Microfinance loans: Big business

These small loans have grown.

Banco del Desarrollo is a bank with a twist. Founded by a Catholic archbishop, Cardinal Raúl Silva Henríquez, in Chile in 1983, it is designed to serve the poor. The bank boasts 19 years’ experience operating a microfinance subsidiary, which provides self-employed tradespeople and micro-businesses with small loans — from US$300 to US$1,000, on average.

One such borrower was Mario Nunez, the travelling hairdresser of Santiago. He roamed the streets with his bag of tools, looking for clients. After receiving a microcredit loan from Banco del Desarrollo, he started up a storefront business — and caught the eye of the proprietor of the local Hilton hotel. Nunez now runs his salon out of the hotel; he employs a dozen people.

Such stories are common in the annals of microfinance. The sector made news in 2006 when Dr. Muhammad Yunus, the founder of Grameen Bank, one of the first microfinance organizations, won the Nobel Peace Prize for helping thousands lift themselves out of poverty. Following the Grameen model, microfinance loans are made to groups of borrowers, without collateral, over a short period of time. Liability is shared: if you default, your friends have to pay, thus ensuring historically high repayment rates.

Recently, some microfinance institutions (MFIs) have gone commercial. With growth has come increased competition, greater profits, access to international debt and equity markets — and controversy.

Last fall, Scotiabank acquired the bulk of Banco del Desarrollo for US$810 million. According to Jeremy Pallant, Scotia’s vice-president of international banking retail lending, the acquisition helps Scotia tap almost half of the borrowers in Chile.

Investment banks have also initiated several bond offerings, securitizing microfinance loans. To diversify the risk, these banks, which include Citigroup and Morgan Stanley, use an instrument known as a collateralized loan obligation: repackaging pools of loans from MFIs into tranches of notes representing varying levels of risk, and then selling them to bondholders. Sound familiar? This instrument is essentially interchangeable with the collateralized debt obligation, or CDO — used to secure subprime loans in the United States.

Scotia’s Jeremy Pallant is quick to point out the differences between subprime risk and microfinance. “Subprime mortgages were long-term loans, given to clients with bad credit history,” he explains.“In microfinance, the type of lending product is very short-term, low value, and to clients with good credit histories.”

Making loans to low-income borrowers is a risky business. “One Burma-style cyclone, and your returns are wiped out,” says Emmanuel Arnaud, a consultant who has worked with the Centre for Microfinance, an Indian non-profit. But with risk comes reward — and the potential opportunity for investment banks is considerable. The Consultative Group to Assist the Poor, or CGAP, a microfinance organization based in Washington, D.C., estimates MFIs’ demand for capital at US$2.5 billion to US$5 billion annually.

More controversial are the high interest rates that MFIs charge their low-income borrowers. The reason is cost: it’s expensive and labour-intensive to deliver tiny loans to large numbers of people without collateral. Scotia’s Pallant did not initially want to disclose the rates Banco del Desarrollo charges. It turns out that at 21%, they are on the low end of the scale.

A more extreme example is Compartamos, a Mexican microfinance institution. Its recent interest rates have averaged 86%. Last April Compartamos launched an initial public offering; it was 13 times oversubscribed. Demand stemmed from Compartamos’s profitable business model: by charging its borrowers high interest, the bank was able to offer investors return on average equity (ROAE) of 56.2% in 2005. (This dwarfs the 15% ROAE of standard Mexican banks in recent years.)

The IPO valued Compartamos at US$1.5 billion; existing shareholders received about US$450 million.

In a note published last June, one of Compartamos’s initial sources of funding, CGAP, criticized not the fact of its success, but its source and scale. CGAP was concerned by “the large portion of those returns that were created by charging higher-than-necessary interest rates to borrowers.” For his part, Dr. Yunus condemns the commercial model.In a recent article in The New York Times, Compartamos’s co-CEO Carlos Danel defended its business model, arguing the bank’s decision to tap the boundless pool of investor capital will help more poor people than the limited pool of donor money.

Sara Nadel, a former consultant with international non-profit Innovations for Poverty Action, worked in Peru for two years, evaluating microfinance from a development perspective. She argues that in some cases, more competition has brought over-indebtedness. “Too many organizations, lending to the same people,” she says. “This meant borrowers had loans with two or three organizations.” The most egregious example is Bolivia, where exactly this scenario happened. In 2001, the market collapsed.

Nowadays, many countries, including Chile, have credit bureaus that track microfinance loans. Banco del Desarrollo, for example, evaluates potential microfinance borrowers by gauging their debt-service ratios.

As the travelling hairdresser story shows, microfinance can be good news for everyone involved. A former banker with Citigroup, Leslie Barcus heads the Microfinance Management Institute, an organization based in Washington, D.C., that trains bankers in microfinance risk management. “It is not inconsistent for microfinance organizations to maintain financial profitability while meeting social goals,” she says. “It is just more of a struggle.” In other words, when lending to the very poor, handle with care.