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Microfinance: The Good, The Bad and The Ugly
Robert Katz, 20 Apr 08

The other day in New York, I had the pleasure of attending a round table organized by the Council on Foreign Relations entitled The Commercialization of Microfinance: The Good, The Bad and The Ugly. Moderated by CFR Senior Fellow Isobel Coleman, the discussion featured comments from Mary Ellen Iskenderian (of Women's World Banking) and Roshaneh Zafar (of the Kashf Foundation.)

I arrived early, set up my laptop and grabbed a bite to eat (if you're curious, the CFR building is beautiful and they do a good lunch spread). Before I was through my sandwich, the room had filled to capacity and CFR staffers were scrambling to set up overflow seating – there’s clearly a lot of interest in the recent controversy surrounding microfinance. It was quickly apparent that women outnumbered men in the audience by a ratio of about 2:1 – interesting, though not completely unexpected given the importance of women in microfinance and the fact that the speakers and moderator are all women.

Coleman kicked off the session with brief introductions and quickly segued into the topic at hand – the good, bad and ugly of microfinance. She stated – without dissent – that microfinance now finds itself at an inflection point. On the one hand, there have been calls for microfinance not to profit off the backs of the poor, notably in the New York Times' coverage of Compartamos' IPO. On the other hand, those who know microfinance realize that it can't scale – from 100 million clients today to its potential market of 4 billion – without the capital markets, and the formality capital markets require.

I thought Coleman did a good job setting the stage here. From my perspective as a quasi-insider, there wasn't much new – but it is important to say nonetheless. Microfinance can and will go one of two directions, and it's pretty clear that there are strong arguments being made by advocates on either side.

Mary Ellen Iskenderian was next to speak. She is President and CEO of Women's World Banking (WWB), the world’s largest network of microfinance institutions and banks. Iskenderian leads the WWB global team, based in New York, providing hands-on technical services and strategic support to more than 50 top-performing microfinance institutions and banks around the world. Iskenderian told us that WWB's network MFIs have a total portfolio value of $1.4 billion and an average loan size of just $500. Those MFIs serve roughly 9 million clients and there are another 14 million clients served through WWB affiliate banks. Of WWB's 23 million clients, approximately 70 percent are women.

Iskendarian took the helm of WWB after 17 years at the International Finance Corporation and a stint at Lehman Brothers. She holds a BS in International Economics from Georgetown University (my alma mater) and a MBA from the Yale School of Organization and Management. In a 'small world' moment, she and I have collaborated in our previous professional endeavors (she at the IFC and I at World Resources Institute) and got a laugh out of the fact that we found ourselves at the event today.

After Mary Ellen's initial comments, Roshaneh Zafar took the microphone. Zafar is the Founder and President of the Kashf Foundation, the third-largest (and fastest growing) microfinance institution in Pakistan. (Full disclosure: Kashf is an Acumen Fund investee; I am employed by the Acumen Fund.) Before founding Kashf, Zafar worked at the UN Development Program and at the World Bank. In 1993, while at a conference, she found herself discussing the idea of starting a microfinance organization in Pakistan with Grameen Bank founder Muhammad Yunus – who later sent her a plane ticket to Bangladesh to study the Grameen model.

In 1996, she decided to take the step from thinker to practitioner by founding Kashf. By early 2008, Kashf had served over 250,000 clients and held a $110 million loan portfolio. Zafar earned a BS in Finance from Wharton, a BA in Economics from the University of Pennsylvania and a Masters in International Development Economics at Yale.

Zafar began her remarks by reflecting that upon seeing the title of the event – The Good, The Bad and The Ugly – she first thought of Clint Eastwood, which elicited a laugh from the crowd. She went on to describe the state of microfinance in terms of those three descriptors.

First, the good – microfinance does bring about change in the household, according to Zafar. Her Kashf Foundation has seen that a household that has taken 3 loans generates at least 70 percent more income. In general, the Pakistani sector is growing by 30 percent per year. Government policy is open and liberal towards microfinance, which will help bring about commercialization and formalization (code for scale).

The primary 'bad' when it comes to microfinance is that it hasn't scaled. Most MFIs are not profitable; since 2003, Kashf is the only MFI in Pakistan that is financially sustainable. What makes this truly bad is Zafar's belief that a non-sustainable MFI is fraudulent. I was intrigued by this line of argument. Why fraudulent? Zafar argues that, by going out and asking people to take a loan and then pay it back, you have to use that trust and be there for the long term; unsustainability (and the risk of closing) breaks that trust.

Finally, the ugly: economic conditions in Pakistan are affecting Kashf client households (and others throughout the developing world) in terms of food and energy prices. They are developing what they call vulnerability products – like savings. Secondly, there's a need to document borrowers (here, Zafar references Hernando de Soto; I wonder how many in the room are familiar with The Mystery of Capital…). She argues that formality is so important, because a BoP client can never really come out of poverty if they are in the informal economy.

Coleman asked the panel a first question – how do you see commercialization unlocking opportunity, and what are some parameters MFIs could put in place to ensure borrowers are not taken advantage of. I thought it was a good question, getting right to the core of the recent debate.

Iskenderian began her answer by observing that microfinance NGOs – many of which have been part of microfinance since its beginning – have distinct social missions. To fulfill those missions, these organizations must have more capital; without access to the capital markets, they simply won’t be able to raise that money. Secondly, these NGOs want to offer new products – such as savings – but they need more money to develop these sophisticated products. Overall, she observed, commercialization has been a positive vehicle for achieving social missions.

That said, as the microfinance sector has grown and reached more clients, Iskenderian observes a worrying trend: the percentage of women clients has been declining rapidly. If you take that figure as a proxy for the organizations' focus on poverty, then this decline indicates commercialization may be bad for achieving social missions. At this, Coleman interjects and mentions that, with all the fury over Compartamos, it is interesting to note that Compartamos' percentage of women borrowers has actually stayed stable during and after their IPO. Personally, I am not sure that the best metric for measuring MFIs social impact is the percentage of female borrowers; this back-of-the-envelope thinking (and the lack of dissent among the audience) worried me a bit.

In her answer, Zafar pointed out that commercialization is necessary to sustain growth rates; Kashf grew 86 percent in 2007 and 90 percent in 2006. She offered four specific stages of a MFI's commercialization:
- get your money back
- be efficient and achieve cost effectiveness
- reach the capital markets
- take deposits and offer financial services

Kashf is at step four – they are setting up a bank as well as maintaining its current foundation model. The biggest challenge of step four – taking deposits – is to keep transaction costs low. Kashf is going to try a branchless banking approach and see if that can keep costs down.

On the lending side, Kashf is looking at the bottom rung of entrepreneurs: small businesses needing $800 to $2000 loans. According to Zafar, the thinking behind this is all about job creation in low-income communities. The key is getting from income generation (self-employment) to small enterprise (hiring others), which creates a multiplier effect in BoP communities. To make a dent in the lives of poor households, you need to make them part of the financial system.

Coleman's second question was simple: should there be a cap on interest rates?

According to Mary Ellen Iskenderian, "just because you can charge a certain interest rate doesn't mean you should." In the case of Compartamos, she noted, there hasn’t been any competition; as a result, Compartamos has been allowed to grow up as an inefficient organization. Covering costs is one thing, she noted, but if you aren't pushed by competitors, then you can do whatever you want to. The good thing about the Compartamos IPO is that it is bringing this competition into Mexico. In sum, she says there should be no interest rate caps, because they would discourage competition and innovation.

In her answer, Zafar brought up the Bolivian market, where pre-commercialization microfinance rates were at 70 to 80 percent. But in the past 10 years, when Bolivia has become perhaps the most-commercialized microfinance sector in the world, the interest rate has dropped to 35 to 45 percent – a decrease that Zafar chalks up to competition. At the same time, the original players in that market may charge a higher rate because of the risk they're taking on.

There is also a moral element at play. In Pakistan, moneylenders charge 200 to 350 percent – compared to Kashf's 36 percent. Zafar noted, "I cannot stress this enough: you cannot put a cap on interest rates." If you do, she says, you doom commercialization. According to Zafar, Kashf is sometimes considered usurious and has been called out in the press as such. Ultimately, the ethics are important – could Compartamos have brought their rate down from 90 percent to 70 percent? Maybe they could have – which Zafar sees as a moral, not a business, question.

The third big question to the panelists was about new technologies and branchless banking – what kind of affect they would have on the sector. In her response, Iskenderian noted that operational inefficiencies have to be brought down for microfinance to scale. Unfortunately, the real problems facing MFIs aren't going to be solved by branchless banking; rather they are straightforward but difficult nuts to crack.

First off, there's a primary human resources challenge – how do you hire enough staff when your organization is growing at 90 percent per year? And how do you retain them? (Zafar nodded vigorously as Iskenderian described this issue. I was sitting next to Kashf’s CFO, Khaled, who was also nodding his head.)

The second issue facing MFIs is technology-related – but not cell phones and wireless. Rather, it's about basic, back end systems and MIS that can be adapted to the unique needs of microfinance. Not sexy stuff, but critically important.

Kashf, according to Zafar, has seen some great results with technology. They just started a cell phone project, and worried that they would have high training costs – teaching their borrowers how to use the drop down menus and SMS on phones. That wasn't the case at all; their low-income clients picked up on the user interface quickly – which taught Kashf that "you have to trust your clients."

The problem with the cell phone project wasn’t technical – it was regulatory. Thankfully, the woman who runs the State Bank of Pakistan has been helping them deal with these issues. (Mentioning this, Zafar observes – laughing – that there's no coincidence that the problem got solved by a woman.) The other problem for Kashf's mobile banking pilot was with the telco – working with them to develop the back end systems to get client information quickly and cleanly. This is not news, really – we've been talking about this in the Base of the Pyramid universe for the past 2 years.

At this point, the audience began to ask questions. The first asked about know your customer (KYC) regulations, and how they have been an issue for growing MFIs. For Kashf, KYC has been a huge issue, in addition to anti money laundering rules. Documenting who your client is can be really hard in Pakistan, because not even 35 percent of Kashf's clients have national identity cards that are required to register with the bank. So, to meet KYC requirements, Kashf has to do social mobilization and help their potential clients get cards – this market building is an extra cost for Kashf, and is something we see throughout the microfinance industry.

One of the day's final questions asked if there is a risk of there being too much money chasing too few opportunities. In response, Iskenderian pointed out that CGAP just put out a report on risk in microfinance – and 'too much money' was the number one risk. Data in the report show that 82 percent of all microfinance clients worldwide are being served by just 2 percent of the MFIs. (This is a staggering number; I had no idea the gap was this big.) There’s also another tier of MFIs that we can start to develop – and help consolidate. The vast majority of MFIs have 3,000 borrowers or fewer – and WWB believes that you need to have at least 5,000 to really be sustainable.

How does that consolidation happen? It will vary by country. For example, in Colombia, WWB had two MFIs merge and then partner with BBVA to create a specialized microfinance bank. From Zafar's perspective, it's not as much about mergers as it is about scale – how do we reach all of these people who don’t have access?

Overall, the event was well organized, well attended and well run. I left with a better understanding of microfinance and the challenges it faces. I was especially struck at how easily Iskendarian and Zafar can move from discussing the business aspects of microfinance to the social aspects. Their organizations seem to have been able to merge these two goals – financial sustainability and poverty alleviation – without compromising either.

(This post first appeared on NextBillion.net)

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