How Microfinance Can Thrive in Tough Times
Investors provide funding for the microfinance organizations that make millions of small loans. These investment decisions shape the microfinance sector.
Microfinance has become big business.
Microfinance first drew wide attention in 2006, when Muhammad Yunus won the Nobel Peace Prize for his work with the Grameen Bank. The Grameen Bank and other microfinance organizations (MFOs) offer loans to poor people unable to borrow from traditional banks. Microfinance’s benefits are many: more small businesses, greater household financial stability, and increased power for women.
Today, MFOs operate in almost every country and provide $60-100 billion annually in loans. MFOs, in turn, receive the money they loan out from a variety of funders. Some of these funders are public organizations, such as governments and aid agencies. Others are private capital firms.
“The coal face of micro-finance is bare feet in rural villages,” says management professor Tyler Wry (University of Pennsylvania). “But upstream, it’s high finance — billions and billions of dollars.”
Wry and colleagues Adam Cobb (University of Pennsylvania) and Eric Zhao(Indiana University) looked at what kinds of MFOs different funders favour. For their work, they won the 2017 Research Impact on Practice Award. The award, sponsored by NBS and the Academy of Management’s Organizations and the Natural Environment Division, recognizes sustainability research that has important implications for practice.
The researchers drew on a proprietary dataset of all traceable loans made to MFOs globally between 2004 and 2012, as well as more than 30 interviews with funders.
Their findings: Private and public sector funders prioritize different MFOs. Private sector funders tend to give to large MFOs, as more stable. Governments and aid agencies fund smaller MFOs. But when a country faces political or financial instability, public funders also direct their money away from small microfinance organizations and toward larger ones. That narrower focus can weaken the microfinance sector as a whole.
Smaller MFOs can take steps to improve their chances of securing funding in these situations. And funders can do more to help them.
To understand how microfinance operates, we need to understand what it means to rely for funding on different financial institutions, says Wry. “These things aren’t neutral: they come with a different agenda.”
Why Funder Type Matters
Traditional banks finance their lending through deposits. However, MFOs generally don’t accept deposits; they rely instead on external funders to provide a steady flow of capital. MFOs worldwide receive about $30 billion annually in funding.
Over time, private finance has become an important part of the microfinance funding mix; it’s now the largest and fastest-growing source of capital.
Different funders have different goals. For private funders, the priority is getting their money back. “We need returns to capital and need to make sure we’re involved with [MFOs] who can ensure this,” one fund manager told the researchers. “It’s a pure investment case driving our decisions.”
As a result, private funders tend to fund larger MFOs, because large organizations are less likely to default on loans.
Public funders want to see a country’s entire microfinance sector develop, and that means supporting smaller, emerging MFOs. Smaller MFOs tend to be better at outreach, and a larger number of MFOs means more competition and better opportunities for borrowers. “We’re a mission-driven organization,” one manager from a public sector funder explained. “This means [we’re] interested in developing the sector and…supporting poverty alleviation.”
When Times Get Rough, Funders Play It Safe
In normal times, the different priorities of private and public funders fit together, supporting a range of MFOs. But the researchers found that when countries become unstable, public funders start acting more like private ones.
Instability can be political (e.g., less support for the rule of law) or financial: increased debt, a recession, or an interest rate spike. Instability makes larger MFOs seem like a better bet even to the public sector funders. A staffer at one public funder explained: “When a country gets volatile…you need someone to prop up the cornerstone institutions….Sad as it is to say, the little guys are going to be exposed…the top tier [MFOs] are going to be able to pay you back.”
That shift can mean more hardship for a country’s most vulnerable people. “Smaller micro-finance institutions that lend to those most at risk can’t get funds,” explains Cobb. “The most at-risk groups can’t get funds a time when they need it most.”
Ultimately, a shift to larger organizations weakens the MFO sector, resulting in less competition, service, and outreach.
Three Ways to Overcome the “Small MFO” Disadvantage
There are a few ways small microfinance organizations can make themselves more attractive to funders.
First, the small institutions can effectively increase their size, by merging with another organization or forming an alliance or consortium.
Second, the researchers suggest that MFOs increase their transparency and improve their financial reporting. Transparency may increase an MFO’s appeal to both public and private funders.
Small MFOs can also attempt to become financially self-sustaining. The researchers are now studying how MFOs might become independent of funders. Their preliminary finding: any MFO can integrate professional management practices, to reduce operating costs and lending risks.
However, country setting matters as well. For example, MFO transactions cost less when there are fewer cultural barriers (discrimination, lack of trust) to working with the poor.
Some solutions require broader intervention. For example, public funders could form a reserve capital pool to help small MFOs weather uncertainty. They could also offer loan guarantees or other protection to funders, or provide loan insurance to smaller MFOs.
Microfinance Can Be Improved
Microfinance can be important for poverty reduction, but it’s not perfect, says Cobb. “It’s a market-based solution to a social problem,” he explains, and “markets are not always great at solving social problems.”
Ultimately, microfinance is a tool, and “like all tools, it can be sharpened, improved, amended, added on to.”
Video on the research (Academy of Management Journal)
Article: Cobb, J. A., Wry, T., & Zhao, E. Y. 2016. Funding financial inclusion: Institutional logics and the contextual contingency of funding for microfinance organizations. Academy of Management Journal, 59: 2103-2131.