As part of the preparation before my Kiva Fellows training this week in San Francisco, I was assigned to complete the United Nations Microfinance distance learning course. It has been a while since I graduated college and boy have I forgotten what it was like to sit through a comprehensive online learning course. Thankfully, a gruelling 10 hours later, I did feel a lot more informed about the concept of microcredit.
When we think about microfinance, there are generally 3 groups of parties involved: The borrower, the lender (microfinance institution), and the source of funds (commercial funds, kiva funds etc.). I had 3 main takeaways from the course:
1. High MFI interest rates
MFIs plug the void left by traditional banking institutions by providing small loans to borrowers who need them, often at significant interest rates. There are many reasons for this, ranging from the high administrative costs of managing multiple small loans to higher operational costs of a more “hands on” lending approach. A typical borrower profile could be someone living in a rural area who is looking for funds to start a new sundries shop in his or her village. There are a few fundamental reasons why borrowers may prefer smaller loans at higher interest rates. One of the primary reasons is simply having access to such loans, as traditional banks may not lend out micro loans due to the burden of managing many small, disparate accounts. Secondly, even if traditional banking systems are available to borrowers, the overall cost of borrowing a lower-interest rate loan from a bank may be higher than that of a higher-interest rate loan from an MFI located in the vicinity, due to a multitude of other factors including cost of travel to the bank, cost of obtaining legal documents/notaries, opportunity cost of time away from work etc. Additionally, MFIs typically accept non-traditional loan collaterals such as jewellery and inventory which are not considered legal collaterals by traditional banking systems. As such, MFIs continue to play a critical role in development and poverty alleviation in many developing countries.
2. Types of “borrowers”
One would traditionally think of a borrower as an individual. However, in the microfinance world, there are various models of borrowers. They include: individuals (based on individual character and capacity to repay), solidarity groups of 3-10 (often based on stepped lending secured by the group collateral), village banking (financial intermediary formed to disburse loans, collect payments and follow up on delinquencies) and branch banking through groups (combination of the latter two). I personally felt that group lending was definitely an innovative milestone in microfinance – having group members conduct self-selection, choosing members they trust and providing group collaterals generally reduces delinquency and provides sustainability.
3. Strategies to control delinquency
In rural settings, it is unlikely that an MFI will “take a delinquent borrower to court”. Instead, strategies are put in place to minimize the delinquency rate within a pool of borrowers. Firstly, lending is based on an important set of criteria such as the repayment capacity (overall household income streams) and relationships/character references. Also, loan sizes often start small, and increase in amounts over time/track record if necessary. Loan officers also establish frequent contact with borrowers to assess their business operations, and help create incentives for on-time repayment (using the carrot rather than the stick).
Ten hours of navigating the course and countless spreadsheets later, my major takeaway is that microfinance continues to be heavily dependent on relationship-based lending. Effective and efficient MFIs are often connected to responsible borrowers by word of mouth and vice versa. At the end of the day, borrowers who lack access to traditional banking systems are willing to pay significant interest rates to access the micro loans (which they would otherwise have no alternative sources) as a means to the end of working hard for a better life.