Di Marco Graziano
The goal of this article is to dispel two myths: finance proper being the exclusive dealing of banks and microfinance being short of charity in disguise.
On the contrary, the sector of microcredit has been experiencing for some time extensive professionalisation and diversification, developing a set of practices, skills and organisational features akin to those of traditional banks without forgoing its core mission of helping people out of poverty.
However, even before this Wave of “professionalisation” in microfinance, relevant differences with the charity did exist. Indeed microcredit was born as a bet on the existence of a demand for credit and savings even in the poorest corners of the world, where banking penetration is virtually non-existent.
In a sense microcredit evolved specifically as a financial tool to respond to such demand in a way that is rather unique and differentiated both with respect to traditional commercial banking and charity. All MFIs, different though they may be, are linked by the provision of financial services to a specific set of clients, defined as “micro-entrepreneurs”.
They are characterised by the predominantly informal nature of their enterprises: traditional technologies, small volume of trade and poor business education are all common features.
In order to understand the nature of microfinance, let us consider it as a market solution to a problem of economic inefficiency.
Lenders in poor countries face first of all severe information asymmetry: it is extremely difficult and costly to assess credit history (if any) and reliability in a poor, often rural environment. Therefore traditional banks are adversely selected by borrowers. As a result, interest rates go through the roof and any opportunities of offering banking services are effectively snuffed out.
Another relevant issue is that of moral hazard: financial institutions face hurdles in enforcing contracts in regions where the informal sector is predominant and the legal framework is weak, hence failing to provide incentives for repayment.
All this, together with the frequent lack of any collateral, makes lending an extremely risky business and prevents traditional banks from effectively servicing the enormous markets of poor countries.
Microcredit, especially in its early incarnation introduced by Dr. Muhammad Yunus, addresses the asymmetry mainly by making use of local information (hiring local trusted agents or creating a chain of small-scale local intermediaries).
With respect to lack of collateral and moral hazard, the single most important innovation introduced is peer monitoring, employed jointly with group lending. This combination is extremely powerful in an environment where there is one and only collateral to be exploited: reputation within the community. Borrowers who fail to make payments are responsible first and foremost to their fellow villagers, whose loan is jointly guaranteed, hence providing an incentive for repayment that is often much more efficient that legal enforcement.
Within this framework, it is clear that microcredit is intrinsically a financial activity built, like any other, on interest-bearing transactions involving time and money. In spite of its goal being clearly one of social betterment through poverty reduction, the possibility of MFIs being sustainable if not profitable is not far-fetched, thus qualifying them more as social enterprises than as charity organisations.
Such steering towards the business model of a social enterprise is a hot topic of debate both in academic and entrepreneurial circles. This evolutive path is far from uncontroversial and it has attracted criticism from Dr. Yunus himself, amid worries that microfinance might lose its reputability. However, it is doubtless that a trade-off between sustainability and mission does exist and must be addressed in order for microfinance to blossom to full maturity .