Microfinance Must Embrace the Free Market

By Philip Vassiliou

The Economic Times Online

 

In their efforts to alleviate poverty, the pioneers of modern microfinance made a remarkable discovery - the poor could serve as reliable borrowers - and developed this insight into a worldwide industry capable of leveraging the commercial capital markets to deliver financial services to millions of poor. As MFIs attempt to reach ever more of the world’s poor, the role of commercialisation is being widely debated.

Critics of increasing commercialisation propose a hybrid alternative combining non-profit and for-profit models. Advocates of this approach call for MFIs to return profits back to the poor in the form of lower rates. The 2006 Nobel laureate Mohammad Yunus, widely recognised as the founding father of modern microfinance, is perhaps the most prominent opponent of the idea of profits in microfinance.

An increasing number, however, advocate the exact opposite - a more business-based approach to grow the sector and increase its reach and service to the poor. Former ACCION CEO and Harvard Business School professor Michael Chu sees self-interest and profitability as essential: “Poverty can only be truly addressed if you meet four conditions: you must have huge scale to reach the billions who are in poverty; solutions must be enduring and last over generations; solutions must be truly effective and make a difference; and all this must happen efficiently.”

To reach its full potential, the microfinance sector must embrace free market principles of competitive pricing and commercial incentives. Modifying these incentives, however noble the intention, will only damage the natural development of the sector.

Compartamos IPO fuels the debate: Since its IPO, in April 2007, Mexican MFI Compartamos has delivered a remarkable ROE of over 45% and profit margins of 33%, demonstrating that some MFIs can be very profitable. Compartamos now serves over 850,000 poor and has a market capitalisation of around $1.75 billion, an enormous valuation given the size of the MFI sector’s entire loan portfolio was $30 billion in 2006. While Compartamos interest rates and cost of funds were equivalent to those of its eight peer MFIs in Mexico in 2006, its operating income was far superior, driven by greater efficiency. Critics contend that Compartamos’ high profitability has come at the expense of the poor. Although caps on profit margins and interest rates may benefit a limited segment of impoverished borrowers in the short-term, arbitrarily regulating MFIs will stifle the natural incentives of MFIs, restrict competition, and impede the commercial capital that the sector needs to scale.

The role of commercialisation: Demand for microfinance is estimated by the World Bank at nearly $300 billion, 10 times the sector’s 2006 supply. At a conservative debt to equity ratio of 5:1, the sector will need $45 billion in fresh equity to meet the $270 billion in excess customer demand. Even ignoring inefficiencies built into philanthropic and multilateral capital and aid, these sources of capital are simply not large enough to meet the excess demand. The sector must continue to attract commercial capital which will alleviate critics’ concerns as more MFIs compete to serve ever more clients. Increased competition will ultimately reduce interest rates and increase the quality of services provided to the poor. For example, interest rates in Bolivia have fallen from 70-80% in the early 1980s to a current average of 28%, thanks to increased competition and commercialisation. Bolivian MFIs have also become far more efficient - the median operating expense ratio for the top four MFIs in Bolivia is down 33% compared to 1996, while the number of clients served by these MFIs over the same period has increased four-fold.

Give the market time to mature: The demand-supply gap of capital is enormous, and increased activity from current market participants will not immediately bridge this divide. With market-based incentives, more entrepreneurs and investors will compete to provide microfinance services and as a result, MFIs will be able to attract the necessary talent, ultimately reducing costs to borrowers.

Like any rapidly-maturing sector, microfinance will face challenges. It is time to embrace free market principles and commercial capital to overcome these challenges, help the sector reach new heights, and further unleash the potential of the world’s poor.

(The author is managing director, Legatum Ventures)