) European Bank for Reconstruction and Development (EBRD) European Investment Bank (EIB) Netherlands Development Finance Company (FMO) International Finance Corporation (IFC) Inter-American Development Bank Multilateral Investment Fund (MIF) Inter-American Investment Corporation (IIC) Kreditanstalt fu¨r Wiederaufbau (KfW) a

Public Sector Shareholders

Government of Spain

Percent of Geographic Focus Equity Held by Public Sector 100%

Global, special focus on LAC a

Government of Belgium/ 81.5% Belgian Corp. for International Investment 99.9% Multilateral – Latin American governments and Government of Spain Multilateral: Member 100% Governments, EIB, EU

Global

Multilateral: Member States of EU Government of Netherlands

100% 51%

Africa, Caribbean, Pacific (ACP) Global

Multilateral: Member Governments Multilateral: Member Governments

100%

Global

100%

Latin America/ Caribbean

Multilateral: Member Governments

100%

Latin America/ Caribbean

German Federal Government 80%; German States 20%

100%

Global

Andean countries

E. Europe/Central Asia

BIO is 50% controlled by Belgian Department of Development Cooperation and 50% by Belgian Corporation for International Development, which is in turn 63% controlled by public institutions.

THE GREAT DIVIDE IN MICROFINANCE: POLITICAL ECONOMY IN MICROCOSM Bruce E. Moon A scholar trained in international political economy (IPE) cannot encounter the Great Divide in microfinance (Morduch, 2000) without noting strong parallels to IPE’s own grand chasm (Gilpin, 1987). The classical schools of thought in political economy make the same ideological arguments, accept the same gross assumptions, and commit the same errors as their newer microfinance counterparts. There is considerable irony in this because one source of the great interest in microfinance lies precisely in its potential to bridge the ideological divide found elsewhere in the political economy of development (Weber, 2002, 2004). This chapter discusses those commonalities, identifies several issues central to the microfinance literature anticipated by the IPE literature of a generation earlier, and sketches components of a microfinance research agenda appropriate for IPE and development scholars.

1. THE GREAT DIVIDE IN MICROFINANCE Woller, Dunford, and Woodworth (1999) and Morduch (2000) were among the first to discuss the existence of a ‘‘schism’’ in the study of microfinance. Although the exact dimensions of this divide are stated differently by various authors, the existence of alternative schools of thought is widely Moving Beyond Storytelling: Emerging Research in Microfinance Contemporary Studies in Economic and Financial Analysis, Volume 92, 109–144 Copyright r 2009 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1569-3759/doi:10.1108/S1569-3759(2009)0000092007

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accepted (Brett, 2006; Bhatt & Tang, 2001; Mitlin, 2002; Robinson, 2001; Rhyne, 1998). Morduch’s (2000, p. 618) schism ‘‘between rhetoric and action’’ is defined narrowly around the necessity of subsidies. On the one hand, exponents of commercialized microfinance – such as the Consultative Group to Assist the Poor (CGAP) – associate subsidies with inefficiency, impermanence, and a limited scale of operations. Thus, the compilation of ‘‘best practices’’ by CGAP eschews subsidy and embraces commercialization. Those commercialized MFIs that operate without subsidies are able to grow in scale to meet widespread unmet demand for access to financial services. The key performance criteria for this school of thought is ‘‘sustainability’’ and the practical essence of their position is that the best, perhaps only feasible, method of delivering microfinance services to the billions of poor is through the quintessential market participant, the for-profit enterprise. On the other hand, many practitioners who aim primarily at reducing poverty doubt that unsubsidized services delivered through the market can be cheap enough to benefit the very poorest, who they often conceive as the target of microfinance. These practitioners interpret the unavailability of financial services for the poor as an instance of ‘‘market failure’’ that reflects fundamental limitations of what markets and firms can contribute to poverty alleviation. In particular, they contend that subsidies are necessary to fill the gap between the high transaction costs inherent in very small-scale lending and the interest rates that can be afforded by the poor (and justified by the commitment to avoid usury). Morduch (1999, p. 1587), for example, estimates that no more than 5% of all MFIs are profitable without subsidies. Without them, lenders are forced to move upscale to richer clients that demand (and can service) larger loans, because fixed operational costs comprise a lower percentage of these larger loan volumes and thus allow lower interest rates. According to most practitioners, the trade-off is real between outreach – the number of poor successfully targeted – and sustainable financial performance – operating at break even or better. The trade-offs include serving urban over rural areas to cut costs, emphasizing account volume over portfolio quality, keeping field staff salaries low and work levels high, dealing mostly with clients in retail trade and services with high cash flow, de-emphasizing manufacturing, agriculture, and fixed asset loans, and an upward creep in the prosperity of clients. Woller et al. (1999) see a broader schism between ‘‘welfarist’’ vs. ‘‘institutionalist’’ perspectives, which encompasses cleavages on issues such as (1) the populations thought to be best served by microfinance (welfarists

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are concerned with the poorest while institutionalists tend to emphasize the entrepreneurial poor), (2) lending designs (the alternatives include individual, small solidarity groups, or large village banks), (3) institutional structure (options include non-governmental organizations (NGOs), community-based credit unions and banks, commercial banks and finance companies, and state programs including rural development banks). Robinson (2001) refers to them as the ‘‘poverty lending’’ and ‘‘financial systems’’ approaches, respectively. Acceptance of the necessity of subsidies is an element of a ‘‘welfarist’’ approach, which is defined by the vision that microfinance is but one tool to achieve broad-scale social or human development. Consequently, the practitioners and development-oriented scholars who make up this school of thought naturally compare the performance of microfinance against other humanitarian programs that seek developmental outcomes. In an interview, Ryan Young of Common Interest International in Chang Mai, Thailand, illustrated the perspective perfectly. His largest donors, a private family in Canada, viewed microfinance as a charitable contribution designed to solve development problems, and different from direct grants only in that the partially rotating fund leveraged their initial donation. Grameen and FINCAstyle village banking exemplify the welfarist approach’s principled commitment to poverty alleviation and various other development goals. They support MFIs to the extent that they succeed in promoting those goals, but they frequently combine microfinance with other programs to do so. The ‘‘institutionist’’ approach instead views microfinance from the perspective of banking practices and the potential of microfinance to surmount the four great problems of small-scale finance: high transaction costs, the difficulty of measuring risk, the cost of monitoring clients, and the absence of collateral. Adherents to this approach are committed in principle to commercialized microfinance, and their efforts sometimes seem to welfarists like a solution in search of a problem. Woller associates it with ‘‘virtually all the literature coming out of the Ohio State University Rural Finance Program, the World Bank and its CGAP, and USAID. It is also found in the many writings of Maria Otero (ACCION International) and Elisabeth Rhyne (formerly of USAID) (see, for example, Otero & Rhyne, 1994). Most published literature in the field of microfinance espouses the institutionist view.’’ Operational examples are BRI and BancoSol, the former a commercial branch of a state-owned bank and the latter a commercialized successor to an NGO. The antecedents of both approaches, but now more closely identified with the welfare orientation, lie in the early government rural credit programs

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that proliferated in the 1960s and 1970s. They were introduced in the context of overall efforts to improve economic productivity through technical assistance, ‘‘green revolution’’ technologies, irrigation, etc. (Tapella, 2002). Rural (mostly agricultural) finance was the instrument for achieving that productivity, often dangling loans as incentives for individual farmers to adopt innovations likely to achieve the various goals embraced by government programs. Gonzalez-Vega and Graham’s (1995, p. 3) view is indicative of the OSU critique of rural development banks: Prominent among the reasons for the generalized failure of most state-owned agricultural development banks were precisely attempts to use them as instruments to promote a number of (development) objectives (growth of agricultural production, adoption of new technology, agrarian reform and regional development) at the expense of sound financial intermediation, when such directives created excessive costs and risks for the organizations. Moreover, arbitrary (politicized) criteria adopted in the approval of loans contributed to worsen, rather than improve, resource allocation.

This critique mirrors the broader neo-classical economic literature in holding that any goal other than profit maximization erodes systemic efficiency. Thus, the best guarantee of welfare maximization is a free market among modern corporations that embody that goal-oriented behavior. In response, the early institutionist approach narrowed the programmatic focus to finance itself, with market interest rates, a smaller role for the state, and de-emphasis of the other elements of development to focus more narrowly and effectively on finance. In the words of Rhyne and Otero (1994, p. 11), ‘‘The principles behind the emerging techniques for offering financial services to the poor are the same as those found in any financial system’’ (italics added). A welfarist would offer the rejoinder that ‘‘the principles behind the emerging techniques for offering financial services to the poor are the same as those found in any’’ development program designed to help the poor. In effect, microfinance is less the arena in which finance and development converge than where they collide. Whereas Littlefield and Rosenberg (2004) have written on ‘‘breaking down walls between microfinance and formal finance,’’ a welfarist seeks to break down walls between microfinance and development. For example, one of Gonzalez-Vega’s four problems with state-owned rural banks is that they are reliant on agriculture, an inherently precarious sector. From the standpoint of running a successful bank, this critique is accurate: if you are expecting stable profitability, agricultural clients are indeed a poor choice. But from the standpoint of alleviating poverty, your choices are limited because more than half of the world’s poor are employed

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in agriculture or live in rural areas where their best hope for employment lies in agriculture (World Bank, 2007). If you run away from agriculture, you are running away from a majority of the problem. These microfinance approaches mirror political economy concerns over how human interactions should be ordered, especially with respect to the allocation of things of value. The Great Divide in Microfinance is often defined as a clash over whether financial services for the poor should be provided by market-oriented private firms, state-run development banks, or NGOs that represent broader societal interests and values. However, this choice reflects deeper disagreements that have ideological counterparts in the political economy literature, discussed in the next section. More troubling yet, as discussed later, there remains remarkably limited empirical basis for arguing one way or another.

2. THE IDEOLOGIES OF POLITICAL ECONOMY Political economy re-emerged as a multi-disciplinary field in the 1970s after a century of division between its economic and political side. When it did, its agenda was dominated by conflict over mechanisms of allocation, especially between the state and market (Best & Connolly, 1982). The iconic formulation of Robert Gilpin (1987, p. 25) defines the field as conceived in its first two decades of re-birth: ‘‘It may not be an exaggeration to say that every controversy in the field of international political economy is ultimately reducible to differing conceptions of the relationships among society, state, and market.’’ Allocation can occur through different processes, in accordance with different institutions, expressing different values or priorities, and generating different norms and standards of behavior. In economic processes centered on the market, individuals buy and sell according to their wealth. In political processes centered on the state, individuals acquire opportunities, rights, and income according to their access to political power. In social processes like those of civil society, individuals acquire things of value according to convention or the goodwill (or power or obligation) of others. The latter is the academic province of sociology and anthropology, whereas the first describes the venue of economics and the second the realm of political science. The institutionist approach to microfinance can be seen as one expression of the (neo-) liberal perspective embodied in orthodox economics. Markets should be largely free from political interference by the state so as to achieve efficiency, growth, individual welfare, and freedom. The system rests on

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individual rationality, a materialist conception of utility, and the conviction embodied in Adam Smith’s ‘‘invisible hand’’ that individual pursuit of selfinterest yields maximization of aggregate welfare. If these premises are accepted, the case for commercialization of microfinance follows. The Great Divide in microfinance exists precisely because mainstream economics starts from those premises, whereas one must look long and hard to find a political scientist, sociologist, or anthropologist who does not instinctively reject them (Fallows, 1993; Polanyi, 1944; Rodrick, 1997). In political economy traditions, the strongest competitor to the market is the state. Its advocates doubt the normative foundations and actual performance of markets and then note the special strengths of the state. In standard democratic theory the state represents the broad interests of all citizens (by implication more or less equally) and is the only institution to do so (Dahl, 1998). Often, an implicit ‘‘social contract’’ mythologizes a necessary link between the needs of society and the behavior of the state, as in Hobbes, Locke, and Rousseau. More pluralist views expect the state to operate in the public interest via the leverage ‘‘the people’’ have over politicians competing for their vote with good policy. Such pluralist perspectives form the core of development theories that emphasize statist programs. If accepted, these democratic-pluralist premises lead to a belief that state-run microfinance institutions would outperform commercial ones, in part because such values as equity, empowerment, and long-run development would receive due consideration, especially where markets regularly fail. Even where markets work, the center-left hopes for a more expansive state as a check on market power that inevitably benefits the wealthy. The center-right, by contrast, fears that state efforts to be ‘‘fair’’ will degenerate into populist redistribution, compromising efficiency and growth. Although the early, predominantly centrist, political economy literature was dominated by such ‘‘state vs. market’’ clashes, the left constructed not only the most theoretically sophisticated critique of the state but also the most vehement attack on the market (Gold, Lo, & Wright, 1975). The same appears to be true of the critical literature in microfinance. At the left’s most extreme, the instrumentalist Marxist contends that the state is the ‘‘executive committee for managing the common affairs of the whole bourgeoisie’’ (Marx & Engels, 1998[1848]) and therefore incapable of correcting ‘‘market failure’’ (Sweezy, 1942; Miliband, 1969). As a practical matter, this view rules out the possibility that the state could act against the interests of dominant economic actors, which would seem to preclude any optimism that state-run banks could challenge the dominance of formal financial institutions in microfinance (or anywhere else). Hegelian and Gramscian

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traditions would emphasize that such dominance would take the form of theoretical hegemony, in which the superiority of private finance is pronounced as an objective fact, dissent from which is seen as not just mistaken but positively delusional. Commercialization’s bid for theoretical hegemony seems an obvious example. Structuralist Marxists also reject the democratic-pluralist view of the state (Poulantzas, 1969; O’Connor, 1973). As Baran (1952, p. 80) puts it, ‘‘Mechanically, one could list the steps a state could take to correct market outcomes, but the exercise would reveal the utter implausibility of the view that they could be carried out by the governments existing in most underdeveloped countriesyThe crucial fact rendering the realization of a developmental program illusory is the political and social structure of the government in power.’’ This more empirical perspective underlines the absence of any good reason to expect such governments to advance the interest of the mass public against more powerful actors. If no pluralist-democratic state exists, some other agency to avoid the limitations of markets must be found. These limitations include the ‘‘market failure’’ acknowledged by neo-classicals as well as the more extensive ‘‘ravages of the satanic mill’’ Polanyi (1944) associates with unregulated markets. In the modern era, this role is fulfilled by the various institutions of civil society, represented at the international level by values-oriented NGOs, the vaunted ‘‘third force’’ (Florini, 2000). As a practical matter, NGOs are growing exponentially because they are wildly popular among nonideological reformists, but they remain under-theorized by their supporters and viewed with great suspicion by both ideological wings. Neoliberal theories, with their basic conviction that ‘‘markets function most efficiently when drained of social content and encumbrances’’ (Skidmore, 2001), are little more tolerant of NGOs than states. Critics from the left question the ability of NGOs to avoid the limitations of all organizations lodged within capitalist structures (Petras, 1997; Cooley & Ron, 2002). Such a structural understanding informs critics of microfinance who see it as a thinly disguised effort to co-opt those who would otherwise direct their rage about development failures toward a more radical and system-threatening critique. Gilpin (1987) argues that political economy is the struggle between these alternative methods of social organization – the state, the market, and civil society. Each tries to organize the world according to its own principles. Each has theories and ideologies to support its case as a superior form of organization. Each supports some values and opposes others. Each benefits some groups and harms others. Political economy is the study of the struggle between these imperialistic forces. So is the Great Divide in microfinance.

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3. WHAT LESSONS CAN MICROFINANCE LEARN FROM POLITICAL ECONOMY? There are at least four, discussed more thoroughly below. 1) We must avoid polarizing attitudes, false comparisons and over-simplifications. Great Divides are usually more apparent than real, the product of an inherent need for simplicity in the face of complex arguments. But reducing multiple controversies into a single rigid ideological division impedes conversation and progress. 2) Forms of organization are not as important as ideologues think. To subsidize or not to subsidize is not the question. Successful microfinance can – and has – occurred in state-run programs, for-profit firms, and NGOs; it is not exclusive to any one type. We must focus on the methods used by successful organizations, not their sources of funds. 3) We must place the diagnosis of poverty before the solution to poverty. A proper diagnosis is logically before treatment, but much of the writing and practice in the institutionist vein has assumed that the lack of credit was responsible for poverty. We cannot ignore either the general theory that identifies the requisites of development nor the specific presence or absence of those requisites in individual cases. 4) We must join empiricism to theory by conducting proper evaluation studies to establish truths rather than relying on ideology. Deeper understanding of microfinance impacts will follow from a better specification of ‘‘process tracing,’’ which identifies the mechanisms or channels through which effects are conducted. Moreover, research should seek explanations for variance rather than universality in microfinance experiences. 3.1. The Dangers of Over-Simplification and Polarization The construction of schools of thought can help organize a wide-ranging literature, but should not be taken too seriously for at least two reasons. First, such gross simplifications invariably conceal differences within groups and exaggerate differences between groups. Second, these constructions encourage the formation of ideological positions that can be very difficult to break through. Both tendencies impede honest exploration of underlying questions and potentially cross-fertilizing ideas. This is especially damaging in an area like microfinance where different intellectual traditions and academic specializations must meet. In IPE the economics vs. politics divide has never really

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narrowed and continues to impose real constraints on intellectual progress (Rao & Woolcock, 2007). Indeed, fighting ideological and disciplinary battles often appears more important than solving the underlying problems. For studies of microfinance to fulfill the rich potential of energizing disciplinary intersections in the social sciences, we need to de-emphasize ideological divisions or actively seek to bridge them. One pole is defined by CGAP (1996), in which Richard Rosenberg lays out financial sustainability ‘‘best practices’’ that allow ‘‘win-win’’ optimism for institutionists (Morduch, 2000, p. 619). Similarly, ‘‘The Pine Book’’ (CGAP, 2004) emphasizes the regular reporting of core performance indicators to improve information and incentives. Key indicators are outreach (number and economic status of clients), cost-recovery, loan collection, and efficiency (reasonable administrative costs). Those best practices are served on a bed of pure neo-liberalism: financially sustainable programs can make the greatest dent in poverty thanks to scale obtainable only by attracting commercial finance, which in turn requires a minimal level of profitability. Critics from the opposite pole are already put off by the language of ‘‘best practices,’’ which implies far greater certainty and universalism than seems warranted by the absence of rigorous evaluation studies, a recurrent theme in the remainder of this essay. According to Dunford (2000, p. 7), ‘‘Seibel (1998) challenges the use of the adjective ‘best’ and its implication that there is only one optimal way of doing things. Instead, ‘[g]iven the great diversity of microfinance organizations, strategies and situations, there cannot possibly be a unitary set of best practices, only diverse sets of sound practices’.’’ So too, the focus on financial self-sufficiency is seen as overly narrow and suspiciously in tune with neo-liberal perspectives. Motivations are questioned in a way that stilts conversation where it occurs at all. Consider Woller et al.’s (1999, p. 53) skepticism: According to Elisabeth Rhyne (1998, p. 7), for example, ‘‘Sustainability is but a means to achieve [outreach]yonly valued for what it brings to the clients of microfinance. This is a point on which the ‘poverty’ camp frequently misstates the motives of the ‘sustainability’ camp. It would do wonders for the state of the debate if the poverty camp more readily acknowledged that the sustainability camp values sustainability only as a tool.’’ While we do not doubt the sincerity of Rhyne’s avowal, it is contradicted both in the writings of leading institutionist writers and in the internal logic of their arguments.

The reaction of such welfare-centric scholars is no doubt a consequence of their prior engagement with the ideological battles in political economy, where complex social phenomena and the theoretical ideas surrounding them have been reduced to comic books. One example concerns the famous ‘‘Washington consensus,’’ a compilation of neoliberal development

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policy best practices established by the IMF, World Bank, and U.S. Treasury early in the Reagan years and still the dominant paradigm in many circles (Gore, 2000). John Williamson (1993, p. 1329), who coined the phrase, described the Washington consensus as a ‘‘universal convergence’’ and ‘‘the common core of wisdom embraced by all serious economists,’’ though it was, of course, nothing of the sort in the Global South or among development scholars. It was, however, widely applied in exactly the imperialist manner discussed by Gilpin. Indeed, Williamson acknowledged that ‘‘none of the ideas spawned by the development literatureyplays any essential role in motivating the Washington consensus,’’ which constitutes an ‘‘implicit dismissal of the development literature as a diversion from the harsh realities of the dismal science.’’ Many economists who thought they were pretty serious in their critiques of neoliberalism were deeply offended by Williamson’s dismissal of them as ‘‘cranks’’: [T]he superior economic performance of countries that establish and maintain outwardoriented market economies subject to macro-economic discipline is essentially a positive question. The proof may not be quite as conclusive as the proof that the Earth is not flat, but it is sufficiently well established as to give sensible people better things to do with their time than to challenge its veracity. (p. 1330)

It is no wonder that a leading IPE textbook (Lairson & Skidmore, 2003, p. 12) observes that ‘‘the arguments of (neo)liberals sometimes extend beyond respecting to worshiping markets.’’ Nor is it surprising that Fallows (1993, p. 65) comments that The Anglo-American [liberal] system of politics and economics, like any system, rests on certain principles and beliefs. But rather than acting as if these are the best principles, or the ones their societies prefer, Britons and Americans often act as if these were the only possible principles and no one, except in error, could choose any others. Political economics becomes an essentially religious question, subject to the standard drawback of any religion – the failure to understand why people outside the faith might act as they do.

Thus, the study of microfinance must avoid the certainty of ideologues, especially when we have, as discussed below, such limited empirical evidence. Three kinds of pernicious simplifications well known in the IPE literature should be avoided in dealing with microfinance, especially to prevent potentially complimentary viewpoints hardening into impenetrable ideologies. First, we must avoid critiquing microfinance institutions by false counterfactual comparison with strictly theoretical archetypes. The IPE literature is full of descriptions, for example, of the failures of import substitution policies in Latin America, which are then compared to what

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liberal theory predicts from hypothetical free trade. On the other side, the dismal record of stabilization policies through the IMF is paired against the theoretical benefits of a hypothetical program more sensitive to state concerns. The lesson is clear: actual arrangements can never meet the standard of theoretical alternatives. Yes, state-owned rural development banks did not perform as well as liberal theory indicates a modern, efficient, commercial bank would have. But it is equally true – and equally irrelevant – that actual commercial banks underperform the ideal public-sector bank described by statist theory. Empirical comparisons are the appropriate method of adjudicating such disputes; but, as importantly, the very insistence that such disputes must be cleanly adjudicated is itself part of the problem. It is not at all clear, as we see below, that the ownership form of the MFI is an especially important determinant of its success. A second apples-to-oranges comparison occurs when evaluation criteria do not match up with goals. Liberals, who espouse growth goals, laud the superiority of liberal policies because they generate faster growth than statist policies. State-planning theorists, who espouse equity goals, laud the superiority of statist policies because they achieve greater equity than liberal policies. Since both can be right (or wrong), reducing the chest-thumping might produce dialogue with more satisfying outcomes. Similarly, it cannot be a surprise that commercial banks structured to achieve profit are closer to profitability than NGO programs structured to empower individuals or alleviate poverty. Third, we must acknowledge that many debates in microfinance entail differing levels of analysis (Singer, 1961). In effect, the ‘‘double bottom line’’ contains one set of goals – sustainability or profitability – expressed at the level of the program or firm and a second set – poverty alleviation, empowerment and the like – that makes sense mainly at the level of the community. This implies that evaluations must encompass both levels. For example, microfinance proponents often attribute its success in part to joint liability schemes that reduce the costs of evaluating and monitoring clients. However, Marr (2004) argues that such functions remain and are still costly, but that the burden shifts from the bank to civil society, with costs in the form of lost social capital rather than money. Monitoring takes time, and imposing social sanctions on neighbors undermines trust and affects social interactions. Friendship patterns are disrupted by selection or non-selection into a group and by failures to repay. Nor do joint liability groups necessarily perform these functions well, because participants’ motives are divided between microfinance-related incentives and other factors, including structural power relationships and social status. We cannot ignore social

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psychology and non-economic effects in our zeal to achieve income gains. That requires a conscious balancing of effects that arise at both the firm and societal level of analysis.

3.2. Forms of Organization and the Issue of Subsidization The Great Divide in Microfinance is most easily defined in terms of controversies over which of the ownership forms (and the program attributes that flow from them) are most likely to achieve success. Although plausible arguments support each main form – for-profit firms, states, and NGOs – there are theoretical, empirical, and practical reasons to doubt that any such generalized answer is possible. Mitlin (2002, p. 176) summarizes. ‘‘A broad sweep of history suggests that there are three sources of development finance for pro-poor activities, in addition to the funds of the poor themselves: market investment funds, state redistribution and charitable contributionsy[T]heir presence shows remarkable persistence.’’ Institutionist arguments seem to be translations from the conservative wing of the broader political economy literature: the state and other non-profit or subsidized enterprises are doomed to inefficiency. ‘‘Nancy Barry of Women’s World Banking (CGAP, 1995) asserts, for example, that ‘few low income entrepreneurs end up benefitting from subsidized programs, because these programs fail before they reach significant numbers’’’ (Morduch, 2000, p. 623). But, as Morduch notes, ‘‘this is hard to reconcile with the experience in Bangladesh to date, where subsidized programs like the Grameen Bank and Bangladesh Rural Advancement Committee, for example, have together reached around four million borrowers.’’ Furthermore, the state-run IRDP of India is about four times that size. The highest penetration of the poor reached by microfinance occurs in Thailand, largely through the efforts of the state-run BAAC. The findings of Rosenberg (2006, p. 6) – that the projects involving the most government involvement perform the worst – deserve greater scrutiny, particularly in light of his conclusion that ‘‘In the final analysis, the quality of technical input and managementyis more important than project structure.’’ Why can’t government programs work? Good microfinance is said to be difficult for governments because the soundest principles (higher interest rates, exclusion of high risk borrowers, vigorous enforcement) are not politically popular, so the program needs to be insulated from political forces. Also, state-run programs are vulnerable to political intrusion, including loan forgiveness. Woller et al. (1999, p. 40) identifies the origin of this institutionist

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position in the interpretation by researchers at OSU’s Rural Finance Program of governmental rural development institutions in the 1960s and 1970s, not recent ones: ‘‘From the beginning these RDIs were plagued by a number of problems, including a grant mentality among clients, high overhead and transaction costs, and heavy corruption.’’ They also suffered poor repayment rates and concentration of subsidies to the already rich. However, it is not at all obvious why we should attribute these failures to ‘‘stateness’’ when the alternative explanation is just that they were first attempts, from which we have subsequently learned. Barry (1995, p. 3) argues that what we have learned is that we ‘‘cannot depend on governments and donors as reliable, long-term sources of subsidized funding.’’ Really? But what is the evidence that they fail or that outcomes are bad when they do? It is far from clear that subsidization precludes sustainability, if that refers to the actual continuation of programs rather than a formal accounting concept concerning covering costs. After all, program sustainability and financial self-sufficiency are two different things, since measures of the latter typically exclude subsidies from actual revenues and add imputed (market) rates of interest to actual costs. Any relationship between sustainability and self-sufficiency should be argued theoretically and established empirically. On both grounds, we have reason to doubt that the institutionist perspective relies on anything more than what Mitlin (2002, p. 175) refers to as ‘‘somewhat incredulous faith in markets.’’ Morduch (2000, p. 619) denies that subsidized programs will necessarily fail, because he questions ‘‘the belief that funding will be pulled away from programs, even those able to demonstrate sustained social effectiveness.’’ Donors are as rational as any other investors and will value efficiency in ‘‘bang for the buck’’ terms even if measured in outcomes other than profitability. As a result, subsidized programs are not inherently inefficient or short-lived. Robinson (2001, p. xxxi) dismisses Grameen – ‘‘the poverty lending approach has required large amounts of continuing subsidies and has not proven a globally affordable model’’ – without acknowledging the fundamentally ideological meaning assigned to ‘‘sustainability’’ or ‘‘affordable.’’ In point of fact, the continuation of subsidies enjoyed by Grameen seems to establish that they are sustainable by the soundest possible empirical criteria: they have actually been sustained! The Grameen family now consists of more than two dozen organizations and its microlending program has reached more than five million borrowers (Grameen, 2007). Moreover, non-profit organizations are ubiquitous outside of microfinance, and it is not obvious why their success in other development areas cannot be duplicated in microfinance. Many NGOs are revealed as highly

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efficient by the well-developed theory of shadow prices computed in connection with net social gain, transaction prices, and the like (Thys, Tulchin, & Ohri, 2005). Among them are familiar names that operate at large scale and over a long period of time: FINCA, CARE, Catholic Relief Services, Save the Children, Christian Children’s Fund, Red Cross, United Way, March of Dimes, and Greenpeace. Freedom from Hunger has operated since 1946 through subsidies. Gonzalez-Vega and Graham (1995, p. 15) contends that ‘‘in order to survive, the agricultural development banks must first emphasize their role as financial intermediaries.’’ Even if he is right, can’t that be done as easily by government banks as commercial ones? The doubts about the effectiveness of non-profits seem especially ironic given their source: most of these writers are employed by public universities, international organizations funded by states, and NGOs! The absence of a bottom line cannot be the major problem; if these individuals have managed somehow to produce excellent work despite the nature of their organizations, can’t the same be done in microfinance? Similarly, Morduch (2000, p. 619) acknowledges some failed past efforts with subsidized credit but draws the lesson that what is required is ‘‘efficiency, transparency, and appropriate management incentives,’’ outcomes not exclusively associated with any particular form of MFI. He denies that subsidization, inefficiency, and limited scale go hand-in-hand, and that governments or NGOs cannot achieve success. Indeed, Rich Rosenberg of CGAP (2006, p. 5) observes that the United Nations Capital Development Fund (UNCDF), which supported microfinance operations for UNDP, used a model called ‘‘MicroStart’’ that produced great success, illustrating that technical competence and good administration can flow as easily from an NGO as a commercial operation. It is striking that CGAP, an international organization, has been a leader in improving functionality, as has the LINKS program of Catholic Relief Services (Dingcong, 2004). The welfarist perspective similarly re-creates an ideological perspective deeply rooted in political economy. Woller states the case with unusual candor: ‘‘the fear is that the commercialization of microfinance will divert the industry from its ‘spiritual foundation,’ which was and is the movement’s animating force. The result is a profitable but soulless endeavor.’’ Woller’s concern is understandable, but may be misplaced. The first mistake will be hard to see for most welfarists: the ‘spiritual foundation’ is not necessarily THE animating force for microfinance and definitely not the only one. Without the promise of eventual profitability, microfinance is just another form of aid – and interest in aid has been declining, not rising, in recent decades. Welfarists must be more open to accepting multiple goals

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as legitimate. The second error is the seemingly knee-jerk equation of markets with soulless endeavors. Commercial enterprises are not the only entities facing competition that could divert focus from the welfare of the poor: government programs and NGOs face it too. The emphasis on sustainability and, especially, high repayment rates and other performance indicators attractive to commercial finance have developmental implications beyond forcing MFIs up the income curve to avoid the poorest and riskiest. It also encourages low-risk, quick-return enterprises over those with greater long-term developmental potential, such as production of asset-deepening goods or services. Small loan sizes may even create the perverse incentive to use cheaper, but less productive, technology, thus eroding productivity. Similarly troubled, Woller regards evangelistic commitment to a particular hegemonic form of service delivery as dangerous to experimentation and diversity in MFI operations. As microfinance moves toward commercialization and larger loan balances, more individual and less group lending, it is in short becoming less distinctive. Littlefield and Rosenberg (2004, p. 39) observe that ‘‘Most leading MFIs operate today on a commercial basis using the techniques and disciplines of commercial finance. They are investing in more sophisticated management and information systems, applying international accounting standards, contracting annual audits from mainstream auditing firms, and seeking ratings from commercial rating agencies.’’ There is no shortage of writers arguing for a middle ground in creating effective MFIs, an approach that would be made much easier by calling off the ideological war between market and state. Padhi (2003) suggests marrying the capacity of NGOs as ‘‘change agents’’ with banks as financial intermediaries. NGOs have a crucial role in group formation, capacity building, credit absorption capacity, social intermediation (making the poor more productive and better risks), skill development, etc. Littlefield and Rosenberg (2004) detail a range of models of cooperation. Lapenu (2000) describes an appropriate state role. Three developments may make a cease fire a little easier to achieve. First, between the classic political economy division of state vs. market lies civil society and the actor that exemplifies it at the global level, the international NGO. That NGOs have been extremely active in microfinance disturbs the neat symmetry of a state vs. market dichotomy (Bornstein, 2004). Second, the boundary between state, market, and civil society – between state-run agency, commercial bank, and international NGO – are rapidly eroding. Third, empirical studies have so far found little evidence of MFI performance differences among the categories.

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Civil society has occupied an important role in development discourse at least since Putnam’s famous popularization of ‘‘social capital’’ as a significant productive resource. Social capital is to civil society what power is to politics or wealth is to markets. Social capital refers to the institutions, relationships, and norms that shape the quality and quantity of a society’s social interactions. Increasing evidence shows that social cohesion is critical for societies to prosper economically and for development to be sustainable. Social capital is not just the sum of the institutions which underpin a society—it is the glue that holds them together. (World Bank, 1998, p. 1)

Putnam argues that a vibrant civil society populated by institutions that bind the population together contributes to development as fully as do the land, labor, and capital emphasized by economists or the good governance and policy environments championed by political scientists. These ideas have been widely adopted in microfinance particularly, serving as an important conduit for earlier IPE concepts. Rankin’s (2002) discussion of social capital in the form of trust emphasizes the norm of reciprocity which Polanyi posed as an alternative to the market (or charity) as a means of gaining cooperation. The ‘‘social collateral’’ championed by Grameen – one’s social standing, which failure to repay puts at risk – follows directly from Polanyi’s discussion of social standing. Dowla (2006) similarly applies ‘‘social capital’’ to Grameen Bank’s creation of trust, norms, and networks. Interestingly, critics of NGOs from the left seem to agree with critics from the right who advocate market institutions, especially commercialized banks. Both see NGOs as too small and not sufficiently sustainable to accomplish what more permanent organizations – be they governments or firms – can do. Petras (1997, pp. 13–14), for example, warns that the ‘‘NGO ideology of ‘private voluntaristic activity’ undermines the sense of the ‘public’: the idea that the government has an obligation to look after its citizens and provide them with life, liberty, and the pursuit of happiness; that the political responsibility of the state is essential for the well-being of citizens.’’ Although the earlier discussion makes clear that the introduction of NGOs has not by itself dissolved ideological rigidities, they may be easier to break down because the categories that define this schism are themselves disintegrating. Not only are NGOs and state-run banks adopting business principles in their operations, and regulated commercial banks emulating the social goals of non-profits, but also hybrids are everywhere. It is no longer easy to construct a typology of MFI organizational forms. ‘‘In reality, non-governmental organizations are not non-governmental’’ (Petras, 1997, p. 13), because so much of their funding comes from states;

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instead they are merely subcontractors of states and IGOs. In addition to NGOs, commercial banks, government rural development banks, and traditional moneylenders, there are credit unions, and cooperatives of various sorts and lots of amalgams. Differences in technique also involve individual lending, revolving funds (without professional management), selfhelp groups, and savings-based groups. It is even harder to fit individuals into the categories. Despite its image as the quintessential response to the failure of the market, Grameen is a chartered bank. Since Banco Sol (Bolivia) became the first NGO to transform into a Regulated Financial Institution (RFI) in 1992, lines have increasingly blurred. At least 39 had followed as of 2003 (Fernando, 2003) and many more have since. Similarly blurred partnerships between all three institutional forms are represented in India. A state requirement that 18% of the net credit of commercial banks must go to agriculture has caused commercial banks without rural branches to partner with NGOs (Meehan, 2004, p. 13). The microfinance program of India’s National Bank of Agriculture and Rural Development – the Self-Help Group–Bank Linkage Program (SBLP) – is the world’s largest partnership between development NGOs and commercial banks, with more than 1.5 million groups averaging 15 clients per group (El-Mahdi, 2005). Thailand’s BAAC is a state-run bank that operates heavily through cooperatives and its microfinance operations have long been financed by a subsidy of sorts from the requirement that all state agencies use state banks for any banking activities. One wonders if a typology neither mutually exclusive nor mutually encompassing deserves to be the focal point of such ideological controversy. Finally, the vehemence of the belief that microfinance must be commercialized is odd given the dearth of studies that ask whether performance varies across different kinds of MFIs – not to mention the few differences found when the question is asked. Hartarska and Nadolnyak (2007) find little difference in the performance of regulated and nonregulated MFIs, although better capitalized organizations and those that take deposits do better, so there may be some indirect regulatory effect. Chavan and Ramakumar (2002) generally find better performance from NGO MFIs than government programs, specifically India’s Integrated Rural Development Programme (IRPD) and regional rural banks (RRBs). Cull, Demiguc-Kunt, and Morduch (2006) is the most elaborate study. They find various differences between group- and individual-lending MFIs, but little difference remains based on ownership after controlling for lending and various other covariates. Similarly, Mersland and Strom (2007) analyze the performance differences between 132 NGOs and 68 shareholder-owned

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firms (SHFs, 13 banks, 55 non-bank financial institutions) in 53 countries and find no difference in cost-effectiveness or return. Nor were NGOs more socially oriented. ‘‘Although costs and risk are higher in the NGO, this type of organization has developed a business model that has a ROA on par or better than the SHF. This indicates that the NGO should be sustainable in the long term, contrary to our hypothesisy’’ (Mersland & Strom, 2007, p. 18). Perhaps it should not be so surprising that differences are hard to find since, as they observe (p. 5), ‘‘Most equity holders in SHFs are NGOs, donors or social oriented investors.’’ More important than the form of the MFI is the clientele they target, the priorities they set, and the diagnosis of poverty and its alleviation that is implicit in those choices. We discuss these inter-related considerations in the next sections.

3.3. Diagnoses of Poverty The conviction that microfinance can help alleviate poverty is hardly absent theoretical support. Indeed, the variety of theoretical justifications offered for microfinance is a greater problem than the dearth of them. Skeptics face a slippery opponent as any challenge to the theoretical underpinnings of a program can be met with a shift of theoretical focus. ‘‘No income growth? OK, but women are empowered.’’ Advances in microfinance research – and improvements in microfinance’s effectiveness as a poverty tool – must begin with a more rigorous stipulation of the underlying theory and a more careful probe of the match between theory and conditions in any particular case. Currently, donors and investors fear a bait-and-switch ploy, and evaluation researchers miss opportunities presented by measurable intermediate targets suggested by theories of poverty and poverty alleviation. The number of proposed channels through which microfinance could help alleviate poverty are nearly all both plausible and easily illustrated with anecdotes. The channel most responsible for the allure of microfinance involves unleashing microenterprise previously blocked by the absence of capital. This story is in the glossy presentation of nearly every microfinance institution – and it is compelling. FINCA’s home page features a Tanzanian woman who needed money for bicycle repairs to take her tomatoes to market. Pro Mujer’s has a Mexican woman in her sewing studio financed with a loan. The second paragraph of Muhammad Yunus’s autobiography tells of the Bengali woman whose profit in her bamboo stool business was

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eroded by usury (Yunus, 1999). Even Robinson’s (2001) multi-volume academic treatise goes only 14 pages before describing an Indonesian man who expanded his business making stoves from scrap metal. By this theory, capital is critical to poverty alleviation and the creation of new microenterprises is a central goal of microfinance. The argument is not only clear and compelling for donor audiences but also well-grounded in accepted economic theory for academics. The diagnosis is lodged squarely in standard microeconomics of the firm: productive potential is a function of available land, labor, and capital, and their efficient combination through entrepreneurial and management skills. Aggregated to the macro level in the form of Solow growth theory, this conception underlies much of modern development theory (Solow, 1956; Swan, 1956). Growth theory translates into a theory of poverty by treating shortfalls in factors of production as a blockage to growth, especially when one factor is noticeably missing. Lipton’s (1977) classic of political economy Why Poor People Stay Poor answers the title question by implicating the market failure whereby capital does not find its most productive use. In the absence of extensive policy interventions, rural areas do not receive adequate inflows of capital. In the Solow account, the marginal return to capital is highest when capital is scarce but the other factors are present in relatively large quantities. Lipton then alerts us to the very high returns that must follow from the massive factor imbalances in poor rural areas, where capital is both difficult and expensive to acquire. Enter microcredit – and the market failure argument of institutionists that the poor can afford to pay very high interest rates because the marginal return to capital is higher yet. The common image of microfinance is an entrepreneurial woman with marketable skills and a sound business plan, but no capital to finance the creation of a microenterprise. This theory is supported by empirical research that establishes the importance of business ownership: even for modest microenterprises, the income of owners is far higher than those who do not own a business (Felkner & Townsend, 2007). Unfortunately, the poverty diagnosis embodied in this micro-enterprisecentered story is often inconsistent with either the facts on the ground or the operations of MFIs or both (Cohen, 2002). In the absence of business opportunities in poor economic environments and the entrepreneurial skills to take advantage of them, the marginal return to capital and the debt tolerance of the borrower may be closer to zero than the high interest rates usually associated with sustainable microfinance. Indeed, many microfinance proponents and critics alike doubt that entrepreneurship is for everyone (Paulson & Townsend, 2004). CGAP CEO Elizabeth Littlefield

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(2007) herself questions whether ‘‘the world can absorb that many selfemployed micro-entrepreneurs’’ and Are all of these urban, mobile, savvy young people going to want to be microentrepreneurs? Are they going to want to sell bananas and tomatoes on a little handkerchief on the side of the street like their mothers did? Or are they going to want jobs? I think they may want jobs.

If so, it is not obvious that microfinance can ‘‘shift its focus from selfemployment to jobs’’ – or that it should. Job creation, which by definition involves expanding and managing enterprises significantly larger than typical microenterprise start-ups, is a mission far removed from the central story of microfinance, and its underlying poverty theory does not match that of microfinance. As Schreiner and Woller (2003, p. 1567) put it, ‘‘Microenterprise is a good choice for a few extraordinary poor people, but wage jobs, additional education, and job training are still the most common paths out of poverty.’’ To assume otherwise is to create a myth of ‘‘entrepreneurs as decathletes,’’ skilled in multiple areas. That may be less offensive, but hardly more helpful, than the stereotype of the poor as helpless objects of development planning unable to contribute meaningfully to their own futures. A related goal is to enhance profits in existing businesses by reducing financing costs, which may not even involve output expansion. This is possible by replacing high cost informal finance, especially from local moneylenders who have a reputation for exploiting near-monopolies in local capital markets. Interestingly, Muhammad Yunus cites this scenario as the inspiration for his innovation, not the absence of capital preventing the creation of new enterprises. Despite similar underlying logic, the practical implications of the differences are significant. Yet, existing literature has not given much attention to either the role of competition or the effect of existing as opposed to prospective microenterprises. Exceptions include Goldberg’s (2005) plausible suggestion that Coleman’s (1999) finding of no poverty impact for marginal provisions of microcredit in northeast Thailand was due to the prior saturation of credit markets by BAAC. Indeed, there is good reason to believe that the model case used in microfinance public relations – the total absence of financial services – is actually quite rare. Armenda´riz de Aghion and Morduch (2005) sketch the alternative sources often available and cite one study in which a third of borrowers are engaged in more than ten different credit arrangements at any one time. Most development scholars and increasing numbers of leading MFI practitioners doubt that access to credit is the sole (and many doubt that it is even the main) bottleneck to development. Surely it varies, and so must the

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operational assumptions of MFIs. Consider the provision of capital to potential entrepreneurs with the skills profile of a typical woman in Bangladesh, where the average education level is less than two years of schooling. If such people are good management prospects, why have MBAs? If they are not, then finance must be packaged with other programs. Much existing literature does not recognize that building skills and capacity in business operations, new technologies, and marketing are vital in some environments and unnecessary in others. On the contrary, the recognition of the multiplicity of needs implicit in the recent evolution from microcredit to microfinance (adding savings, insurance and other financial services) is a hopeful trend. In response to poverty diagnoses not centered on capital, many NGOs use microfinance as an entry point for other social interventions, just as the sovereign debt mechanism enables international lenders from the IMF, World Bank, and national aid programs to gain leverage on the macroeconomic policies of poor states. Pro Mujer and Freedom from Hunger use weekly meetings to provide education on health issues, for example, and Bangladesh’s BRAC is often identified as the most thorough in this respect. Multiple goals are frequently at work in microfinance, but it is seldom clear exactly what theory of poverty justifies some financial interventions, namely those that do not translate into investment which yields future returns large enough to repay debt while securing long-term growth. Even Marguerite Robinson, an ardent champion of the financial services approach, points to the alternative goal of building the self-confidence of the poor. A particular manifestation of that goal is women’s empowerment, mentioned by many MFIs. Such a goal need not involve new enterprises, but rather an understanding that the exclusion of the poor from other aspects of social life due to deep-rooted structural inequalities is at least as important as limited financial access. Group-based approaches are especially likely to be tailored to these kinds of social outcomes because they create networking opportunities otherwise blocked by local power constellations, cultural norms, or geographic considerations. That said, it is still not clear through what channel loans generate the capacity to repay them. This gap makes microfinance critics very nervous. Although the theoretical case for loaning money for investment purposes is clear, the underlying economic theory suggesting net long-term benefits of consumption loans is decidedly more murky. That the time discount rate exceeds the interest rate is one clear boundary condition, but even that assumes an ability to pay, which cannot be assumed as a matter of course. The greater outreach sought by institutionists may not be good if credit is extended to

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people who cannot use it effectively – or for whom alternative programs might work better. The challenge is to prove that alternatives to MFIs, such as rotating savings and credit associations or cooperatives, cannot do the job with lower overhead costs. In this respect, advocates of the financial systems approach seem more realistic than the poverty lending school in arguing for explicitly limiting microfinance to the economically active poor, not the extremely poor who are of greater interest to welfarists. There is some evidence that this targeting is sound. In one of the first impact studies, Hulme and Mosely (1996) find that the benefits to those borrowers above the poverty line was substantial, but to those below the line minimal. The explanation is found in the pattern of funds use: Nearly 70% of loans were used for consumption by those borrowers with incomes less than 80% of the poverty line, whereas it was about 14% for richer borrowers (who also had larger loan sizes). The goal of income smoothing that underlies most consumption loans implies a very different assumption about time-series trends in the ability of borrowers to pay. Critics note that income smoothing loans offered in nonemergency environments invite borrowing beyond capacity to service the loan, because the target income is above the long-term average. Parallel to the concerns of institutionists that borrowers will acquire a ‘‘grant mentality’’ that makes default cognitively easy are the concerns of critics that they will acquire a ‘‘debt mentality’’ that easily accepts more-or-less constant and permanent insolvency that makes default inevitable. Welfarists from the political economy tradition are likely to feel that a socially responsible lender committed to the ‘‘creation of value’’ (Woller & Schreiner, 2002) should avoid unsuitable loans, but this implies that both fund usage and the liquidity of the borrower be more closely monitored than is usually possible. Moreover, economists schooled in the neo-classical tradition are likely to find judging the value of a transaction to a willing participant unnecessary, uncomfortable, and/or impossible. Instead, their deep philosophical commitment to individual autonomy in utility maximization (such as consumer sovereignty) makes it natural for them to assume that actual behavior ‘‘reveals preferences.’’ If a peasant takes out a loan, it is an indication that it is in his interest to do so, at least as far as he – or anyone else – can tell. To the contrary, political economists and behavioral economists do not regard the proposition that individuals act in their self interest as a truism that should stand as an unexamined assumption. Instead, they treat it as either a hypothesis to be tested empirically or a poetic abstraction based upon the myth of humans as unitary, consistent, integrated, and rational actors. They accept that poor people will frequently borrow money against

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their own interests. In the formal economy of developed countries, it is the state that intervenes to protect the foolish or the misled, but in the poorly regulated environment of microfinance the responsibility should fall to the provider, especially when they are self-defined as agents of the poor.

3.4. Evaluation Studies The discussion thus far emphasizes the importance of empirical assessments of the arguments that roil the field. It is widely acknowledged that relatively little is known. As Zeller and Meyer (2002, as quoted in Weiss, Montgomery, & Kurmanalieva, 2003; p. 1) put it: MFI field operations have far surpassed the research capacity to analyze them, so excitement about the use of microfinance for poverty alleviation is not backed up with sound facts derived from rigorous research. Given the current state of knowledge, it is difficult to allocate confidently public resources to microfinance development.

Yet agreement on the necessity of filling that gap (and how thoroughly) is far from universal (Copestake, Bhalotra, & Johnson, 2001). Adams (2001) argues, for example, that ‘‘[impact assessment studies] are fraught with insurmountable methodological problems and the costs of doing them usually exceed any benefits they might provide.’’ He is certainly right about the problems: from the point of view of practitioners and most donors, the marginal dollar of revenue is better allocated to providing loans than to studies and reports appreciated mostly by academics. However, the value of impact studies depends centrally on how seriously one takes the goal of cost-efficient poverty reduction. There is some skepticism among welfarists about the commitment of many commercial MFIs to really achieving the double bottom line. If the operation is profitable, targeting the poor and a handful of anecdotes may be good enough. Financial services analysts and others do not question welfarists’ determination to alleviate poverty but may doubt their dedication to achieving it through non-aid channels. They sense that many microfinance NGOs are comfortable with microfinance as disguised aid. In neither case is a ‘‘bang for the buck’’ assessment really essential. Among those committed to impact analysis, the most fundamental question is whether microfinance actually produces the outcomes claimed. Beyond that, theorists will want to know whether successful outcomes develop through expected channels or other mechanisms. Practitioners will focus on whether differential success can be explained by variables MFIs

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can control, such as products and procedures, or by external factors. Both will be concerned with environmental conditions: practitioners for guidance on location choices; theorists for new clues to the eternal question of why development occurs in some places and not others. It is clear that microfinance has worked better in some places than others. It seems likely that this results at least as much from different environmental circumstances as from scale or different practices by MFIs. For example, cultural effects might help explain why group lending works better in some environments (Tapella, 2002; Gine, Jakiela, Karlan, & Morduch, 2006). Evaluation studies exploring such complex socially embedded sources of variance require greater participation by development economists, sociologists, anthropologists, and other social scientists attuned both to development problems and to their diversity across different settings. Most evaluations thus far explore internal performance measures rather than external outcomes (Rosenberg, 2006; Dingcong, 2004). Chavan and Ramakumar (2002, p. 957) summarize the consensus: ‘‘Most of the available studies narrowly focus on their ‘programmatic success’ (Rahman, 1999, p. 67), where the principal variables studied are the number of beneficiaries, amount of credit disbursed, recovery rate, and profit flows among others.’’ Such business criteria as default rates, administrative costs, and subsidy dependence will be monitored routinely and at low cost by the MFIs themselves, whereas external impact measures will usually require a skilled outside methodologist to conduct carefully controlled (and expensive) studies, which face a more methodologically demanding and skeptical audience. The next advance beyond business criteria usually analyzes targeting success, such as the percentage of clients in a target segment, usually defined by income or wealth (e.g., for Grameen, women with less than .5 acres of land). Some programs explicitly aim for the ‘‘working poor’’ or ‘‘entrepreneurial poor,’’ whereas others declare focus on the poorest of the poor. Some microcredit programs worry that loans may reach richer customers who already have access to formal credit arrangements and so do not need microfinance services. This is a particular problem where loans are subsidized and therefore available at below market rates. Others are anxious to avoid loans to those too poor to enjoy their benefits, as when the absence of other resources makes microenterprise unattainable even with adequate credit. Since income data may be difficult to gather (or to interpret and compare), the size of the average loan in relation to the poverty line is a frequent proxy for the targeting of the overall portfolio, under the assumption that the relatively better off will seek larger loans. Such data

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are readily collected by the MFI, but clearly the fit between measure (loan size) and concept (income of the borrower) is weak. By emphasizing outreach (via targeting studies) and sustainability (business criteria), most analysts have assumed away the more fundamental question: are poor people really made better off by microfinance? Concerning welfare benefits, poverty reduction, and other social changes, there have been more surveys of evaluation studies (Goldberg, 2005; Montgomery & Weiss, 2005; Weiss et al., 2003; Kabeer, 2005; Littlefield, Morduch, & Hashemi, 2003; Armenda´riz de Aghion & Morduch, 2005; Meyer, 2002; Sebstad & Cohen, 2000) than really rigorous evaluation studies. And more guidelines concerning how to evaluate (Hulme, 1997; Westley, 2002; Simanowitz, 2004; Copestake, Dawson, Fanning, McKay, & Wright-Revolledo, 2005) than actual evaluations. That pattern reflects a complex of methodological challenges, most of which apply to policy evaluations in general, but some of which are unique to microfinance. Among the former is the long lag between the provision of services and poverty outcomes. Consider, for example, that microfinance may increase school enrollment and the empowerment of women, which will carry developmental consequences for decades (Honohan, 2004). Similarly problematic, loan recipients can show both immediate consumption gains and a decline in net assets due to debt liability. Welfare judgments then depend on the time frame and breadth of the analysis. There is no simple way around such difficulties, especially the dual endogeneity issues of program location and client self-selection. Both problems threaten to conflate the actual impact of microfinance with the effect of unmeasured variables correlated with program participation. These patterns may bias upward the apparent effect of microfinance, exaggerating the impact. For example, simple comparisons between the growth rates of villages with microfinance programs and those without will show a spurious positive effect if MFIs chose their locations wisely. Practitioners aim limited resources where they are most likely to have a positive impact – such as in villages with good transportation and communication and where economic opportunity abounds. But in the logic of evaluators, this non-random selection makes it impossible to distinguish the impact of microfinance from the unmeasured effect of location. The endogeneity of project placement may also reflect the tendency to place projects in areas where poverty is worse, so the bias could be either positive or negative. Perhaps even more disruptive is the self-selection bias: those who choose to participate are probably the most entrepreneurial, best educated, and most well endowed in other attributes that predict success (such as wealth, health,

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and access to social, political, and economic networks). Group banking formats that restrict participation to those accepted by others accentuate the tendency toward those most likely to be successful. Therefore, if participants increase incomes more rapidly than non-participants it may be a consequence of pre-existing attributes, not microfinance itself. Participation bias can be eased with a control group as close as possible to the treatment group in the relevant attributes. Identifying a control group of those who wish to participate is one possibility. Karlan and Zinman (2008), for example, identified those initially rejected for loans but just below qualifying thresholds and randomly assigned some to a treatment group approved for loans and others to a control group. Alternatively, the control group could consist of future borrowers, as when a program interviews and accepts clients but does not begin the program immediately, like the joint studies by the Bangladeshi Institute of Development Studies (BIDS) and the World Bank (Khandker, 1998, 2005; Pitt & Khandker, 1998). Comparing older borrowers to newer ones is another possibility, recommended in Cohen and Gaile (1998). However, attrition levels are typically high enough to make old borrowers a nonrandom subset of the original borrowers, among other biases generally thought to overstate impact (Karlan, 2001; Armenda´riz de Aghion & Morduch, 2005, pp. 208–210; Alexander-Tedeschi & Karlan, 2007). A useful primer on the difficulties of dealing with these biases can be assembled from the BIDS-World Bank reports together with their critiques (Armenda´riz de Aghion & Morduch, 2005). The problem of participation bias can be ducked entirely by measuring outcomes at the village level, so that the availability of credit (not the use of credit) becomes the independent variable, and no distinction is made between participants and non-participants. Indeed, many explicit goals are defined at the village or community level: creating successful role models, introducing business practices, creating mobility, building social capital in the form of village-level institutions or the trust of self-help groups. Even the employment of loan officers from the community itself spurs development. They may also be defined at the household level, as when frequent repayment of debt transfers control of family finances to the most responsible member of the household. From an evaluation standpoint, none of these goals require increased personal income in the short-run. Moreover, if goals are defined at these higher levels of aggregation, evaluation studies can be defined there also, inviting more creative approaches to validating the claims of microfinance advocates. While mitigating some of the usual econometric problems, such studies would also deal with the possibility that aggregate

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effects may be smaller than individual ones if microfinance redistributes income rather than increases it. On the contrary, aggregate effects could be higher than for individual clients if, for example, substantial numbers of potential borrowers simply know credit would be available in the event of enterprise failure (such as crop loss). They could then be less risk averse in production decisions and thus achieve greater growth. Impact assessments would need to distinguish access to programs from actual participation (Diagne & Zeller, 2001). Many may benefit without actually using that access. Whether the majority of benefits stems from externalities to communities or is contained by borrowers is an interesting related theoretical question yet unaddressed. Even without estimation complications, the challenge of impact evaluation is formidable. Data on either social or income outcomes are likely to be pretty poor, and, where multiple sources of finance are available, so too will be the data on credit use. The most straightforward way of identifying benefit is simply to ask the recipient, but, as Coleman (2001, p. 5) reports participants will generally tell evaluators (who are generally hired by the program itself) that the program is helping them, even if it is not. To do otherwise could be viewed as rude or ungratefulyVillagers who had worked themselves into a vicious circle of debt told a visiting program sponsor that the program had greatly benefitted them. Later, and privately, some of those same clients asked me how they could extract themselves from the program and have their debts forgiven.

Deliberate misrepresentations are probably less severe than recall errors, especially when borrowers are unmotivated to take the evaluation seriously. Problems include under-reporting, recall bias, and inaccurate evaluations of income in kind. Aach (2008) reported great difficulty in securing the cooperation of borrowers, a problem that probably could have been eased by greater participation by MFI officials but at the cost of Coleman’s warning above. Alternatives to self-reporting range from direct observation of asset holding, which invites substantial measurement error, to reliance on aggregate social indicators such as education levels or health measures, which may be quite insensitive to the relatively small and short-term changes that would be the most easily mapped to microfinance operations. With large measurement error – even if random (itself a heroic assumption) – standard errors would be so inflated that the actual impact would have to be quite high to show statistically significant results. Yet there is good reason to believe that actual impacts of microfinance may be rather small. Since interest rates are high, even quite good returns on investment yield relatively small net income improvements. Indeed, Brett’s (2006)

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ethnographic account cites net losses because interest rates are higher than productivity gains, a constant fear expressed by many others. Similarly, Coleman (1999, 2006) finds that virtually all the effects of microfinance on rank and file borrowers are erased after using controls, with only members of the village bank committee receiving significant benefits. Furthermore, microfinance inherently produces small gains because it is dealing with poor people and only a portion of their income. As discussed earlier, benefits accrue mainly to those with sufficient skill and a favorable market, so only a minority may experience much positive impact. This would account for the tendency of anecdotal, qualitative interviews to suggest big improvements for some individuals whereas quantitative surveys of all participants usually show much less. Honohan (2004) is less kind. He sees a great deal of ‘‘cherry-picking’’ as analysts emphasize findings that support their point and ignore others. Consider Pitt and Khandker’s (1998) well-known study that shows (controversially, see Morduch, 1999) a marginal improvement in consumption of 18% from loans to women and 11% for men. By any standard – certainly for any poverty alleviation program – this is a strong and noteworthy result. If it could be reproduced over time, 5% of borrowers could lift themselves out of poverty each year. With about a quarter of the population in Bangladesh actually covered by microfinance, that means about 1% of the population per year would cross the poverty threshold. However, given that poverty declined by about 1% a year over the last decade throughout Bangladesh, would the signal be heard over the noise? (Khandker, 2005) Doubtful, it would seem, but Khandker’s (2005) study shows a clear effect in what appears to be among the most theoretically sophisticated studies. But this later study recalculates the much-cited benefit described earlier, reducing the gains to 8% or less and notes no return at all to loans to men. Another set of evaluation challenges arise in the form of measuring outcomes of interest beyond income, including skills development, gains in production or sales, cost reduction, technological progress, reductions in labor time, improvements in health and education, and various types of asset accumulation (land, livestock, productive or working assets, household assets, consumer durables, etc.). To add plausibility to positive findings and also to document more fully the channels through which microfinance could have impact, process tracing methods would focus on these as well as on other intermediate outcomes. As an example of the latter, Coleman (2006) finds that access to and use of microfinance does not reduce the volume of high interest loans outstanding from moneylenders, a key channel through which microfinance was presumed to augment net income. An internal study by BRAC (Kabeer & Matin, 2005) claimed to have found an impact of

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BRAC membership on trust, political participation, and political awareness, other mechanisms of social capital thought to carry the effect of microfinance on participant welfare. However, it is hard to find much evidence of differences between new (less than two years) members and old members (more than five years, on average more than eight), so the effects seem quite small. Furthermore, good studies would also have to investigate negative effects as well as positive ones, because there could be a trade-off. Even with respect to the usually presumed benefits of microfinance – on income and food security – some studies find negative or null effects. Diagne and Zeller (2001) find a negative (but statistically insignificant) impact of credit usage on net crop incomes, per capita income, food security, and nutritional status. Negative aspects of microfinance also include the loss of privacy inherent in group processes, which often had negative economic consequences when public knowledge of the financial affairs of the poor weakened their bargaining ability in dealing with moneylenders and others (Marcus & Acharya, 2005). Also fears of debt peonage and the resulting personal responsibility are deemed real by participants. Although it would seem to outsiders that reliance on MFIs would be less damaging than moneylenders, small farmer cooperatives and village banks can become political tools for powerful local families. Local powers gain control over more resources, sometimes defaulting their way to greater wealth and other times securing the lion’s share of loans and then loaning them, in turn, at the higher rates associated with traditional moneylenders. If local political structures are a key issue, surely the prospects for microfinance and the design and analysis of programs should be sensitive to variations in different locales: for example, in levels of inequality, the incidence of participation in political and social structures, the amount of trust endemic to social relations, and the degree of communitarianism found in local cultures. Of course, these variables are potential outcomes of microfinance as well (Marcus & Acharya, 2005, p. 10): ‘‘development should be about escaping the oppressive predictability and grinding social relations of local lived experience in the country and enter into new and hopefully better, but at least different, relationships with the state, the international economy, and people outside their locale.’’

4. CONCLUSIONS In light of all these potential pitfalls, the fundamental question remains: can we say that microfinance helps alleviate poverty? The most sophisticated

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impact analyses derive from the BIDS-World Bank studies of Bangladesh noted above, the series in Thailand by Robert Townsend and his associates (Kaboski and Townsend, 2005, 2006); the Coleman (1999, 2006) studies of northeast Thailand, and Karlan and Zinman (2008) in South Africa. To simplify greatly, the BIDS studies and Karlan and Zinman show a positive impact, the Coleman studies do not, and the Townsend studies are mixed. Kaboski and Townsend (2005) summarize: We find that institutions, particularly those with good policies, can promote asset growth, consumption smoothing and occupational mobility, and can decrease moneylender reliance. Specifically, cash-lending institutions – production credit groups and especially women’s groups – are successful in providing intermediation and its benefits to members, while buffalo banks and rice banks are not. The policies identified as important to intermediation and benefits: the provision of savings services, especially pledged savings accounts; emergency services; and training and advice. Surprisingly, much publicized policies such as joint liability, default consequences, or repayment frequency had no measured impacts.

Many other impact studies have been conducted, but their statistical analyses are generally insufficient in dealing with the estimation biases discussed earlier. The known list of others that have achieved the imprimatur of wellknown peer-reviewed journals is surprisingly short (Goetz & Sen Gupta, 1996; Pitt et al., 2003; Hashemi, Schuler, & Riley, 1996; PanjaitanDrioadisuryo & Cloud, 1999). Other notable impact studies include Chavan and Ramakumar (2002), Smith (2002), McKernan (1996), and Kevane and Wydick (2001). Can a conclusion be reached in light of the weaknesses of existing studies? The leading surveys of microfinance impact studies offer two. There is no study yet that has achieved wide consensus as to its reliabilityy.’’ (Armenda´riz de Aghion & Morduch, 2005, p. 222) Various studies, both quantitative and qualitative, document increases in income and assets and decreases in vulnerability of microfinance clients. A few studies have failed to find positive impacts from microfinance and in rare cases have identified a negative impact. However, the frequency of such outcomes has been too low to cast much doubt on the generally favorable conclusion indicated by the bulk of the evidence. (Littlefield et al., 2003, p. 2)

Unfortunately, this last judgment, by well-respected scholars and practitioners, would be more persuasive were it not that their first two examples (MkNelly & Dunford, 1998, 1999) come from studies identified by Honohan (2004, p. 25) as best exhibiting the ‘‘cherry-pick’’ phenomena.

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Finally, Honohan (2004, p. 29) offers a summary of summaries: A poll of unbiased observers reading the evidence – both the positive reported experience of practitioners as documented in countless reports and the relatively ambivalent or weak econometric evidence – would at present likely return a cautiously optimistic verdict.

Although fair-minded, this judgment barely touches our real need for rigorous impact assessment, which must go far beyond the increasingly banal question of whether microfinance ‘‘works’’ or not. After all, we have known intuitively for a long time what these studies have demonstrated more systematically in recent years: microfinance produces benefits in some places at some times for some people, and not others. We need to know more about those variations and we also must evaluate microfinance against other wellestablished programs so as to identify cost effectiveness in poverty alleviation.

REFERENCES Aach, M. (2008). Microfinance as a tool for alleviating poverty: Practice and implications. Thesis, International Relations Department, Lehigh University, Bethlehem PA. Adams, D. W. (2001). Discussion posted in Devfinance email discussion list. Alexander-Tedeschi, G., & Karlan, D. (2007). Cross-sectional impact analysis: Bias from dropouts. Available at http://research.yale.edu/karlan/downloads/MicrofinanceDropouts. pdf Armenda´riz de Aghion, B., & Morduch, J. (2005). The economics of microfinance. Cambridge: MIT Press. Baran, P. (1952). On the political economy of backwardness. The Manchester School, 20(1), 66–84. Barry, N. (1995). The missing links: Financial systems that work for the majority. CGAP Focus 3. Best, M., & Connolly, W. (1982). The politicized economy (2nd ed.). Lexington, MA: DC Heath. Bhatt, N., & Tang, S. Y. (2001). Delivering microfinance in developing countries: Controversies and policy perspectives. Policy Studies Journal, 29(2), 319–333. Bornstein, D. (2004). How to change the world: Social entrepreneurs and the power of new ideas. New York: Oxford University Press. Brett, J. A. (2006). ‘‘We sacrifice and eat less’’: The structural complexities of microfinance participation. Human Organization, 65(1), 8–19. CGAP. (1996). Microcredit interest rates, CGAP Occasional Paper 1 (August). Washington, DC: Consultative Group to Assist the Poor. CGAP. (2004). Building inclusive financial systems: Donor guidelines on good practice in microfinance. Washington, DC: Consultative Group to Assist the Poor. Chavan, P., & Ramakumar, R. (2002). Micro-credit and rural poverty: An analysis of empirical evidence. Economic and Political Weekly, 37(10), 955–965. Available at http://www.epw. org.in/uploads/articles/3882.pdf

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Cohen, M. (2002). Making microfinance more client-led. Journal of International Development, 14, 335–350. Cohen, M., & Gaile, G. (1998). Highlights and recommendations of the second virtual meeting of the CGAP working group on impact assessment methodologies, April 14–28, 1998. Available at http://www.microfinancegateway.org/redirect.php?mode¼ link&id ¼ 1224 Coleman, B. E. (1999). The impact of group lending in northeast Thailand. Journal of Development Economics, 60(1), 105–141. Coleman, B. E. (2001). Measuring the impact of microfinance programs. Finance for the Poor, 2(4), 5–8. Asian Development Bank. Coleman, B. E. (2006). Microfinance in northeast Thailand: Who benefits and how much? World Development, 34(9), 1612–1638. Cooley, A., & Ron, J. (2002). The NGO scramble: Organizational insecurity and the political economy of transnational action. International Security, 27(1), 5–39. Copestake, J., Bhalotra, S., & Johnson, S. (2001). Assessing the impact of microcredit: A Zambian case study. Journal of Development Studies, 37(4), 81–100. Copestake, J., Dawson, P., Fanning, J. P., McKay, A., & Wright-Revolledo, K. (2005). Monitoring the diversity of the poverty outreach and impact of microfinance: A comparison of methods using data from Peru. Development Policy Review, 23(6), 703–723. Cull, R., Demiguc-Kunt, A., & Morduch, J. (2006). Financial performance and outreach: A global analysis of leading microbanks. World Bank Policy Research Working Paper. The World Bank, Washington, DC. Dahl, R. (1998). On democracy. New Haven: Yale University Press. Diagne, A., & Zeller, M. (2001). Access to credit and its impact on welfare in Malawi. Research Report 116. Washington, DC: International Food Policy Research Institute. Dingcong, C. (2004, December). Review of MAGI assessment experiences in South East Asia. LINKS CRS SEAPRO, Manila. Dowla, A. (2006). In credit we trust: Building social capital by Grameen Bank in Bangladesh. Journal of Socio-Economics, 35, 102–122. Dunford, C. (2000). In search of ‘sound practices’ for microfinance. Journal of Microfinance, 2(1), 6–12. El-Mahdi, H. (2005, October). What contribution can banks and NGOs make to micro finance programmes? The case of the National Bank of Agriculture and Rural Development (NABARD) in India. MSc dissertation, International Development Department, School of Public Policy, University of Birmingham. Fallows, J. (1993). How the world works. The Atlantic Monthly (December), pp. 61–87. Felkner, J. S., & Townsend, R. M. (2007). Enterprise and the wealth of villages. Available at http://cier.uchicago.edu/papers/2006/felkner_townsend_2006.pdf Fernando, N. A. (2003). The changing face of microfinance: Transformation of NGOs into regulated financial institutions. Asian Development Bank, Manila, April 30. Available at http://www.adb.org/Documents/Slideshows/Microfinance/Changing_Face_Microfinance. pdf Florini, A. (Ed.) (2000). The third force: The rise of transnational civil society. Washington, DC: Carnegie Endowment for International Peace. Gilpin, R. (1987). Political economy of international relations. Princeton, NJ: Princeton University Press. Gine, X., Jakiela, P., Karlan, D., & Morduch, J. (2006, July). Microfinance games. World Bank Policy Research Working Paper 3959.

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Goetz, A. M., & Sen Gupta, R. (1996). Who takes the credit? Gender, power, and control over loan use in loan programs in rural Bangladesh. World Development, 24(1), 45–63. Gold, D. A., Lo, C. Y. H., & Wright, E. O. (1975). Recent developments in Marxist theories of the capitalist state. Monthly Review (October and November), 29–51. Goldberg, N. (2005, December). Measuring the impact of microfinance: Taking stock of what we know. Grameen Foundation USA. Gonzalez-Vega, C., & Graham, D. H. (1995). State-owned agricultural development banks: Lessons and opportunities for microfinance. Rural Finance Program, Economics and Sociology Occasional Paper 2245. Gore, C. (2000). The rise and fall of the Washington consensus as a paradigm for developing countries. World Development, 28(5), 789–804. Grameen. (2007). http://www.grameen-info.org. Hartarska, V., & Nadolnyak, D. (2007). Do regulated microfinance institutions achieve better sustainability and outreach? Cross country evidence. Applied Economics, 39, 1207–1222. Hashemi, S., Schuler, S., & Riley, A. (1996). Rural credit programs and women’s empowerment in Bangladesh. World Development, 24(4), 635–653. Honohan, P. (2004). Financial sector policy and the poor: Selected findings and issues. World Bank Working Paper 43. Available at http://info.worldbank.org/etools/library/ latestversion.asp?128759 Hulme, D. (1997). Impact assessment methodologies for microfinance: A review. Available at http://www.microfinancegateway.org/content/article/detail/1226 Hulme, D., & Mosely, P. (1996). Finance against poverty. London: Routledge. Kabeer, N. (2005). Is microfinance a ‘‘magic bullet’’ for women’s empowerment? Analysis of findings from South Asia. Economic and Political Weekly, October 29. Kabeer, N., & Matin, I. (2005, March). The wider social impacts of BRAC’s group-based lending in rural Bangladesh: Group dynamics and participation in public life. Research Monograph Series 25. Research and Evaluation Division, BRAC, Dhaka. Kaboski, J. P., & Townsend, R. M. (2005). Policies and impact: An analysis of village-level microfinance institutions. Journal of the European Economic Association, 3(1), 1–50. Kaboski, J. P., & Townsend, R. M. (2006). The impacts of credit on village economies (Available at http://cier.uchicago.edu/papers/2006/kaboski-impact-credit-0506.pdf.). University of Chicago. Karlan, D. (2001). Microfinance impact assessments: The perils of using new members as a control group. Journal of Microfinance (December). Karlan, D., & Zinman, J. (2008). Expanding credit access: Using randomized supply decisions to estimate the impacts. Unpublished. Kevane, M., & Wydic, B. (2001). Lending to female entrepreneurs: Sacrificing economic growth for poverty alleviation? World Development, 29, 1225–1236. Khandker, S. (1998). Fighting poverty with microcredit. Oxford, UK: Oxford University Press. Khandker, S. (2005). Microfinance and poverty: Evidence using panel data from Bangladesh. World Bank Economic Review, 19(2), 263–286. Lairson, T. D., & Skidmore, D. (2003). International political economy: The struggle for power and wealth (3rd ed.). Thomson Wadsworth. Lapenu, C. (2000, June). The role of the state in promoting microfinance institutions. Food Consumption and Nutrition Division Discussion Paper 89. International Food Policy Research Institute, Washington, DC.

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Lipton, M. (1977). Why poor people stay poor: Urban bias and world development. Cambridge, MA: Harvard University Press. Littlefield, E. (2007). Keynote speech at the Chicago Microfinance Conference, May 25, 2007. Available at http://www.chicagogsb.edu/news/2007-05-25_microfinance/01-littlefield.aspx Littlefield, E., Morduch, J., & Hashemi, S. (2003). Is microfinance an effective strategy to reach the Millennium Development Goals? CGAP Focus Note 24. Available at http:// www.cgap.org/docs/FocusNote_24.pdf Littlefield, E., & Rosenberg, R. (2004). Microfinance and the poor: Breaking down walls between microfinance and formal finance. Finance and Development (June), 38–40. Marcus, A., & Acharya, Y. P. (2005). Local culture, local power: Microfinance in rural Nepal. Working Paper 01/05. Melbourne University Private Working Paper Series. Marr, A. (2004). A challenge to the orthodoxy concerning microfinance and poverty reduction. Journal of Microfinance, 5(2), 8–42. Marx, K., & Engels, F. (1998[1848]). The communist manifesto. New York: Penguin Group. McKernan, S. M. (1996). The impact of microcredit programs on self-employment profits: Do noncredit program aspects matter? Review of Economics and Statistics, 84, 93–115. Meehan, J. (2004). Tapping the financial markets for microfinance: Grameen Foundation USA’s promotion of this emerging trend. Grameen Foundation USA Working Paper Series. Mersland, R., & Strom, R. O. (2007). Microbanks: Ownership, performance and social tradeoffs – a global analysis. Available at http://ideas.repec.org/p/pra/mprapa/ 2063.html, accessed 5/19/2007 Meyer, R. L. (2002). Track record of financial institutions in assisting the poor in Asia. ADB Institute Research Paper 49. Miliband, R. (1969). The state in capitalist society. New York: Basic Books. Mitlin, D. (2002). Sustaining markets or sustaining poverty reduction. Environment and Urbanization, 14(1), 173–177. MkNelly, B., & Dunford, C. (1998). Impact of credit with education on mothers and their young children’s nutrition: Lower Pra Rural Bank Credit with Education Program in Ghana. Freedom from Hunger Research Paper 4. Davis, CA. MkNelly, B., & Dunford, C. (1999). Impact of Credit with Education on Mothers and Their Young Children’s Nutrition: Credit with Education Program in Bolivia. Freedom from Hunger Research Paper 5. Davis, CA. Montgomery, H., & Weiss, J. (2005, February). Great Expectations: Microfinance and poverty reduction in Asia and Latin America. Asian Development Bank Institute Research Paper Series 63. Morduch, J. (1999). The microfinance promise. Journal of Economic Literature, 37(4), 1569–1614. Morduch, J. (2000). The microfinance schism. World Development, 28(4), 617–629. Otero, M., & Rhyne, E. (Eds). (1994). The new world of micro enterprise finance: Building healthy financial institutions for the poor. West Hartford, CT: Kumarian Press. O’Connor, J. (1973). The fiscal crisis of the state. New York: St. Martin’s Press. Padhi, B. (2003). Mainstreaming microfinance. Economic and Political Weekly, 38(46), 4832–4836 Available at http://www.epw.org.in/uploads/articles/3466.pdf Panjaitan-Drioadisuryo, R. D. M., & Cloud, K. (1999). Gender, self-employment and microcredit programs: An Indonesian case study. Quarterly Review of Economics and Finance, 39(5), 769–779. Paulson, A. L., & Townsend, R. (2004). Entrepreneurship and financial constraints in Thailand. Journal of Corporate Finance, 10(2), 229–262.

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Petras, J. (1997). Imperialism and NGOs in Latin America. Monthly Review, 49(7), 10–27. Pitt, M., et al. (2003). Credit programs for the poor and the health status of children in rural Bangladesh. International Economic Review, 44(1), 87–118. Pitt, M., & Khandker, S. (1998). The impact of group-based credit programs on poor households in Bangladesh: Does the gender of participants matter? Journal of Political Economy, 106(5), 958–996. Polanyi, K. (1944). The great transformation. New York: Farrar and Rinehart. Poulantzas, N. (1969). Political power and social classes. New York: New Left Books. Rahman, A. (1999). Microcredit initiatives for equitable and sustainable development: Who pays? World Development, 26(12), 67–82. Rankin, K. N. (2002). Social capital, microfinance, and the politics of development. Feminist Economics, 8(1), 1–24. Rao, V., & Woolcock, M. (2007). Disciplinary monopolies in development research: A response to the research evaluation process. World Bank. Available at http://siteresources. worldbank.org/INTPOVRES/Resources/DisciplinaryMonopoly.pdf ? resourceur% 20l name ¼ DisciplinaryMonopoly.pdf Rhyne, E. (1998). The yin and yang of microfinance: Reaching the poor and sustainability. MicroBanking Bulletin, 2, 6–8. Rhyne, E., & Otero, M. (1994). Financial services for micro-enterprises: Principles and institutions. In: M. Otero & E. Rhyne (Eds), The new world of micro enterprise finance: Building healthy institutions for the poor. West Hartford, CT: Kumarian Press. Robinson, M. (2001). The microfinance revolution: Sustainable finance for the poor. Washington, DC: International Bank for Reconstruction and Development. Rodrick, D. (1997). Has globalization gone too far? Washington, DC: Institute for International Economics. Rosenberg, R. (2006). Aid effectiveness in microfinance: Evaluating microcredit projects of the World Bank and the United Nations Development Programme. CGAP Focus Note 35. Schreiner, M., & Woller, G. (2003). Microenterprise development programs in the United States and in the developing world. World Development, 31(9), 1567–1580. Sebstad, J., & Cohen, M. (2000). Microfinance, risk management, and poverty. Background Paper for World Development Report 2001. World Bank. Seibel, H. D. (1998). Microfinance for the poor: Outreach vs. institutional viability – some observations. Working Paper 1998-9. University of Cologne, Development Research Center. Simanowitz, A. (2004). Issues in designing effective microfinance impact assessment systems. ImpAct Working Paper 8. University of Sussex, Institute of Development Studies, Brighton. Singer, J. D. (1961). The level-of-analysis problem in international relations. World Politics, 14(1), 77–92. Skidmore, D. (2001). Civil society, social capital and economic development. Global Society, 15(1), 53–72. Smith, S. C. (2002). Village banking and maternal and child health: Evidence from Ecuador and Honduras. World Development, 30, 707–723. Solow, R. M. (1956). A contribution to the theory of economic growth. Quarterly Journal of Economics, 70(1), 65–94. Swan, T. W. (1956). Economic growth and capital accumulation. Economic Record, 32, 334–361. Sweezy, P. (1942/1970). The theory of capitalist development. New York: Monthly Review Press.

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Tapella, E. (2002, September). Old wine in new bottles? Rural finance and social funds in Argentina. Working Paper 370. Institute of Social Studies, The Hague, Netherlands. Thys, D., Tulchin, D., & Ohri, C. (2005, October). Social return on investment and its relevance to microfinance. Progress Note 12. The Seep Network. Weber, H. (2002). The imposition of a global development architecture: The example of microcredit. Review of International Studies, 28, 537–555. Weber, H. (2004). The ‘‘new economy’’ and social risk: Banking on the poor? Review of International Political Economy, 11(2), 356–386. Weiss, J., Montgomery, H., & Kurmanalieva, E. (2003, December). Micro finance and poverty reduction in Asia: What is the evidence? Research Paper Series 53. Asian Development Bank Institute. Westley, G. D. (2002). Guidelines for monitoring and evaluating projects of the social entrepreneurship program. Washington, DC: Inter-American Development Bank. Williamson, J. (1993). Democracy and the ‘‘Washington consensus’’. World Development, 21(8), 1329–1336. Woller, G. M., Dunford, C., & Woodworth, W. (1999). Where to microfinance? International Journal of Economic Development, 1, 29–64. Woller, G. M., & Schreiner, M. (u.d. circa 2002). Poverty lending, financial self-sufficiency, and the six aspects of outreach. Available at http://www.iadb.org/sds/doc/MicMSchreinerE.pdf World Bank. (1998, April). The Initiative on defining, monitoring and measuring social capital: Overview and program description. Social Capital Initiative Working Paper 1. World Bank. (2007). World development report 2008: Agriculture for development. Washington, DC: World Bank. Yunus, M. (1999). Banker to the poor. New York: Public Affairs. Zeller, M., & Meyer, R. L. (Eds). (2002). The triangle of microfinance: Financial sustainability, outreach, and impact. Baltimore: Johns Hopkins University Press.

THE NEW MONEYLENDERS: ARE THE POOR BEING EXPLOITED BY HIGH MICROCREDIT INTEREST RATES?$ Richard Rosenberg, Adrian Gonzalez and Sushma Narain 1. INTRODUCTION Over the past two decades, institutions that make microloans to low-income borrowers in developing and transition economies have focused increasingly on making their lending operations financially sustainable by charging interest rates that are high enough to cover all their costs. They argue that doing so will best ensure the permanence and expansion of the services they provide. Sustainable (i.e., profitable) microfinance providers can continue to serve their clients without needing ongoing infusions of subsidies and can fund exponential growth of services for new clients by tapping commercial sources, including deposits from the public. The problem is that administrative costs are inevitably higher for tiny microlending than for normal bank lending. For instance, lending $100,000

$

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Moving Beyond Storytelling: Emerging Research in Microfinance Contemporary Studies in Economic and Financial Analysis, Volume 92, 145–181 Copyright r 2009 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1569-3759/doi:10.1108/S1569-3759(2009)0000092008

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in 1,000 loans of $100 each will obviously require a lot more in staff salaries than making a single loan of $100,000. Consequently, interest rates in sustainable microfinance institutions (MFIs) have to be substantially higher than the rates charged on normal bank loans. As a result, MFIs that claim to be helping poor people nevertheless charge them interest rates that are considerably above the rates richer borrowers pay at banks. No wonder this seems wrong to observers who do not understand, or do not agree with, the argument that MFIs can usually serve their poor customers best by operating sustainably, rather than by generating losses that require constant infusions of undependable subsidies. In today’s microfinance industry, there is still some debate about whether and when long-term subsidies might be justified to reach particularly challenging groups of clients. But there is now widespread agreement, within the industry at least, that in most situations MFIs ought to pursue financial sustainability by being as efficient as they can and by charging interest rates and fees high enough to cover the costs of their lending and other services.1,2 Nevertheless, accepting the importance of financial sustainability does not end the discussion of interest rates, and where to draw the line is a complex issue. An interest charge represents money taken out of clients’ pockets, and it is unreasonable if it not only covers the costs of lending but also deposits ‘‘excessive’’ profits into the pockets of an MFI’s private owners. Even an interest rate that only covers costs and includes no profit can still be unreasonable if the costs are excessively high because of avoidable inefficiencies. High microloan interest rates have been criticized since the beginning of the modern microfinance movement in the late 1970s. But the criticism has intensified in the past few years, and legislated interest rate caps are being discussed in a growing number of countries. Part of the reason for the increased concern about rates is simply that microfinance is drawing ever more public attention, including political attention. Another factor is that quite a few MFIs are now being transformed into private commercial corporations. In the early years, most MFIs were ownerless not-for-profit associations, often referred to as nongovernmental organizations (NGOs). If an NGO generates a profit, the money normally stays in the institution and is used to fund additional services. But many NGO MFIs have eventually wanted to add deposit-taking to their activities, because they see savings services as valuable for their clients and because capturing deposits allows them to fund expansion of their microlending. When NGOs approach a government banking authority for a license to take deposits, they are usually required to

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reorganize their businesses into for-profit shareholder-owned corporations. Once this happens, profits can wind up in the pockets of private shareholders, inevitably raising the specter of such owners making extreme returns on their investment by charging abusive interest rates to poor borrowers who have little bargaining power because their other credit options are limited. A firestorm of controversy erupted in April 2007 when shareholders of Compartamos, a Mexican MFI with a banking license, sold a part of their shares in a public offering at an astonishingly high price, which made some of the individual sellers instant millionaires. One important reason for the high price was that Compartamos was charging its clients very high interest rates and making very high profits. The annualized interest rate on loans was above 85 percent (not including a 15 percent tax paid by clients), producing an annual return of 55 percent on shareholders’ equity (Rosenberg, 2007). In fact, most MFIs charge interest rates well below those that provoked controversy in the case of Compartamos. But the story tapped into a deep well of concern about high microcredit interest rates and the trend toward commercialization of microfinance. This chapter asks whether microcredit rates are abusively high. Obviously, there can be no one-size-fits-all answer to this question, not only because there are huge variations in the interest rates and related circumstances of individual MFIs around the world but also because there is no agreed standard for what is abusive. There is an intense dispute about how high interest rates and profits would have to be to qualify as excessive and indeed about whether terms like this have any useful meaning, at least in the arena of for-profit microfinance. In this chapter, we are not using any theoretical framework or benchmark against which to measure what is excessive or not. We present available data and then form our own admittedly intuitive judgment about the reasonableness of the general picture appearing from that data. Of course, readers will apply their own criteria or intuition to the data in judging whether rates or profits strike them as ‘‘abusive,’’ ‘‘exploitative,’’ ‘‘excessive,’’ ‘‘unreasonable,’’ and so on. Some MFIs are charging their clients rates that seem hard to justify from a development perspective. Rosenberg (2007) argues that this was the case at Compartamos, at least after it became able to fund expansion of its services from other sources besides retained profits.3 But are these rare exceptions or do they represent a pervasive problem in the industry? We approach the question from several perspectives. In Section 2, we report on how high microcredit rates actually are around the world.

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Then, we look at how those rates compared with the cost of other forms of credit often available to low-income people, including consumer credit, credit unions, and informal moneylenders. The section closes with a look at trends: Are microcredit rates moving up or down? In Section 3, we ‘‘deconstruct’’ interest rates by looking at what they fund. Mathematically, an MFI’s interest yield is equal to the sum of costs and profit on its loan portfolio. Most people would agree that it is fair to criticize an MFI’s interest rates as unreasonable only if its profit or some controllable element of its costs is unreasonable. In addition to profits, we analyze MFIs’ cost of funds, loan loss expenses, and operating (i.e., administrative) costs. Section 4 briefly considers the question of whether we can rely on competition to bring down interest rates and profits. Section 5 summarizes the findings and our conclusion that, despite occasional exceptions, MFI interest rates generally seem quite reasonable and that there is no evidence of any widespread pattern of abuse.

1.2. A Note on MFI Data Financial information on MFIs is drawn from the databases of the Microfinance Information Exchange (MIX). Not all MFIs report to MIX, but those that do (currently over 1,400 MFIs) account for over 58 million borrowers worldwide in 98 countries.4 MIX maintains two different, though overlapping, MFI databases. The MicroBanking Bulletin (MBB) dataset currently includes 890 institutions that report their data confidentially. MBB adjusts the financial information of these MFIs to compensate for the effect of any subsidies they receive and, thus, tries to present a picture of what the industry would look like if it had to pay market cost for all of its resources. MBB organizes MFIs into ‘‘peer groups’’ of institutions with similar characteristics and reports overall peer group performance. The other dataset is MIX Market (www.mixmarket.org), which publicly reports individual performance of over 1,300 MFIs but does not adjust the reported data.5 Most MFIs are included in both datasets. MFIs that report to MBB but not to MIX Market are guaranteed that individually identifiable data about their institutions will not be disclosed publicly. Thus, we report only aggregate results, and we generally cannot discuss what is happening, in particular, MFIs. When analyzing revenues, costs, and profits, we usually use a large database that includes the 555 sustainable MFIs that reported their results

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to MIX for 2006.6 Why only sustainable MFIs? The reason is that much of the analysis in this chapter depends on relationships between interest rates and costs. We usually exclude unsustainable MFIs because their interest rates are not constrained by their costs – that is, an unsustainable MFI can set its interest rates as low as it wants no matter how high its costs are, as long as some donor or government is willing to provide the subsidy necessary to cover the losses. Not surprisingly, sustainable MFIs tend to charge higher interest rates than unsustainable MFIs. The average interest yield (weighted by loan portfolio) for MFIs reporting to MIX in 2006 was 28.1 percent for sustainable MFIs, compared with 20.5 percent for unsustainable MFIs.7 Thus, if we had included unsustainable MFIs in our analysis, the interest rates reported in the chapter would have been substantially lower. One might assume that sustainable (i.e., profitable) MFIs are typically for-profit commercial companies, but this is not the case. In fact, almost two-thirds of the 555 sustainable MFIs are NGOs, cooperatives, public banks, or other not-for-profit organizations. When tracking recent year-to-year trend lines, we had to use a smaller dataset: all 175 sustainable MFIs who reported their data for both 2003 and 2006. These sustainable MFIs are a minority of the MFIs reporting to MIX, but they account for about half of all the borrowers and microloan portfolio amounts that were reported by participating MFIs (both public and private) each year. We believe this set is large enough and representative enough to give a meaningful picture of recent industry trends at a worldwide level. For a snapshot of levels at a particular point in time, the larger dataset – all 555 sustainable MFIs reporting in 2006 – is obviously more reliable.8 In presenting data from these two sets, we do not use simple averages or distributions, because doing so would distort the picture of the industry by giving as much weight to a tiny MFI with 1,000 clients as to a huge one with a million clients. Instead, we give more weight to larger MFIs. Usually, we weight by the size of the MFIs’ gross loan portfolio (GLP), because most of the income, costs, and profits are analyzed as percentages of loan portfolio. Occasionally, we also weight by numbers of clients.9 In looking at interest rates, we use interest yield on GLP, which is the total amount of cash borrowers pay the MFI during a period for interest and loan fees divided by the average outstanding GLP over the same period. As a measure of what clients are actually paying, this is far more meaningful than an MFI’s stated interest rate.10

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Finally, readers may occasionally notice a seeming disparity in data – for example, interest yields, costs, or profits may be somewhat different in different graphs or tables. There are several reasons for these differences:  Point-in-time data are usually based on all 555 sustainable MFIs reporting to MIX for 2006, while trend-line data are based on a different set – the 175 sustainable MFIs that reported for both 2003 and 2006.  Some figures present average values, which will differ from the median shown in a graph reporting the distribution of individual values.  The ratios being reported may have different denominators. For instance, administrative costs as a percentage of interest earnings will look much higher than the same administrative costs expressed as a percentage of GLP.

2. HOW HIGH ARE MICROCREDIT INTEREST RATES? WHERE ARE THEY MOVING? 2.1. 2006 Interest Rate Levels Most MFIs charge interest rates far below those that have provoked controversy in the case of Compartamos. In 2006, the most recent year available, the median interest income for sustainable MFIs in MIX, weighted by GLP, was 26.4 percent of loans outstanding.11 Fig. 1 shows the distribution of interest yields, worldwide and by region, compared with Compartamos’ interest yield. The regional breakdown consists of East Asia and the Pacific (EAP), Eastern Europe and Central Asia (EECA), Latin America and the Caribbean (LAC), Middle East and North Africa (MENA), South Asia (SA), and Sub-Saharan Africa (SSA). The Compartamos case was striking and prompted a lot of discussion. But it is a serious mistake to assume that Compartamos’ interest rates were typical of the industry, or even of a substantial part of the industry. In fact, less than 1 percent of MFI borrowers worldwide were paying rates as high as Compartamos was charging. Some MFIs require borrowers to make compulsory deposits before they can receive a loan; borrowers typically must maintain these deposits during the life of the loan. The interest rates borrowers receive on these deposits are well below the rates borrowers pay on their loans. The effect of such deposit requirements is to reduce the net additional cash borrowers realize from their loans and, thus, to increase the effective cost of the loan to them.

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Fig. 1. Interest Income as Percentage of Gross Loan Portfolio, 2006. Note: 555 sustainable MFIs reporting to MIX, distribution weighted by gross loan portfolio. The thick horizontal bars represent medians; the top and bottom of the white boxes represent the 75th and 25th percentiles, respectively; and the high and low short bars represent the 95th and 5th percentiles, respectively.

About one-third of the sustainable MFIs reporting to MIX for 2006 required such savings deposits, and on average, these MFIs are smaller than the ones that do not use compulsory savings. Data limitations prevent us from calculating the additional cost due to compulsory savings in individual institutions. It is important to keep the interest and fees paid to the MFI in context: they are only part of borrowers’ total loan costs. Transaction costs can be substantial, including, for instance, the time borrowers have to spend away from their businesses, their transportation expenses, and the negative impact of delays in receiving loan funds. Because interest charges can be quantified easily, they tend to receive much more attention than borrowers’ transaction costs. In fact, these transaction costs often represent a greater expense for the borrower than the interest being charged on the loan. Sometimes, borrowers with other credit options are willing to pay a higher interest rate to an MFI because the MFI loan entails lower transaction costs (Adams, Graham, & von Pischke, 1984; Meyer & Cuevas, 1992; Robinson, 2001; Tran, 1998; Cuevas, 1989). 2.2. Microcredit Rates versus other Small-Loan Rates How expensive is microcredit compared with other credit available to poor and low-income borrowers? Answering this question poses data challenges.

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From MIX, we have good country-by-country information on interest rates for a large set of MFIs (using the most recently reported year, as of March 2008). But it has been much more difficult to assemble information on rates for consumer credit or credit unions; the challenges of determining rates for informal moneylenders are even greater. We found small amounts of published country data and supplemented them by canvassing our contacts in various countries.12 We cannot guarantee the accuracy of each piece of information we were given. And in some cases, it is hard to be precise about the effective annual rate based on that information. However, we think we have enough to start drawing a rough general picture, at least with respect to consumer credit and informal credit rates. 2.2.1. Consumer Credit Table 1 compares loan rates in sustainable MFIs with consumer credit rates in 36 countries for which we had reports. Consumer credit includes credit cards, installment loans for furniture or appliances, and other similar loan Table 1.

MFI Rates versus Consumer Lending Rates.

Lower than Credit Card/Consumer Interest Rates Bangladesh Bolivia Cambodia Congo Ethiopia India Indonesia Jordan Kenya Kyrgyzstan Mongolia Nepal Nicaragua Pakistan Philippines Serbia/Montenegro Sri Lanka Togo Thailand

Close to Credit Card/ Consumer Rates Armenia Bosnia and Herzegovina Colombia Ecuador Egypt Ghana Madagascar Mexico Romania Tajikistan

Higher than Credit Card/ Consumer Rates Cameroon Morocco Peru Senegal Tanzania Uzbekistan Zambia

Note: Latest available year; MIX data for sustainable MFIs, CGAP research for consumer lending rates.

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products. MFI rates appear lower than consumer credit rates in a majority of these countries; they are higher than consumer credit rates in less than one-fifth of the countries.13 In consumer lending, borrowers are typically salaried, and therefore, assessing creditworthiness usually can be done automatically, using computerized scoring algorithms. By contrast, microlending tends to require a more labor-intensive relationship between loan officer and client. In light of this higher cost, one might expect microcredit rates to average higher than consumer credit rates, rather than lower, as appears to be the actual case. On the contrary, credit cards may involve more frequent transactions than microcredit, which could offset their cost advantage in terms of borrower evaluation. Installment financing of merchandise would not seem more transaction-intensive than microcredit, and these ‘‘hire-purchase’’ lenders usually have collateral and the means to sell it when repossessed. Notwithstanding these factors, the general picture suggests that microcredit rates are on average lower than consumer rates. 2.2.2. Informal Credit We found 34 reports on rates for informal lending (mainly unregistered moneylenders and pawnshops) in 21 countries and the West African Monetary Union. In all of those countries except Ghana, microcredit rates were lower – usually far lower – than informal rates. The median informal rate reported was 10–25 percent per month. Rates of 5–20 percent per day were reported in five countries. Both informal credit and microcredit are generally uncollateralized and are used by lower income borrowers. But there are big differences, the most important of which from the customer’s perspective is that informal loans are usually available very quickly. It is commonly assumed that the astronomical rates found in informal lending reflect moneylenders’ exploitation of poor borrowers’ lack of options and weak bargaining power. However, a body of research suggests this characterization is only occasionally accurate. Usually, the biggest driver of high informal rates is the high cost of such lending (see, for example, Robinson, 2001). 2.2.3. Credit Unions We were able to compare MFI rates with credit union rates in only 10 countries. The average MFI rate in these countries was usually higher than the rates reported to us for regular credit union loans (Table 2). However, in five cases where credit unions also have a special product aimed at lower end microcredit clients, MFI rates have tended to be about the same or lower.

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Table 2.

MFI Rates versus Credit Union Rates.

Regular Credit Union Loan Products

Specialized Credit Union Microcredit Products

Bolivia Colombia Ecuador Ethiopia India Kenya Mexico Nepal Peru Philippines

Bolivia Columbia Ecuador Peru Philippines

¼ þ þ þ þ ¼ þ ¼ þ þ

¼  ¼,– ¼ ¼

Notes: þ, MFI rates generally higher than credit union rates; –, MFI rates generally lower than credit union rates; ¼ , MFI and credit union rates generally in same range.

It is difficult to draw conclusions from these comparisons with credit unions, for reasons that go beyond the small sample size. MFIs often claim that they are reaching poorer customers than credit unions are, though there is little statistical evidence about whether this is the case.14 Other dimensions of the comparison are ambiguous as well – for instance, loan officers in many MFIs spend much of their time in neighborhoods bringing services to clients where they live and work, whereas this is much less common in credit unions. Nor is it clear what to make of the comparison between MFI rates and the rates credit unions charge for their special microcredit programs, because many of these credit union programs are aimed at a low-end village banking clientele, which may in fact be poorer than the average clientele of the country’s MFIs. Finally, most of our credit union data come from relatively small groups of credit unions that have been recipients of technical assistance from the World Council of Credit Unions, and that may not be typical of credit unions in their country. Credit unions have been serving some substantial number of poor and low-income clients for many years. It would be very useful to have research that gives a clearer picture of how they stack up against MFIs in terms of outreach, loan products, costs, and interest charges.

2.3. Are MFI Rates Climbing or Dropping? Microcredit techniques and the institutions that employ them are relatively new, having sprung up over the past 20–30 years. The industry is still in a

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nascent state in most countries. Standard theory would lead us to expect reductions of costs (driven by learning curve and economies of scale) and prices (driven by competition). Have such reductions in fact happened? Bolivia is a frequently cited case where the answer is clearly yes: from 1992 to 2007, microcredit interest rates dropped 43 percentage points, from about 60 percent to about 17 percent (Fig. 2). During the same period, bank rates dropped only about 12 percentage points. But is the Bolivia case representative? In Bangladesh, another microcredit pioneer, interest rates have not dropped substantially (though rates there started out quite low). What has been the worldwide pattern in recent years? To answer these questions, we used data from the set of 175 sustainable MFIs that reported to MIX in both 2003 and 2006. Fig. 3 shows that the interest yield on their combined loan portfolio has been dropping quite fast over the period everywhere except for South Asia, averaging 2.3 percentage points each year.15 A separate analysis for 2000–2005, using a larger dataset of MFIs, but a somewhat less rigorous methodology, showed even steeper declines – 3.4 percent per year. During the same period, loan rates for commercial banks in developing and transition economies fell by about 0.8 percent per year.16 Later, in Section 4, we look more closely at the question of whether competition is driving the decline in rates. But regardless of how it is explained, the substantial downward trend in rates is certainly encouraging.

Fig. 2. Evolution of Bolivian Microcredit Rates, 1992–2007. Sources: GonzalezVega and Villafani-Ibarnegaray (2007) and Banking Superintendency data.

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Interest Yield Trends, 2003–2006

Fig. 3. Interest Yield Trends, 2003–2006. Note: Total interest and fee income/average total GLP: average of 175 sustainable MIX MFIs, weighted by loan portfolio.

3. THE COMPONENTS OF MICROCREDIT INTEREST RATES Four main components are reflected in an MFI’s interest rate: cost of funds, loan loss expenses, operating expenses, and profits. In this section, we break out these components and discuss how they may affect interest rate trends. MFIs use their interest income to cover costs, and the difference between income and costs is profit (or loss). A simplified version of the relevant formula is as follows:17,18 Income from loans ¼ Cost of funds þ Loan loss expense þ Operating expense þ Profit Lowering interest rates would require lowering one of the four components on the right-hand side of the equation. If we want to judge whether interest rates are reasonable, the most direct approach is to look at whether each of these components that are funded from interest income is at a reasonable level. Fig. 4 shows the relative importance of each of those elements, expressed as a percentage of after-tax income. Worldwide, operating expenses consume more than half of income, followed by funding costs, profits, and loan losses.

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Fig. 4. Costs and Profits as Percentage of Income, 2006. Note: 554 sustainable MFIs reporting to MIX for 2006 weighted by GLP. The Unit Desa system of Bank Rakyat Indonesia is excluded from this calculation because its reported cost of funds reflects artificial pricing arrangements between Unit Desa and the rest of the bank. The income on which the percentages are based is interest yield plus other income minus taxes.

Fig. 5. Average Cost of Funds (Interest Expense) as Percentage of GLP, 2006. Note: 554 sustainable MFIs (without BRI) reporting to MIX, weighted by GLP.

3.1. Cost of Funds The relatively high price MFIs have to pay for money they borrow contributes substantially to the interest they charge borrowers. As of 2006, total funding cost (interest expense) for 554 sustainable MFIs was equivalent to 8.3 percent of their total average GLP for the year (Fig. 5). Fig. 6 shows no downward trend in cost of funds (here expressed as the ratio of interest expense to loan portfolio) for MFIs worldwide.

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Compared with commercial banks, MFIs tend to be less leveraged – that is, less of their portfolio and other assets are funded by liabilities on which they have to pay interest. Fig. 7 compares MFIs’ interest expense with their liabilities rather than with their loan portfolio and shows that their borrowings have been relatively expensive – averaging 5.1 percent in 2006, compared with about 3 percent for commercial banks in the same countries.19 Are MFI managers prejudicing their borrowers by incurring unnecessarily high funding costs? In general, it would seem unfair to criticize MFI managers much on this score, because even though they can control their

Fig. 6. Trend in Funding Costs (Interest Expense as Percentage of GLP), 2003– 2006. Note: MIX data for 174 sustainable MFIs reporting in both years. BRI has been excluded because its reported cost of funds is artificial.

Fig. 7.

MFI Interest Expense as Percentage of Liabilities, 2006. Note: 554 sustainable MIX MFIs, weighted by liabilities.

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own operations, they usually have little control over their rate of borrowing/ funding costs. Most of them get funding where they can find it and tend to be price takers rather than price makers when it comes to the interest rates they pay. Increasing reliance on deposit funding will lower costs over the longer term, as regulators authorize more MFIs to take savings. However, this option is unavailable to managers of MFIs if their country does not have the enabling regulation or if their business is not yet solid enough to meet the hurdle for depository licensing.

3.2. Loan Loss Expenses Loan losses due to borrower default have relatively little effect on MFI interest rates, for the simple reason that such losses are quite low in most MFIs, especially in large ones that account for most of the market. Fig. 8 shows the global and regional medians for loan losses, weighted by portfolio. As a point of reference, the general rule of thumb in microcredit is that annual loan losses of more than about 5 percent tend to become unsustainable. Above that level, loan collection must be improved quickly and substantially or it will spin out of control. MFIs usually have delinquency and default rates well below those of commercial banks in their countries. (Interestingly, emerging evidence also suggests that MFIs are more stable than banks when it comes to the effect of general economic stress on their loan collection, Gonzalez, 2007b.) The high average loan loss rate for Africa (4.9 percent) is driven by a few outliers.20

Fig. 8. Global and Regional Loan Losses as Percentage of GLP, Averages for 2006. Note: Data from 555 sustainable MFIs reporting to MIX for 2006, weighted by gross loan portfolio.

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Annual Loan Losses as Percentage of GLP, 2003–2006. Note: 175 sustainable MIX MFIs.

Fig. 9 shows 2003–2006 trends in loan losses. Regional trends vary, but loan losses measured globally are down slightly. Further improvement might be possible, but there seems to be little room for an improvement big enough to have a substantial effect on the interest rates clients have to pay. Indeed, loan loss rates can go too low. An MFI that has no loan losses at all is probably being too risk-averse in its selection of borrowers, which hurts not only the expansion of poor people’s access to finance but also the MFI’s own profitability. If there is any widespread abuse in microcredit interest rates today, it certainly cannot be traced back to excessive loan loss expense.

3.3. Operating Expenses (Efficiency) The majority of MFIs’ interest income goes to pay operating costs (salaries and other administrative costs), which are about 60 percent of total MFI costs. The worldwide median operating expense was 11.4 percent of GLP in 2006 (Fig. 10).21 Ninety percent of the values lie between 7.9 and 33.7 percent. The range is considerably narrower if Africa is excluded. Are MFIs reasonably efficient or do their operating expenses include substantial waste? Unfortunately, one cannot calculate an answer from available performance statistics. MFIs vary widely in a range of factors that affect operating costs, including not only loan sizes but also age, scale, client location and density, type of loans provided (e.g., group vs. individual lending), client stability, communication and transport infrastructure, salary levels, and rural versus urban location. MIX categorizes MFIs into various peer groups for rough comparison purposes, but each peer group contains

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Fig. 10. Distribution of Operating Expense Ratio, 2006. Note: 555 sustainable MIX MFIs, weighted by GLP. The thick horizontal bars represent medians; the top and bottom of the white boxes represent the 75th and 25th percentiles, respectively; and the high and low short bars represent the 95th and 5th percentiles, respectively.

so wide a range of circumstances that one cannot confidently judge an MFI’s efficiency just by comparing its indicators with those of its peer group, let alone judge whether the peer group as a whole is reasonably efficient. Currently at least, the only reliable way to tell whether an MFI’s operating costs are appropriate is to conduct an on-the-ground study of its individual situation and operations, including many factors that are not part of any public database. Nevertheless, there are a number of considerations that shed light on issues surrounding operating costs. 3.3.1. Effect of Small Loan Sizes The principal justification offered for high microcredit interest rates is the claim that administrative costs are inevitably higher when placing a given amount in many tiny loans rather than a few big loans. This claim sounds plausible enough in theory, and Fig. 11 suggests that it stands up empirically. The figure shows the results of a regression analysis testing the relationship between average loan size and OER, both measured as percentage of gross national income per capita (GNIPC). The regression screened out the effect of other variables such as age, scale, productivity,

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Fig. 11. Predicted Change in Operating Expense Ratio, by Loan Size. Note: Regression results based on 1,144 MIX Market and MBB MFIs reporting data for 1999–2006. The percentage scale at the left of the figure measures relative change but does not correspond to absolute operating cost levels (Gonzalez, 2007a).

legal status, savings mobilization, region, macroeconomic environment, and some proxies for physical infrastructure. It is clear that loan administration will cost MFIs more than it costs banks that make much larger loans. But is the actual level of operating costs for most MFIs the inevitable result of loan size or does it reflect unreasonable inefficiency? One cannot calculate an answer to this question from available performance statistics. MFIs vary widely in a range of factors that affect operating costs, including not only loan sizes but also age, scale, client location and density, type of loans provided (e.g., group vs. individual lending), client stability, communication and transport infrastructure, salary levels, and rural versus urban location. MIX categorizes MFIs into various peer groups for rough comparison purposes, but each peer group contains so wide a range of circumstances that one cannot confidently judge an MFI’s efficiency just by comparing its indicators with those of its peer group, let alone judge whether the peer group as a whole is reasonably efficient. The only reliable way to tell whether an MFI’s operating costs are appropriate is to conduct an on-the-ground study of its individual situation and operations, including many factors that are not part of any public database. Nevertheless, there are a number of considerations that shed light on issues surrounding operating costs. 3.3.2. Economies of Scale Even though small loans cost more to administer than big ones, we might look for those costs to be lowered by economies of scale as MFIs grow

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Fig. 12. Predicted Change in Operating Expense/GLP Ratio, by Scale. Note: Regression results based on 1,144 MIX/MBB MFIs reporting data for 1999–2006 (Gonzalez, 2007a). The percentages shown to the left of the graph show relative costs but do not correspond to actual cost levels.

larger. Some observers express disappointment that the growth in size of MFIs has not improved efficiency as much as they expected: should not an MFI that can spread its fixed operating costs over a million borrowers have a much lower cost per loan, and be able to charge a lower interest rate, than an MFI with only a few thousand clients? The regression result in Fig. 12 is surprising. MFIs appear to capture most of their scale benefits by the time they reach about 2,000 clients; they appear to gain relatively little from scale economies after that very early point. This is probably because microcredit is so labor-intensive: salaries make up the majority of most MFIs’ operating expenses, and fixed costs are relatively low compared with variable costs. MFIs that are still small enough to reap major economies of scale account for only a tiny percentage of microcredit loans and customers. In short, economies of scale cannot do much to offset the added expense that comes from making very small microcredit loans. 3.3.3. Trend of Operating Costs Fig. 13 shows good news. MFI efficiency has improved substantially – that is, operating costs have declined – in recent years in all regions except South Asia, where operating costs were already quite low. Why are Operating Cost Ratios Dropping: Learning Curve, Loan Size, or Competition? The decline in operating costs is a major contributor to the

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decline in interest rates that borrowers are paying. What is causing this improvement in efficiency, and can we expect it to continue? Learning Curve. One driver – perhaps the most important driver – of improved MFI efficiency seems to be the increasing age of large MFIs as the industry develops. As institutions mature, they learn their business better and are able to control costs more effectively. Regression analysis (Fig. 14) shows that the age of an MFI is strongly associated with lower operating

Fig. 13.

Operating Costs as Percentage of GLP, 2003–2006. Note: 175 sustainable MFIs reporting to MIX for both 2003 and 2006.

Fig. 14. Predicted Change in Operating Expense/GLP, by Age of MFI. Note: Regression results based on 1,144 MIX Market and MBB MFIs reporting data for 1999–2006 (Gonzalez, 2007a). The percentage scale at the left of the figure measures predicted relative change but does not correspond to actual operating cost levels.

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costs, even after separating out the effects of loan size, scale, and other relevant variables. Not surprisingly, the effect weakens over time, but it continues for quite a while. The OER tends to drop by 2–8 percentage points for each of the first six years, 1–2 points for each of the next five years, and less than 1 point for each year thereafter. We do not have a good statistical proxy for the competitiveness of an MFI’s market, and therefore, we cannot quantify how much of this age effect can be attributed to competition. However, it is likely that most of the effect is due to the learning curve, because relatively few MFI markets are competitive yet. Loan Size and Mission Drift. Since smaller loans are associated with higher operating expenses, an MFI could reduce its OER by simply making larger loans. If an MFI whose borrowers all have $100 loans suddenly lets these borrowers double their loan size, or finds new borrowers who want larger loans, the MFI does not need to double its staff or other administrative expenses. Are the improvements in efficiency shown in Fig. 13 nothing more than the result of increasing loan sizes, which might reflect a movement toward serving a richer clientele?22 Fig. 13 reported the most common measure of efficiency: OER, which is administrative cost divided by the amount of the loan portfolio. This OER automatically makes MFIs with larger loan sizes look better. A more useful measure for our immediate purpose is administrative cost divided by the number of borrowers. Normalizing the resulting ‘‘cost per borrower’’ by expressing it as a percentage of per capita national income produces an indicator that is better at describing MFIs from different countries without automatically giving an advantage to those that make larger loans or that have lower labor costs in their country. Fig. 15, which shows the 2003–2006 efficiency trend using normalized cost per borrower, suggests that the efficiency gains are not simply the result of larger loan sizes but that they reflect true improvement in the cost of serving each client. The same conclusion can be drawn from the regression in Fig. 14, which shows that the learning curve drives a strong efficiency improvement even after screening out the impact of loan size. Will cost per borrower tell us which managers are efficient and which are wasteful? Measuring normalized cost per borrower, rather than cost per dollar lent, filters out the effect of loan size and, to a lesser extent, country differences in labor and other input costs. But this measure does not filter out the effect of many other variables that impinge on an MFI’s cost, such as geographical density of clients, transport and communications

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Fig. 15. Operating Expenses per Borrower as Percentage of per Capita Gross National Income. Note: 175 sustainable MFIs reporting to MIX for both years, weighted by GLP.

infrastructure, or the flexibility and sophistication of the products offered to clients. Also, MFIs report their total administrative expenses. They are seldom able to separate costs associated with lending from costs associated with other products, like savings. Therefore, if an MFI adds savings services, its reported cost per borrower will rise, but this does not signal deterioration in efficiency. Finally, at a certain level, larger loan sizes do translate into larger administrative expenses per borrower – for instance, small business loans need more sophisticated and expensive analysis than microloans, and therefore, one would not expect to see cost per borrower as low in Eastern Europe as it is in South Asia. As a result of all these factors, one cannot automatically conclude, for example, that managers of East Asian MFIs are more efficient than managers in Latin America, just because the former have a lower cost per borrower. The various factors that impinge on cost per borrower affect individual MFIs differently. However, they stay more or less the same for a given MFI from one year to the next, and therefore, the overall decline in cost per borrower shown in Fig. 15 very probably reflects true efficiency improvement. We know of no statistical approach that can directly measure whether MFI administrative costs are abusively high today. But the data have permitted us to make some relevant observations. The plausible argument that costs need to be higher when smaller loans are being delivered is

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supported by regression analysis of a large set of MFIs. MFI operating cost levels have dropped substantially in recent years, and we have seen that this represents real operating improvements, not just the effect of increasing loan sizes. Regression analysis suggests that much of this improvement reflects the learning curve as MFIs gain experience. This still does not tell us how much avoidable ‘‘fat’’ is built into MFI operating expenses. Because most microfinance markets are so young and because most are not yet competitive, it would be unrealistic to expect MFIs in those markets to be operating at the most efficient levels possible. Immature industries always have some level of correctable inefficiency. We know of no evidence suggesting that MFIs in general are out of line with the normal evolution of efficiency for businesses in immature markets. Finally, the year-to-year cost of operating expenses shows an encouraging decline, however we measure it.

3.4. Profit Of the four components of microcredit interest rates, profit is the one that is most obviously subject to management control. It is also the most controversial. Some observers are uncomfortable with the notion of private parties making any profit from microlending, which they view as a service to poor people, and not as a business opportunity. Others accept the idea of private profits in microlending but are concerned that MFIs will exploit the weak bargaining position of their borrowers to extract abusive levels of profit. Still others think that high profits in the early stages are a positive good, because high returns will attract more investment and more rapid outreach of services to people who need them and because they are confident that competition will eventually moderate those profits. 3.4.1. How High are MFI Profits? In most countries, the microcredit market is still immature, with low penetration of the potential clientele by MFIs and little competition so far. Standard economic theory predicts that profits will be higher in such markets than in more developed markets where competition constrains prices. Fig. 16 compares MFI profitability with bank profitability, measured by both return on assets and return on equity. When profit is measured against assets, it does seem to average higher for MFIs than it does for banks, most of which face more competition than the MFIs in their countries do.

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Fig. 16. Returns on Average Assets and Equity – MFIs versus Banks. Note: Assetweighted averages of all MIX MFIs with 2006 data available, except BRI Unit Desa, whose reported equity is artificially low because of its relationship to the larger bank. Most MFIs in the sample report to MBB, where their returns are adjusted to compensate for the effects of subsidy. Bank data by Christoph Kneiding, based on the most recent year available in Bankscope, for countries that have MFIs reporting to MIX.

But compared with MFIs, banks can leverage their capital structure more, that is, they fund more of their assets with other people’s money – deposits and other borrowings – rather than with their own equity. As a result, MFIs, despite their higher return on assets, do considerably less well than banks in producing returns for their owners. Return on equity averages about 5 percent lower for MFIs than for banks. (Note that we are including all MIX MFIs here, not just the profitable ones, because profitability is the variable being examined, and MFIs are being compared against all banks, including the unprofitable ones.)23 Fig. 17 gives the distribution of return on equity for all MIX MFIs. Overall, the returns are moderate, at least by commercial standards. However, some of the profits look quite high in the upper percentiles. Further analysis of these most profitable MFIs sheds some light. To begin with, the top 5 percent of the distribution in South Asia seems to be extremely profitable.24 However, the very high figure shown there for return on equity is driven by a few Indian MFIs with very odd balance sheets: almost no equity and therefore extremely high leverage. As the denominator of the ratio (equity) gets close to zero, the calculation produces very high numbers, even if profits in relation to loan portfolio or assets are moderate. The return on assets at the 95th percentile in South Asia is 11.2 percent, which is similar to the comparable figure for other regions.

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Fig. 17. Distribution of MFI Returns on Average Equity, 2006. Note: All MIX MFIs with 2006 data available, except BRI Unit Desa, weighted by GLP. The thick horizontal bars represent medians; the top and bottom of the white boxes represent the 75th and 25th percentiles, respectively; and the high and low short bars represent the 95th and 5th percentiles, respectively.

Turning from South Asia back to the worldwide distribution summarized in Fig. 17, we find that the most profitable 10 percent of worldwide loan portfolio (i.e., at or above the 90th percentile, which is not shown in the figure) produced 2006 returns on equity above 35 percent. Over two-thirds of the MFIs with these high returns were not-for-profit organizations. Absent illegal manipulation, net earnings of NGOs do not go into private pockets but remain in the organizations to fund further expansion of financial or other services for their target clientele. One of the very-highprofit MFIs is a large government operation. Profits of government MFIs are available to expand outreach or to fund other government priorities. Such profits would be captured by private pockets only in cases of corruption, and we know of no reason to think that microfinance-generated profits would be more subject to corruption than any other government revenues. The remaining third of these most profitable MFIs are organized as forprofit business corporations. Most of them started out as not-for-profit NGOs and transformed to qualify for a deposit-taking license or for some other reason. In such cases, the NGO usually retains some significant portion of the shares, and the profits accruing to those shares stay in the NGO to fund its work. Finally, some significant part of the shares in the

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for-profit MFIs is owned by private individuals or companies. Profits on those privately owned shares – and only those profits – make their way sooner or later into private pockets. Again, the high profits accruing to private owners of MFIs in the top 5 or 10 percent of the profit distribution are exceptional rather than typical in the microfinance industry. But they are not insignificant, and they do raise a question of appropriateness. Some observers think it is immoral for private parties to take a profit, or anything but a minimal profit, out of services to the poor (a view that has been expressed by Nobel laureate Muhammad Yunus). To them, those high profits going to private parties are abusive by definition, as are most of the lower profits reported in our data, at least to the extent that they are being captured privately. Other observers think that commercial investment, which requires returns at least as high as those found in ordinary banks, will enable microfinance services to reach a greater number of poor clients faster. From this perspective, the appropriateness of high-end profits in this minority of cases can be addressed only by investigating individual circumstances, including most importantly the risk investors took on when they put in their capital without knowing what the results would be. CGAP has published such a review for Compartamos (Rosenberg, 2007). In the past few years, there has been a proliferation of international investment funds (microfinance investment vehicles (MIVs)) that lend to MFIs or invest in their shares. The objectives of MIV investors cover a spectrum. At one end are public development finance institutions whose core objective is development and who typically are willing to accept higher risks or lower returns than a commercial investor would. At the other end are commercial actors who may like the cachet of microfinance but have no intention of investing in any MFI whose risk-return profile is not competitive from a purely commercial standpoint. An unpublished 2008 CGAP study found that the composition of MIV funding has been changing in recent years. The majority of MIV money is now coming from investors at or near the fully commercial end of the spectrum. MIV investments are heavily concentrated in the largest MFIs. Three quarters of MIV money goes into loans to MFIs, which are, of course, less risky than the other quarter that is invested in equity. 3.4.2. What Kind of Profits are MIVs Making? Assembling data is not easy, but the CGAP study was able to analyze returns for a set of MIVs that were organized in 2002. The average annual return reported for debt investments has been 6.3 percent. The reported return on

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riskier equity investments has been 12.5 percent. Both figures reflect gross returns; they do not include the effect of the funds’ administrative costs, which tend to range from 2 to 6 percent, mostly toward the lower end. These returns are respectable but far from spectacular, especially considering the relatively brief track record of MFIs in most countries, and the fact that most MIV investments face substantial country risk, including currency and political risks. 3.4.3. Are MFI Profits Rising or Falling? Fig. 18 presents weighted average after tax profits (interest yield þ other income  expenses  taxes) the same way that earlier figures have shown funding costs, loan losses, and operating costs – namely, as a percentage of loan portfolio for the 175 sustainable MFIs that reported their performance to MIX Market/MBB for both 2003 and 2006. There has been a substantial downward trend – 0.6 percentage points (about one-tenth of their value) each year. 3.4.4. What is the Impact of Profits on Interest Rates? It is axiomatic that if MFIs were to shrink their profits, they could charge their clients lower interest rates. But how much lower? Fig. 19 looks at net MFI profits (including profits from other activities besides lending) in relation to the interest they collect from borrowers. It tells us how much an MFI could reduce the interest it charges if it completely eliminated all profit. This is, of course, a drastic and unrealistic scenario. The MFI would be

Fig. 18.

After-Tax Profit as Percentage of Average GLP, 2003–2006. Note: GLPweighted average of 175 sustainable MIX MFIs.

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Fig. 19. MFI Net Income as Percentage of Interest Yield, 2006. Note: 555 sustainable MIX MFIs, weighted by loan portfolio. The thick horizontal bar represents medians; the top and bottom of the white box represent the 75th and 25th percentiles, respectively; and the high and low short bars represent the 95th and 5th percentiles, respectively.

forgoing not only returns to its owners but also growth in equity capital to expand the business. Fig. 19 shows that an MFI at the median could reduce its interest rate by 17 percent of the interest rate (not 17 percent of the loan amount). In other words, completely eliminating all profit would reduce the median MFI’s interest rate by only about one-sixth, an effect that is smaller than many people might expect. By way of comparison, the hypothetical interest reduction by eliminating all profit is less than the drop in rates that actually happened from 2003 to 2006. If all sustainable MFIs swore off profits tomorrow, they would still have to charge interest rates that might look abusive to those who do not understand the high costs that tiny lending inevitably entails. Cutting out profit would have more substantial effects at the upper percentiles, especially the top 5 percent, where interest rates could be shaved by almost two-thirds. One of the things going on here is that MFIs above the 75th percentile get a lot more of their income from sources other than lending. Over 20 percent of their income comes from nonlending activities (mainly other financial services and returns on investments), compared with

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7.5 percent for the other three quartiles. Lowering interest rates enough to eliminate all profit would mean that these MFIs would be subsidizing losses on their loan portfolio with the net income from other activities.

4. COMPETITION People who are enthusiastic about the commercialization of microfinance have sometimes taken it as an article of faith that markets will eventually approach saturation, at which point competition will put downward pressure on interest rates, forcing MFIs to lower their profits and become more efficient. But it is not guaranteed that such effects will always occur. For instance, credit card rates in the oversaturated U.S. market have proved stickier than other credit rates, probably in considerable part due to the substantial time investment required for a customer to search for and switch to a new card with better terms (Calem & Mester, 1995; Ausubel, 1991). Also, lenders might compete for customers by increasing their advertising or enhancing service quality, instead of lowering their interest rates (Bertrand, Karlan, Mullainathan, Shafir, & Zinman, 2005; Wright & Alamgir, 2004). It is widely thought that microloan customers are not very sensitive to interest rate changes. If true, this would reduce competition’s downward effect on rates, profits, and costs. But two recent studies have found considerable price sensitivity among customers of a Bangladesh microlender and a South African consumer finance provider (Dehejia, Montgomery, & Morduch, 2005; Karlan & Zinman, 2007). Three other CGAP-commissioned studies are testing interest rate sensitivity in other markets. The Gates Foundation is also investing in such research. David Porteous (2006) has analyzed microcredit competition and its effects in Boliva, Uganda, and Bangladesh. At the time of his study (in 2005), interest rates had not yet declined much in Uganda, but Porteous judged that the microcredit industry was still in a consolidation phase there and thus that classical competition theory would not yet predict price competition. Markets in Bolivia and Bangladesh were more highly saturated. Interest rates had indeed declined steeply in Bolivia, but considerably less in Bangladesh. Porteous reported that the rate reductions that had occurred there resulted more from political pressure than from competition. Interest rates, profits, and operating costs started out much lower in Bangladesh than was typical elsewhere in the world, probably mainly due to the attitudes of pioneers there toward the business. Thus, there was less

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room for reductions than in some other places. Nevertheless, some large Bangladesh MFIs are now generating profits that are high enough to suggest room for further interest rate reduction.25 It is unclear why competition is not squeezing profits in Bangladesh more seriously. One possibility is that many or even most borrowers with more than one option may want to borrow more than any single MFI will lend them, and therefore, they take multiple loans wherever they can get them, even if one of the providers is more expensive than another. MFI managers in Bangladesh report high levels of multiple indebtedness. Another theoretical explanation would be implicit collusion among the few MFIs that occupy most of the market. Blaine Stephens (2007) reviewed 2003–2005 trends in four competitive microcredit markets – Bolivia, Bosnia, Morocco, and Peru – and found interest rates and operating expenses had dropped in parallel each year in all four markets. As the market in Cambodia has become more competitive, interest rates there have dropped by about a half between 2000 and 2007, according to Eric Duflos, a senior microfinance analyst from CGAP.26 A forthcoming MIX Benchmarking report for Mexico, where competition has set in quite recently, shows modest declines in interest rates and profits during 2007. Knowledgeable observers tell us that microfinance is becoming competitive in important markets in India and that it has resulted in downward pressure on interest rates. Taken together, these data points suggest that competition may not inevitably produce lower interest rates, profits, and operating expenses in all markets, but that such effects do appear to be happening in most of the markets now regarded as competitive. Present data suggest an optimistic picture, but it is still too soon for any robust prediction about how universal the lower-interest-rates-through-competition scenario will be. Perhaps, the more relevant fact is the substantial worldwide decline in interest rates, administrative costs, and profits that we discussed earlier in the chapter. All this is distinctly positive for borrowers, who may not care very much whether we attribute it to competition or some other factor.

5. SUMMARY AND CONCLUSIONS The question we have tried to address is whether microcredit borrowers are being abused by unreasonably high interest rates. Here are what we see as the highlights of the evidence we have assembled.

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Level of Interest Rates  Using the best data available, the median interest rate for sustainable (i.e., profitable) MFIs was about 26 percent in 2006. The 85 percent interest rates that drew so much attention to the Mexican MFI Compartamos are truly exceptional, rather than representative of the industry.  MFI interest rates have been declining by 2.3 percentage points a year since 2003, much faster than bank rates. Comparison with Other Rates Paid by Low-Income Borrowers  MFI rates are significantly lower than consumer and credit card rates in most of the 36 countries for which we had rate indications and significantly higher than those rates in only a fifth of the countries.  Based on 34 reports from 21 countries, MFI rates were almost always lower – usually vastly lower – than rates charged by informal lenders.  MFI rates were typically higher than credit union rates in the 10 countries for which we found data. In the cases where the credit unions offered a specialized microcredit product, their interest charges tended to be the same as, or higher than, prevailing MFI rates. However, it is hard to make much of this information, not only because the sample size is so small but also because we know so little about the comparability of customers and products. Cost of Funds  MFIs have to pay more than banks pay when they leverage their equity with liabilities, and their cost of funds as a percentage of loan portfolio showed no sign of dropping in 2003–2006. But MFI managers do not usually have much control over these costs, in the medium term at least. Loan Losses  MFI interest rates are not being inflated by unreasonable loan losses. In fact, default rates are very low – about 1.9 percent in 2006. Administrative Expenses  Tiny loans require higher administrative expenses, which are not substantially offset by economies of scale. On the contrary, the learning curve of MFIs as they age produces substantial reductions.  Administrative costs are the largest single contributor to interest rates, but they have been declining by 1 percentage point per year since 2003.

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This decline appears to be a true improvement in the cost of serving each borrower, not just the result of expanding loan sizes.  We have no statistical way to quantify how much avoidable fat remains to be trimmed from MFI operating costs. Given the finding that the level of these costs is strongly related to the age of the MFI, it would be unrealistic not to expect substantial inefficiency at a time when most MFIs are relatively young and when most national microfinance markets are immature and noncompetitive. We are unaware of any evidence to suggest that MFIs in general are out of line with the normal evolution of efficiency for businesses in such markets. Profits  MFIs on average have higher returns on assets than commercial banks do, but MFIs produce considerably lower returns on equity for their owners. The average return on MFI owners’ equity in 2006 was moderate – 12.3 percent, compared with 17.7 percent for banks. The very high profits that have drawn so much attention to Compartamos are outliers, not at all typical of the industry.  At the same time, the most profitable 10 percent of the worldwide microcredit portfolio produced returns on equity above 34 percent in 2006, a level that is no doubt high enough to raise concerns about appropriateness for some observers. Much of this profit is captured by NGOs and never reaches private pockets. But some of it does go to private investors. A judgment about whether such profits are ‘‘abusive’’ would depend not only on the observer’s standard for what is a reasonable profit but also on investigation of individual MFI circumstances, including the risk levels faced by investors when they committed their funds.  The burgeoning volume of money passing through international microfinance investment funds is coming mainly from investors who are not willing to accept higher risks or lower returns for the sake of social objectives. Yet, the profits generated by these funds seem unimpressive so far.  Profits of sustainable MFIs, measured as a percentage of loan portfolio, have been dropping by about one-tenth (0.6 percentage points) per year since 2003.  Profits are not a predominant driver of interest rates. For the median MFI, the extreme and unrealistic scenario of complete elimination of all profit would cause its interest rate to drop by only about one-sixth. Such an interest reduction would not be insignificant, but it would still leave

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microcredit rates at levels that might look abusive to politicians and the public, neither of whom usually understand the high costs that tiny lending inevitably entails. Competition  One cannot assume that competition will always lower interest rates. Interest rates appear to have dropped in the markets where microcredit has already become competitive, except for Bangladesh. But it is still too early to make any robust prediction about how universal the lowerinterest-rates-through-competition scenario will be.  Whatever the role that competition plays, the important fact is that interest rates, profits, and administrative costs have shown a marked downward trend in recent years. How all this information is put together is up to each reader. We approach the issue from a development perspective, where the main concern is not financial results but rather client benefit – including, of course, those future clients who will get access to financial services as new investment expands the outreach of MFIs. A few MFIs have charged their borrowers interest rates that may be considerably higher than what would make sense from this perspective. Indeed, it would be astonishing if this were not the case, given the diversity of the industry and the scarcity of competitive markets. The real question is whether unreasonable MFI lending rates are more than occasional exceptions. We do not find evidence suggesting any widespread pattern of borrower exploitation by abusive MFI interest rates. We do find strong empirical support for the proposition that operating costs are much higher for tiny microloans than for normal bank loans, and therefore, sustainable interest rates for microloans have to be significantly higher than normal bank interest rates. We are encouraged by the rapid decline in interest rates, operating costs, and profits in recent years, and we would expect this trend to continue in the medium-term future.

NOTES 1. The term ‘‘microfinance’’ usually refers to the provision of financial services to poor and low-income clients who have little or no access to February 2009 conventional banks. The term is often used in a more specific sense, referring to institutions that use new techniques developed over the past 30 years to deliver microcredit – tiny loans – to informal microentrepreneurs. The range of services can include not only microcredit but also savings, insurance, and money transfers.

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This chapter focuses on interest rates charged on microcredit; it does not address other microfinance services. 2. Among borrowers who have loans from nongovernmental organizations and private MFIs, a majority are served by financially sustainable institutions (Gonzalez & Rosenberg, 2006). 3. On the contrary, some defenders of Compartamos argue that its example – including its high profits – have benefited potential borrowers by supercharging the expansion of microcredit services in Mexico. 4. Our definition of ‘‘microfinance institution’’ here is somewhat circular: an institution that describes itself as providing ‘‘microfinance.’’ Almost all of these institutions make use of the new microcredit methods that have been developed in the past 30 years. It is important to recognize that poor and low-income clients get financial services from many other institutions that usually do not describe themselves and are not described by others, as doing microfinance. See Christen, Rosenberg, and Jayadeva (2004). 5. In the rest of the chapter, the term ‘‘MIX MFIs’’ includes those MFIs that report to MBB, MIX Market, or both. 6. MFIs were classified as sustainable if their adjusted return on assets, or their unadjusted return when adjusted return was not available, was positive. 7. Includes all countries with three or more MFIs reporting. 8. The chapter is based on MIX data through 2006, updated as of April 2008. MIX data for 2007 became available in October 2008, too late for inclusion in this chapter. 9. Weighted averages will be familiar to most readers, but perhaps not weighted distributions. The concept is that all MFIs are spread out along a line, in order of their interest yield (for example). In a normal unweighted distribution, each MFI occupies the same amount of space along the line, regardless of the MFI’s size. In a weighted distribution, each MFI occupies a space proportional to the size of its loan portfolio (for instance). Once this line is assembled, the median is a point halfway along its distance, and the 90th percentile (for instance) is a point one-tenth below the high end of the line. 10. Some MFIs offer multiple loan products that may entail varying levels of cost and profit. The interest yield calculated by MIX in such cases represents combined interest and fee income divided by the combined portfolio. 11. When the interest yields of the individual MFIs are weighted by number of borrowers, the median is 28.7 percent. The average yield weighted by GLP is 28.4 percent. 12. The data permitted comparison of microlending rates to at least one form of alternative credit in 36 countries: Cambodia, Indonesia, the Philippines, and Thailand (EAP); Armenia, Bosnia and Herzegovina, Kyrgyzstan, Mongolia, Romania, Serbia/ Montenegro, Tajikistan, and Uzbekistan (EECA); Bolivia, Colombia, Ecuador, Mexico, Peru, and Nicaragua (LAC); Morocco, Jordan, and Egypt (MENA); Nepal, Bangladesh, Sri Lanka, India, and Pakistan (SA); and Cameroon, Congo, Ghana, Ethiopia, Kenya, Madagascar, Senegal, Tanzania, Togo, and Zambia (SSA). 13. Some of the consumer credit rates reported to us may be lower than the true effective cost of the loans once payment timing and fees – especially annual fees – are factored in. The rates used for MFIs are actual interest yield on portfolio, which is a

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more reliable index of actual cash cost to the client. None of the rates we analyzed includes clients’ transaction costs such as time or travel. 14. Grace (2007) reports 2006 data from 11 Ecuadoran credit unions that are affiliated with the World Council of Credit Unions. Average per capita income of members was in the bottom quartile of the national distribution. One-third of the loans was identified as microenterprise loan. Loan balances below $1,000 accounted for only 7.7 percent of the outstanding loan portfolio, but 36.1 percent of the number of active borrowers. 15. If interest yield is calculated individually for each MFI and then weighted by number of borrowers, the 2003 worldwide average was 33.0 percent, dropping an average of 1.2 percent a year to 29.3 percent in 2006. 16. Calculated from International Financial Statistics (IMF). 17. ‘‘Operating expense’’ is the term used by MIX to describe personnel and administrative costs, such as salaries, depreciation, and maintenance. 18. The full formula is Income from loans þ Other income ¼ Cost of funds þ Loanloss expense þ Operating expense þ Tax þ Profit We want to look at costs and profit as percentages of loan portfolio, but taxes and other income do not relate directly to the portfolio. In addition, the current MIX reporting structure does not allow us to derive taxes and other income as separate items: we can calculate them only as a single net figure (i.e., other income – taxes). To solve these problems for the purposes of Fig. 6, below, we have netted out taxes against other income on the left-hand side of the equation, leaving us with the formula as follows: Income from loans þ ðOther income-TaxesÞ ¼ Cost of funds þ Loan loss expense þ Operating expense þ Profit 19. Commercial bank computation by Christoph Kneiding based on the most recent BankScope data for countries that have MFIs reporting to MIX, weighted by liabilities. 20. The 2006 distribution of loan losses, weighted by GLP, was Region

5 percent

25 percent

Median

75 percent

95 percent

Africa EAP EECA LAC MENA SA World

0.3 0.1 0.3 0.8 0.0 0.0 0.2

0.7 0.9 0.8 1.2 0.2 0.4 0.9

2.3 0.9 1.6 2.2 1.8 1.7 1.6

3.9 0.9 2.0 3.6 1.8 2.4 2.7

22.4 1.1 2.7 10.0 2.0 2.7 5.7

21. This chapter’s version of the operating expense ratio (operating expense/GLP) is different from the one used by MIX (operating expense/total assets).

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22. Some observers interpret growth in average loan sizes as a sign of ‘‘mission drift’’ away from poor clients, but it is far from clear how often this is valid. The link between loan size and client poverty is only a very rough one at best. Most MFIs have a sequential ladder of loan sizes for clients, and the very small loans at the beginning of that ladder often reflect the MFI’s risk management policy rather than the actual needs or repayment capacity of the borrowers. When borrowers move into later and larger loans, or when the MFI relaxes its size limits on initial loans, the MFI’s average loan size will climb even if there has been no change in the kind of client it is serving. And even where the MFI is adding better off clients (i.e., small business operators) as it grows, that does not necessarily mean restricting service for poorer customers. A much more reliable way to judge mission drift is to look at the character of the villages, towns, and neighborhoods where the MFI is opening its new branches. 23. Including the unprofitable MFIs here does not affect the results as much as one might think. Over half of MIX MFIs are unprofitable, but they account for only about a fifth of the world loan portfolio or world assets, which reduces their influence in an average or distribution that is weighted by those variables. 24. The 127 percent figure here represents not the most profitable 5 percent of the MFIs in South Asia but rather the most profitable 5 percent of the loan portfolios in South Asia. The large losses in the lower percentiles for EAP are driven by a single huge government MFI – the Vietnam Bank for Social Policies. 25. Return on average equity for 2006 was 26.1 percent at ASA, 23.3 percent at BRAC, and 22.2 percent at Grameen. Return on average assets was 14.4 percent for ASA, 6.9 percent for BRAC, and 2.4 percent for the more heavily leveraged Grameen (MIX Market data). ASA and BRAC are launching major efforts to move into other countries, and we speculate that they are probably using their profits to finance this major expansion of services. 26. According to unweighted MIX data, median MFI interest rates in Cambodia dropped from 42 percent in 2003 to 32 percent in 2006.

REFERENCES Adams, D., Graham, D., & Von Pischke, J. D. (1984). Undermining rural development with cheap credit. Boulder, CO: Westview Press. Ausubel, L. (1991). The failure of competition in credit card markets. American Economic Review, 81(1), 50–81. Bertrand, M., Karlan, S., Mullainathan, S., Shafir, E., & Zinman, J. (2005). What’s psychology worth? A field experiment in the consumer credit market. Yale University Economic Growth Center. Discussion paper no. 918. New Haven, CT: Yale University Press. Calem, P. S., & Mester, L. J. (1995). Consumer behavior and the stickiness of credit-card interest rates. American Economic Review, 85(5), 1327–1336. Christen, R., Rosenberg, R., & Jayadeva, V. (2004). Financial institutions with a ‘double bottom line’: Implications for the future of microfinance. Occasional Paper 8, July. CGAP, Washington, DC. Cuevas, C. E. (1989). Loan transactions and borrowing costs in developing countries. American Journal of Agricultural Economics, 71, 1356.

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Dehejia, R., Montgomery, H., & Morduch, J. (2005). Do interest rates matter? Credit demand in the Dhaka slums. Financial access initiative. New York: NYU Wagner Graduate School. Gonzalez, A. (2007a). Efficiency drivers of microfinance Institutions (MFIs): The case of operating expenses. MicroBanking Bulletin, No. 15. MIX, Washington, DC. Gonzalez, A. (2007b). Resilience of microfinance institutions to local macroeconomic events: An econometric analysis of MFIs asset quality. MIX Discussion Paper 1, July. MIX, Washington, DC. Gonzalez, A., & Rosenberg, R. (2006). The state of microcredit – Outreach, profitability, and poverty findings from a database of 2600 microfinance institutions. Presentation at World Bank Conference, Access to Finance, May 30. Gonzalez-Vega, C., & Villafani-Ibarnegaray, M. (2007). Las Microfinanzas en la Profundizacio´n del Sistema Financiero: El caso de Bolivia. El Trimestre Economico, 74(1), 5–65. Grace, D. (2007). Middle is not a four-letter word. MicroBanking Bulletin, 14(Spring), 3. Karlan, D., & Zinman, J. (2007). Observing unobservables: Identifying information asymmetries with a consumer credit field experiment. Yale University Economic Growth Center Working Paper 911. Yale University Press, New Haven, CT. Meyer, R. L., & Cuevas, C. E. (1992). Reduction of transaction costs of financial intermediation: Theory and innovations. In savings and credit for development. Report of the International Conference on Savings and Credit for Development, Klarskovgard, Denmark, 28–31 May, 1990. United Nations, New York. Porteous, D. (2006). Competition and microcredit interest rates. Focus note 33. Washington, DC: CGAP. Robinson, M. (2001). The microfinance revolution (Vol. 1). Washington, DC: World Bank. Rosenberg, R. (2007). CGAP reflections on the compartamos initial public offering: A case study on microfinance interest rates and profits. Focus note 42, June. CGAP, Washington, DC. Stephens, B. (2007). Commercialization continues apace. MicroBanking Bulletin (Spring), 35. Tran, D. (1998). Borrower transaction cost, credit rationing, and segmented market: A study in the rural credit market in Vietnam. Canberra, Australia: National Center for Development Studies, Australia National University. Wright, D., & Alamgir, D. (2004). Microcredit interest rates in Bangladesh: Capping v. competition. Unpublished. Available at http://www.microfinancegateway.org/p/site/m// template.rc/1.9.25138/31.pdf

MICROFINANCE DURING CONFLICT: IRAQ, 2003–2007 Frank R. Gunter Microfinance is not a conflict resolution tool. (Izdihar, 2007b, Section 2.3) The good news is that microfinance has indeed worked in many post-conflict settings. (USAID, 2001, p. 2, Brief 1) In December 2007, the first two loans from Fallujah branch of the Al-Takadum microfinance institution (MFI) were made. One was for home improvement and the other for a clothing shop—total $4,000. In November 2007, the first microfinance loan was made in Salah ad Din for $3,000 to purchase inventory for electrical components shop. In September 2007, the first microfinance loan was made in Al-Qaim. It was for $2,000 to the owner of a mobile phone shop. (Izdihar, 2007d)

1. INTRODUCTION The Government of Iraq (GoI) and the U.S.-led coalition in Iraq have used microfinance institutions (MFIs) as part of their counterinsurgency campaign. This raises several questions. What role can MFIs play in counterinsurgency? Are the economic or civilian and military motivations for supporting microfinance convergent or divergent? What constraints does conflict impose on microfinance borrowers, lenders, and institutions and how can an MFI ameliorate these constraints? Analyzing these issues is the core of this chapter. Moving Beyond Storytelling: Emerging Research in Microfinance Contemporary Studies in Economic and Financial Analysis, Volume 92, 183–214 Copyright r 2009 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1569-3759/doi:10.1108/S1569-3759(2009)0000092009

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To set the framework for this discussion of Iraq MFI, this chapter begins with a short discussion of the research on MFI during conflict. This is followed by an overview of the four major political, cultural, and social environmental issues that impact MFIs in Iraq in Section 3. These include the Iraqi macro economy, violence, corruption, and the banking system. In Section 4, an overview of the seven MFIs operating in Iraq at the end of 2007 and the MFI regulatory environment is given. Then, in Section 5, the chapter focuses on a discussion of microfinance and counterinsurgency. The final section, Section 6, discusses Islamic microfinance, banks as competitors and allies, and the credit culture in Iraq. Although microfinance in Iraq is less than five years old and is operating in an extremely challenging environment, it has had some notable successes. Among the few studies of the Iraqi microfinance experience, Desai (2007) examines the three critical requirements for successful microfinance in a post-conflict economy. Izdihar (2007b) provides an excellent detailed analysis of microfinance strategy in Iraq. Both of these works provide valuable insights although their treatment of MFI and counterinsurgency is limited.

2. MICROFINANCE DURING CONFLICT: LESSONS LEARNED Iraq is not the only nation attempting to establish a sustainable microfinance system during conflict. While the situations in Bosnia and Herzegovina, Cambodia, the Palestinian West Bank and Gaza, Sierra Leone, and the Sudan are not the same as that of Iraq, there appear to be some common challenges and, possibly, common lessons learned that may provide policy guidance for Iraq (Bruett, Norell, & Stephens, 2004). Desai (2007, pp. 4–5) and USAID (2001, Brief 5) note three commonsense differences between microfinance in a post-conflict (and conflict) environment and similar operations in a peaceful society. ‘‘First, post-conflict MFIs are faced with major human resource limitations.’’ ‘‘Second, MFIs must engage in extensive education and advocacy efforts when working in post-conflict economies.’’ ‘‘Third, security considerations affect post-conflict MFIs by limiting operations and raising costs.’’ As will be discussed below, each of these is true in Iraq. These characteristics of MFIs in a conflict environment require different MFI procedures that might be expressed as lessons learned.

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What are the lessons learned from study of MFIs during conflict? Bruett et al. (2004) identify 10 conditions, which are discussed in the following. (1) Focus on the clients’ security and (2) Work with trusted institution. Clients’ security must be paramount and any service that they perceive to increase their security will be in demand. In Cambodia, MFIs were able to build trust by simply providing their clients with a secure place to put their funds (Bruett et al., 2004). Trusted institutions not only vary among nations and regions but also tend to change over time. It is likely that government officials and organizations are not trusted by the client population, and an effort may be necessary to distance the MFIs from these authorities. In Iraq, the MFIs established by the international nongovernmental organization (NGO) seek to distance themselves from both the GoI and the U.S.-led coalition. (3) Provide a range of services and (4) Separate microfinance from relief operations. Providing a range of services in a conflict or post-conflict situation is often necessary to fill the gaps that otherwise would prevent a successful credit transaction. These additional services need not be altruistic. Meeting clients’ non-credit and savings needs may increase the chances of achieving microfinance sustainability (Meissner, 2005). For example, a potential small business borrower may need not only short-term finance but also guidance on accounting methods and help in identifying customers. It might be possible for an MFI to form a partnership with other NGOs or agencies to provide a range of desired services. However, it is important to psychologically (and maybe physically) separate MFIs from relief operations. Otherwise, MFIs run the risk of confusing the client about the nature of the credit and savings transactions that are generally the core of the MFI mission. If a client is offered a menu of services, including several that are free or heavily subsidized, then the client may believe that a credit transaction is really a grant. (5) Adjust product design and delivery MFI products must be adjusted to meet local conditions that may include displaced persons, damaged infrastructure, dangerous travel, and the strong possibility that collateral may be stolen or destroyed (Bruett et al., 2004). As a result, cookbook MFI products and procedures are unlikely to succeed. This reality further increases the need for a local MFI staff person who can carefully analyze local situations combined with an incentive system that encourages that staff person to develop creative responses.

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(6) Share, cooperate, and collaborate with stakeholders Successful MFIs during conflict require a careful balance between two contrary requirements. To increase the probability of achieving sustainability for the MFIs in the chaotic circumstances of a nation in conflict, it is important to share detailed information with other MFIs, NGOs, and local governments. These information flows should lead to a more accurate microfinance picture of the local business and political and security environment which, hopefully, will lead to higher quality decisions. And yet, sharing such information may increase the likelihood of a threat against MFI personnel or the institution itself. One or more of the stakeholders may use the shared information to seek bribes or even pass the information to criminal or insurgents. A more common although less severe problem with information sharing is that NGOs and local governments may have little knowledge of finance. These organizations may focus on their commonalities with MFIs, such as the disbursement of funds, rather than the key difference that MFIs expect the loans to be repaid. They are not grants. (7) Think long-term Thinking long-term is difficult in a conflict situation. Because of security costs and the chaos of conflict, it will take more time for an MFI to become established, grow to an efficient scale, and achieve sustainability. However, the governments and NGOs that regulate and often initially finance MFIs are seeking a rapid impact. There can be substantial pressure on MFIs to adopt inappropriate lending practices to make as many loans as possible quickly regardless of the impact on sustainability (Bruett et al., 2004). The solution is easy to state and difficult to achieve. There must be not only a clear understanding on the part of all parties of the role of microfinance and the requirements for long-term success but also a willingness to provide a short-term window for the MFIs to establish the foundation for success. As discussed below, this shortterm vs. long-term debate over the role of microfinance is crucial to understanding the evolution of MFIs in Iraq. (8) Develop human resources and ensure staff safety Staffing MFIs during conflict is complicated by the actions of both enemies and friends. As discussed below in the case of Iraq, it can be extremely difficult to hire and train an effective, honest MFI staff. There is always a concern that the insurgency will try to infiltrate MFIs. In addition, effective MFI personnel management can also be undermined by friendly NGOs and businesses. Once an MFI has vetted and trained supervisors or managers, it is likely that they will be hired by a NGO or

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business at a salary that the MFI cannot match. Or an international NGO will use an MFI that it has funded to provide temporary employment for its non-MFI personnel to smooth gaps between contracts or grants. (9) Ensure access to information and systems and (10) Maintain portfolio quality The final lessons learned discussed in the 2004 study of Bruett et al. are to ensure access to information and maintain portfolio quality. Unexpected security-related events can prevent individual MFI staff members from entering their offices or even returning to the town in which they were working. Clients may suffer the theft or loss of their productive assets. Surprisingly, if the loan records are preserved and can be accessed from outside the MFI office by a replacement loan officer, then the chance of repayment on schedule is quite good. The primary incentive for a client to repay a loan on schedule is not the possibility of legal sanctions but rather the opportunity of receiving further financing – possibly for a larger amount – in the future. As long as an MFI is believed to be in the business of making loans for the foreseeable future, even during conflict, clients will generally make a strenuous effort to meet the terms of the loan agreement. This is true even in a country like Iraq where the environment for microfinance is hostile.

3. ENVIRONMENT FOR MICROFINANCE The Microenterprise Best Practices study (USAID, 2001, Brief 4) listed three essential and three ‘‘preferred’’ conditions for successful post-conflict microfinance. The essential conditions are a certain degree of political stability, sufficient economic activity, and a stable client population. The authors of the Best Practices study argue that if one or more of these essential conditions are missing in a country, then microfinance should not be attempted. For the past five years, Iraq has lacked both the first and, as a result of a large internal and external refugee population, the third conditions. However, the question of whether Iraq should allow microfinance is academic since seven MFIs have already been established with at least two more on the way. Probably more interesting to this study are the ‘‘preferred’’ conditions, which are macroeconomic stability, social trust, and functioning commercial banks. Unfortunately, the excessive dependency of the economy on oil,

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violence, corruption, and the moribund banking system violate all three of the ‘‘preferred’’ conditions. While varying amounts of progress are being made in all four areas, none of these problems is going away in the foreseeable future.

3.1. Economy of Iraq Despite the insurgency, real economic growth in Iraq continues. The International Monetary Fund (IMF) estimates that after adjusting for inflation, gross domestic product (GDP) growth was expected to reach 7.1% in 2008, compared to 1.3% in 2007 and 6.2% in the previous year (IMF, 2008, Table 1). Because of the usual difficulties in measuring activity in the underground or informal economy, the 2008 estimate is probably a lower bound. There is a wide divergence in real growth rates among provinces. The Kurdish provinces experience the highest growth rates. Unemployment was still stuck in the 18–22% range although underemployment was much greater. These unemployment rates do reflect some progress since the first year after the invasion when unemployment was an estimated 25–30%. It is estimated that about half of all Iraqi employment is in the informal (underground) economy. Petroleum earnings increased sharply beginning in the last half of 2007 as a result of both higher world oil prices and rising export volume. From a low of 1.47 million barrels per day (mbpd) in June 2007, exports rose 31%, to 1.93 mbpd in December. This is important because the petroleum industry accounts for approximately two-thirds of the economy in Iraq and also 84% of government revenues (Brookings Institution, 2008). As a result of rising oil export earnings and the failure to spend more than half of the capital budget in previous years, Iraq now has more than $26 billion in reserves (IMF, 2008, Table 7). As a result, even after subtracting generous reserves for import coverage, the GoI controls a large amount that could be spent on reconstruction and economic development. Limited government managerial capacity – not a shortage of funds – is the current binding constraint on spending on economic development in general and infrastructure in particular. Iraq is in the midst of a messy transition from a socialist or statist economy to one that provides an important role for the market. One of the challenges currently faced by the market economy in Iraq is a rear guard action by the remnants of Saddam Hussein’s socialist experiments. The ministerial bureaucracies in Baghdad and their associated state-owned

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enterprises see their role as not simply providing regulation but also providing large-scale employment for favored regional political, sectarian, or ethnic groups. Many individuals in Iraq prefer government employment to entrepreneurship or working for a private firm because employment at oil-financed government agencies combines higher incomes with reduced work intensity. And high 2007–2008 oil prices have provided ministries with generous funding further weakening incentives for adopting modern, more efficient management procedures.

3.2. Violence Widespread violence continues to trouble attempts to grow the Iraqi economy. However, it is important to consider the pattern of violence. First, as has been widely reported, overall violence decreased sharply during the last year. During the first 11 months of 2007, insurgent attacks per day have decreased 39% while civilian casualties have decreased almost 80% (Brookings Institution, 2008). The most dramatic reduction occurred in Al Anbar province where attacks fell from 35 per day at the beginning of the year to about 5 per day in November 2007 (Brookings Institution, 2008). The second critical characteristic of the pattern of violence in Iraq is that it is very unevenly distributed among and within provinces. Measured as attacks per day per million residents, five provinces (An Najaf, As Sulaymaniyah, Arbil, Dahuk, and Maysan) have averaged zero attacks over the last year while another four provinces (Al Muthanna, Dhi Qar, Karbala, and Wasit) have averaged less than one a day. Even among the remaining nine more violent provinces of Iraq, insurgent violence is unevenly distributed within each province. One town suffers almost continual attacks while another less than 30 miles away is at peace. One conclusion is that it is simplistic to argue that since MFIs require security and Iraq is very dangerous, there is no role for microfinance in Iraq (Izdihar, 2007b, Section 2.2).

3.3. Corruption Iraq is not the most corrupt country on Earth. But according to the 2007 Transparency International Corruption Perceptions Index, Iraq is in second to last place of the 180 countries for which reliable corruption surveys were available (Transparency International, 2007).

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As stories of Iraqi corruption proliferate in the media, including a leaked U.S. Embassy corruption study, there is a greater awareness of the scale of corruption there. Corruption ranges from senior government bureaucrats in Baghdad accepting bribes of hundreds of millions of dollars to buy defective military equipment to flour agents in poor southern villages selling bushels of wheat intended as charity for poor families. While Iraq has a generationlong history of large-scale corruption, it has worsened since the 2003 invasion by the U.S.-led coalition. While corruption under Saddam was severe, it was also organized and, to an extent, predictable. Since Saddam’s fall, corruption has become entrepreneurial, resulting in a sharp increase in corruption-related uncertainty. It has reached the point where corruption is so pervasive that it may be a greater threat to the future of Iraq than the insurgency. Stuart Bowen, the Special Inspector General for Iraq Reconstruction, refers to corruption as Iraq’s ‘‘second insurgency.’’1 There is a symbiotic relationship between corruption and the insurgency. Corruption is good for the insurgency. Corrupt activities including official theft, extortion, and ghost workers provide funding for the insurgency. Organizations and trails used by smugglers provide secret routes and safe houses for insurgents and IED makings and provide part of the logistics tail for the insurgency. Finally, corruption undermines public confidence in both the GoI and the coalition. And the insurgency is good for corruption. The reality of terrorist attacks justifies bypassing procedures and provides a ready excuse for corruption-related losses. Fighting the insurgency increases the urgency of getting things done regardless of the cost, which facilitates bribes and extortion (Gunter, 2007). Less attention in the media has been paid to the question: Why is Iraq so corrupt? Researchers have identified some environmental or cultural characteristics that tend to be associated with higher levels of corruption and Iraq possesses many of them. Countries tend to show higher levels of corruption if they have an inhospitable climate, French or socialist legal system, Catholic or Muslim religion, high rates of cousin marriage, and corrupt neighbors (Svensson, 2005). All of these characteristics describe Iraq and little can be done about changing them. However, there are existing policies that facilitate corruption in Iraq that can be changed. The GoI has made limited efforts to fight corruption through better governance including attempts to prosecute the corrupt. These efforts have been undermined by the willingness of the various ministers, including Prime Minister Nuri al-Maliki, to block corruption investigations using Article 136B of the Criminal code. This Saddam era article requires investigators to get the permission of the minister of an agency before it can

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take any case involving that agency to court. Judge Rahdi Hamza al-Radhi, in his testimony to the U.S. Senate, stated that the use of Article 136B, as well as repeated threats and acts of violence against corruption investigators, have stalled most high-level anti-corruption investigations in Iraq (al-Rahdi, 2007). While al-Rahdi’s and other recent reports emphasize failures to successfully investigate and prosecute corruption, some progress has been made in reducing the economic incentives for corruption as well as mobilizing public anger at the corrupt through the media. Under pressure from the IMF, Saddam-era fuel subsidies have been sharply reduced. Previously, these subsidies not only ensured huge gains to those who had the influence to divert fuel supplies into the black market but also necessitated massive government-financed fuel imports (International Monetary Fund, 2007). Gasoline prices and other fuel prices are now roughly in line with those of Iraq’s neighbors, which has reduced the incentives for fuel smuggling and the associated bribes. Corruption continues but it is now somewhat harder to earn a dishonest dollar. Progress in eliminating other major subsidies, such as electricity, water, and food, is much slower. The extensive coverage of governmental successes and criticism of its missteps illustrates another favorable anti-corruption trend – the growth of a vibrant non-governmental media. While many of the media outlets are associated with various parties or sectarian groups, biting cartoons, stories, and editorials against corruption are a common denominator. Studies of successful anti-corruption efforts reveal the importance of a free press in changing the culture of corruption (Brunetti & Weder, 2003). While reducing incentives for corruption and marshalling the power of a free press have weakened the corruption culture in Iraq, further progress requires improved governance as well as more effective anti-corruption law enforcement.

3.4. Banking Industry The public Iraqi banking system is moribund. As a result, almost all transactions in the Iraqi economy are in cash. Antiquated procedures combined with a lack of secure communications means that such common banking transactions as electronic funds transfers (EFT), payment by check, and the use of debit/credit cards are unavailable, expensive, or unreliable. It is estimated that while the Central Bank of Iraq (CBI) processed over two

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million transactions last year, it only successfully completed about 1,000 transactions on the new nationwide payment system (Izdihar, 2007c). As a result, businesses and individuals are forced to travel with large amounts of cash to pay suppliers, employees, and so on, with the associated risk and inconvenience. In fact, the Iraqi Army generally provides a few days leave to soldiers following each payday to allow some of them to drive hundreds of miles to transport cash to their families. The public banks are believed to have a negative net worth as a result of exploitation by Saddam Hussein who used these banks’ deposits as personal sources of ready cash for his family. In addition, public banks were forced to make loans to politically favored firms and institutions and then roll over these loans in lieu of repayment. The absence of reliable timely audited accounting information adds to the uncertainty of the current status of the Iraqi banking industry. Despite their inefficiencies, Iraqi banks receive a large inflow of deposits monthly for which the banks pay zero or low interest. The primary motivation for these deposits is the lack of other secure savings instruments. The bulk of these deposits are then re-lent to the CBI. Only a small proportion is lent to individuals or firms. The CBI provides strong incentives for such transactions since it pays a greater rate on 14-day deposits than the market rate (Izdihar, 2007c). There is little cash flow lending. Loans to individuals or firms are generally made only on real collateral such as real estate and generally at a multiple of the value of the loan. Loans may charge negative real interest rates to borrowers but, because of their access to low cost deposits, banks have a large positive interest margin. The loan process tends to be a long drawn out and very bureaucratic in part because a large percentage of all loans must be approved by the banks’ Board of Directors (Izdihar, 2007c). There is a widespread belief that obtaining a bank loan requires connections or a bribe. For all of these reasons, the Iraqi banking system rarely lends to smaller firms in the formal economy, and entities of any size in the informal economy are excluded entirely. Rafidain and Rasheed banks,2 the two state-owned banks, were once the leading financial institutions of the Middle East. They currently possess 94% of total bank assets and have a nationwide system of branches that includes most cities and large towns but generally excludes smaller towns and villages. These public banks are considered to be insolvent and grossly mismanaged. They both suffer from large-scale over-employment and are extremely bureaucratic.

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As of October 2006, there were 25 private banks with 23 actually in operation (Izdihar, 2007c). These private banks account for the remaining 6% of total banking assets. Most private bank lending has been for trade finance. These banks have 14 or fewer branches and are generally limited to major cities (Izdihar, 2007c). There are many large towns without any private bank branches. While it is difficult to obtain timely audited accounting statements, it is thought that about half of the private banks are insolvent. Most of the private banks’ management personnel are former employees of the Rafidain bank (Izdihar, 2007c). The quality of management varies widely. Eight international banks have licenses to operate in Iraq. Currently, most of these international banks are still researching the market and are seeking possible local banking partners. In addition to security, the binding constraint to a more rapid expansion of the international banking in Iraq is the difficulty of hiring quality local personnel. Of the international banks, HSBC is considered to be most advanced in its operations in Iraq. There are several significant challenges facing the Iraqi banking system. The CBI must begin to exercise supervisory responsibilities to enforce sound banking practices. There is a need for legislation to support diversification in the banking sector. Rafidain and Rasheed must be either re-capitalized or sold. And, as mentioned above, a secure modern communication system is needed to support EFT, checks, and debit/credit cards. Finally, a means must be found to encourage banks to make loans to small or medium enterprises (SMEs). One immediate method of encouraging banks to increase their loan/ asset ratio would be a sharp reduction in the rate paid by the CBI on bank deposits. Of course, this would have an impact on the nation’s inflation rate (El-Gamal, El-Megharbel, & Inanoglu, 2000). It should be noted that there are alternatives to both the banking system and the MFIs. Informal finance, including loans from traditional moneylenders, family, friends, tribal leaders, and suppliers, has always served as an important source of finance (Izdihar, 2007b, Section 2.1). As in most trading cultures, larger merchants often give credit to smaller ones, not as a distinct transaction but as part of a complex (especially to outsiders) business relationship. The fact that such credit transactions are part of more extensive relationships may explain why some borrowers prefer more expensive credit from their business partners than cheaper credit from MFIs or government-subsidized sources (Geertz, 1963). However, financing from these various sources cannot fulfill all credit requirements because they tend to be small scale, require intense family, social, or business connections, and are often expensive. There is also a concern that informal finance may involve criminal or insurgent groups.

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4. CURRENT STATUS OF MICROFINANCE 4.1. Overview Before the 2003 invasion, there were no MFIs in Iraq. SMEs had no role in the statist economic vision of the Ba’ath Party, a pan-Arab socialist party founded in Damascus in 1940 that governed Iraq. Since his capture of the GoI in July 1978, Saddam focused on over 200 state-owned enterprises subsidized by petroleum exports as a means of both managing the economy and rewarding his supporters. While the private economy never disappeared during the 25-years of Saddam’s rule, it existed in a legal vacuum and was starved for finance. Since the invasion, there has been a sharp increase in both the number and the variety of MFIs in Iraq. There are now seven MFIs, listed in Table 1, including three organized by international NGOs and four organized by indigenous NGOs. One might think that having fewer MFIs in Iraq would lead to significantly lower operating expenses. However, MFIs tend to reach their minimum efficient scale3 relatively quickly. A study of 1,003 MFIs in 84 countries revealed that while expanding to 2,000 borrowers per MFI did lead to an estimated 11% fall in operating expenses, any further increase in the number of borrowers had little impact on Table 1.

Iraqi Microfinance Institutions.

Established

Branches

Initial Funding USAID and CPA

CHF Internationala

July 2003

ACDI/VOCA (Al Thiqa) Relief International Al Aman Al Bashair

January 2004 July 2006

Baghdad, Al Basrah, Karbala’, An Najaf, Babil, Dhi Qar, Al Muthanna, Al Qadisiyah, and Wasit Baghdad, Al Ta’mim, Diyala, Arbil, and As Sulaymaniyah Maysan, As Sulaymaniyah, Wasit

July 2006 August 2006

At Ta’mim Baghdad and Al Anbar

Al Takadum

August 2007

Al Anbar

Salah ad Din

October 2007

Salah ad Din

a

Only MFI legally registered.

USAID and CPA USAID

USAID and MNC-I USAID and MNC-I USAID and MNC-I

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per-loan expenses (Gonzalez, 2007). At the end of 2007, the seven Iraqi MFIs currently had offices and were making loans in all 18 Iraqi provinces. The only prohibited loans are those to finance purchases of land, gold, and cars (Perry, 2008). From July 2003 when the first Iraqi MFI was established by CHF International until July 2007, a total of 52,768 loans have been made with a total value of $109,471,162. While this reflects a rapid rate of growth, it probably only meets a small fraction of the demand for SME finance in a nation of 28 million persons4 with a per-capita income (PPP) of approximately $3,600 (CIA, 2008). With respect to the types of MFI loans, an April 2007 study showed that approximately 78% were to small businesses, 20% for housing loans, and the remainder for agribusiness and other (Izdihar, 2007a). Almost all of the MFI loans in Iraq are individual loans rather than the solidarity or group lending that is more common in the worldwide MFI movement (Bruett et al., 2004). Individual loans are preferred because it is believed that they have a more immediate impact. As of July 2007, outstanding MFI loans totaled 19,019 representing a value of $26,765, 351. Average loan size was $1,407 – equal to about 72% of average per-capita income (Izdihar, 2007a). The Iraqi MFI average loan size is more than three times larger than that of the world average, which was approximately $456 in 2006 (Microfinance Information Exchange, 2007). And if the comparison is limited to MFIs in the Middle East and North Africa (MENA), then Iraq is even more of a statistical outlier. The median MENA MFI loan in 2006 was about $263 (Microfinance Information Exchange, 2007). One explanation of the difference in average loan size between Iraqi MFIs and those in the rest of the world has to do with the fact that MFIs serve two different clienteles. While the term microfinance refers ‘‘to the provision of financial services to low-income clients, including the self employed’’ (Ledgerwood, 1999, p. 1), the demand for MFI loans can be divided (in theory) between income smoothing and business finance. An example of the former would be a client taking out a loan to pay for a funeral with the intention of repaying this loan from his or her earnings. An example of the latter would be a one-man butcher shop taking out a loan to purchase a generator. Both types of loans may alleviate poverty and, in reality, it is sometimes difficult to determine whether a particular loan should be classified as income smoothing or business finance. In fact, even the lender may not be clear about the real purpose of a loan or the borrower may intend a single loan to serve both purposes.

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However, on average, business finance loans tend to be larger than income smoothing loans. And, as discussed below, there is a strong drive in Iraq to use MFI credit to reduce the unemployment among young men. This bias toward business finance rather than income smoothing tends to result in a larger average loan size. For reasons of both culture and policy, only 13% of the Iraqi MFI loans were to female clients. Studies in other countries show that female loan officers are usually better able to recruit female clients (Meissner, 2005). However, security concerns combined with the general prejudice against females in positions of responsibility (in the more religiously conservative regions of Iraq) result in relatively few Iraqi female loan officers. Since the average loans to females were smaller than those to males, loans to females accounted for about 10% of total value (Izdihar, 2007a). This is significantly less than world averages. In 2006, about two-thirds of all MFI loans worldwide were to women. And the ratio in MENA was even slightly higher (Microfinance Information Exchange, 2007). With the exception of agricultural entities, almost all of the borrowers from the Iraqi MFIs are in the informal (underground/black) economy. While it is difficult to evaluate the contradictory data on the size of the Iraqi informal economy, a rough estimate is that the informal economy accounts for one-third of the country’s GDP and about half of its employment. Because of the Baghdad bureaucracy’s complexity and hostility toward the private sector, it is difficult and expensive for an Iraqi entrepreneur to join the formal economy. Some of these difficulties are illustrated in Table 2 that compares some aspects of doing business in Iraq to the average of the Middle East nations and the nations of the OECD (World Bank, 2007). The fact that almost all of their clients are in the informal economy not only complicates the current operation of Iraqi MFIs but also has adverse implications for the future. It is expected that, as the insurgency recedes and security is gradually restored, the ministries will begin to enforce the employment, export, construction, regulations, and so on that are now often ignored. Some MFI customers will make the difficult transition to the formal economy, but it is expected that others will either go out of business or cut all contact with entities such as MFIs to reduce the possibility of regulation or taxation of their informal economy operations. How successful or effective are Iraq’s MFIs under these very difficult conditions? Obviously, this question has several dimensions. The question of whether the development of a nationwide MFI system has aided the

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Table 2. Difficulty of Doing Business. Iraq Start a business Employment rigidity Export approval Bankruptcy procedures

77 days 60 days 102 days No practice

ME Region 39 days 42 days 25 days 3.7 years

OECD 15 days 39 days 10 days 1.3 years

Source: World Bank (2007). Notes: ‘‘Start a business’’ refers to the time necessary to perform all of the procedures necessary to begin a new business including all licenses, permits, and official notifications. Furthermore, it is assumed that the entrepreneur knows all procedures. In Iraq, there are 11 separate procedures involved with starting a business. The estimated cost of meeting these requirements is roughly two-thirds of the average Iraqi annual income. ‘‘Employment rigidity’’ is an index of the difficulty of hiring new workers – zero represents a nation where there are no restrictions to hiring a new worker while 100 is a situation of maximum rigidity and difficulty in hiring. In Iraq, employers in the formal economy cannot use term contracts, are limited in assigning workers to night work, and must pay a minimum wage equal to a ratio of the firm’s average value added. ‘‘Export approval’’ refers to the time necessary to complete the necessary procedures to export legally a common manufactured product. It is assumed that contract and letter of credit are already arranged, the product is legal, and it does not require any special handling or approval. One reason why it takes more than three months to legally export an item from Iraq is that 10 separate documents are required that must be signed by multiple ministries in a specific order.

counterinsurgency efforts of the GoI and the U.S.-led coalition will be discussed in Section 5. Have MFIs contributed to the reduction of poverty or accelerated economic development in Iraq? Because of the youth and relatively small scale of MFI lending, it is too early to answer this question definitively. However, initial results are encouraging. One possible way of measuring MFI success is the number of direct and indirect jobs created as the result of microfinance loans. Of course, to estimate such job creation, one must first clearly define which jobs should be counted. For example, an MFI loan to a mechanic to purchase tools may allow him to open his own auto repair shop and hire two assistants. The existence of this auto repair shop in a town may make it easier and cheaper for other small businesses to maintain their vehicles, leading possibly to a further expansion of employment. How much of this expansion of employment should be credited to the microfinance loan? Pessimists would argue that the job creation may be zero if the mechanic and his workers were already employed (even if underemployed) before the loan. In this case, there may have been a reduction in underemployment but not of unemployment.5 Taking a relatively restrictive

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view of employment creation that only counts the direct job creation (only the mechanic in the example), data suggest that approximately one permanent job was created by each MFI loan in Iraq (PSD-IRMO, 2006). While this is over 50,000 directly created jobs since 2003, one might argue that this is a small accomplishment in a country of 26–28 million persons suffering 18–22% unemployment. Another measure of success is how close the Iraqi MFIs are to sustainability. As of April 2007, an estimated 95.6% of the outstanding MFI loans were being repaid on schedule. Possibly, this number is biased upwards because five of the Iraqi MFIs have only recently started making loans. Relief International, Al Aman, and Al Bashair MFI opened in 2006 while Al Takaduma and Salah ad Din made their first loans in 2007. For these MFIs, it may be early for defaults to appear. On the contrary, there has been a slight decrease in delayed loan repayments (Portfolio at Risk (PAR)) from 5.4% PAR over 30 days in November 2006 to 4.4% in April 2007 (Izdihar, 2007a).6 While the Iraqi experience is worse than the MFI worldwide average PAR over 30 days of 2.8%, it is within the regional range of 1.2% (Europe and Central Asia) to 5.0% (Africa) (Microfinance Information Exchange, 2007). Whether any of the MFIs will be able to achieve and maintain long-term sustainability will also depend on expected changes in the regulatory environment.

4.2. MFI Regulatory Environment One of the challenges that continues to face MFIs in Iraq is a confusing and contradictory regulatory environment. The MFI regulatory confusion is only partially a result of the difficulties of constructing a new financial structure following the collapse of Saddam Hussein’s socialist fantasy. It also reflects the opposition of the public banking system to the development of alternative means of SME finance. Despite their current small size, MFIs are seen as a future competitive threat to the public banks, and these banks apparently use their influence with the Baghdad bureaucracy to either restrict the scope of MFI enabling legislation or render it contradictory and incomplete. Under current law, three organizations have overlapping MFI regulatory responsibilities: the CBI under the CBI law, the Ministry of Trade under the Saddam-era Company law, and the NGO Assistance Office under the post-invasion CPA-era NGO law.

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With respect to the MFI, the CBI is governed by Article 4(2) of the CBI Law that states that the CBI may take ‘‘whatever action is deems necessary to y regulate and supervise lending companies, microfinance companies and any other non-bank financial institutions not otherwise regulated under Iraqi law.’’ However, Article 3(6) of the CBI Law provides that ‘‘activities performed pursuant to micro and small business credit access or similar grant programs by entities other than banks shall be permitted as authorized by entities exercising governmental authority.’’ One interpretation of these contradictory statements is that MFIs are exempt from the licensing supervision, regulation, and other provisions of the Banking Law (Izdihar, 2007c). The Ministry of Trade which is one of the entities ‘‘exercising governmental authority’’ as stated by Article 3(6) of the CBI law is currently the place where for-profit MFIs will register under the Saddam-era Company Law No. 21 of 1997. The efficiency of this registration process is unknown since no for-profit MFI has attempted to register. As a side note, the Ministry of Trade is considered to be one of the more corrupt ministries in the Iraq government. Non-profit MFIs are expected to register with the NGO Assistance Office – another entity ‘‘exercising governmental authority.’’ The authority for the Assistance Office is CPA Order No. 45, on NGOs. Both international and indigenous MFIs have found it difficult and expensive to register with and operate under the guidance of the NGO Assistance Office. As an example of its accessibility, the NGO Assistance Office actually closed its office from June through September 2006. And not only did this office refuse requests to register MFIs during this period but it also refused to hear requests for guidance on acceptable procedures (USAID, 2007). As of the end of 2007, only one international NGO has successfully registered an MFI, CHF International (Izdihar, 2007d). Other conflict or post-conflict countries have struggled with the problem of non-existent or contradictory MFI regulation. Based on their experiences, the lack of a clear MFI regulatory framework in Iraq, while frustrating, may be a second best solution. Tunisia is an example of policy makers making an awkward system worse by imposing a completely inappropriate system of MFI regulations.7 On the contrary, Cambodia gradually transitioned from regulatory laissez-faire in the beginning to a rational set of MFI regulatory controls (Desai, 2007). Hopefully, Iraq will follow a similar path and avoid the bureaucratic temptation to strangle MFI with inappropriate regulations.

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5. MICROFINANCE ISSUES 5.1. Microfinance and Counterinsurgency Desai (2007, p. 3) and USAID (2001, Brief 5) characterize post-conflict microfinance as follows: ‘‘embodies the creation of permanent institutions that will provide on-going financial services to an ever-widening clientele and that will remain in operation past the crisis period to become part of the long-term economic development strategy of the country.’’ This definition appears to be too narrow, at least with respect to MFIs in Iraq. What is missing is the encouragement of microfinance by the GoI and the U.S.-led coalition as not just a means to decrease poverty and raise living standards but also as a tool to undermine the insurgency. In a series of studies of MFIs during conflict, the USAID has determined three necessary preconditions for successful microfinance. First, there must be a degree of political stability. The population in the area must have a reasonable degree of confidence in their personal safety and security as well as the security of their transactions with the MFIs. Second, there must be sufficient economic activity to create demand for credit. If a region is a battlefield where persons focus solely on survival, there may be great need and privation but little scope for MFI loans. Finally, a stable client population is required. If the population is composed mainly of displaced persons that expect to have to flee again with little notice, then developing the necessary credit culture will be almost impossible. Many will be eager to borrow to meet their desperate needs but with little honest intention to repay. The government and other counterinsurgency forces take a somewhat similar view, but the apparent agreement conceals a fundamental difference in the perceived goal of microfinance. According to the ‘‘new’’ view of counterinsurgency, restoration of essential services and facilitating economic development are key elements of successful counterinsurgency.8 If the population has access to essential services and benefits from economic development, then they will be more willing to support the government and counterinsurgency forces and less willing to provide material support to an insurgency. Of course, as Iraq exemplifies, the insurgency will attempt to prevent any shift of loyalty to the government by attempting to destroy essential services and block efforts to accelerate economic development. Along with combat operations, the 2007 U.S. Government Counterinsurgency Field Manual ranks restoring essential services and economic development as critical logical lines of operations (LLO) in counterinsurgency

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operations.9 Essential services include police, fire protection, water, electricity, schools, transportation networks, medical availability, sanitation, food supply, fuels, and basic financial services. Economic development is not directly defined in the Counterinsurgency Manual but, from the context in which it is used, economic development activities are those that will lead to a robust improvement in the population’s living standards. Examples of these activities are job creation, local investment, clarifying property ownership and conflict resolution, protecting property rights, market creation, vocational training, and more advanced financial services. Microfinance would generally be included in the economic development LLO (Counterinsurgency Field Manual, 2007). One critical difference between efforts to restore essential services and achieve economic development in counterinsurgency is sequencing. According to the Counterinsurgency Manual, restoration of essential services must begin immediately regardless of the security situation in the country. In fact, restoration of essential services is stated to be a key component of any successful counterinsurgency operation. On the contrary, economic development efforts must wait until security is essentially restored. This seems to be an area of agreement between the civilian and the military views of microfinance as one means of accelerating economic development – both believe that a degree of security is necessary for microfinance to succeed. However, the agreement is more apparent than real. The international and some of the indigenous NGOs are focused on microfinance as a means of reducing poverty and accelerating economic development on a sustainable basis. However, the GoI and the U.S.-led coalition seem to view microfinance primarily as a counterinsurgency tool. If it helps defeat the insurgency, then it is a good thing, and if it reduces poverty and accelerates economic development, then that is a bonus. One might say that the civilian NGOs see developing a sustainable MFI as a means to the end of a better life for the Iraqi people while the military sees microfinance, sustainable or not, as a means to the end of defeating the insurgency. There are no military MFIs in Iraq. However, much of the seed money for MFIs has come either from the GoI or from the civilian organizations associated with coalition members such as USAID. Since these civilian organizations have as one of their more important goals the support of military in its counterinsurgency efforts, the military voice will be heard. Of course, some in the military think that voice is so faint that it is easily ignored while some of the civilians think that the military voice is so loud that it dominates all debate! Table 3 gives a possibly exaggerated summary of the differences between the different views of MFIs during conflict.

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Table 3. Civilian View of MFIs Requires secure environment Key goal – Poverty reduction Bias lending toward women, refugees, and so on Long-term institutional goal: Sustainability Open affiliation with coalition is dangerous

Civilian-Military Divergence. Military View of MFIs Willing to accept risk of non-secure environment Key goal – Create quality jobs Bias lending toward young men to reduce support for the insurgency Long-term institutional goal: Transition Affiliation to increase support for the coalition

The first entry in Table 3 reflects the different attitudes toward security. Of course, there is more than differing goals at work. The complexity of the situation on the ground often makes it difficult to tell whether security has reached acceptable levels or not. As mentioned above, not only is there wide divergence of violence among the 18 provinces but also there are substantial differences in perceived security within each province. Thus, whether and to what degree to pursue economic development through microfinance in any except the most peaceful provinces is a difficult judgment call. If MFI operations begin too soon, then disrupting them may put MFI staff at risk as well as provide propaganda victories for the insurgency. On the contrary, if there is a delay in economic development too long, one misses the opportunity to undermine the insurgency by building public support more rapidly for the government. The difference in the goal of MFI lending is important. ‘‘Microfinance is not a conflict resolution tool’’ is the conclusion of one study (Izdihar, 2007b, Section 2.3; see also Meissner, 2005). However, even if microfinance is not an efficient method of directly resolving conflict, there can be some indirect benefits. An MFI that makes a serious effort to avoid discriminating along sectarian or political lines may increase the perception of basic fairness in society. Also to the extent that MFI loans facilitate trade and production, they may bring together various groups in business relationships that reduce the likelihood of continuing conflict. However, the dominant view among international NGOs is that microfinance works best for poverty reduction, not conflict resolution. However, the GoI and the U.S.-led coalition have a different perspective. Unemployed men are not only unable to contribute to the care of their families but also, in Arabic culture, lose some of their manhood. Such men, who feel shamed in the eyes of their neighbors, are ideal recruits for the

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insurgency. Therefore, if MFI loans can directly or indirectly create good jobs for unemployed young men in Iraq, then it will reduce the pool of potential recruits for the insurgency. A related issue is the belief that by providing loans to young men in rural areas, microfinance can encourage these men to remain in their villages and reduce migration into urban areas that are recruiting grounds for the insurgency (Desai, 2007). This leads to the next divergence between the civilian and the military views of the proper role of MFIs. The international NGOs see MFIs as a way of reducing poverty by empowering groups such as women that are often excluded from traditional bank lending. The military would prefer a direct focus on providing loans to young men, even former combatants, and loans that strengthen the coalition’s status in areas that are important in the counterinsurgency effort. Accepting former combatants as microfinance clients is controversial. They need help in reentering civilian society, and an MFI loan to establish a small business may provide a dignified opportunity. While some MFIs especially target former combatants for loans, a few commentators argue that the best way to aid reentry is to treat former combatants the same as other clients (Meissner, 2005). Another view is that, based on their previous activities, former combatants are very poor loan risks. They lack the skills needed to succeed even in a small business and tend to view any loan as an entitlement rather than a credit commitment (USAID, 2001, Brief 7). In addition, there is sometimes a concern that the combatant is still secretly engaged in the conflict or expects to return to the conflict in the future. The long-term institutional goals are also different. Most MFIs, especially those associated with the international NGOs, seek sustainability – ‘‘generating enough revenue to cover the costs of providing financial services’’ (Ledgerwood, 1999, p. 34). This requires not only charging an interest rate that covers the cost of funds but also the overhead costs of operating the MFI in a steady state. None of the MFIs in Iraq has reached sustainability. The interest charged does cover the cost of funds, but the large expenses involved in dealing with the lack of security as well as expanding the MFI networks, especially the cost of hiring and training quality employees, have to a great extent been paid for with one-time grants. The military goal is different. They seek not sustainability but transition. If a reasonable degree of success in counterinsurgency can be achieved, then the coalition will seek to transfer completely the financial and other responsibilities for MFIs to international NGOs, indigenous NGOs, or to the GoI. In a dangerous environment like many parts of Iraq, there is a serious concern with safeguarding its employees, the most valuable asset of the

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MFI. To the MFI, open association with the GoI or the coalition is dangerous. Such association makes the employees of MFIs targets for terrorist attacks from the insurgency. This is not just because these employees represent MFIs. In a chaotic conflict situation, anyone who becomes prominent in a community for whatever reason is suspected of supporting one or more of the warring parties. And there is often a tendency for the insurgency or others to reason: ‘‘He is not our man therefore he must be with the opposition.’’ This reaction is not unique to Iraq. For example, MFI personnel along with other community leaders in Guatemala were harassed or denounced (Meissner, 2005). On the contrary, MFIs in Iraq often need the direct support of GoI or U.S.-led coalition forces to establish and maintain their lending program. In Iraq, such support has taken several forms. The U.S. military may provide helicopter transportation for some MFI personnel in areas where road travel is too dangerous. Some MFIs may initially operate from areas specially secured by GoI or coalition forces. But except where absolutely necessary, open association with the GoI and coalition is generally avoided by MFIs. This rational decision frustrates the GoI and the coalition since keeping the MFI at an arm’s length reduces the ability to get the message across that the GoI and the coalition are trying to accelerate economic development and increase living standards of the Iraqi people. In a few cases, people in towns seem to believe that the insurgent forces are the ones doing good things. A local leader of an insurgent-related group may aid an MFI loan agent or branch by providing local contacts and a degree of security. In addition, the leader will direct his family, friends, and supporters to the MFI loan agent or branch. Those who receive loans are then apt to credit the local leader for his help rather than the GoI or the coalition.

5.2. Dealing with Risk As discussed above, like all nations in conflict, Iraq suffers from political instability and a large refugee population. Experienced MFI personnel associated with international NGOs tend to be cautious about working in conflict areas. Unlike military or relief professionals, long-term MFI personnel are generally neither trained nor psychologically prepared for working in a conflict environment. As a result, ‘‘microfinance programs in post-conflict environments are often dominated by those with the least experience in microfinance and with few links to the technical expertise they need’’ (USAID, 2001, p. 3, Brief 1). In Iraq, especially in the first several

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years, there were a relatively small number of experienced MFI professionals attempting to guide a much larger number of participants in the MFI process. In fact, many of the people who helped establish MFIs in Iraq had never worked on microfinance until the day they were told to make it work. Obviously, the shortage of skilled personnel makes the requirement of ‘‘engage in extensive education and advocacy efforts’’ more difficult. If MFIs are to succeed in the long term in Iraq, then it is necessary to train Iraqis to fill all of the positions including management, accounting, loan officer, and so on. There is an economy-wide shortage of persons with the appropriate market-oriented business skills needed by MFIs. As a result, the MFIs often have to engage in fairly basic instruction in business practices. Recruiting quality personnel is also directly impacted by the ongoing insurgency in several ways. The insurgency often seeks to infiltrate its own people into private and public institutions to gather information, divert money or resources to support their operations, or, possibly, to target MFI clients. In addition, the turnover of trained personnel can be high as insurgents’ threats cause them to quit. And when quality personnel are identified and trained, they may not stay with the MFI. There is a continuing brain drain from Iraq to bordering countries. Trained personnel, such as loan officers, will quit the MFI to seek employment with better career opportunities (Izdihar, 2007b, Section 3.3). And yet, the most important asset of any MFI is its personnel. And dealing with the risk to these personnel has dominated much of MFI planning in Iraq. The most practical means of dealing with the risk of operating an MFI during conflict is, of course, to avoid the bad neighborhoods. With the exception of Baghdad, this led to a clear pattern during the first three years of MFI activity in Iraq. MFI loan activity and branches tended to be in the more peaceful provinces or at least the more peaceful regions of more violent provinces. Table 4 gives the outstanding MFI loans as of July 1, 2007, and the attacks per million of population in these provinces. Loans in these seven provinces accounted for almost three-quarters of all MFI loans. Since the nationwide average of attacks per million was 6.1, it can be seen that only in Baghdad, the population, trade, and financial center of Iraq, were there significant MFI loans despite violence above the national average. Three MFIs have opened branches in Baghdad: Al Bashaer, Al Thiqa, and CHF. Of course, there are areas in Baghdad that are considered relatively safe. In general, the MFIs have discovered that the best ways of avoiding threats to their employees are easy to state and difficult to achieve. Integrate the MFI and its personnel into the community. Hire and train quality local

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Table 4.

Al Basrah Karbala As Sulaymaniyah An Najaf Babil At Ta’min Baghdad

Loans and Violence.

Outstanding MFI Loans (1 July 2007)

Attacks per Million Population

$3,800,000 $3,200,000 $3,000,000 $2,600,000 $2,500,000 $2,400,000 $2,200,000

3.2 0.3 0.0 0.0 1.4 5.9 7.3

employees. Cultivate local religious and political leaders. Develop local information sources. Develop and practice good protocols for making hard decisions such as closing a branch or evacuating the staff. Security problems have forced the temporary closure of MFI branches in Fallujah, Mosul, and Ba’qubah as well as curtailing of MFI operations in several other areas (USAID, 2007). The security situation may prevent even fundamental coordination activities such as exchanging email addresses or hosting a public website (Izdihar, 2007b, Annex 3). CHF Iraq has adopted a system of keeping scanned loan documents stored outside of the office (Bruett et al., 2004). There are also many detailed methods of increasing the safety and security of MFI in Iraq but it would not be useful to discuss them.

5.3. Islamic Microfinance Through the end of 2007, almost all microfinance loans in Iraq took the usual form of charging interest for the use of funds for a set period. However, influential Islamic spokesmen argue that if MFIs are to continue in Iraq, then they must restructure their procedures to be consistent with Islamic law or Sharia. This would impose two major restrictions. Fixed interest on loans and investing in unlawful businesses would be forbidden. Fixed interest is forbidden because it allows creditor to gain from a financial transaction without the risk of loss since the debtor must repay even if his intended enterprise fails (Dhumale & Sapcanin, 1999). However, it is appropriate for the creditor to earn a profit from a financial transaction since this assumes the sharing of risks and uncertainty. The other restriction of ‘‘haraam’’ or forbidden businesses includes those that sell pornography, alcohol, or pork. Three Sharia compliant methods of structuring MFI

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activities have been proposed. (See UNDP, 2002, as well as Dhumale & Sapcanin, 1999, for details of the three methods). Murabaha is a form of trade finance. An MFI buys goods or equipment and resells them to an entrepreneur for the price of the goods or equipment plus an administrative fee. This fee would incorporate the return to the MFI. Payment is usually made in installments. As a legal issue, the MFI maintains ownership of the goods until the last installment payment is made by the entrepreneur. Murabaha has been used by MFIs in Yemen since 1997 (Dhumale & Sapcanin, 1999) and by the Iraqi MFI Al-Takadum, which does business in Al Anbar province. In an astute effort to gain public support, the Al-Takadum MFI successfully petitioned religious leaders in Fallujah to declare the MFI murabaha loans to be ‘‘halal’’ or acceptable (Izdihar, 2007d, Desai, 2007). Musharaka is equity participation or joint venture. The entrepreneur and the MFI both contribute capital to the business and then divide up the profits (or losses) according to a pre-determined ratio. Unlike murabaha, a musharaka investment is not required to be paid back on a pre-determined date. In effect, the MFI has become a shareholder in the entrepreneur’s business. In a muddharaba, the MFI owns the firm’s capital and has right to a predetermined percent of profits. However, the MFI should not request collateral to reduce its credit risk. Unlike musharaka, the entrepreneur is not required to invest his own capital. The partnership is limited. The total loan and any profit are repaid on a pre-determined date, and the partnership is dissolved. It is expected that any transition in Iraq to Sharia-compliant MFI lending such as murabaha, musharaka, and muddharaba will be gradual. In fact, some commentators think that a variety of lending procedures will remain. MFIs that make loans in the more religious areas such as Al Anbar province and the four sacred cities will be Sharia-compliant while MFIs in the more secular cities and parts of the country will continue to lend for interest.

5.4. Banks as Competitors and Allies for Microfinance Banks tend to see MFIs as unthreatening in the short-term but potentially dangerous long-term competitors. Currently, most public and private banks see loans to micro or SME enterprises as high risk and prefer to direct their assets to either deposits at CBI or large loans secured by collateral. The fact that private banks have limited geographical coverage further reduces competition for MFIs.

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However, if the long-term competition between banks and MFIs should become more serious and if the banks are able to skim the cream of loans to SME, then the sustainability of MFIs could be called into question. If they decide to compete seriously for SME loans, then the banks will have two advantages. First, banks in Iraq tend to charge low or even negative real interest rates on their loans that are lower than most MFIs can afford to charge. Such loans are profitable for banks because, with access to deposits for which the banks pay little or no interest, the banks can count on a large positive interest margin. To achieve sustainability, MFIs that lack access to zero interest deposits must charge an interest great enough to cover both their cost of funds and that of their overhead (Izdihar, 2007c). Second, the Iraqi Company for Bank Guarantees (ICBG) was established by 11 Iraqi private banks and received initial funding in August 2007. The ICBG is intended to reduce the risk to banks of making Micro Small Medium Enterprise (MSME) loans. The ICBG now provides partial guarantees of both principal and interest for loans to MSMEs by member banks. Member banks can obtain a guarantee for up to 75% of the loan principle in return for a 2% loan guarantee fee. The allowable loans are extensive with loans to manufacturing, services, tourism, trade, and agriculture entities allowed. The major exclusion is loans to purchase other financial instruments. Loans are permitted for either cash flow or collateral lending. Maturity is limited to one year for working capital and five years for loans for fixed assets (The Iraqi Company for Bank Guarantees Ltd, 2007; Izdihar, 2007c). If the banks with the support of the ICBG decide to compete more aggressively for the SME business, then MFIs will have several possible options. They can continue to compete by being more nimble – it can take weeks or months for the major banks to make a loan decision. They can focus on clients who, because of the lack of even minimal amounts of collateral and education, find themselves excluded from consideration for bank loans. For example, there is a largely untapped market for small loans to women in Iraq. The MFIs may keep their better clients by bundling loans with valuable business services and training. Finally, all SME loan markets are local. It is likely that different loan products will be in demand in different parts of the country and maybe in different villages. As mentioned above, some areas may prefer Sharia-compliant arrangements. Another possible differential would be the types of businesses that the SMEs are in. For example, small agricultural loans tend to be structured differently than loans for small-scale manufacturing. It would seem that the MFIs would be

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more capable of flexibly developing new ways of doing business than the bureaucratic banks. But the potential conflict between the banks and MFIs should not be overstated. At least in the short-term, they can be allies. In view of the unsettled security situation, the MFIs often wish to avoid any handling of funds. Clients who are approved for loans are often directed to the appropriate branch of one of the public banks to receive their funds from their MFI account. For example, CHF uses bank checks to disburse MFI loans (Bruett et al., 2004). If the banking system can make some progress toward making secure, quick, and cheap Iraq-wide transfers, then the cost and inconvenience of running an MFI should decrease significantly. However, MFIs in Iraq continue to find dealing with banking institutions to be a difficult and frustrating process. In addition to the bureaucracy, there have been reports of bank employees seeking bribes to process MFI business (Izdihar, 2007b, Section 3.6). Further complicating lending to SMEs by both MFIs and banks is the absence of reliable credit information for almost all of the institutions and individuals in Iraq. Accurate information on assets and liabilities is rarely revealed lest the entity or person become a target either of insurgents or corrupt government officials. As a result, even when such information is gathered by an MFI or other institution, it is rarely if ever shared or sold. MFIs must expend their own resources to evaluate accurately the credit worthiness of potential borrowers. Several studies of MFIs show that in the absence of credit bureaus, MFIs tend to experience an increase in operating expenses of approximately five percentage points (Gonzalez, 2007).

5.5. Threats to the Iraq Culture of Credit Before Saddam’s attempt to establish a socialist economy in Iraq, the country’s merchants were renowned for their business savvy and their acceptance of the culture of credit. The culture of credit is the concept that loans should be used to expand productive capacity – not for consumption – and that loans should be paid back on schedule.10 During the 25 years of Saddam’s rule, the culture of credit was undermined in two ways. First, loans were generally made not on the basis of credit worthiness and a solid business plan but because of friendship, political imperatives, or corruption. For example, the public banks were ordered to make massive loans to state-owned enterprises selected by Saddam’s supporters. Second, it was understood, even when not explicitly

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stated, that these loans would not have to be repaid. The banks would periodically simply mark interest as paid and add the value of the formerly overdue interest to the principle of the loan. On paper, the banks were profitable while in reality they were drowning in defaulted debt. These activities substantially weakened the culture of credit in Iraq. Fortunately, there was only one generation between Saddam’s attempt to establish a statist economy and its subsequent collapse. As a result, an older generation that understands the market still exists. Also, financial institutions such as MFIs have served a valuable role over the past five years in reviving the credit culture. However, there have been some recent initiatives that could potentially reduce or reverse this progress. The Ministry of Labor and Social Affairs (MoLSA) was established to assist workers seeking employment and protect Iraq’s most vulnerable citizens through a network of social services. In October 2006, there was a proposal to finance a MoLSA effort to actually create jobs by making government backed low or zero interest loans (USAID, 2007). While the details of the program are still under negotiation, the 2008 GoI budget included $510 million for the MoLSA loan program. As a matter of scale, this would be equal to about 20 times the outstanding loans of all Iraqi MFI. There is reason to fear that this government loan program will seriously undermine the tenuous recovery of an Iraqi credit culture. One concern is that as a government bureaucracy, MoLSA will be more concerned with the volume – not the quality – of loans. MoLSA officials will see their primary responsibility in lending out the full amount as soon as possible rather than ensuring that the borrowers will be able to pay it back. Also, it will be difficult to determine the proper interest rate for these loans. MoLSA’s cost of funds is effectively zero and its overhead will remain part of the national budget. According to initial planning, interest rates on MOLSA loans will be below those required by either private banks or MFIs. A further concern is that like most of the Baghdad ministries, MoLSA has political, ethnic, and sectarian characteristics or preferences as well as a tendency for corruption. It is likely that loans will be made based on preferences or bribes rather than rational economic criteria. Finally, the average Iraqi is smart enough to realize that after a period of time the elected officials of the GoI will come under a great deal of political pressure to declare a debt holiday, suspending loan repayments on government loans, or canceling penalties. By making loans on non-economic criteria at below-market rates combined with the expectation that the loans will not have to be repaid,

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this program can be expected to retard the restoration of a credit culture and a market economy in Iraq (Izdihar, 2007b, Section 4.3).

6. CONCLUSION While MFIs in Iraq have achieved many successes, they face serious shortand long-term challenges to achieving sustainability. In the short-term, MFIs face security threats and a moribund banking system. In the longterm, the GoI, flush with funds from oil exports, will be tempted to derail the credit culture through large-scale low interest loans or zero interest grants. At the same time, the international and domestic MFIs struggle to reconcile their programs with the counterinsurgency efforts of the GoI and the U.S.-led coalition. In view of the relative success of MFIs in Iraq despite these short-term and long-term challenges, it might be appropriate to re-evaluate microfinance best practices for a post-conflict situation. As mentioned above, a fair assessment of the nation of Iraq in 2003–2007 must conclude that the country violated all three essential conditions for successful post-conflict microfinance: a degree of political stability, sufficient economic activity, and a stable client population (USAID, 2001, Brief 4). There are two possible explanations for the MFI success in Iraq despite the absence of ‘‘essential’’ conditions. First, the micro-environment of town or provincial security and economy is the critical factor – not the national environment. Especially in a counterinsurgency situation, it is quite possible that one province (or group of towns) may be relatively peaceful with a working economy and stable population while a neighboring province (or group of towns) is suffering conflict-induced political and economic chaos. By avoiding ‘‘broken’’ provinces, MFIs may have a chance to thrive despite an ongoing conflict. Second, the U.S.-led coalition was willing to expend a great deal of resources to establish and maintain MFIs in Iraq. Altruism was probably not the primary motive although only a complete cynic would disregard it entirely. However, the primary motivation for supporting MFIs was to weaken the insurgency by both providing quality employment for young Iraqi males and by increasing confidence in the GoI through economic development. Regardless of the motivation, the U.S.-led coalition not only financed the establishment of many of the MFIs but also provided a degree of local and regional security that the Iraqi government was incapable of providing and that would have been ruinously expensive for the MFIs to

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pay for by themselves. Like every other statement about Iraq, this claim is controversial. Some MFI spokespersons state that any MFI association with the U.S.-led coalition, even at an arm’s length, increases security risks. Maybe the only firm conclusion is that MFIs have the potential of reducing the human cost of conflict and facilitating recovery. Hopefully, the Iraq experience will advance the understanding of microfinance during conflict to increase the chances for success in other conflict situations.

NOTES 1. The paragraphs in this section closely follow Gunter (2007). 2. In January 1989, Rashid bank was spun off from Rafidain and encumbered with most of the non-performing assets. 3. Minimum efficient scale is an output level where all economies of scale are exhausted. 4. Estimates of the size of Iraq’s current population range widely. Twenty-eight million is probably an upper estimate that assumes that the roughly 2 million external refugees return to Iraq. 5. Unemployment is generally defined as a person without a job who is actively looking for employment. Underemployment refers to a person who is employed but in a job that does not use his or her skill set, for example, a skilled plumber working as a ditch digger. A discouraged worker is someone who is without a job but is not counted as unemployed because he or she has become discouraged and has stopped looking for employment. 6. However, of the smaller proportion of loans in default, a larger ratio of those loans in default have a PAR greater than 180 days – 1.5% in April 2007 versus 1.2% in November 2006 (Izdihar, 2007a). 7. From online discussion sponsored by USAID on ‘‘Making Microfinance Work Better in the MENA,’’ November 2005. 8. Whether this is in fact a ‘‘new’’ view is subject to controversy. The prescient Marine Corps Small Wars Manual (1940) emphasized the importance of providing essential services and economic development in a successful ‘‘small war.’’ 9. LLO are used to visualize operations such as counterinsurgency when geographic locations are of little use. While there is no list of LLO that applies to every situation, the 2007 Counterinsurgency Field Manual lists six possibilities: information operations, combat operations, host nation security, essential services, governance, and economic development (CFM, FM 3-24, Fig. 5-2). 10. This culture of credit is believed to be one of the fundamental factors of economic development. Of course, there are both positive and negative incentives for persons to adopt the culture of credit. Persons who live according to this culture can expect to not only be able to borrow larger sums in the future but also, as their reputation for using credit wisely spreads, have increased business opportunities. On the contrary, failure to repay loans on schedule leads to inability to both borrow in the future and sanctions.

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REFERENCES al-Rahdi, R. H. (2007). Testimony to the house committee on oversight and government reform on the status of corruption in the Iraqi government, October 4. Brookings Institution. (2008). Iraq index: Tracking variables of reconstruction and security in post-Saddam Iraq, February 19. Available at http://www.brookings.edu/saban/iraqindex.aspx Bruett, T., Norell, D., & Stephens, M. (Eds). (2004). Conflict and post-conflict environments: Ten short lessons to make microfinance work. Progress Note 5, September. SEEP Network, Washington DC. Brunetti, A., & Weder, B. (2003). A free press is bad news for corruption. Journal of Public Economics, 87(7–8), 1801–1824. CIA. (2008). The world factbook – Iraq. Available at https://www.cia.gov/library/publications/ the-world-factbook/geos/iz.html Counterinsurgency Field Manual. (2007). U.S. Army Field Manual 3-24 and Marine Corps Warfighting Publication 3-33.5. Desai, S. (2007). Post-conflict microfinance: assessment and policy notes for Iraq, September. Jena Economic Research Paper 2007-060. Dhumale, R., & Sapcanin, A. (1999). An application of islamic banking principles to microfinance, December. Working Paper. Regional Bureau for Arab States, UNDP. El-Gamal, M. A., El-Megharbel, N., & Inanoglu, H. (2000). Beyond credit: A taxonomy of SMEs and financing methods for Arab countries, March 6–8. Paper presented at ECES Workshop in Cairo. Geertz, C. (1963). Peddlers and princes. Chicago: University of Chicago Press. Gonzalez, A. (2007). Efficiency drivers of microfinance institutions: The case of operating costs. The MicroBanking Bulletin, 15(Autumn), 39–40. Gunter, F. R. (2007). Economic development during conflict: The petreus-crocker congressional testimonies. Strategic Insights, 6(6), 7. International Monetary Fund. (2007). Staff Report for the Article IV Consultation. July 18, Table 9. International Monetary Fund. (2008). IMF Country Report 08/17, January. The Iraqi Company for Bank Guarantees Ltd. (2007). Potential ICBG Outreach through the Private Banks Operating in Iraq Brochure, April. Izdihar. (2007a). Iraq microfinance industry performance & benchmarking to MENA MFIs and all MFIs. Iraq Second Microfinance Workshop, June 9. Izdihar. (2007b). The Iraq microfinance strategy, February 25. USAID Working Paper. Izdihar. (2007c). An overview of the Iraqi banking system, March 30. USAID Working Paper. Izdihar. (2007d). Press Releases. December 14, November 27 and September 17. Ledgerwood, J. (1999). Microfinance handbook: An institutional and financial perspective. Washington D.C: World Bank. Meissner, L. K. (2005). Microfinance and social impact in post-conflict environments, December. Master’s thesis, American University. Microfinance Information Exchange. (2007). The MicroBanking Bulletin, 15(Autumn), 46. Perry, T. (2008). U.S. ‘micro-loan’ effort yields big results in Iraqi province. Los Angeles Times, February 22.

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Private Sector Development – Iraq Reconstruction Management Office – PSD-IRMO. (2006). Micro-finance funding request: increasing Iraq’s successful micro-lending program, April. IRMO Working Paper. Svensson, J. (2005). Eight questions about corruption. Journal of Economic Perspectives, 19(3), 19–42. Transparency International. (2007). Corruption perceptions index. Available at http:// www.transparency.org. UNDP. (2002). Islamic banking principles applied to microfinance case study: Hodeidah microfinance programme, Yemen. Available at http://www.uncdf.org/english/microfinance/pubs. USAID. (2001). Microenterprise best practices technical briefs. (Brief 1) Microfinance Following Conflict: Introduction to Technical Briefs; (Brief 2) Developing a PostConflict Microfinance Industry: The Case of Cambodia; (Brief 3) Developing PostConflict Microfinance Institutions: The Experiences of Liberia and Kosovo; (Brief 4) Environmental Preconditions for Successful Post-conflict Microfinance; (Brief 5) Searching for Differences: Microfinance Following Conflict vs. Other Environments; (Brief 6) Security Issues for Microfinance Following Conflict; (Brief 7) Microfinance for Special Groups: Refugees, Demobilized Soldiers and Other Populations. USAID. (2007). The state of microfinance in Iraq, February 20. USAID Note from the Field. World Bank. (2007). Doing business 2007. Available at http://www.doingbusiness.org.

EVALUATING MICROFINANCE PROGRAM INNOVATION WITH RANDOMIZED CONTROLLED TRIALS: EXAMPLES FROM BUSINESS TRAINING AND GROUP VERSUS INDIVIDUAL LIABILITY Dean Karlan, Tomoko Harigaya and Sara Nadel 1. INTRODUCTION In the past decade, microfinance institutions (MFIs) have experienced a boom in innovations of lending products, partly fueled by donors who see microfinance as the next promise to alleviate poverty. Examples of these new products are the combination of credit with health or life insurance, business and health education, savings products, and the adoption of (or conversion to) individual loan liability. The add-on features generally aim at reducing the vulnerability of clients while contributing to asset creation, hence improving repayment rates and the sustainability of the service. The product innovations typically result from organizations striving to extend outreach, increase impact, and promote sustainability. As in other industries, MFIs typically decide whether to adopt new strategies based on

Moving Beyond Storytelling: Emerging Research in Microfinance Contemporary Studies in Economic and Financial Analysis, Volume 92, 215–249 Copyright r 2009 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1569-3759/doi:10.1108/S1569-3759(2009)0000092010

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other MFIs’ success with the innovations. Many new microlending products and approaches continue to be developed. However, MFIs must generally rely on qualitative and descriptive case studies and anecdotal evidence on the effectiveness of these innovations to decide whether to implement the new strategies. The usual case study approach does not provide tangible evidence that can enable other organizations to know what changes can be expected if they were to adopt similar product changes. In this chapter, we discuss how randomized controlled trials can help test the effectiveness of new lending products. Similar to biomedical studies that test new pharmaceuticals, randomized controlled trials in the field of microfinance isolate the effect of a chosen innovation by assigning a random selection of individuals or villages to the innovation (the treatment group), and another equivalent selection of individuals or villages to maintain the status quo (the control group) and comparing results between the groups. Given the increasing innovation of lending product designs among MFIs, it is critical to establish a systematic and reliable evaluation method that measures the impact of specific characteristics of a lending product. Throughout the chapter, we present as an example an ongoing randomized controlled evaluation of group versus individual liability loans in the Philippines and of a business-development training that was offered in conjunction with a credit program. Many of the issues discussed in this example, however, apply to evaluations of a wide variety of microlending product innovations. We discuss a few further examples at the end of the chapter. Many MFIs test new product designs by allowing a few volunteer clients to use a new lending product, or by offering to a small group of particularly chosen clients (often, their best) a new product. Alternatively, an MFI can implement a change throughout one branch (but for all clients in that branch). We argue that such approaches are risky for lenders, and inferences about the benefits of changes evaluated in such a manner can be misleading. As explained in Section 2, one cannot conclude from such non-experimental approaches that the innovation or change causes an improvement for the institution (or the client). Establishing this causal link should be important not only for the MFI implementing the change but also for policymakers and other MFIs that want to know whether they should implement similar changes. This is a situation in which randomized controlled trials are a win-win proposition: less risky (and hence less costly in the long run) from a business and operations perspective, and optimal from a public goods perspective, because the lessons learned from research can be disseminated to other MFIs.

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The primary operational differences between experimental and typical non-experimental evaluations are twofold: First, experimental evaluations include random (rather than self-selected or MFI-selected) assignment of individual clients (or groups of clients) to different program designs or products. This eliminates the chance that results will be confounded by factors not causally related to the intervention (such as one’s entrepreneurial spirit, which led her to join the program, but could have helped her improve her business, irrespective of the credit). Second, experimental evaluations are prospective (i.e., both participants and the control group are randomly assigned at the outset of the study) whereas typical (but not all) non-experimental evaluations are retrospective (i.e., a comparison group of non-participants who are selected to be similar to participants is chosen after the treatment). The prospective nature of randomized evaluations makes planning before the innovation is launched the most important stage of the evaluation. This chapter hopes to provide insights into the motivations for and possibilities of using experimental evaluations to assess different microfinance product designs. The chapter is written primarily for microfinance practitioners. The rest of the chapter is organized as follows. In Section 2, we discuss the problems with non-experimental approaches usually used in microfinance to evaluate program innovation and the reasons why the randomized controlled trial methodology is preferable. In Section 3, we introduce an experimental pilot approach to product innovation and the steps to design a randomized controlled trial. In Section 4, we discuss some key issues that need to be considered when designing an experiment. In Section 5, we present an example of a randomized controlled trial on credit with education versus credit alone in Peru. Section 6 presents an example of testing group versus individual liability in the Philippines. Section 7 provides further examples of different microfinance programs in which randomized controlled trials could be employed to evaluate the program impact. Finally, Section 8 concludes.

2. WHY DO WE NEED A CONTROL GROUP AND HOW CAN WE GET IT? In evaluating a lending product innovation, we typically discuss an existing loan program to which some change is being made. Therefore, an existing client base already exists. Program innovation evaluations seek to compare the actual outcomes of an innovation to a program with the outcomes that

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would have resulted in the absence of the innovation. Because a potential client can be either borrowing in the program with the new lending feature or not, and cannot do both, the potential outcomes in the absence of the new lending feature are unobservable for those who receive the new product. Any evaluation then attempts to establish the counterfactual outcome: what clients’ outcomes would have been had the new lending feature not been introduced.

2.1. Why do We Need a Control Group? In the field of microfinance, practitioners frequently evaluate new lending products by using non-experimental designs. Most often, they let a few volunteer clients use the new lending product under study or offer it to a small group of selected clients (usually their best). Alternatively, they introduce a product change throughout an entire branch of a lending institution with all clients in that branch using it. The evaluator then attributes the observed change in the clients’ outcome indicator to the product change introduced, without explicitly constructing what would have happened had the change not taken place (the counterfactual outcome). This type of evaluation contains a strategic error. The problem is that in addition to the introduced product change there may be other factors that also contribute to the changes in clients’ outcomes. These other factors may come from the environment in which the clients live or may be peculiar to the clients. For example, suppose we are interested in the change in the clients’ income. The observed increase in the clients’ income may be due to several factors: (i) the product change introduced; (ii) general economic improvement in the region; (iii) new income-generating opportunities (e.g., a new factory in the region); (iv) the ability of the borrower to use the loan effectively; and so forth. Consider a farming community that enjoyed unusually favorable weather conditions at the onset of the introduction of a new product. It is observed that clients’ income rose during the study time. Given only this observation, an evaluator cannot be sure if the rise in income was completely attributable to the new product, or is mostly due to better harvest that results from good weather. The estimation error (also called bias) in this case is the growth in income due to better harvest brought about by favorable weather. Accurate evaluations must control for these external intervening factors. If we could observe the same client at the same point in time both borrowing

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and not borrowing the new loan product, this would effectively account for any other observed and unobserved intervening factors. Since this is impossible, to isolate the effect of the product change from effects caused by other intervening factors, a control group is necessary. We need a comparison group of clients not availing of the new lending product but having similar characteristics as those borrowing. Simply observing the change in clients’ outcomes without a control group makes it impossible to assess the true, isolated impact of the product feature being evaluated. Even evaluating the success of a product change based on the experience of one entire branch to which the innovation was introduced is erroneous. In such evaluations, the evaluator assumes that results of clients in the selected branch would have been similar to results of clients in other branches that did not receive the innovation, had they themselves also not received the product change. This approach is flawed because each branch is unique in its characteristics, with different geography, economic conditions, and human resources of the branch staff. Just as before, when the improvement in clients’ incomes might have been caused by favorable weather, two branches with different characteristics can have quite divergent experiences. For example, if the branch with the product innovation being evaluated happened to have clients with more entrepreneurial ability, comparing it with other branches could cause the MFI to falsely attribute the difference to the effect of the innovation. An MFI with a sufficient number of branches could in fact compare several branches that receive the innovation to several branches that do not. This would require the branches to be randomly assigned to treatment and control groups, as described later, and a sufficient number of branches to allow for an adequate sample size.

2.2. Why the Control Group Should be Randomly Chosen The objective of product change evaluation is to establish a credible control group of individuals who are identical in every way to individuals in the treatment group, except that they are not accessing the new product. Establishing such a credible control group faces some difficulties in practice. The problem is that in reality borrowers and non-borrowers usually are different. Microfinance programs usually target certain groups of clients such as women in poor neighborhoods. This targeting effectively makes borrowers and non-borrowers different in some set of characteristics (e.g., on average borrowers have a lower income than non-borrowers).

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When participation is voluntary, the fact that clients select themselves into the program indicates differences (observable or unobservable) between borrowers and non-borrowers. For instance, borrowers in microcredit programs designed to promote household businesses may be intrinsically more entrepreneurial than non-borrowers. Or in a program of credit with education designed to promote children’s education, borrowers may choose to borrow because they value their children’s education more than nonborrowers do. Because institutions choose where to lend and not to lend deliberately (known as ‘‘endogenous program placement’’), and because participants choose to borrow or not borrow (known as ‘‘endogenous program participation’’), those who are not borrowing are often not a good comparison group for those borrowing. The reason why an institution enters one area, and allows some individuals in or why some individuals choose to borrow is critical to understand, and yet also difficult if not impossible to fully understand. Merely observing that some characteristics are similar between borrowers and non-borrowers is not sufficient. Often the unobserved characteristics are believed to be the most important (e.g., entrepreneurial spirit, or expected economic growth in an area). When these selection issues are not dealt with properly, the observed difference in outcomes can be attributed to both the program’s impact and the pre-existing differences between the two groups. The comparison between the two groups will yield the accurate program impact only if the two groups have no pre-existing differences other than access to the product change being evaluated. The key feature in experimental methods is random assignment. Random assignment removes any systematic correlation between treatment status and both observed and unobserved characteristics of clients. Clients (or groups of clients) are randomly assigned to a treatment group (who will borrow the new lending product under study) and a control group (who will not borrow). By construction, the randomization procedure ensures that the two groups are similar at the outset, across both observable and unobservable characteristics. Individuals in these groups live through the same external events throughout the same period of time, and thus encounter the same external intervening factors. The only thing different between the two groups is that those in the treatment group borrow the new product and those in the control group do not. Therefore, any difference in the outcomes between the two groups at the end of the study must be attributable to the product change. Random assignment assures the direction of causality: the product innovation or change causes an improvement for the client (or the institution).

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Phase 1: Small Pilot (resolve operational issues, establish basic client interest and self-reported satisfaction)

Phase 2: Full Pilot (randomized controlled trial in which some receive the new product, some the old, all randomly chosen). Use this to evaluate impact of change on both institutional and client outcomes

Phase 3: Full Launch (if Step 2 succeeds)

Fig. 1.

Basic Phases of Experimental Approach to Microfinance Product Innovation.

3. EXPERIMENTAL PILOT APPROACH TO PRODUCT INNOVATION In a randomized controlled trial, one program design is compared to another by randomly assigning clients (or potential clients) to either the treatment or the control group. If the program design is an add-on or conversion, the design is simple: The MFI randomly chooses existing clients to be offered the new product. Then, one compares the outcomes of interest for those who are converted to those who remained with the original program. A similar approach is also possible with new clients, although it is slightly more difficult. In this section, we discuss the logistics of how to change an existing product, where clients already use some service in the program. The flowchart in Fig. 1 presents the basic phases. Often, MFIs innovate by doing a small pilot and the full launch (Phases 1 and 3), but not a full pilot (Phase 2). Hence, this chapter focuses heavily on why this second step is important and outlines its basic steps.

3.1. Identify the Problem and Potential Solution and Conduct a Small Pilot Product innovation typically aims at solving a problem of the existing product or improving the impact and feasibility of the product. The first step is to identify the problem of the current product and potential solutions through a qualitative process. This should include examination of historical

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data, focus groups and brainstorming sessions with clients and staff, and ideally discussions with other MFIs that have had similar problems. Once a potential solution is identified, an operating plan and small pilot should be planned. An operating plan should include specifics on all necessary operations components to introduce the proposed change. This includes, for instance, development of training materials, process for training staff, changes to the internal accounting software, compensation systems, and marketing materials. To resolve operational issues and depending on the complexity of the proposed change, a small pilot implementation should be done next. This can be done on a small scale and is merely to test the operational success of the program design change. This initial pre-pilot does not answer the question of impact to the institution or the client. It instead intends to resolve operational issues, so that the full pilot can reflect accurately the impact from a full launch.1 After the proposed solution has been identified and a small pilot is conducted, the testing is not over. It is important to know the impact of the product innovation on both the institution (repayment rates, client retention rates, operating costs, etc.) and the client (welfare, consumption, income, social capital, etc.). To measure such outcomes properly, one cannot merely follow the participants and report their changes. The flaws of this were discussed in the previous section. One needs a control group.

3.2. Identify Treatment Assignments Often a proposed solution has a main change, but many minor issues that need to be decided. For instance, when testing Credit with Education in the Foundation for International Community Assistance (FINCA) program in Peru (Karlan & Valdivia, 2006), we had to select which type of education modules to offer, and when testing group versus individual liability (Gine´ & Karlan, 2006), we needed to determine how to set the savings policies. A careful experimental design can include tests of such subquestions. Specific examples will be provided below when we discuss testing group versus individual liability. These questions often arise naturally through the brainstorming questions. Any contentious decision is perfect for such analysis, since if the decision is contentious then the answer is not obvious!

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3.3. Sample Frame and Sample Size The sample frame is the pool of clients (or potential clients) who are included in the impact study. One will assign clients (or potential clients) randomly to ‘‘treatment’’ or ‘‘control’’ groups (i.e., clients will be divided randomly into at least two groups. Members of one group will get the innovation and members of the other will not). Two types of sample frames should be considered: existing clients and new clients. When the innovation is a change to an existing product, an initial test can consist of existing clients. Defining a sample frame of potential clients can be more difficult. The following section shows how this is being done with the group versus individual liability evaluation in the Philippines. Determining necessary sample size is also key to a successful evaluation. To calculate the necessary sample size, one needs to consider (a) what a ‘‘successful’’ outcome looks like (e.g., if repayment rates are 90%, would increasing them to 94% be considered satisfactory enough to then warrant a full conversion to a new product?), (b) what the current level is for the outcome measure, and (c) if the outcome measure is not a binary variable (e.g., being in default), then one needs to know the typical variation (i.e., the standard deviation) of the outcome of interest.2

4. ISSUES TO BE CONSIDERED WHEN DESIGNING AN EXPERIMENT 4.1. Spillovers The validity of experimental designs rests on the integrity of the data from treatment and control groups. The results are improved when treatment and control groups remain intact throughout the study.3 However, in microfinance programs, this cannot always be guaranteed and spillovers may arise. With proper care and information about non-compliance, this can be dealt with in the analysis (although if the non-compliance is severe, this could irreparably damage the study). There are two types of spillovers to consider. One merely affects the experimental design and involves what to do when someone from the treatment (or control) group learns about the existence of the other group and asks why they are not receiving what the other person is receiving. We will call this the ‘‘experimental spillover.’’ Experimental spillovers are

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often more of a concern in theory than in practice. However, this does not mean they should be ignored. They need to be minimized and also should be carefully recorded because they may affect the results of the evaluation. For instance, in the group versus individual liability experiment with the Green Bank of Caraga in the Philippines (discussed in more detail in the next section), we identified ‘‘sibling’’ barangays (neighborhoods or villages) as those which border each other and for which there is much social interaction. We treated them as one barangay for the sake of the randomization, thus ensuring that no ‘‘sibling’’ barangays were split whereby the barangay received different program designs. In the credit with education experiment with FINCA Peru, both treatment and control groups actually met in the same location. Although there was much concern about whether jealousy would cause problems, proper training of the staff to explain what was happening was effective. The few individuals that asked were told that FINCA Peru was rolling out the education slowly in order to learn whether it is effective or not. Still, all experiments must be prepared for the groups to learn about each other. Staff must be trained in how to deal with these questions. We have found that the truth works best when clients ask ‘‘Why did I receive X when my cousin, who is also a client, is receiving Y?’’ The truth is that the MFI is considering making a change and is testing it out carefully on a subset of clients. Clients had an equal and fair chance at being selected for the change, it was not done preferentially. If it works well, then it will be expanded fully. Ideally, the MFI can record information about all such inquiries, because learning about such interest (or disinterest) can help when evaluating the outcome and deciding whether to proceed with a full launch of the change. The other type of spillover has to do with the indirect effects brought about by the program – not on clients but on others, including clients’ families, neighbors, or community members. We will call this second type ‘‘impact spillovers.’’ Impact spillovers can be both good and bad. A ‘‘good’’ spillover refers to the effect on other people of providing one person with a particular service or product. By only treating one person, often times you treat many more. De-worming interventions are a perfect example of this. In a study in Kenya, researchers found that de-worming school-aged children did not pass a cost–benefit analysis relative to other interventions when you only consider the direct effect. However, when you take into account the indirect effects as well (the ‘‘spillovers’’ in this situation take place because worms are passed from one child to another through the dirt in communal play areas), the intervention does indeed pass a cost–benefit analysis (Miguel & Kremer, 2004). In microcredit, several examples exist for

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spillovers, both positive and negative. For credit with education programs, clients may share what they learn with others in their community or family. For credit itself, the increased business of one client may create employment in the community. For group lending, it may help build social capital among the group members, which may influence others to form similar bonds (due to observing the success of the group members). A bad spillover may come from competitive pressures: if the MFI funds an individual to start a particular type of business, this may adversely affect other similar businesses in the community (although it might increase aggregate welfare for the community by lowering prices or improving product quality for the consumers in the community).

4.2. Ethical Considerations Stakeholders sometimes have ethical arguments about randomization, as some perceive them as arbitrarily and unethically depriving the controls from positive benefits. Although ethical concerns are important to consider in any intervention, the presumption that randomized controlled trials introduce additional ethical considerations rests on two assumptions that typically are flawed. First, this concern is based on the assumption that the program change is unequivocally good. If there is no doubt that the change should occur, that it not only will improve the situation for everyone but that it will do so more than any other change, then indeed testing the change would be a waste of resources. Such situations are rare, however. More often than not policy changes are debated and although strong hypotheses may exist, there is not adequate evidence to know unequivocally that the change will yield positive results for everyone. The MFI initiating a product change must decide the amount of resources it is willing to invest in testing the change based on how much uncertainty there is regarding the consequences of the change. If there is doubt about the efficacy of the change, then the experimental test may indeed be the most reasonable choice, so that the organization learns whether to implement the project further. Second, this ethical criticism assumes unlimited resources for the change to reach everyone in the program. In many cases, this is not true for either budgetary or logistical reasons. For example, if the intervention is credit with education, the training of staff to provide the education modules is both costly and time consuming. Large organizations cannot do this all at once, but rather usually stagger the training of their employees on how to

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teach the material to the clients. In this way, a randomized rollout of the product can be offered to just as many clients as the organization has the capacity to reach, with or without the experiment.

4.3. Cost of Randomized Experiments Experimental methodologies are often perceived as more costly than non-experimental methodologies. Relative to no evaluation at all, certainly an experimental evaluation costs more in the short run. Yet an experimental evaluation may be less costly in the long run if the results from the evaluation help to guide the long-term decisions and planning for the institution. For example, an MFI is considering whether or not to increase the interest rates of its loans. An increase in interest rates may meet the MFI’s financial targets in the short run. However, raising interest rates too high will drive away customers and reduce the loan repayment rates. This in the long run may erode the surpluses generated by the program’s clients. It is therefore critical for the MFI to understand the net effect of an interest change to set the most desirable rate. Thus, spending some money now to have a credible assessment on the client’s response to the proposed interest increase is far less costly than saving the money and making a wrong decision.4 Relative to non-experimental evaluations, experimental evaluations are often less costly in the short run, and certainly less costly in the long run, when the benefits of more accurate results are factored in. When household surveys are used, they encompass the largest component of the budget, typically. However, the cost of collecting data for a non-experimental evaluation is often more expensive than for an experimental evaluation because non-experimental evaluations usually require larger datasets to process complicated econometric models. The analysis for an experimental evaluation, if designed correctly, is quite simple: one can obtain the answer simply by comparing mean outcomes between treatment and control groups. The bottom line is that the cost of random experiments must be judged within particular contexts. The literature on microfinance provides no specific information on the overall or unit costs of evaluations but a vast array from a few thousand to multiple million dollars, depending on the questions studied and the number of MFIs involved (Hulme, 1997).5 A simple experiment such as an evaluation of a program innovation may not require surveys at all, but rather just the MFI administrative data (e.g., repayment rates), to measure the efficacy of the change. In this case, the data

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can be retrieved at no cost from the MFI’s accounting software or management of information system. The cost of the experiment is merely the management time required to design the experiment and train and motivate the staff in why the program innovation is being tested in this manner, as well as to analyze the data. If the organization is undergoing change to its products or processes, then enacting this change with an experiment rather than ad-hoc may not even add any further costs.

5. CREDIT WITH BUSINESS EDUCATION: PERU In this project, we designed a randomized controlled experiment to evaluate the impact of adding a business training component to a traditional community bank microlending project. Many microfinance organizations have begun to include trainings in conjunction with their credit program. As this practice grows, and is adopted in various forms – the topic, training method, and whether the training is required or optional vary widely across organizations – it is useful and important to evaluate these programs to determine their effectiveness and the value the training adds to the microcredit product which is usually the central mission of the delivering organization. The study described later examines a particular business training that was conducted in conjunction with a regular community bank microfinance product. The randomized controlled method applied here provided important information about the success of the training in meeting various goals and offers useful information about future implementations of similar products.

5.1. Motivation of Study Business training is one of the many add-on training programs that is gaining popularity globally. Microfinance organizations such as Pro Mujer have made trainings a central part of their credit model and NGOs such as Freedom From Hunger specialize in working with microfinance organizations to adopt training sessions in conjunction with their credit meetings. Previous studies have suggested that members of community banks that include training about important health practices are more likely to know which nutritious foods to feed their children, the importance of breast feeding, and how to treat a child with diarrhea (MkNelly, Watetip, Lassen, & Dunford, 1996). However, these studies were conducted ex-post and thus selection biases may have persisted in the way the comparison group was

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formulated (i.e., the comparison group did not actively decide to join a credit with education program, whereas the treatment groups did). Indeed, one can identify both positive and negative potential effects on a microfinance organization that also offers or requires training, particularly business training. Without conducting a rigorous evaluation of a credit with training product, it is impossible, in practice, to determine whether the positive effects outweigh the negative effects. The potential advantages to pairing business training with credit programs include the following:  As clients improve their business practices, the chance of default decreases  As clients’ businesses grow, they borrow larger loans  Many clients are small business owners with little education. Teaching basic business practices could have huge effects on their business for relatively low cost  Client retention could increase as a result of a greater feeling of indebtedness to the lending institution for providing valuable training  Potential clients may choose to enter the loan program of the financial institution offering training in part because they want to receive that training. However, business training also has potential disadvantages. Such disadvantages include:  The length of communal bank meetings are often already a source of discontent among clients, who may be displeased to be forced to sit through an additional training, and eventually leave the program  Clients may blame the lending institution for downturns in their business, and therefore become more likely to default in such a situation  Talented credit officers may be less talented as teachers of business practices, resulting in poor quality of training  As opposed to the teaching of good health practices, business acumen could be an inherent skill that is impossible to teach. The benefit of including business trainings in credit is debatable and many persuasive arguments can be made both in favor of and against it. It is therefore extremely valuable for an MFI to test the impact of such a practice before fully incorporating business training into its credit model. In a worstcase scenario, adding business training to a credit program could lead to increased default and dropout rates without affecting the business practices of loan clients. On the other hand, the potential benefits of including

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business training in a credit program – increased retention, increased repayment rates, and larger loans for clients who succeed in increasing the size of their business – are so great that many organizations may benefit from such a product. As with the transition from a group liability model to an individual liability model, credit with education provides an ideal opportunity for a randomized controlled evaluation. There are convincing arguments both in favor and against the practice, so the value of implementation is not obvious. Furthermore, since such programs are growing in popularity, it is important that the microfinance community have a thorough understanding of both the positive and negative impact that such a product could have on credit programs.

5.2. Objective of the Study and Hypotheses This study was implemented with FINCA Peru (Box 1), a longstanding microfinance organization that operates in Lima and in Ayacucho, a provincial capital in the Andean Region. We worked with them as they implemented a business training program in both regions. In particular, we designed a study that considered the following potential impacts.  Loan repayment:  If businesses generate increased revenues, repayment may improve;  The additional training may engender feelings of goodwill and reciprocity, causing loan clients to be more likely to back loans, even during difficult periods;  If a client’s business falters, particularly because of a risky business decision, she may blame the business training, and hence the credit organization, and default on the loan.  Loan sizes and savings volumes:  If clients manage cash flows better, they may need less credit, and loan sizes could decrease;  On the contrary, if clients increase their businesses activities, they may need more credit, and loan sizes will increase.  Household decision-making:  Improved businesses could empower female microentrepreneurs with respect to their husbands/partners in business and family decisions, leading to greater control over their finances and other areas.

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Box 1. Community Bank Lending Programs in FINCA Peru Foundation for International Community Assistance is a small, nonprofit (but financially sustainable) MFI that has been operating in Peru since 1993. In addition to operations in Ayacucho and Lima, FINCA has operations in Huancavelica, another Andean province. FINCA’s mission is to improve the socio-economic situation of the poor and to empower women through the promotion of the village banking methodology. Typically, FINCA provides loans in cycles of four months to groups of 30 women to help them expand their individual small businesses. Every loan is guaranteed by the entire community bank, meaning that all loan clients are responsible for paying off a defaulted loan. In addition to providing credit, FINCA teaches its clients to save by requiring regular savings deposits that correspond to the size of their loans and by encouraging additional voluntary savings for which they receive market interest rates. In Ayacucho, community banks meet weekly, and in Lima, community banks meet bi-weekly. Each weekly (bi-weekly) payment includes interest, 1/16 (1/8) of the original loan principal, and a mandatory savings deposit of 1/80 (1/40) of the original loan principal. Clients are also encouraged to add to their voluntary savings. All savings, mandatory and voluntary, function as collateral for loans. FINCA further empowers clients by giving them the opportunity to run their banks through rotating participation on the village bank board. FINCA members are relatively young and have little formal education, particularly those in Ayacucho. FINCA clients hold, on average, $233 in savings whereas the average loan is $203, with a recovery rate of 99%. FINCA charges sufficient interest to be selfsustainable. Its sustainability indicator (total income/total expenses) was 99% in 1998; 105.5 percent in 1999; and 132.2 percent in August, 2000.

 Child labor:  Changes to the household enterprise could cause an increase in family requirements that children contribute their labor to the family business;  Conversely, businesses could generate more income and result in a shift in family priorities to the education of children.

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 Client retention:  If the client’s business grows enough, her credit requirements may exceed the capacity of the microfinance organization, and she may leave to seek a loan with a formal lending institution;  The training could be perceived as an additional benefit of membership in the community bank, and client retention could improve.

5.3. Experimental Design The implementation of this experiment was based on the following design: 5.3.1. Design of Training Materials The training materials were designed by Atinchek, a firm specializing in business training materials for microentrepreneurs, and by Freedom from Hunger, a US-based NGO that works with MFIs globally to develop training in microfinance products, capacity building, and education in health and business development. The training materials differed between Lima and Ayacucho, due to the distinct characteristics of the clientele in each district. In Lima, the training materials were in Spanish, and clients were expected to do homework between meetings. In Ayacucho, the training materials were occasionally in Quechua, and due to the higher illiteracy rate among those clients, the training materials relied heavily on visual aids and clients did not have homework. 5.3.2. Pilot Implementation and Credit Officer Training Before the full experiment was implemented, the training materials were piloted in two to four community banks in Lima and Ayacucho to determine the feasibility of the program and evaluate the training materials. This was a useful step not only for FINCA to finalize the program itself but also for the study because we could conduct focus group sessions with one or more of the banks used in the pilot to gather qualitative information about the program. During this phase, all FINCA credit officers were taught how to conduct the trainings. These sessions took place over four months before the launch of the program.

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5.3.3. Randomization All FINCA banks that did not take part in the pilot trainings were randomly assigned, by computer, to one of the following groups:  Mandatory treatment (Lima: 49 banks; Ayacucho: 55 banks): All clients were required to arrive early or stay after the meeting to receive training. Clients were fined for missing training, and continued absence could lead to expulsion from the bank.  Optional treatment (Ayacucho: 34 banks): In this group, which included banks only in the Ayacucho location, attendance at training was voluntary; clients could leave after the regular meeting before the training began.  No training/control (Lima: 50 banks; Ayacucho: 51 banks): The control group clients did not receive training, but continued to have their regular credit meetings as they had in the past. The treatment group in which the credit officer conducted the training at the end of the meeting and clients were not required to stay was included only in Ayacucho. This occurred because FINCA did not think that optional trainings were feasible in Lima for operational reasons. We conducted the randomization at the community bank level. The randomization was designed so that the selection of banks included in the control was similar to the selection of banks included in each of the treatment groups. In addition to conducting the randomization so that there were no discernible differences between the banks of either of the treatment groups or the control group, each credit officer had a proportionate number of banks randomized into each group. This prevented the possibility that the quality of the credit officer herself could skew the outcomes of one particular group of banks. 5.3.4. Baseline Survey Before the implementation of the project, we conducted baseline surveys in all banks, both treatment and control. The survey collected information about business processes, knowledge, and savings practices of the client, her business activities, and information about her household, in particular, decision-making processes with her spouse. Every treatment group was surveyed before beginning training, which coincided with the beginning of a new loan cycle. We were careful to conduct surveys in control groups over the same period of time as we conducted surveys in treatment groups, although we were not bound by the same restrictions of completing the surveys before the beginning of the following loan cycle.

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5.3.5. Program Implementation: Training Conducted in Credit Meetings During the phase of program implementation, the trainings were conducted until all sessions had been delivered, or until the end of two years. Some banks were delayed in completing all 22 sessions within the two-year time frame. However, these banks were considered treatment group banks during analysis. Had we only included those banks that completed the training in our analysis, we would have failed to consider the impact of the trainings on all banks, but rather would have only learned the impact of the training on banks that were able to complete the training in the allotted time frame. During the study, there were some problems with experimental spillover: since all credit officers had learned to administer the training, one challenge we faced was to prevent them from training certain individuals or entire banks in the control group who either asked for the training, or for whom they believed that the trainings could be particularly beneficial. This problem, however, was resolved by explaining the purpose of the study and the study design to credit officers. Once the officers understood that the control group was only temporary and was necessary to assess the success of the training and that once the study was complete, all clients and banks would be eligible to receive training, they accepted their directive to only train treatment group banks. 5.3.6. Follow-Up Survey At the end of the two-year implementation period, follow-up surveys were administered. Follow-up surveys, in addition to collecting information similar to that of the baseline survey, also asked specific questions about the allocation of profits and record keeping of business financial information. In Lima, the follow-up survey included questions about child labor practices within the family. These surveys were administered to everyone interviewed in the baseline survey who we were able to locate, and who were willing to conduct the interview, regardless of their current member status in FINCA (76% of the clients surveyed in the baseline survey). We did not interview women who had become members of FINCA after the baseline survey and therefore had not been interviewed at the start of the project.

5.4. Measuring Impact We measure the impact of the program by comparing data from the baseline survey, the follow-up survey, and FINCA financial transaction data, which

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includes information about loan payments, interest, mandatory and voluntary savings and some socio-economic characteristics. These data were analyzed in two ways. In the first type of analysis, for indicators of interest, a comparison was made between the control and treatment groups. Second, for indicators of interest, a comparison was made between the change exhibited by treatment groups during the length of the study, and the change exhibited by control groups during the same time period.

5.5. Results Our analysis was divided into the following four outcome variables:  Institutional outcomes: Analysis of FINCA financial transaction data revealed that repayment among treatment groups is 3% higher than among control groups and that clients in treatment groups were 4–5% less likely to drop out than clients in control groups. However, treatment group clients were more likely to name the length of the meeting as a reason for dropout. This supports the hypothesis that the clients find the training useful and valuable, and either they are more able to pay back their loans or prioritize repayment more than non-treatment clients. There was no difference in loan size or in cumulative savings between treatment and control groups. Interestingly, these results are the strongest for clients with larger businesses and clients who had expressed the least interest in the program during the baseline survey. This suggests that a market approach, in which the additional service is offered optionally, on a pay basis, may not be the most successful approach since the clients who reacted most favorably to the training did not want it at first.  Business skills and practices: In the follow-up surveys, clients were asked questions about their business practices. The questions were designed to specifically test information that had been covered in the business training sessions. Results indicate that treatment groups in general demonstrated greater business knowledge and better business practices, but only in limited areas. Clients in treatment banks were more likely to reinvest profits in their business, maintain sales records for their business, maintain withdrawal records for their business, and be able to point to changes or innovations that they have made in their business over the past year.

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 Business results: In addition to business practices, surveys collected information from clients about their actual businesses. Again, results indicate that the business training did impact the success of the clients’ business. For example, treatment groups had sales in the month prior to the survey of 16% higher than control groups and reported sales during their worst month that were 28% higher than the sales of control groups during their worst month. Despite an increase in overall sales, there was no change in the profit margin on the most common product sold.  Household outcomes: Household information collected from the surveys, focusing on decision-making processes and child labor practices within the household suggested that there was no impact on decision-making processes with respect to use of loan, nor was there change in whether clients separated money from their husband or partner or methods of tracking family finances. However, this could be because the FINCA model already emphasizes female empowerment in household decisionmaking, so the business training could add little value in that area. With respect to child labor, there was no overall effect when male and female children are looked at together, but there is a positive treatment effect for number of hours that female children dedicate on average to school and schoolwork. In summary, the evaluation of FINCA’s business training with credit program found that many of the anticipated benefits of the project did, in fact, occur. Clients in the treatment group demonstrated greater business savvy, and the institution benefited from an increased repayment rate and greater client retention. The concern over increasing the length of the meeting by adding a training session also proved to be accurate in that a greater percentage of treatment group dropouts complained about meeting length. However, since retention was higher in treatment groups, the increased length of the meeting was, for the most part, outweighed by the perceived benefit of the training.

5.6. Replications of the Study As more microfinance organizations include trainings in their lending model, the types of training and methods of implementation become more and more diverse. For this reason, this study should be replicated before making broader general statements about the impact of credit with education

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programs. Factors that are unique to FINCA that may have influenced the outcome of the education product include:  Location of meeting: In Ayacucho, FINCA holds meetings at the FINCA center near the downtown area, although many of the clients live outside the town. Since clients already have to travel long distances to come to the meetings, it could be a bigger burden for clients to spend an additional 30–60 minutes there during the training than it is for members of community banks that meet in the neighborhoods where the clients live.  Credit officers as trainers: FINCA trained their credit officers to conduct trainings, but some other organizations hire professional educators to facilitate trainings. Since credit officers may not be natural or interested teachers, it is possible that expecting them to double as educators could results in less interesting lessons and thus less interested clients.  Type of clients: As in many, but not all, microfinance organizations, FINCA targets female entrepreneurs as clients. Since the clients are already entrepreneurs, they many react more favorably and absorb more easily the content of the business training than clients with other types of income sources.  Context: Both Lima and Ayacucho are saturated with credit options, particularly in Ayacucho, where FINCA’s program is very well known and highly regarded, the addition of a training program could either cause FINCA’s program to stand out as unique among the options, or become burdensome because of the additional time commitment. In either case, clients are aware that they can receive credit from other sources if the FINCA model no longer suits them. This could result in different reactions from clients than one would see in an area with fewer loan options.

6. EVALUATING GROUP VERSUS INDIVIDUAL LIABILITY LOANS: THE PHILIPPINES CASE A randomized controlled experiment was designed in the Philippines to evaluate the impact of group versus individual liability lending programs. Although group lending programs are still prominent in microfinance practice, a small but increasing number of MFIs are expanding rapidly using individual lending. As these institutions explore the benefits of individual liability loans for the poor, there is an opportunity to apply randomized

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controlled trials to evaluate rigorously the impact of the innovation compared to the group liability program. Indeed, given the popularity and apparent success of the two methodologies, as well as the lack of rigorous evaluations of both of them, it is difficult to know the real advantages and disadvantages of each – and therefore to formulate policies on this matter. An example like the one proposed can fill this void and provide useful guidance to the microfinance industry at large.

6.1. Motivation of the Study Unlike individual liability, under which each borrower is only responsible for her own loan, joint liability requires members of a defined group to help repay the debt of other members when they cannot repay. Unless the group as a whole repays the total amount due, no member will be granted another loan. The Grameen Bank in Bangladesh developed a lending methodology based on joint liability that is now employed by many NGOs and MFIs around the world. The success and popularity of this approach can be linked to its numerous perceived advantages. (Some of the advantages, while associated with group liability, are not inherent to group lending alone, as will be shown below.) Such oft-cited advantages include:  Clients face both peer and legal pressures to repay their loans.  Clients have incentives to screen other clients so that only trustworthy individuals are allowed into the program.  Low transaction costs as clients meet and pay at the same time and location.  Cheaper training costs as clients all gather periodically.  Clients have incentives to market the program to their peers, thereby helping to bring in more clients.  Group process may help build social and business relationships. As is the case with most methodologies, joint liability is not without potential disadvantages. These include:  Clients’ dislike of the tension caused by the peer pressure could lead to lower client satisfaction and hence higher dropout.  Older clients tend to borrow significantly more than newer clients, and this heterogeneity often causes tension within the group, because new clients do not want to be responsible for others’ much larger loans.

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 Group lending could be more costly for clients since they are often required to repay the loans of their peers.  Clients dislike the longer meetings typically required for group lending.  Default rates could be higher than if there were no group liability because bad borrowers can bring down good borrowers (i.e., once your peer has gone into default, you have less incentive to pay back the loan yourself).  Default rates could be higher than if there were no group liability because clients can free ride off of good clients. In other words, a client does not repay the loan because the client knows that another client will pay it for them, and the bank will not care because they still will get their money back.  Villagers with fewer social connections might be hesitant (or even unwelcome) to join a borrower group. Given the existence of these potential negative aspects and the fact that the last three advantages listed can be obtained without resorting to group liability,6 there is a strong case to be made for an MFI to experiment with offering individual loans to their clients. The concern over the excessive tension generated among members by imposing group liability is precisely the main motivation for the shift from group to individual liability loans. Practitioners worry that the conflict among members could not only lead to high dropout rates and affect the sustainability of the program, but also potentially harm social capital so valuable to the poor who lack economic security. Two features of this innovation make it a perfect case for a randomized controlled evaluation. First, there are conflicting arguments for and against individual liability loans, and the net impact of such programs compared to group liability lending programs is not clear. Besides the obvious benefit of removing group liability for the clients (reducing pressure and tension among members), the individual liability loans may also benefit the lending institution by increasing the client retention rate (because clients prefer individual liability) and thereby the MFI’s portfolio. However, the lender will lose a crucial enforcement mechanism when group liability is removed. It would negatively affect the repayment rate if none of the group members is willing to make a voluntary contribution to cover the repayment of defaulted members. Using a randomized controlled trial, the relative merits of group versus individual liability loans for both clients and institutions can be evaluated. Second, in recent years individual liability loans in the microfinance community have gained popularity around the world. Although replication

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of the study is necessary to generalize the results of this particular evaluation, it will help identify the effective environment and design of the program, benefiting not only the lending institution and its clients but also the entire microfinance community. As such, it can play an important role in both policymaking and product design.

6.2. Objective of the Study and Hypotheses We collaborate with Green Bank (Box 2), a commercial bank based in Mindanao, as it expands its microfinance operation in Leyte and Samar islands in the Philippines, to conduct a pilot-testing experiment to evaluate individual liability loans. In this experiment, we seek to evaluate the following impacts: 1) Relative impact of group versus individual liability on clients and their communities 2) Relative cost and benefit of group versus individual liability loans for Green Bank 3) Impact of credit on individuals and their communities Specifically, we pose the following questions: 1) How does group relative to individual liability affect institutional outcomes such as repayment, client retention, loan size, and operating (labor) costs? 2) Does group liability motivate peers to monitor and/or enforce repayment of loans? 3) Does group liability motivate peers to select less risky clients for a bank? 4) How does selection on other dimensions (e.g., poverty, social connectedness) differ under group versus individual liability? Are those lessconnected (hence perhaps less likely to have good informal social safety nets) less likely to participate in group lending than individual lending programs? 5) What is the impact on the household, enterprise, and community from a MFI offering credit in their community? How does this impact differ for group versus individual liability loans? 6) What are the impacts, positive and negative, on social networks from group versus individual liability loans?

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Box 2. Group Versus Individual Loan Programs at GREEN BANK Green Bank is a for-profit commercial bank that was established in 1975 and currently operates in northern Mindanao and the Visayas. Its microfinance department started in the late 1990s, and their group liability lending program BULAK in 2000. BULAK follows a modified version of the Grameen approach. In BULAK there are four different units, which from smallest to largest are: individuals, groups, centers, and branches. Up to five low-income women come together to form a group. The group is formed by them and not by the bank. Then, three to six groups come together to form a center. The center is where all of the groups jointly hold their weekly meetings and collect payments. Typically a barangay (sub-municipality) will have one center. In total, Green Bank has over 12,000 clients. All loans given under the BULAK program are to be used for expanding the client’s microenterprise. The initial loan is between 1,000 and 5,000 pesos (roughly $18–$90) and increases by 5,000 pesos after every cycle, such that the maximum loan size in the 5th cycle is 25,000 pesos. However, the loan size is a function of the repayment of their last loan, attendance at meetings, business growth, and contribution to their personal savings. Loans are charged an interest rate of 2% per month over the original balance of the loan. The client has between 8 and 25 weeks to repay the loan, but payments must be made on a weekly basis. As part of the BULAK program, clients are also required to make mandatory savings deposits at each meeting. Each member has 100 pesos ($1.80) deducted from every loan release. In addition, 10% of their weekly due amount (principal plus interest) is deposited in their individual savings account. Member savings may be used to repay debts and may also be used as collateral in case of default. Finally, 10 pesos ($.36) per meeting are required for the group and center savings. These center savings mostly cover the construction of the center meeting place and are only used as a last resort to repay member loans. The individual liability program (BULAK II) being pilot tested in the experiment has all the features of the BULAK program, including weekly repayment meetings and consolidation of repayment by center groups, except for the following two features: first, no client is liable for her group members’ loans, and second, there are no longer mandatory center and group savings. All center activities are paid individually on a per activity basis.

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6.3. Experimental Design The experimental design employs one strategy for ‘‘existing areas’’ and one for ‘‘new areas.’’ The ‘‘existing areas’’ strategy involves converting existing centers to individual liability loans. The results of this initial study can be found in Gine´ and Karlan (2006). The advantage of this approach is that one can attribute the differences between group and individual liability to differences in the loan liability, and not to differences in the individual characteristics of the clients per se. This is true because all existing clients joined the program under a joint liability scheme. Thus, there is no selection bias as would be inherent in comparing the outcomes of clients who have chosen group liability to the outcomes of clients who have chosen individual liability. The disadvantage is that there may be differences between clients who have enrolled in a group liability program and the borrowers that would enroll in an individual liability program. Therefore, although the results from the ‘‘existing areas’’ strategy will be accurate for those who are willing to sign up for group liability, we cannot say from this strategy alone how the product will work among clients who know from the outset they are joining an individual liability program. It is then important to understand these potential differences among borrowers, especially when generalizing the results of the costs and benefits of joint liability. For this reason, the study includes a ‘‘new areas’’ strategy by working with Green Bank as it expands to new areas on the eastern coast of Leyte (Tacloban) and the neighboring islands of Cebu and Samar. This expansion also provides a unique opportunity to test the impact of the credit itself. A randomized program placement strategy is employed to assign barangays to either individual or group liability, and also to a control group. This allows us to test the impact on household, enterprise, and community outcomes from receiving either group or individual liability loans. 6.3.1. Pilot Phase Since the change to individual liability is significant, careful testing is required before the full launch of the experiment can be implemented. For this reason, a small pilot test was conducted in Leyte, which will also serve as the location of the full study. Green Bank has 186 lending centers in Leyte, with an average membership of 25 individuals (or 5 groups) per center. For the pilot phase, one center from each credit officer’s portfolio was randomly chosen, 11 centers in all, to convert to the new individual liability methodology. This random selection of centers is critical. If, for

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instance, one were to pick only the best centers, then one would not know whether the results were generalizable to the inferior centers. One might falsely conclude that individual liability is better, when it in fact is perhaps only good for the best groups. This pilot phase began in August 2004 and proceeded with little to no difficulties. 6.3.2. Existing Areas Full Launch (Group Versus Individual Liability Experiment 1) In early November 2004, 24 more centers were randomly converted. The full pilot phase as of May 2005 included 93 converted centers and 93 original (group liability) centers. The findings are striking: there is no change in repayment among the Green Bank centers that shifted to individual liability, relative to its centers which remained in group liability. We find that the individual liability centers attract more new clients, and lose fewer clients to dropout. We also find no change in the time required of the credit officer, so there is no indication that this shift will reduce the capacity of an individual credit officer to manage centers. The full results can be found in Gine´ and Karlan (2006). 6.3.3. New Area Plan (Group Versus Individual Liability Experiment 2) Evaluating the relative impact of group versus individual liability loans poses a challenge in conventional non-experimental evaluation method because the two programs attract different types of clients – unobservable heterogeneity between the two groups of clients may confound the results. In a randomized controlled trial, random selection of the sample allows you to compare between the two groups. The procedure to start operations in new areas is novel and another contribution of the study. It consists of two parts, the identification of eligible barangays and of potential clients through a marketing meeting.  Identification of the Barangays: The first step is to gather basic information about the barangays from the municipality office. This information is mainly used to exclude barangays with low population density as it is deemed too costly to start operations in these areas. The credit officer visits the selected barangays and conducts a survey to verify the following criteria: (i) the number of microenterprises, (ii) the residents’ main sources of income, (iii) the barangays’ accessibility and security, and (iv) the perceived demand by the residents for microcredit services. The survey is administered to the secretary of the barangay, typically the person with the most information about the administrative aspects of the barangay.

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 Census of Microentrepreneurs: The purpose of the census is to construct the sample framework to assess which businesses are interested in credit and could eventually be clients of Green Bank. The census records basic information regarding the size of their business and their credit history. While it is being conducted, they are told about the marketing meeting. The sample villages identified are randomly assigned to the following four groups. 1. BULAK: Green Bank will offer the group liability loan program. 2. BULAK to BULAK II: Green Bank will offer group liability loans and remove group liability after the first loan cycle. 3. BULAK II: Green Bank will offer the individual liability loan program. 4. NO CREDIT: Green Bank will not offer their services (control group). It is important to note that our sample in groups 1, 2, and 3 is NOT composed only of the actual borrowers, but rather the ‘‘potential clients.’’ This is because if we were to compare those who choose to participate in the program in the areas in which the program is offered to those in the control group, our estimate of impact will suffer from self-selection bias. We would capture, in addition to the true effect of the program, the extra motivation of the clients who decide to enroll. However, instead of watering down our estimate of average impact (calculating the average outcomes among those who do participate, as well as all those who do not), we can improve our estimate – and keep it unbiased – by employing a technique called propensity score matching (PSM) and weighting the impact estimate by the likelihood that each individual becomes a client. The key in this sample formation is to identify those who would receive a loan from Green Bank if Green Bank were to operate in the village. PSM uses the baseline characteristics of the potential clients to identify statistically those most likely to participate in the program. We measure the impact on each client by comparing their outcomes to the outcomes of those in the control group with a similar propensity to participate. Because the sample selection in the four groups is consistent, sample bias in sub sets from these groups is consistent, and we can compare the impact between any of the four groups. This experimental design provides a unique opportunity to measure the clean impact of credit by comparing groups 1, 2, and 3 with group 4.

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6.4. Measuring Impact We measure the impact by comparing different outcome measures between the treatment groups and control groups. The impact of the program can be measured at three different levels: individual client, community, and institutional. By looking at the impact not only at the client and institutional levels but also at the community level, we can evaluate the broader implication of the program and how it could affect the local economic status. In order to make necessary comparisons, the data will be collected in three different methods:  Baseline survey: The information on sample villages and clients is collected before the experiment takes place. This information is used in validating the randomization as well as in analyzing the post-experiment impact. In the Green Bank study, we collected information on loan history, business status, household well-being (economic and psychological), social networks, and risk preferences of the sample individuals. By definition, randomization will create comparable treatment and control groups; however, it is always a good idea to validate the random assignment by checking some key variables from the baseline survey before the launch of the experiment (comparing the means of the variables for treatment and control groups and ensuring they do not differ significantly).  Follow-up survey on clients: The survey conducted after the study period will be used to evaluate the program impact. The information collected will include clients’ performance in the Green Bank program and clients’ business performance as well as their household welfare.  Activity-based cost exercise: This exercise records all activities of development (loan) officers. By comparing the total time spent on BULAK II versus BULAK centers, we will be able to calculate the cost for the institution of the individual liability program relative to the group liability program.

6.5. Replication of the Study Given the decision by several MFIs to employ individual liability loans, it is not only in Green Bank’s interest, but also in the interest of the microfinance community as a whole to learn the impact of group versus individual liability programs. However, we cannot draw a general conclusion from

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the result of this specific program evaluation in the Philippines. Only after replications of the evaluation, with different MFIs in different places and with different clients, can we make more general statements about the impact of group versus individual liability loans. Many factors may make the results of the evaluation unique to Green Bank and its context. The following are some of such factors:  Initial social network: The importance of social networks among program members depends on many exogenous factors: culture, the size of the village, and its economic activities. The more economically vulnerable clients are, the more they rely on their social networks for support. If this is the case, removing group liability among uncollateralized clients may result in better repayment performance among lower-income groups than among those with more stable income flows.  Type of clients: For example, Green Bank targets small female entrepreneurs in rural areas. There is a large volume of literature that concludes that female borrowers repay better than male borrowers. The impact of group versus individual liability loans could well be different between the gender groups.  Type of institution: Green Bank is a commercial bank; thus the financial sustainability of its microfinance programs is a critical part of its operational goal. The implications of cost–benefit analysis would be different for Green Bank than for subsidized institutions.  Context: In most areas where Green Bank operates, it competes for clients with other lenders. For the most part, these tend to offer group lending loans, so the impact of introducing individual liability will be affected by the presence of other lenders and their specific products.

7. PILOT EXPERIMENTAL APPROACH FOR OTHER LENDING PRODUCT INNOVATIONS In the previous section we used an example from a randomized controlled trial designed to evaluate the impact of group versus individual liability programs with Green Bank in the Philippines. This experiment pilot approach is applicable to many other innovations whose net impact on clients and benefit for the institution is not known. Below are some examples of such cases.

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7.1. Mandatory/Voluntary Savings Rules for Lending Programs Savings schemes in lending programs aim to reduce clients’ vulnerability to unexpected negative economic shocks, as well as to improve clients’ financial management skills by encouraging them to make small regular savings. However, if clients lack the discipline to save, they might view mandatory savings merely as an additional burden, reducing the number of borrowers.

7.2. Savings Products with Commitment Features Owing to self-control or household (e.g., spousal) control issues, some people prefer to have commitment savings products in which deposits are withheld from their access until a specific savings goal is reached. Such products take on many forms, but little empirical evidence of their effectiveness currently exists (Ashraf, Gons, Karlan, & Yin, 2003; Ashraf, Karlan, & Yin, 2006, 2010).

7.3. Frequency of Payments Frequency of payment varies from program to program. MFIs generally demand relatively frequent repayment schedules (often weekly) while clients often prefer less-frequent payment. Particularly for those who have inconsistent income flows, a frequent repayment schedule could increase the default rate. One example of a randomized study of repayment frequency is Field and Pande (2007).

7.4. Health/Life/Disability Insurance Insurance offered with credit aims at reducing the vulnerability of clients. Clients as well as MFIs may benefit from the insurance services as they are insured for certain types of economic shocks. However, insurance services may cause adverse selection by attracting riskier clients to the program, which could lead to higher default rates. Or insurance could cause advantageous selection by attracting risk-averse clients, which could lead to lower default rates.

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7.5. Local Public Goods (Community ‘‘Empowerment’’ Training) The mission of some MFIs is not merely increasing credit access for the poor, but also to empower the economically/socially marginalized sector of a population. Empowerment training may increase impact on clients by improving women’s mobility and ability to make economic decisions; or it could increase client exit if the clients do not have an interest in the training. 7.6. Human Resource Policies (e.g., Credit Officer Incentives) Providing incentives for credit officers could improve repayment rates if they use enforcement power appropriately. However, the incentive schemes could cause conflicts between the officers and clients because the officers now have a personal stake in better repayment rates. Such friction between the credit officers and clients may affect the retention rate. 7.7. Interest Rate Policies Little is known empirically about the elasticity of demand with respect to interest rates (the extent to which clients are willing to accept higher interest rates, and the extent to which demand for loans increases at lower interest rates). Furthermore, much economic theory has been written about how higher interest rates might drive down repayment rates through information asymmetries such as adverse selection and moral hazard. Some authors try to examine these issues using survey data, see for example Dehejia, Montgomery, and Morduch (2005) and Gross and Souleles (2002). Experimental studies can be done to study the relationship between interest rates, demand for credit and repayment rates. See Karlan and Zinman (2006a, 2006c) for an example of such a study. 7.8. Credit Scoring and Credit Evaluation Decision-Making Many financial institutions are employing credit scoring to facilitate the credit granting decision. Questions remain, particularly for typical microfinance clients, how to balance objective and subjective inputs into the credit approval process, and specifically how to balance human versus computer decision-making. Furthermore, depending on how the credit scoring is implemented, one can use the process to create randomly assigned treatment

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and control groups to assess the impact of receiving credit on the welfare of the client (e.g., see Karlan & Zinman, 2006b).

8. CONCLUSIONS In this chapter, we examined the flaws in methods commonly used to assess the impact of microfinance programs and showed that modifications to the design of microfinance programs may be best evaluated through randomized controlled trials. Randomized evaluations can be performed ethically and cost effectively, and the accuracy of their results makes them valuable both to the institution implementing the evaluation and to the microfinance community at large. Through the example of individual liability loans in the Philippines, we showed the steps involved in performing an experimental evaluation. Many questions remain, however, and until an evaluation has been replicated in a variety of settings, it remains unknown whether a particular innovation is likely to work for other programs. This is the nature of all evaluative work, regardless of the methodology employed. To stimulate the experimental evaluations of more program innovations we have provided a list of several product modifications that could be tested using similar methodology.

NOTES 1. This chapter does not elaborate on this step any further, as much has been written on it already by organizations such as Micro-Save Africa. In this chapter we put forth a process that begins where such organizations stop. 2. We recommend the free software Optimal Design for helping to determine sample sizes. It can be downloaded from http://sitemaker.umich.edu/group-based/ optimal_design_software. 3. In some experimental designs, treatment is not mandatory for the treatment group, and/or members of the control group are permitted to get treated. These are called encouragement designs, in which everyone receives the treatment but only the treatment group is given an encouragement to participate in the treatment (but is not required to participate). The control groups are not given the encouragement (but are allowed to participate in the program if they choose to do so). These work as long as the encouragement leads to a higher enough take-up rate in the treatment group than the control group. See Ashraf et al. (2006, 2010) for an example of such a design. 4. More generally, findings from good random experiments can help avoid costly mistakes. For example, Duflo and Hanna (2005) find that in an education program in India adding a second teacher to the classroom makes no improvement in students’ test scores and this helps redirect the funds to other more effective initiatives. Such decisions can have vast financial implications for programs at a national level.

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5. One example of the cost of a comprehensive non-experimental evaluation, reported by Montgomery, Bhattacharya, and Hulme (1996), is the 1994 impact evaluation of BRAC’s credit program that cost $250,000. 6. For instance, under the methodology employed by the MFI ASA, clients still meet together but are individually liable for their loans.

REFERENCES Ashraf, N., Gons, N., Karlan, D., & Yin, W. (2003). A review of commitment savings products in developing countries. Economics and Research Department Working Paper no. 45. Asian Development Bank, Manila. Ashraf, N., Karlan, D., & Yin, W. (2006). Tying Odysseus to the mast: Evidence from a commitment savings product in the Philippines. Quarterly Journal of Economics, 121(2), 673–697. Ashraf, N., Karlan, D., & Yin, W. (2010). Female empowerment: Impact of a commitment savings product in the Philippines. World Development, forthcoming. Dehejia, R., Montgomery, H., & Morduch, J. (2005). Do interest rates matter? Credit demand in the Dhaka Slums. Working paper. Duflo, E., & Hanna, R. (2005). Monitoring works: Getting teachers to come to school. Working paper. M.I.T. Poverty Action Lab. Field, E., & Pande, R. (2007). Repayment frequency and default in micro-finance: Evidence from India. Working paper. Gine´, X., & Karlan, D. (2006). Group versus individual liability: Evidence from a field experiment in the Philippines. Working paper 940. Yale University Economic Growth Center. Gross, D. B., & Souleles, N. S. (2002). Do liquidity constraints and interest rates matter for consumer behavior? Evidence from credit card data. The Quarterly Journal of Economics, 117(1), 149–185. Hulme, D. (1997). Impact assessment methodologies for microfinance: A review. Working paper. University of Manchester Institute for Development Policy and Management. Karlan, D., & Zinman, J. (2006a). Credit elasticities in less developed economies: Implications for microfinance. Working paper. Karlan, D., & Zinman, J. (2006b). Expanding credit access: Using randomized supply decisions to estimate the impacts. Working paper. Karlan, D., & Zinman, J. (2006c). Observing unobservables: Identifying information asymmetries with a consumer credit field experiment. Working paper. Karlan, D., & Valdivia, M. (2006). Teaching entrepreneurship: Impact of business training on microfinance institutions and clients. Working paper. Yale University Economic Growth Center. Miguel, E., & Kremer, M. (2004). Worms: Identifying impacts on education and health in the presence of treatment externalities. Econometrica, 72(1), 159–217. MkNelly, B., Watetip, C., Lassen, C. A., & Dunford, C. (1996). Preliminary evidence that integrated financial and Educational services can be effective against hunger and malnutrition. Freedom from Hunger Research Paper Series 2. Montgomery, R., Bhattacharya, D., & Hulme, D. (1996). Credit for the poor in Bangladesh. In: D. Hulme & P. Mosely (Eds), Finance against poverty (Vol. 2). London and New York: Routledge.

A FRAMEWORK FOR INNOVATION ROADMAPPING IN MICROFINANCE INFORMATION SYSTEMS Todd A. Watkins Industry-wide technology roadmapping programs have had demonstrable significant positive impact in fostering growth and efficiency in several global industries. Based on a series of facilitated collaborative workshop discussions among leading microfinance information technology practitioners, academics, and government officials, this chapter suggests a framework of key innovations needed in microfinance management information systems (MIS).

1. BACKGROUND ON INNOVATION IN MICROFINANCE Despite the remarkable expansion of microfinance over the past several decades, the industry remains in a developmental period of experimentation and rapid growth, exploring which approaches work best under different circumstances. Widespread diffusion and local adaptation of techniques and innovations from pioneering organizations such as ACCION International, Moving Beyond Storytelling: Emerging Research in Microfinance Contemporary Studies in Economic and Financial Analysis, Volume 92, 251–269 Copyright r 2009 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1569-3759/doi:10.1108/S1569-3759(2009)0000092011

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Grameen Bank, FINCA, Bank Rakyat Indonesia, BancoSol, and many others fostered the emergence of a global industry that by most counts now serves more than 100 million clients. Yet along many dimensions of the industry – for example, client methodologies, information technologies and infrastructures, transparency and performance monitoring, product and service portfolios, funding structures, human resource management, health and environmental amelioration, and regulations – significant barriers remain to achieving the broad vision of microfinance as a major contributor in fighting global poverty. The inability to reach large numbers of clients efficiently remains one of the principal challenges for microfinance institutions (MFIs). Most microfinance loans and savings deposits are very small (i.e., $50–$500) but still require account processing and related labor-intensive activities – transactions most often still done by hand and in person. The resulting high transaction costs per loan and resulting challenges in reaching sparsely populated rural areas are significant hurdles to overcome in expanding financial access. MFIs generally need to maintain relatively high interest rates and fees (which critics say are usurious) if they are to cover the full costs of account administration. This is particularly important for longterm growth and sustainability of the microfinance industry as it makes the transition from charitable operations, largely reliant on donors, to sustainable businesses. In response, MFIs are increasingly looking to technological innovation to improve efficiency, better track their operations, reach new customers, and lower transactions costs. For example, Grameen Bank, one of the larger and more famous MFIs, has a Technology Center entirely devoted to microfinance-related innovation. However, while mainstream financial markets are rich in data and in cost-efficient technology for collecting, managing, and analyzing the data, the techniques, data requirements, and business models of MFIs differ substantially. This severely restricts direct technology transfer from commercial banking. Barriers, needs, and potential solutions are widely discussed at a superficial bullet-point level among microfinance industry practitioners. Thoughtful, active professionals have a general sense of overall needs. Everyone in the industry, it seems, ‘‘knows’’ that high transaction costs in client management and information processing are problematic and that certain information technologies may contribute solutions. Everyone knows that better credit scoring techniques and that credit score sharing among institutions may help; that increasing competition among MFIs in saturated markets poses significant industry-wide risks; that financial transparency

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might help attract the commercial-scale funding required for self-sustainability; and that restrictive usury laws and regulations governing collateral hinder serving large fractions of the world’s poorest. The list of innovation target issues is deep and broad. As a result, innovation efforts are diverse, widespread, and well understood as important to progress in the industry as a whole. Some are well publicized and organizationally comprehensive, such as the new product portfolios and client management methods developed as ‘‘Grameen II.’’ Other high-profile experiments focus on narrower key problems, such as Kiva.org bringing retail microfinance lending to the Internet, or ProFund and the Inter-American Development Bank promoting an experimental region-wide Emergency Liquidity Fund for Central American MFIs, or Grameen Foundation’s Mifos initiative developing open source information systems. But such programs remain largely ad hoc and dependent on individual organizations. Collaborative programs do exist among regional networks. But again, such programs are generally ad hoc in terms of specific target needs. For example, the Africa Microfinance Network (AFMIN) developed recommendations for new policies in West African nations and holds conferences for training and information sharing. REDMICROH, a network of 25 Honduran MFIs, supported joint efforts to understand better the hurdles to adapting financial systems across the nation’s diverse rural conditions. The industry as a whole has made significant progress in developing a shared vision of its potential, through industry-wide support organizations such as the Microcredit Summit and the Consultative Group to Assist the Poor (CGAP). Both support and publish occasional academic studies, relatively high-level industry-level strategic and topic overviews, good practice guidelines, case study examples, training brochures, and the like. As beneficial as these collaborative initiatives have been, they remain scattered, idiosyncratic, and fairly high level. Importantly from the point of view of promoting innovation, they most often lack levels of technical detail – coherence between collective vision, breadth, and line-specific actions and targets – to channel the many individual innovative resources most effectively into a balanced industry-wide portfolio. In addition, because many organizations face a few key similar challenges, there can be substantial redundancy in resources aimed at some areas. At the same time, large holes remain that individual efforts cannot effectively address, particularly in shared infrastructures and institutions. Nor are there regular mechanisms that track, evaluate, and update industry-wide innovation progress and needs. In short, though many pieces exist, the

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industry lacks in-depth, comprehensive microfinance innovation roadmapping programs. Particularly absent is a roadmapping program for microfinance MIS, a vital but challenging area given the central role and associated substantial costs of data collection and processing and of managerial and regulatory reporting. For many MFIs, developing and implementing the necessary technologies and the requisite complementary human resource skills remain problematic. As a result, a large fraction of existing MFIs continue to rely on either paper or simple spreadsheets for their back-office data management. More broadly, the industry lacks well-established standards for microfinance MIS in terms of workflow processes, architecture, reporting requirements, and the like. Existing approaches are expensive and their diversity is wide, indications that the industry remains immature in applying information technologies.

2. THE VALUE OF INNOVATION ROADMAPS Industry-wide technology roadmapping programs have fostered growth and efficiency in several global industries. Collaborative development of innovation roadmaps can help guide and intensify an industry’s innovation investments and strategies. Motorola pioneered the technology roadmapping approach at the corporate level in the 1970s. Motorola CEO Robert Galvin (1998) described the process: ‘‘A ‘roadmap’ is an extended look at the future of a chosen field of inquiry composed from the collective knowledge of the brightest drivers of change in that field.’’ Along these lines, the goals of Lehigh University’s microfinance innovation roadmpapping workshop sessions, the initial results of which are reported here, have been to envision, collectively, where MIS are heading in the microfinance industry, identify vital needs over the next decade, discuss the barriers to moving forward, and recommend collective strategies for reaching industry-wide goals. Industry-level roadmapping programs exist in various forms in a remarkable diversity of sectors, including (for a random smattering among the many) photovoltaics, financial services, avionics, windows, steel, wind turbines, nanomaterials, magnesium, and healthcare. Arguably, the most successful and comprehensive innovation roadmap, and a longstanding model for many other industries, has been the International Technology Roadmap for Semiconductors (ITRS].

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One survey (Phaal, Farrukh, Mitchell, & Probert, 2003) studied more than 2,000 organizations undertaking innovation roadmapping activities. One major conclusion was that the process itself, a focusing mechanism for communication and open debate across organizations, is as or more important than the final roadmap itself. As Bill Spencer, the former Chairman of SEMATECH, the leading organization responsible for orchestrating semiconductor roadmapping, and his colleagues put it, a roadmapping program attempts to show what y might be needed to continue down a historical progress/ learning curve, but does not presume to be a precise forecast of which solutions will definitely satisfy the future requirements. It often describes several alternatives y However, it does strongly attempt to indicate where additional long-term research is needed to provide a breakthrough or added capability to remain on the historic trends. The roadmap process is the consensus gathering of the leaders in the industry, universities, and government, and, thus, has the benefit of collective input beyond what any single company, university, or government might provide. It is dynamic information in the sense that it is often updated and may be substantially changed as new technologies and science become available. (Spencer, Wilson, & Doering, 2005)

Industry insiders concur that the ITRS has significantly contributed to the continued remarkable progress in semiconductors over the past two decades in costs, performance, efficiency and technology, and related supplier and user industries: Coordinated efforts to resolve standards, schedules, and other aspects y led to earlier and easier introduction [of new techniques]. The roadmap has also given the entire industry a single voice in the issues it faces. It has gained solid credibility and when resolution is required, reference is often made to the most recent version of the ITRS document. This is true whether setting research or development directions or providing input to the electronics industry where the semiconductor performance is closely watched. In fact, the entire information technology industry uses the roadmap projections to determine the capability of communications and computers in the future. (Spencer et al., 2005)

In short, a successful roadmap:  Recognizes that the industry-wide consensus-building process is valuable in and of itself, perhaps more so than the resulting roadmaps;  Guides innovative efforts into a coordinated collaborative portfolio of activities and research;  Develops a common understanding, language, and vision;  Identifies strengths and weaknesses;  Highlights major barriers, bottlenecks, and needs for complementary enablers;

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 Encompasses and aligns products, architectures, organizations, skills, processes, infrastructures, and policies;  Establishes innovation targets, where research and breakthroughs are needed, and where collaboration and investment can help most;  Aligns detailed and specific action-line efforts with common vision and values; and  Is an ongoing process.

3. ROADMAPPING FRAMEWORK As an initial step in developing an ongoing MIS roadmap process for microfinance, Lehigh University’s microfinance program, together with the help of a Leadership Council (Table 1), convened a diverse group of domestic and international experts and researchers in MIS. The group met in a series of six roadmapping workshop sessions in 2008. Sessions were facilitated by moderators who addressed key questions to select panelists and facilitated exchange among all participants. Appendix Table A1 indicates the topics and discussion issues for the various sessions. The objective was to establish a preliminary framework for a microfinance industry MIS innovation roadmap through consensus building. The participants collectively attempted to identify high priority technical challenges related to microfinance MIS and to outline the central top-level priorities that need to be met moving forward by the microfinance industry, associated industries, and regulatory bodies. The remainder of the chapter presents the initial outlines of that roadmap. Future similar collaborative sessions are planned to add details and specific line-item action items, timelines, and cost estimates. Table 1. Cyrille Arnould Alexander Bloch Wagane Diouf Gautum Ivatury Ira Lieberman Elizabeth Rhyne Alex Silva Todd A. Watkins

MIS Roadmapping Leadership Council. European Investment Bank IBM Global Business Services Africap CGAP LIPAM International ACCION International Omtrix, Inc. Lehigh University

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4. CONSENSUS INNOVATION PRIORITIES FOR MICROFINANCE MIS Participants in the various sessions agreed that a driving top-level goal for the microfinance industry is inclusive access to diverse financial services for the world’s 1–2 billion poorest. Microfinance now only serves roughly 100 million clients worldwide, and the services available often remain quite limited. The goal implies an industry five- to ten-fold larger than at present. Growth will require significantly scaling operations up in size and out geographically by expanding the types, variety, and delivery mechanisms of services available and by substantially cutting costs to improve affordability for the clients and MFI self-sustainability. Discussion centered on what needs to happen to MIS to help facilitate that growth and diversity. Participants agreed that beyond basic (and scalelimiting) approaches to keeping data such as on-paper or spreadsheets, the costs and technical skills demanded by available systems are untenable for all but the very largest MFIs and remain significant barriers to industry growth. Large-scale industry expansion will only come with a far better ratio of MIS functionality to MFI resource realities. Seven target areas for MIS innovation emerged as collective priorities for the industry over the next 5–10 years. 1. 2. 3. 4.

Standardizing MIS process and transaction workflow; Expanding flexibility through parameterization; Enabling interoperability among proprietary systems and processes; Aligning MIS strategy and processes with business strategy and processes; 5. Elevating MIS skills and training as strategic assets; 6. Improving risk and security management; and 7. Promoting complementary external changes.

4.1. Standardizing MIS Process and Transaction Workflow As the industry has expanded, thousands of MFIs have emerged and often developed their information systems independently. Organizational idiosyncrasies in procedures, products, programming skills, managerial preferences, and the like have led to thousands of alternative approaches to essentially similar processes at the fundamental core source code level in MIS software. Participants agreed that the industry needs to develop MIS

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process protocols and standards. Convergence of MIS-level processes will dramatically improve system scalability as client numbers grow, reduce complexity and redundancies in development efforts, increase efficiencies and modularity in software design, and improve interoperability and ease of data migration among alternative systems. This will in turn significantly reduce the MIS share of operating costs as client numbers and product diversity continue to increase. For example, even a single institution might have dozens of different types of loans, variable by term, payment cycles, interest rate compounding methods, and the like. However, there will be common steps in the loan process across most or all of them, such as account opening, entering loan amounts, calculating interest and recording payments, and so on. Ideally, there would be standard process for such transaction workflows. Establishing MIS design standards and protocols would reduce significantly the diversity and redundant efforts at the fundamental core source code level while also supporting customization through flexibility at the parameter level (see Section 4.2). MFIs engage in hundreds of types of common transactions; some examples are given in Table 2. Most have little to do with competitive advantages in the marketplace and should become more consistent from MFI to MFI. Transaction workflows could be standardized by identifying best practices.

Table 2.

Example Common Transaction Workflows that Could be Standardized.

 Account opening and closing  Changing terms of loans  Cash management, cash position keeping  Making loan-loss provisions  Payment collection and recording  Funds transfers  Default recovery  Adding new financial products to system  Handling dormant accounts  Managing deposits

 Linking group and individual accounts  Credit screening and scoring  Client access to account information, client inquiries  Client identification, security  Accounts payable  Reconciling ledgers, internal audits  Recording assets and depreciation  Internal and external reporting

    

External data exchange User logins, security changes Data entry, data backup Override procedures Measuring performance (e.g., portfolio risk, individual and business unit productivity, social impact)  Hiring and payroll  Credit score reporting and sharing

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Indeed, well beyond its value for MIS efficiencies and scale, the collaboration necessary for coming up with and implementing industry standards fosters collective identification, codification, and diffusion of best practices. These best practices can come from and diffuse through leading firms, consultants, external analysts, industry associations, regulators, and MIS vendors. As industries mature, superior solutions naturally start to diffuse and converge, but collaboration on standards can streamline the process and get convergence more quickly. An additional benefit would be that standardizing such processes and identifying best practices would also allow improving and standardizing internal controls at key stages in these transaction flows (e.g., verification that loan disbursements are to valid clients; data input integrity checks; and backup and recovery procedures) and building such control into the information systems so that they could be duplicated from MFI to MFI. One of the near term means for achieving the goal of improving standardization is for MFIs to map explicitly their own current processes and controls. Then, it is easier both internally and externally to review them and to evaluate where they are working properly and where they can change or eliminate inefficient ones. Another means to this standardization goal would be to create a standing industry-wide transaction workflow standards group. Other longer term approaches would include shared open source code development efforts or shared central processing.

4.2. Expanding Flexibility through Parameterization Participants in the various workshop sessions recognized that competitive pressures will continue to drive differentiation in products and managerial approaches among MFIs. MFIs are regularly learning about new needs, new requirements, or new ideas that can work for some set of clients. The information system should not only allow very flexible product design but also accommodate expanding product breadth and dynamic changes. Systems flexible enough to handle the customization required by such differentiation can be enabled with standard core processes that can be adjusted as needed by establishing parameters that users can control and vary without need to modify those underlying core processes. An example pair of customizable parameters is loan cycle and payment frequency. A single core process would be designed to be flexible enough to handle loans of whatever cycle and payment frequency (e.g., 4 months, biweekly;

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Table 3.      

Example Parameters for User Customization.

Loan cycles and payment frequency Minimum/maximum balances Ways to link individuals to groups Client and group categories and status Product types, financial and non-financial Rules for calculating interest (e.g., Type of compounding? Calculated on average balance/minimum balance? Date paid? Rounding?)

 Penalties, fees  Transaction types and frequency  Kinds of collateral  Comingling of client funds  Multiple currencies  Credit scoring criteria

52 weeks, monthly; and 21 days, daily) and the user would chose among a set of parameter options. Table 3 lists just a few example parameters that often vary substantially from MFI to MFI. Systems also need to be robust and flexible to tolerate different and changing operating environments, such as follows  Distributed field, branch, or centralized operational structure;  Remote, rural, periurban, urban locations;  Internet, telecom, 3G mobile, Wireless Application Protocol (WAP) infrastructure availability;  Online or batch processing;  Languages;  Growth in scale of client base;  Modifications in business processes; and  Changes in organizational structure. Accommodating change also suggests reconfigurable reports such as business intelligence reports and performance dashboards. Similarly, the functionality of an ideal system would be independent of the database being used. 4.3. Enabling Interoperability among Proprietary Systems and Processes Taking advantage of the proliferation of front-end applications (e.g., radio frequency identification tags, smartcards, biometrics, ATMs, mobile phone banking, and point of sale devices) and the affiliated variety of communication access networks poses a major challenge for microfinance MIS. Significant convergence, a narrowing of protocols and platforms and stability over time, is required – together with financial switches to route the many and varied transactions – if information systems from the industry’s

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multiple vendors are to be open enough to interact vertically or horizontally with other platforms or alternative enterprise software packages. Front-end application technologies are getting significant traction, being introduced in rapidly increasing numbers of MFIs worldwide. However, if institutions each go in their own direction on the front end, there collectively will be significantly less opportunity for interchange that could expand access among the poor to financial services. As an example, consider a client who chooses an MFI because it is closer to her work but who also might be able use an ATM or point of sale device closer to home from a second MFI. If the two MFIs use different front-end identification techniques (e.g., the first MFI uses magnetic stripe cards while the second uses biometrics), the client’s potential access is restricted. Given their longevity in traditional banking, ATM standards are fairly robust, allowing essentially worldwide data interchange among banks and hence worldwide access for clients. However, there remain very substantive barriers to interoperability among other front-end technologies. For example, biometric fingerprint databases remain idiosyncratic and largely unshared, and smartcards differ in the types and structure of data supported and ways they work online or off-line. Convergence based on what is happening in markets external to microfinance, such as traditional banking and telecommunications, and in the regulatory environment is needed to improve interoperability. However, the path is far from clear. Which standards should be adopted by microfinance? Should interoperability standards apply across the whole industry or only at the national or regional level? Should the approach be to adopt in stages or all at once? Much more discussion and consensus building on such details is still needed. Progress on interoperability is in part beyond the direct control of the microfinance industry itself, relying on external enabling technologies such as transaction switches and telecommunications networks. However, the microfinance industry has grown to sufficient scale and visibility to be able to exert influence in inter-industry standards setting organizations such as the International Organization for Standardization (ISO).

4.4. Aligning MIS Strategy and Processes with Business Strategy and Processes The need for congruence between an organization’s business strategy and information technology strategy is a widely held MIS precept across a broad

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range of other industries, though participants believed it is not widely appreciated in microfinance. Understood or not, information technologies do have substantial potential both to alter and to support the way microfinance organizations manage and assess their business activities, to simplify and improve MFI processes efficiency, and to enable completely new products or other new business opportunities. As discussed in Hall and Liedtka (2007), MIS can facilitate better information flows for internal communication (up, down, and sideways in the organization), and more complex software knowledge management systems allow better information flow about market information, accelerate anticipating client needs, help feed product development, and speed information flow back to decision makers. Conversely, changes such as rapid growth in client numbers and in product diversity or new business models and strategies will all alter the nature of information flows and supporting technologies needed. The business and technology sides are complementary and co-dependent. Hence, MFIs need to view information systems as strategic-level assets rather than as just administrative support. This will require a substantial shift in organizational cultures across the industry. Furthermore, misalignment between business strategies (e.g., product mix, target clients, pricing strategies, and external alliances) on one hand and the MIS strategies (e.g., performance, cost, hardware configuration, interconnections, features, degree of flexibility, and security) on the other results in decreased business performance. To promote congruence, MFIs must develop business and MIS strategies concurrently, rather than attempt to link separately developed strategies after the fact. A related management improvement that participants identified is the need for better strategic planning for how MIS expands as an institution grows. With growth, processes previously put in place will need to change and MIS needs to adjust with it. Business processes should link directly with technology processes in all cases (e.g., steps in lining up a new loan client; internal control validation steps for avoiding fraud; and steps for paying employees). Achieving congruence, planning for growth, and linking processes all necessitate a close working relationship between corporate and IT management. To foster this linkage, the movement in core banking software for traditional large-scale banking is to integrate workflow and business process management components into MIS software packages. Designers of microfinance MIS packages should pursue similar integration as well, as a key target in the innovation roadmap. Of particular importance in achieving strategic congruence is the business knowledge of technology executives. An MFI needs technology managers

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with specific working knowledge of their businesses so that controls over both the information systems and the processes by which they are developed and maintained and other essential control procedures are designed, implemented, and assessed in close collaboration with those developing business strategy. Isolation of MIS planning from business planning is a natural consequence of MFIs’ tendency toward buying off-the-shelf IS packages. Out of necessity, therefore, important IT decisions will be made off-site by vendors who may not fully understand the MFI’s businesses and the MFI’s own business decisions made without solid understanding of the MIS issues involved. In such cases, research from other industries suggests that several areas of core business knowledge are at risk of misinterpretation and misalignment. Moreover, conflicts can arise between operating needs and a vendor’s incentive to minimize costs. For instance, rather than tailoring solutions to the specific strategic objectives of the MFI, the outsourcing vendor may tend toward one-size-fits-all for its many buyers. Conversely, one strong undercurrent of discussion at the various sessions was the perception that pushing for too much customization in accommodating local procedural idiosyncrasies may limit an MFIs’ ability to learn best practices from its vendors’ experience with other MFIs. Indeed, several participants who were from technology vendors strongly suggested that too many MFIs falsely believe that many of their processes are or need to be unique, when in fact only a few key process differences can be competitively differentiating and that too much customization limits potential industrywide efficiencies from scale, scope, and best-practice dissemination.

4.5. Elevating MIS Skills and Training as Strategic Assets Participants uniformly believed that as part of treating MIS systems as strategic assets, MFIs need to expand their investments in information technology and skills, both absolutely and as fraction of overall expenses. Because few MFIs have in-house expertise in managing technologies, as they grow to need large-scale data management systems, they need to bring in that knowledge base. Yet, MFI practitioners from every region represented at the various workshop sessions reported it was often hard to find personnel skilled in MIS, particularly at the experienced MIS management level. Few experienced professionals are available because as the industry grows rapidly, not only are MFIs increasingly competing for personnel with other MFIs they also compete with traditional banks as well as with

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manufacturing and technology industries, which generally offer better pay. The problem is particularly exacerbated for rural operations, participants believed, because skilled technology-oriented people, often young and well educated, tend to prefer urban lifestyles. An industry priority, participants agreed, should be to pay competitive salaries, elevating expectations of what MFIs should be prepared to pay to bring in MIS talent. A substantial gap remains between the prices of the skills MFIs need and the typical MFI’s current willingness or ability to pay. Participants saw this as fundamental problem, stemming in part from the lack of appreciation by MFI upper management of the strategic potential of back-office information systems, noted in Section 4.2. Core banking information systems are obviously critical to the business success of mainstream modern, high-tech banking, and investment firms; yet, in microfinance organizations, IT people are, as one participant put it, often thought of as ‘‘simply a helpdesk for assistance with running desktops.’’ Therefore, a related priority is the need for an industry-wide culture change about the role of IS in microfinance. Such a culture change would include the following:  Elevating MIS to being seen as mission-critical;  Integrating MIS personnel more centrally into strategic planning;  Increasing the presence of information technology issues in administrative decision making;  Hiring and training CIOs and other technical personnel with experience on the business side of the house as well as with technologies; and  Enabling CEOs and CFOs and other non-technical managers to better understand MIS processes and issues. As part of recognizing the strategic value of information, MFIs can develop a culture of continuous training (seminars and workshops) and skills upgrading, to foster better familiarity with emerging technologies. Some training for personnel, loan offices, managers, and clients would be simply in using the equipment and software properly. Along these lines is the need for closer collaboration with and support from MIS vendors. There remains significant potential in developing training tools, including electronic, Internet-based approaches, but the industry has not yet focused on developing such tools. At a higher strategic level, moreover, participants agreed that the industry also needs to improve project management skills for more effective technology implementation. Technical personnel too often have the technical skills but not enough understanding of business processes.

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Given the scarcity of available talent, not only is more internal investment by MFIs called for but also the industry should work collectively in expanding the breadth of the available pipeline of skilled personnel by promoting greater depth in both local and Internet-based support ecosystems of university programs, course modules, vendors, and other training providers. Many of the most experienced MIS professionals in microfinance have come from traditional banking; yet, core banking systems are somewhat different from MIS for microfinance. The industry has reached a scale that it could fund or otherwise support additional specialized technology and IT management training programs directly relevant to microfinance. Indeed, entrepreneurial opportunities exist for universities and businesses to create new models to propagate and develop more talent at the local level.

4.6. Improving Risk and Security Management Along with the increased strategic importance of information technologies to MFIs comes increased levels of risk should those systems fail or data security be compromised. Yet, most MFIs appear not to have ongoing risk management planning processes in place. Thus, another target area for improving microfinance MIS is in improving risk and security management. An operational rule of thumb expressed by participants is that system security needs to increase in proportion to what is protected. As MFI fund volumes, client numbers, and data volumes grow, system security and reliability (of individual transactions, personal information, software applications, whole databases, and entire data networks) should become on par with that expected in retail banking. The consensus was that most MFIs remain far from that benchmark. Key innovation needs include developing methodologies for identifying potential technical and operational vulnerabilities and assessing potential impacts (e.g., expected costs, client service interruptions, and data corruption) and then developing tools for reducing those risks. Elements for identifying vulnerabilities include evaluating communications and power infrastructures, computer system architecture, and the individual elements such as routers and modems. Among the potential impacts, loss of business continuity was a principal concern that emerged during discussion. Methodologies would assess questions such as follows: What is the overall incidence rate of system downtime? Of individual software application failures? Of viruses or other hacker intrusion attempts? What is the hardware reliability in terms of time before failure? Is the infrastructure

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robust to typhoons or other natural disasters? What is the degree and location of data redundancy and backup? How quickly (hours? days?) can the MFI get lost data back and functioning? Quantitative models can then be built to predict expected rate and costs of downtime or frequency of service interruptions and those estimates compared to performance benchmarks in retail banking. With quantitative modeling and related qualitative assessments in hand, MFI management can then make decisions about how to minimize risks in proportion to the potential impact and then should write contingency operational plans. Given potential impacts, they might decide it is not costeffective to buy power generators and data backup systems to guarantee 99.9% system reliability but instead plan and target to balance cost vs. benefits to get, say 98%. Where internal costs appear prohibitive for desired levels, an alternative means to gain security and higher system continuity is to outsource to large-scale operators who can afford higher levels. A risk-related topic only briefly discussed is how MIS affects security of MFI personnel, particularly in the field. Operating procedures that require loan officers to travel with substantial cash on hand create targets for bandits. Information technologies can help reduce such risks but can also increase them. Loan officers carrying expensive PDAs can also attract untoward attention. Hence, similar risk and impact assessment methodologies are needed for application to field operations.

4.7. Promoting Complementary External Changes Finally, some of the biggest barriers and highest potential payoff opportunities related to MFI information systems are external, beyond the direct control of individual MFIs. However, with growth comes influence. Like large banks, MFIs can collectively lobby and actively work for change in a range of complementary external arenas, including infrastructures such as Internet and mobile networks and regulations. Asked to identify the single most important variable differentiating (politically stable) regions where microfinance has grown most quickly from those where it continues to struggle, participants in the various sessions pointed to financial regulations. Regulations to protect client assets and the stability of national financial systems are important; yet, those in place for traditional banking often inhibit microfinance, with its alternative approaches to things such as collateral, group liability, or banking with mobile branch locations.

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Discussion centered around the topic of ‘‘If only governments around the world could figure these out y’’ Many regulation-related comments at the various sessions went well beyond MIS, including alternative rules for microfinance on, for example, savings deposit mobilization, reserve ratios, capital and liquidity requirements, financial funds restrictions, and other topics being broadly discussed in the industry. Focusing more narrowly here, several major MIS-related issues were related to establishing technical standards related to the interoperability discussion in Section 4.3, but at the inter-organizational level. MFIs should work cooperatively with national and regional authorities to develop standards for data communication networks for national or regional financial transaction switches. Other enabling external activities related to information systems that would promote microfinance include the following:  National ID systems; non-existent in many nations, but important for inter-organizational information sharing about clients.  Credit bureaus with established processes and standards for reporting from MFIs, banks, and other institutions with financial transactions such as billing; few developing nations have comprehensive credit bureaus, but one key social benefit as microfinance becomes more competitive and clients have access to multiple MFIs will be to help manage client overindebtedness, a major growing concern.  Standardized international accounting and reporting rules; multinational MFIs and MIS system vendors alike face significant growth and cost barriers in having to modify the reporting and calculations country by country for different regulatory bodies.  Improved technical competencies of regulatory authorities.  Technology standards (e.g., smartcards and biometrics); such standards are moving ahead regardless of microfinance, but more widespread implementation should drive down costs and drive up functionality and robustness, which MFIs will be able to take advantage of.  Branchless banking; a broad set of regulatory changes can enable branchless banking to expand rapidly (e.g., even simply re-defining what is a branch could eliminate the need to go back to the regulatory authority every time an MFI opens a branch; what if the branch is a mobile phone or point of sale device?).  Payment networks (e.g., credit cards, ATMs, billpay, and mobile phone cash); substantial external efforts exist, and MFIs should expand their voice in bodies such as ISO and the International Council of Payment

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Network Operators working on standards and rules. MFIs need to connect efficiently and with low fee structures to existing systems.  Licensing and pricing rates from software vendors at software layers beyond the MIS systems; fees for database software (Sun MySQL, Microsoft SQL, and Oracle) and operating system software (Windows, Unix, and Mac OS/X) are often priced at levels for developed economies and out of reach for MFIs. Cooperatively negotiated alternative pricing structures or licensing arrangements could better align with MFI resource realities.

5. CONCLUDING THOUGHTS Given day-to-day demands, information technology practitioners in this industry have had little opportunity to talk to their peers about issues in back-end information management systems. If microfinance is to grow fiveto ten-fold over the next decade or two, as many hope, then MIS must keep pace. Broader and deeper collaboration across sectors and organizations will be central to form consensus, identify best practices, get standards in place, and guide technical development. The framework of key innovation targets presented here aims to guide and focus the ongoing discussions of that roadmapping process.

REFERENCES Galvin, R. (1998). Science roadmaps. Science, 280(5365), 803. Hall, J. A., & Liedtka, S. L. (2007). The Sarbanes-Oxley Act of 2002: Implications for largescale IT outsourcing. Communications of the ACM, 50(3), 95–100. Phaal, R., Farrukh, C., Mitchell, R., & Probert, D. (2003). Starting-up roadmapping fast. Research Technology Management, 46(2), 52–58. Spencer, B., Wilson, L., & Doering, R. (2005). The semiconductor technology roadmap. Future Fab International, 18, January 12. Available at http://www.future-fab.com/documents. asp?d_ID¼3004

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APPENDIX Table A1. Topic

Workshop Sessions. Discussion Issues

1.

Big picture overview of central opportunities and challenges in back-end MIS for microfinance

    

Scaling down commercial banking MIS systems Scaling up specialized MFI systems Organizational and cultural inertia/resistance to change Regulatory HR management, skills, and training

2.

Issues in back-end outsourcing, shared services and central processing

   

Infrastructure, web access, and reliability Local customization and control Competitive differentiation Risk and security

3.

Challenges to open source MIS for microfinance

       

Robustness and reliability Functionality Quality control and testing Local customization and control Cross-platform Competitive differentiation Security Training and personnel needs

4.

Back-end challenges to implementing emerging front-end technologies

    

Integration with telecoms, credit bureaus, and payment networks Standardization Infrastructure Security Achieving scale

5.

Front-end innovation, needs, and challenges. Where will we be in 5 years?

     

Emerging technologies and business models Branchless and cashless banking ATMs and point of sale devices Mobile phones and PDAs Smartcards and biometrics Credit scoring

6.

Concluding session: Discussion and consensus building

   

Where do we need to be in 5–10 years? Key hurdles and possible solutions? What should the industry do collaboratively? High-value commercial opportunities for innovation?

Note: Complete list of participants at the various sessions available on request.

DOES ONE SIZE FIT ALL IN MICROFINANCE? NEW DIRECTIONS FOR ACADEMIC RESEARCH Joshua K. Ault and Andrew Spicer Although microfinance began over three decades ago as a not-for-profit model, recent efforts have focused on transitioning the industry into a commercial venture (Robinson, 2001). Additionally, global financial entities – such as multinational banks and investment funds – have begun to enter this market, connecting the industry to global capital (Katz, 2005). To date, microfinance researchers have usually focused on examining microfinance’s social impact in improving the lives and opportunities of low-income individuals (for a review, see Goldberg, 2005). In contrast, the commercialization and globalization of the industry presents a different set of questions about profitability, market size, competitive interaction, and governance that were less of a concern to NGO innovators in the field. For instance, the commercial microfinance organization, Banco Solidario, has begun to encounter governance tensions between its profit-oriented board and its social-oriented stakeholders, the business consequences of macro-level market shocks, and shifting consumer preferences toward less-profitable products (Kennedy, 2002). Similarly, Compartamos, a publicly traded

Moving Beyond Storytelling: Emerging Research in Microfinance Contemporary Studies in Economic and Financial Analysis, Volume 92, 271–284 Copyright r 2009 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1569-3759/doi:10.1108/S1569-3759(2009)0000092012

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microfinance organization, faces pressure not only to assist the poor but also to maximize shareholder wealth according to the standards of Wall Streets’ savviest investors (O’Grady, 2008). The myriad business-related issues that commercial microfinance organizations face remain relatively underexplored in the current microfinance literature. In this chapter, we suggest that existing research traditions in the field of international business provide one important theoretical perspective to frame research into these new business issues. Our intent is to define a research agenda to address issues of microfinance commercialization and globalization, rather than to provide definitive answers to the complex issues explored. In particular, we look at how countries’ institutions influence the commercial success of microfinance models. Institutions are the humanly devised ‘‘rules of the game’’ that shape the way actors conduct business in a particular society (North, 1990). The institutional environment of business establishes incentives and rewards for economic actors, provides resources and capabilities, defines legitimate and illegitimate behavior, and determines the contours of the divide between private and public action. To examine the role of national institutions in shaping the global diffusion of commercial microfinance models, we build on the concept of institutional distance as developed in the international business literature. This literature proposes that the degree of institutional similarity or dissimilarity across business environments is likely to be an important factor in the successful transfer of business practices across societies and in the successful entry of multinational organizations into new markets (Kostova, 1999; Xu & Shenkar, 2002). We propose that a future research agenda in microfinance is to tailor theories of institutional distance to the specifics of this industry, looking at what types of microfinance models are likely to work under what types of institutional conditions. We begin our analysis by pointing out that an institutional approach suggests the process of commercialization is likely to prove more difficult than often addressed in much of the microfinance literature. Microfinance research has clearly demonstrated that microfinance can be profitable under the best conditions (e.g., Brill, 1999; Kaplan, 2003; London & Hart, 2004; Economist, 2005). At times, the implicit suggestion seems to be that microfinance can always be profitable, a proposition that likely exaggerates microfinance’s potential. Business researchers and practitioners have long searched for standardized business practices and models that retain profitability across contexts, but, as we will point out below, the institutional distance literature suggests that it is unlikely that any single

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business model will work with the same success across all business environments. For instance, a case examined throughout this chapter is Wal-Mart’s failed strategy to export its business model profitability to all countries. After failing in Germany and South Korea, the company has moved from its initial position that its model can work anywhere in the world to a more careful strategic consideration of when, how, and under what conditions it is most likely to succeed. We suggest a similar institutional approach to research in microfinance. Microfinance practitioners and researchers should not assume that microfinance provides a singular or universal model that can be applied without significant tailoring across the globe. Instead, an important issue for research and practice is to identify the conditions that limit the scale and scope of commercial microfinance, so that appropriate models can be implemented only in those situations where they are most likely to succeed. Non-profit models may be more appropriate than commercial microfinance ventures in some contexts, allowing for a division of labor between these different types of organizational forms. Similarly, group-lending models may prove to be more successful than individual-based models in some contexts, whereas, in others, the reverse may prove to be true. Most likely, it will take a period of trial and error for the commercial microfinance field to identify its own limitations, given a common bias for innovative leaders to be optimistic in their own abilities to overcome potential challenges and difficulties. For instance, Wal-Mart’s executives strongly believed that the success of their business model in North America would easily carry to other countries and continents. It was only through observations of their own failure that they began to more systemically examine their internationalization strategy. From this and other similar examples – where executives have learned that one business model does not fit all situations – international business researchers have developed a research agenda that looks at the role of ‘‘institutional distance’’ in shaping the successful transfer of models and practices across contexts. This chapter applies the lessons of institutional distance to the emerging field of commercial microfinance, arguing that it is easier to learn from others’ mistakes than to repeat them. The chapter is organized as follows. We first review the literature in the international business field that identifies the importance of ‘‘institutional distance’’ in explaining the success or failure of business models across national contexts. We then apply the idea of institutional distance to the study of microfinance, suggesting a number of important areas for future research.

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1. INSTITUTIONAL DISTANCE AND THE MULTINATIONAL ENTERPRISE We are confident that the Wal-Mart concept is ‘‘exportable.’’yIf Wal-Mart had been content to be just an Arkansas retailer in the early days, we probably would not be where we are today. State borders were not barriers, and people and ideas moved freely from one area to anotheryWe believe the successful retailers of the future will be those that bring the best of each nation to today’s consumer. We call it ‘‘global learning.’’ We are committed to being a successful global retailer and we believe the attributes that made us successful in the United States will also lead to success internationally. – David D. Glass, President and CEO, Wal-Mart Stores, Inc. (Govindarajan & Gupta, 2001)

Initially, Wal-Mart’s international strategy was clear: because the business model performed so well at home, it should also perform well abroad. However, Wal-Mart’s recent failures in Germany and South Korea are compelling examples of the consequences of not considering institutional, in addition to economic, forces in international business (Ghemawat, 2007). Whereas Wal-Mart’s executives scrutinized common economic factors such as country population, income levels, and the degree of market liberalization when considering international expansion, it failed to consider institutional factors such as consumer tastes, employee expectations, geographical characteristics, government regulations, and local ethical norms. For instance, Germany’s tradition of unionization and co-determination, which gives employees a say in corporate decision making, conflicted with Wal-Mart’s American-based business model, leading to regular clashes between management and labor. Additionally, strict building codes and a lack of suitable land in Germany made it difficult for Wal-Mart to build the large stores necessary to establish purchasing power. Ghemawat (2007) uses the Wal-Mart example to illustrate the impact of institutional distance in multinational activity. He argues that the successful transfer of a business model across contexts depends on the compatibility of the model with the institutional conditions found in the target country. Wal-Mart, for example, may be able to adapt its model to accommodate local preferences against strangers touching one’s food by allowing customers to bag their own groceries. However, it may be unable to adapt to strict building codes and a lack of suitable land for large buildings because economies of scale are central to Wal-Mart’s core competitive advantage. Ghemawat (2007) argues that, rather than focusing on the entire globe as a single, monolithic market, successful firms should cluster their investments in institutionally similar countries or ones where adaptation is possible. He calls

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this strategy ‘‘semi-globalization,’’ which is neither complete globalization nor complete localization, but somewhere in between. The idea of semi-globalization stands in contrast to arguments that the world is becoming ‘‘flat’’ (Friedman, 2005) or that distance is increasingly irrelevant in global economic markets (Cairncross, 2001). Instead, the institutional distance argument posits that cultural, administrative, geographical, and economic differences have, and will remain, important factors in shaping the conditions of profitable expansion of business models across national and cultural borders (Ghemawat, 2001; Ghemawat, 2007). This literature argues that institutions tend to persist over time because they attain a ‘‘taken-for-granted’’ status, achieve symbolic meaning, or become valued within a society. As such, actors are likely to accept those new institutional models that adhere to established regulatory, normative, and cultural frames and disregard those that do not – even if they have proven technically more efficient in other contexts (Kostova, 1999). Therefore, countries are unlikely to converge on a universal ‘‘global’’ model of business ‘‘best practice.’’ Because institutions are consequential and enduring, this perspective suggests it is not just raw income levels that count in the successful entry to a new market but also differences in the institutional context in which competition takes place. For example, a low-income country may be better suited than a wealthy country to provide certain products and services to other low-income countries because it shares many of the same institutions. Similarly, it is not simply the physical size of the host country that matters but also differences in business costs between the home and host country due to the transportation and communication infrastructure. Other examples of institutional distances include political hostility toward the home country and differences in religious beliefs, climate, race, education systems, and organizational forms. Although Ghemawat focuses primarily on the impact of institutional distance on foreign direct investment, the concept of institutional distance has also been used in multiple studies across international business topics (Xu & Shenkar, 2002). Theoretical research and empirical tests of the institutional distance perspective include trade flows (Linders, Slangen, de Groot, & Beugelsdijk, 2005), the transfer of practices (Kostova, 1999; Guler, Guillen, & Macpherson, 2002; Kostova & Roth, 2002), market entry by multinational corporations (Tsang & Yip, 2007), and ownership strategy for foreign direct investment (Eden & Miller, 2004; Tsang & Yip, 2007). The principles of institutional distance have been tested not only across phenomena but also across institutional dimensions including culture (Kogut & Singh, 1988), normative and cognitive beliefs (Kostova & Roth, 2002;

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Busenitz, Gomez, & Spencer, 2000), state capabilities and regulation (Rodriguez, Uhlenbruck, & Eden, 2005), and geographical attributes (Ghemawat, 2007). Collectively, these studies demonstrate the broad applicability of this perspective. Because of this consistent finding that institutional distance matters, research in this tradition has recently begun to explore specific strategies for coping with institutional differences to provide guidance to multinational managers that are considering entrance into new market settings – such as a global multinational company examining developing countries that have institutional arrangements that differ strongly from more developed societies. For instance, London and Hart (2004), Hart and Christensen (2002), and Hart (2005) suggest specific practices such as working closely with local governments and non-profit organizations – rather than national or multinational governments and NGOs – to identify the needs, norms, values, and regulations specific to that location. Their research even goes so far as to suggest that managers of multinational organizations spend time ‘‘going local’’ to deal with institutional distance – where the manager lives and works for several months in local conditions until he or she has a native’s understanding of the indigenous institutions. Only after this immersion period should the manager attempt to transfer knowledge or make an investment. These strategies allow managers to possess knowledge of local regulations, norms, and mores as well as the goals and functions of the multinational firm. This helps firms to identify the size and nature of the institutional distance between the home and host country and the right strategy based on that finding – whether it is transferring a model wholesale, tailoring the model to fit the local context, or seeking opportunities elsewhere. In short, the institutional distance literature demonstrates that the potential opportunities for multinational enterprises depend on much more than just the potential size of the market or on the previous success of the company in another context. Instead, the similarity or difference of institutional arrangements across social contexts is an important issue to be explored when multinationals decide whether, when, and how to transfer business models abroad.

2. APPLICATION TO MICROFINANCE In this section, we apply an institutional distance perspective to the study of microfinance. Based on an analysis of economic need, the potential demand for commercial microfinance is quite large, as hundreds of millions of poor

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individuals are effectively locked out of traditional financial markets. However, the institutional distance perspective suggests that an analysis of global demand for a new business practice needs to include analysis of institutional as well as economic conditions. Many factors in the institutional environment may restrict the flow of commercial microfinance from one society to another, or even from one location in the same country to another, thus limiting the potential market for a standardized model of this innovation. Overall, the institutional distance literature suggests that one microfinance model is unlikely to fit all contexts, raising a host of questions for microfinance practice and research. Under what institutional conditions is the commercial microfinance model most likely to be profitable? Under what conditions is a non-profit model more likely to succeed? When should managers of commercial microfinance organizations transfer their existing models wholesale across national contexts? When, and how, should they tailor their model to fit local conditions? What are the different types of adaptations that microfinance organizations have already made, and when have they proven most successful? These questions represent an agenda for microfinance research. To address these issues, we begin with an analysis of the commercial microfinance industry. The industry context is an important factor in international business in exploring these questions of local adaptation and global strategy because not all industries are equally affected by institutional distance (Bartlett & Ghoshal, 1998; Ghemawat, 2007). In industries where the underlying technology works relatively similarly across contexts, as in say a cell phone or a jet engine, the need for local adaptation is likely to be less, thus enabling firms to engage in a more standardized global strategy. These types of products enable global players to develop strong positions, as standardization allows for competitive advantages through global economies of scale, scope, and learning. In fact, Ghemawat (2007) argues that companies in these types of industries may even be able to leverage institutional distances into a competitive advantage by locating various production and service facilities in the country most conducive to that function. On the contrary, industries such as television programming or food preparation that require local adaptation are more likely to be dominated by local players that have superior knowledge of indigenous conditions (Ghemawat, 2007). The identification of the global potential remains an enduring topic of research in these particular industries. For instance, initial beliefs in a ‘‘global car’’ led to the emergence of cross-border mega-mergers in the search of global efficiencies and scale. Yet, the power of institutional

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differences in this particular industry proved a powerful explanation of why such global standardization strategies did not end up succeeding (Ghemawat, 2000). An important question for future research into microfinance is to compare the characteristics of this industry to others. For now, we propose that microfinance is likely to fall into the rubric of those industries that require strong local adaptation rather than global standardization. Microfinance is a transaction-intensive market model with high levels of employee discretion, which is highly contingent on the local knowledge of the individual giving the loan. The primary decision of whether to loan in a particular case depends heavily on character assessment and knowledge of local conditions, not on standardized contracts or global risk assessment methods. Group-lending microfinance particularly incorporates the local context into its model, relying on the presence of stable, informal networks as a critical governance tool in economic exchange. This focus on group-lending was originally an innovation designed to cope with broader issues of governance failures in the developing world that has led to the imperfect development of the formal sector. How can micro-lending take place in the absence of reliable information, credible collateral, or a trustworthy judiciary? The answer was to develop a system highly tied to local social structures and knowledge, allowing for an innovative delivery mechanism for finance in low-income communities and societies. These industry characteristics make commercial microfinance particularly amenable to the principles of institutional distance. This original focus on local institutional conditions represents a potential obstacle to commercial microfinance’s ability to extend its scale and scope. As it was specifically designed for specific institutional conditions, the question of when and how commercial microfinance travels to other conditions remains an important research question. In fact, one can understand recent efforts to develop new microfinance models as an attempt to extend microfinance’s reach by removing dependency on local, group structures. For instance, individual-loan models remove the group-lending requirement from microfinance, finding it too cumbersome to reach a large number of potential clients through this delivery model (Armendariz de Aghion & Morduch, 2005). Another microfinance model hopes to achieve a similar goal of increasing scale in microfinance by facilitating the role of retail banks in providing loans to low-income customers. As in the individual-based models, the goal is to remove dependency on local structures and knowledge to achieve broader economies of scale. Given that the group-lending model’s primary innovation was to incorporate local context into its governance design, an important question

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for future research is whether alternative models to group-lending commercial microfinance will be able to achieve the same success. In all, many microfinance models currently compete for dominance – nonprofit, for-profit, traditional banks, group lending, individual lending, progressive lending, solidarity groups, village banking, etc. (Armendariz de Aghion & Morduch, 2005). The rapid development of alternative microfinance models suggests rapid innovation in the field, but we suggest that the assumption should not be made that there will be, or should be, convergence on a single model. Instead, an institutional distance approach suggests that certain types of business model may be best suited for particular types of environment. Therefore, an unproductive approach to study the proliferation of these models is to attempt to provide a definitive answer about which one is best – is the commercialization of microfinance better than a non-profit approach, for example. Instead, an institutional distance perspective suggests that one model may work in one location and another model will work in another location; and some locations may be so institutionally divergent that microfinance may not work at all, in which case public welfare or grant programs may remain the only viable option. The question is not only to look at the potential division of labor between non-profit and for-profit microfinance models but also to study the variation of commercial microfinance models presently entering the field.

3. EXAMPLES OF INSTITUTIONALLY INFORMED MICROFINANCE RESEARCH The question of whether commercial microfinance can work in more institutionally developed economies such as the United States provides one example of research that has begun to look at the institutional contingencies of the spread of the microfinance model. Carr and Tong (2002) demonstrate that hundreds of microfinance enterprises have developed in the United States with the stated goal of serving the same population that has developed within other countries, yet has failed to find the same success. Instead, repayment rates are closer to 48% in the United States (compared to nearly 98% in Bangladesh), demand has remained stagnant, and programs remain small and depend mostly on external funding (Schreiner & Morduch, 2002). To explore the question of why these differences in success have occurred, Schreiner and Morduch (2002) engage in the type of systemic analysis of the U. S. institutional environment suggested in this chapter, identifying the key

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institutional conditions that have prevented commercial microfinance from gaining a foothold there. For example, they find that local norms and values make it unlikely that social-based enforcement mechanisms will invoke the high repayment rates found in other countries. Although the poor in some countries often value strong community ties, such relationships rarely exist in the United States. Instead, microfinance lenders in the United States must often place strangers in the same group, thus losing the original intent of social enforcement. The poor in the United States do not cluster as they do in some countries and are more transient, thus further deteriorating the social capital necessary to make informal enforcement practical. Additionally, the highly developed system of rules, laws, and regulations in the United States make commercial microfinance less viable. For example, American small-business owners must register and obtain a license to operate. Furthermore, when building or expanding facilities or homes, Americans are required to use licensed contractors, who are unlikely to accept small, low-cost, progressive building projects. Finally, strong state capabilities provide both alternative safety nets to microfinance such as welfare and formal financial systems such as credit cards, title loans, and payday loans. This research demonstrates that a model developed for and closely tied to one setting may not work with the same effectiveness when transferred wholesale to another setting with different institutional structures. Instead, the institutional context found in the United States has required extensive tailoring of the original, social-based lending model found in many developing countries. For example, among other adaptations, Accion USA, the largest microfinance organization in the United States, relies heavily on business plans, credit scores, bank statements, collateral, projected cash flows, notaries, and liens to make lending decisions and enforce repayment. Additionally, the average size of the first loan extended is about $6,000, compared to a global industry average of $363; and American borrowers are required to invest a minimum of 30% of total startup costs themselves. Moreover, even with these modifications, Accion USA remains a charity that depends on external subsidization – private contributions accounted for 64% of total revenue in 2006 – suggesting that, within the institutional conditions described by Schreiner and Morduch a non-profit, impersonal, approach may be more appropriate (Microfinance Gateway, 2006; Accion USA, 2007; MiX, 2007). While Schreiner and Morduch explore the obstacles to transferring the commercial microfinance model from poor to wealthy countries, Ault and Spicer (2007) found similar difficulties in transferring the model to other poor, but institutionally divergent, countries, thus further supporting an

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institutional distance perspective in the spread of commercial microfinance. In this study, we first proposed that commercial microfinance is more likely to occur in informal, rather than formal, economies. The initial innovation of the group-lending model was to provide a governance mechanism that did not rely upon the presence of formal mechanisms of contractual adjudication and enforcement, and therefore, its success would most likely take place in economies with similar informal institutional arrangements. Moreover, we further proposed that informal economies should not be seen as a singular type defined by the absence of formal arrangements, but instead these economies differ in their institutional configurations both in degree and type. Current literature often depicts formality and informality as two dichotomous categories with a clear distinction between the two. However, we argue that the degree of informality is better understood as a continuum with complex relationships between the formal and informal sectors. On the basis of comparative institutional research into informal economies (Portes, Castells, & Benton, 1989; Portes, 1994), we posited that commercial microfinance growth was most likely to take place in informal economies where small-scale production networks operate in a relatively stable manner to ensure the conditions of basic survival for its participants. Under conditions of high political stability, informal economies are likely to organize into large impersonal regional, national, and international networks that subcontract to the formal sector – not the tightknit personal networks needed for microfinance. On the contrary, in informal economies with low levels of stability, the informal sector is likely not to organize into networks at all – actors depend on hustling and spot transacting to deal with high uncertainty and low trust. Therefore, we suggested that the best institutional conditions for commercial microfinance growth were in semi-stable informal economic systems. These systems have enough stability to allow for small groups of family members or close relations to enforce one another’s borrowing behavior, but do not have so much stability such that the state and formal sector act as an alternative source of financing. We tested our hypothesis that commercial microfinance was most likely to develop in semi-stable, informal economic systems by studying the growth of commercial microfinance across 178 countries from 1998 to 2006. We measured the number of registered commercial borrowers in each country for each year using data from MiX (2007). We then predicted the change in borrowers using a measure for ‘‘political stability’’ developed by Kaufman, Kraay, and Mastruzzi (2006) and ‘‘informality’’ using the ‘‘contract enforcement’’ measure found in the World Bank’s ‘‘Doing Business in

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2006’’ report (World Bank, 2006). Consistent with an institutional distance perspective, we found that these two measures accurately predicted the nineyear growth patterns in commercial microfinance in ways consistent with our initial hypotheses. Collectively, these studies represent efforts to describe the institutional contingencies that influence the global growth of commercial microfinance. Clearly, however, these are early tests of institutional distance in this industry and future research is needed to define a more comprehensive framework.

4. CONCLUSIONS The primary objective of this chapter was to present a research agenda in microfinance as it becomes increasingly global and commercial. We presented just a small sample of the questions that require the development of theoretical and empirical inquiry and demonstrated how one theoretical perspective – institutional distance – can provide a framework through which these questions can be tackled. Theory can inform, and in return be informed by, existing research within the business literature. We do not in this chapter contend that institutional distance is the only theoretical foundation with which to examine the issues facing the commercial microfinance industry. Instead, we designed this chapter to demonstrate the potential benefits of taking a broader, longer term, and more theoretical approach to the future development of the commercial microfinance industry and its interaction with the non-profit and public policy sectors. Answering these questions will require a holistic research approach that examines the global industry simultaneously and accounts for variance across societies. An important implication of our analysis is that future research should focus on interconnections between individual cases and examples. Stories and case-based research, while necessary, are unlikely to isolate the specific environmental factors that led to particular successes or failures. Research designs that look at the industry as a whole – identifying common issues and challenges as well as differences across countries – is more likely to pick up the important issues of what models work, where they work, and under what conditions. In agreement with the broader goal of this book, academic research has the potential to contribute to our understanding of microfinance as it provides both a method and a forum by which individual experiences and cases can be systematically compared. In short, many questions remain in the continued evolution of the commercial microfinance

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industry, and there is room for fruitful coordination among practitioners, public-policy administrators, and academics as we move forward.

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Kaplan, E. (2003). Microfinance affords success for some in developing world. Wall Street Journal (August 20). Katz, R. (2005). Giants and minnows: Big banks are discovering the market for poor customers. Economist, November 5, pp. 10–12. Kaufman, A., Kraay, D., & Mastruzzi, M. (2006). Governance matters V: Aggregate and individual governance indicators. World Bank Policy Working Papers. Available at http:// siteresources.worldbank.org/DEC/Resources/GM5.pdf. Retrieved on June 22, 2007. Kennedy, R. E. (2002). Banco Solidario: The business of microfinance. Harvard Business Case 9-702-019, January 19. Kogut, B., & Singh, H. (1988). The effect of national culture on the choice of entry mode. Journal of International Business Studies, 19, 411–432. Kostova, T. (1999). Transnational transfer of strategic organizational practices: A contextual perspective. Academy of Management Review, 24, 308–324. Kostova, T., & Roth, K. (2002). Adoption of an organization practice by subsidiaries of multinational corporations: Institutional and relational effects. Academy of Management Journal, 24, 64–81. Linders, G. M., Slangen, A., de Groot, H. L. F., & Beugelsdijk, S. (2005). Cultural and institutional determinants of bilateral trade flow. Tinbergen Institute Discussion Paper TI 2005-074/3. London, T., & Hart, S. L. (2004). Reinventing strategies for emerging markets: Beyond the transnational model. Journal of International Business Studies, 35, 350–370. Microfinance Gateway. (2006). Frequently asked questions. Available at http://www.microfinancegateway.org/section/faq MiX. (2007). Comparative Analysis. Available at http://www.mixmarket.org/en/demand/ demand.profile.comparison.asp. Retrieved on January 28, 2008. North, D. C. (1990). Institutions, institutional change and economic performance. Cambridge: Cambridge University Press. O’Grady, M. A. (2008). Markets for the poor in Mexico. The Wall Street Journal (June 30). Portes, A. (1994). The informal economy and its paradoxes. In: N. J. Smelser & R. Swedberg (Eds), Handbook of economic sociology. Princeton: Princeton University Press. Portes, A., Castells, M., & Benton, L. A. (1989). The policy implications of informality. In: A. Portes, M. Castells & L. A. Benton (Eds), The informal economy: Studies in advanced and less developed countries. Baltimore: Johns Hopkins University Press. Robinson, M. (2001). The microfinance revolution: Sustainable finance for the poor. Washington, DC: World Bank Publications. Rodriguez, P., Uhlenbruck, K., & Eden, L. (2005). Government corruption and the entry strategies of multinationals. Academy of Management Review, 30, 383–396. Schreiner, M., & Morduch, J. (2002). Opportunities and challenges for microfinance in the United States. In: R. Taub, J. H. Carr & Z. Y. Tong (Eds), Replicating microfinance in the United States. Washington, DC: Woodrow Wilson Center Press. Tsang, E. W. K., & Yip, P. S. L. (2007). Economic distance and the survival of foreign direct investments. Academy of Management Journal, 50, 1156–1168. World Bank. (2006). Doing business in 2006: Creating jobs. Washington. DC: World Bank Publications. Xu, D., & Shenkar, O. (2002). Institutional distance and the multinational enterprise. Academy of Management Review, 27, 608–618.

ABOUT THE AUTHORS Julie Abrams, President, Microfinance Analytics, has been a consultant to the microfinance industry for 15 years. She has authored or co-authored 16 publications on microfinance topics including international financial institution funding, foreign investment, MFI debt default, foreign exchange risk, an e-course on financial risk management, capital structure, profitability, financial performance, and MFI appraisals. Julie has been on the review panel and jury for CGAP’s Financial Transparency Awards. She currently serves as an advisor for Research and Analysis to the International Association of Microfinance Investors (IAMFI) and is a member of the Calvert Foundation’s External International Investment Committee, including reviews of MicroPlace and all syndicated lending. She began working in microfinance in 1985 with Women’s World Banking. Julie was a fellow at the Lauder Institute of Management and International Studies, where she earned an MBA from the Wharton School and an MA in International Studies from the University of Pennsylvania and holds a BA in Economics from Oberlin College. Anne Anderson holds the Joseph P. Perella and Amy M. Perella Chair and is associate professor of Finance and director of the Financial Services Laboratory at Lehigh University. Her teaching and research interests include corporate finance, corporate governance, corporate restructuring, mergers and acquisitions, socially responsible investing, and valuation. A graduate of the U.S. Military Academy, her experience includes serving as an officer in the U.S. Army Corps of Engineers and as a plant engineer for Lanier Clothes. She holds a Ph.D. from the University of Arizona. Joshua K. Ault is a doctoral candidate in Business Administration with emphasis on international business in the Sonoco International Business Department, Moore School of Business, University of South Carolina. Bruce Campbell is a mathematician, statistician and software expert who specializes in mining large databases. He has worked with international poverty statistics and microfinance data sources on assignment for AfriCap. 285

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Robert Cull is a senior economist in the World Bank’s Development Research Group. His research focuses on the evolution of public and private institutions to resolve financial market failures. His most current research is on the effects of privatization and foreign entry on developing countries’ banking sectors. Before joining the World Bank in 1996, Bob was an economist at the U.S. Department of Commerce and a visiting assistant professor of Economics at the University of California at Los Angeles. He holds a Ph.D. and M.S. in Social Science from the California Institute of Technology. Asli Demirgu¨c- -Kunt is senior research manager, Finance and Private Sector, in the World Bank’s Development Economics Research Group. After joining the Bank in 1989 as a young economist, she has worked in different parts of the Bank on external finance and domestic financial sector issues. Her research interests include how financial development contributes to economic growth and poverty reduction and how best to improve the stability, efficiency and reach of financial systems. She has published widely in academic journals. Before coming to the Bank, she was an economist at the Federal Reserve Bank of Cleveland. She holds a Ph.D. and MA in Economics from Ohio State University. Adrian Gonzalez is lead researcher at The Microfinance Information Exchange (MIX). He joined MIX in 2004 where he performs global analysis of microfinance institutions data collected primarily by MIX and other leading organizations. His research focuses on topics such as risk and portfolio quality, efficiency, depth of outreach, sustainability and interest rates. Adrian Gonzalez holds a Ph.D. in Finance and Development from the Development Economics Program at The Ohio State University. Zach Grafe is an analyst at New Mexico Community Capital, a capital investment firm, where he works in the Investment Fund team. His responsibilities include deal flow information management, financial analysis and due diligence research of potential investments for the NMCC funds. Previously, he worked for ACCION New Mexico, working with the Council of Microfinance Equity Funds, an industry association of microfinance equity investors. Zach is a Finance graduate of Texas A&M University’s Mays Business School. Frank R. Gunter is associate professor of Economics at Lehigh University. His primary area of research is country risk analysis and he has published studies of the economies of Iraq, China, Colombia and Latvia. From 2005 to 2009, Professor Gunter was in Baghdad, Iraq, for several tours, serving as Chief, Economics Division, Multi-National Force – Iraq. He has also been a

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consultant for the United Nations Development Program, the U.S. Department of the Navy, the Inter-American Development Bank as well as government entities in China and Colombia. He has Ph.D. and MA degrees from Johns Hopkins University. Tomoko Harigaya received her BA (2004) in Economics from Williams College, MA, USA. Since then, she has been working for Innovations for Poverty Action. In 2006, she moved to the Philippines to manage IPA’s operation there. IPA in the Philippines is now working with five major rural banks on a number of evaluation projects of microfinance products and services. Karen Hicks is an adjunct professor at the Martindale Center in the College of Business and Economics at Lehigh University and coordinator of Lehigh’s Microfinance Program. Her research and teaching encompass microfinance, women and reproductive health, and the sociology of the family. She previously was associate dean for Student Life and director of the Women’s Center and assistant professor of Women’s Studies at Albright College. She is author of Surviving the Dalkon Shield IUD: Women vs. the Pharmaceutical Industry (Teachers College Press). She holds a Ph.D. from the University of Pennsylvania. Dean Karlan is professor of Economics at Yale University and president of Innovations for Poverty Action (IPA). He is co-director of the Financial Access Initiative, a consortium created with funding from the Bill and Melissa Gates Foundation, a research fellow of the M.I.T. Jameel Poverty Action Lab and co-founder and president of StickK.com. In 2007, he received a Presidential Early Career Award for Scientists and Engineers and in 2008 an Alfred P. Sloan Research Fellowship. His research focuses on microeconomic issues of financial decision-making, specifically employing experimental methodologies to examine what works, what does not and why interventions in microfinance and health. He has consulted for the World Bank, the Asian Development Bank, FINCA International and the Guatemalan government. He received his Ph.D. in Economics from M.I.T. Daniel Kopf has worked with LIPAM International as a research associate. He is a graduate of New York University and has spent time working in Vietnam and Ghana. He has recently concluded a one-year assignment on a research project with the Chennai-based Centre for Microfinance. Ira W. Lieberman has since 2004 been president and CEO of LIPAM International, an advisory and investment firm consulting for the World Bank, client governments and private sector clients. Before that he was

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ABOUT THE AUTHORS

senior economic advisor to George Soros for the Open Society Institute, a grantmaking foundation. From 1985 to 2004, Dr. Lieberman served in several positions for the World Bank, including senior economist. He was responsible for assisting the World Bank’s client countries in developing and implementing privatization programs, working with governments in Central Asia, Central and Eastern Europe and the Former Soviet Union. From 1995 to 1999, he was CEO of the Consultative Group to Assist the Poorest (CGAP), a microfinance program serving the World Bank and 26 other donor agencies. He received his Ph.D. from Oxford University. Bruce E. Moon is professor of development in the International Relations Department at Lehigh University. Author of Dilemmas of International Trade (Westview Press) and The Political Economiy of Basic Human Needs (Cornell Universtiy Press), his research spans on international political economy (especially trade and globalization), development (especially basic human needs provision and democratization in poor countries) and quantitative research methods. He received his Ph.D. from Ohio State University. Jonathan Morduch is professor of Public Policy and Economics at New York University’s Wagner Graduate School of Public Service. He is also managing director of the Financial Access Initiative. His research focuses on international development, poverty and financial access. Morduch is coauthor of The Economics of Microfinance (MIT Press) and Portfolios of the Poor: How the World’s Poor Live on $2 a Day (Princeton University Press). He has been chair of the United Nations Committee on Poverty Statistics, a member of the UN Advisors Group on Inclusive Financial Sectors and the World Economic Forum Global Agenda Council on Financial Empowerment and is a founding member of the Advisory Council of the Center for Financial Inclusion at ACCION International. He holds a Ph.D. from Harvard University. Sara Nadel graduated from the Harvard Kennedy School with a Masters in Public Administration – International Development in June, 2009. Most recently, she worked as the country director of Innovations for Poverty Action, Peru. She holds a Bachelor of Arts in International Relations from Stanford University and is fluent in Spanish. Sushma Narain is a consultant to the World Bank and the IFC and works primarily on micro-finance and issues in gender and finance. Earlier she was with the Reserve Bank of India where she worked on bank, MFI and nonbank supervision as well as central bank operations. She has produced several educational films for television on issues in both gender and access to

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finance. She holds a master’s degree in Public Policy from Georgetown University. Richard Rosenberg has worked on development finance – mainly microfinance – since 1984. He managed USAID programs in Bolivia and Costa Rica. He served as senior advisor at CGAP – an independent microfinance policy, advisory and research center housed in the World Bank – since its inception in 1995. He has written two dozen technical and policy publications on microfinance and has been a core faculty member at the Boulder Institute’s microfinance training program since it began in 1994. He holds a law degree from Harvard University. Andrew Spicer is an associate professor of international business in the Sonoco International Business Department in the Moore School of Business at the University of South Carolina and director of the Sustainable Enterprise and Development Initiative. His research has examined privatization policies and outcomes in Russia, Czech Republic, Hungary and Poland as well as the role of Western ideas and international organizations in shaping market reform policies in transition economies. He has also studied the effects of national context and national identity on managers’ ethical evaluations and behaviors in international business settings. He received his Ph.D. from the Wharton School at the University of Pennsylvania. Damian von Stauffenberg founded MicroRate, the first rating agency to specialize in microfinance, in 1997 and served as its CEO until 2009. MicroRate was designed to provide transparency and in that way attract commercial funding sources to microfinance. Before starting MicroRate, Damian worked with the World Bank and its private sector affiliate, the International Finance Corporation, for 25 years. Damian is widely referred to as a pioneer of the microfinance industry and continues to develop new ideas for promoting its growth. Todd A. Watkins is Arthur F. Searing Professor of Economics in the Department of Economics, Director of the Microfinance Program and Director of the Entrepreneurship Program at Lehigh University. He is a founding member of the advisory Faculty Council of the Center for Financial Inclusion at ACCION International. He is author of more than 50 publications related to innovation economics and technology policy and management and recently was a member of The National Academies’ Committee on Innovation Models for Aerospace Technologies, to advise NASA on improving their innovation processes. A former engineer, he holds a Ph.D. and M.P.P. from Harvard University.