The Rapid Growth of Microfinance Loans: An Interview with the founder of the first MFI Rating Agency
After twenty-five years with the World Bank Group, Damian von Stauffenberg ventured into the emerging world of microcredit back in 1997, founding the first rating agency to analyze microfinance institutions. The Catholic Finance Association sat down with Mr. von Stauffenberg to discuss the history, rapid growth, and current challenges of microfinance loans.
CFA: On the website for your microfinance rating agency MicroRate, you mention the idea that the best rated microfinance institutions (MFIs) are the ones who use a more holistic approach that goes beyond rating an individual or a group according to the normal indicators and standards of traditional lending. Can you clarify this principle that helps guide how you rate MFIs?
von Stauffenberg: I would put it this way. It’s good to remember that the source of wealth in a country is the creative power of its people. It is in this that you have the massive potential source of wealth within developing countries. Engaging and activating the enormous numbers of unemployed or underemployed people. If you can get their creative energies in action, amazing things can and do happen. You already see it in their creative efforts to survive and just get their daily bread… It is the people who know the needs of those in their local environments, and you have to be plugged into that in order to be able to make micro-lending work well. So the focus of the lender on the human person comes from this foundational principle. To understand what makes an individual person more productive in their particular environment is absolutely essential.
CFA: Maintaining the quality of a microfinance portfolio would appear to require much more involvement than that of traditional banking. It seems that analyzing a microfinance loan demands a lot of “on-the-ground” work and knowledge of local cultures and markets. How are the best MFIs going about this? What are some of the best practices you are seeing in this regard?
von Stauffenberg: First, it’s good to clarify that microfinance is not one thing. It looks quite different when you make $100 loans in Bangladesh than when you make $1000 loans in Honduras, or $5000 loans in the Middle East. If you get into thousands of dollars, you start nibbling at the edges of small business lending, and there, the banks have learned how to start doing that, and after many unsuccessful tries, the big banks are now trying the smaller loans as well.
The bulk of microfinance is still a very hands on and human-touch intensive business, because you need to know your client and you need to do this very quickly. Ultimately, it’s mostly project lending. For example, you need to determine if this particular woman in Indonesia who is selling cabbages will be able to do it successfully, and that’s where local culture comes in, local habits, ways of sizing up people, and so on. While this is very time intensive, the best MFIs are finding ways to do this more efficiently. For instance, many have learned how to use tablet computers in the field. In the early days, tablets were often just a distraction. Everybody became fixated on the technology, and not the client. With more recent improvements, loan officers can get an answer for whether or not to offer a loan right there in the field. But at the end of the day, meaningful contact between the personal loan officer and the client is still the key to success.
At the smallest loan levels ($400 or less), it is too expensive to do much analysis. That’s where group lending comes in. Here, you rely on a group or community to pressure individual members to pay back their loans, because ultimately the whole group is responsible. This has its obvious downsides, but in certain parts of the world, this has been very effective in maintaining high repayment percentages.
CFA: Do microfinance loans work most of the time? When they don’t work, do you know why?
von Stauffenberg: By way of background, it’s good to remember that the initial introduction of microfinance in the developing world was due to the contribution of many large development institutions, and oftentimes, development people don’t think in financial terms, they think in charity terms, falling into a subsidy mode of operation. So if you lend to people who live at the edge economically, and you don’t have the proper mindset or infrastructure in place to properly ascertain whether they can repay, the consequences can be quite dire. A really poor person doesn’t have a way of getting past the consequences of a failed credit arrangement. As many of the early microfinance institutions (MFIs) discovered, reaching a lot of people is easy, but reaching people who can repay a loan is a lot harder.
Early on, MFIs discovered that it was very difficult to work out the collateral part of the equation. Since most poor people don’t have salaries or own property, microfinance loans require a very different type of analysis. You have to figure out if the recipient of a loan can use his or her creativity to create value, and that requires a much more sophisticated process. And if you don’t enable someone to create value with a loan, you just load them with debt, and they can end up far worse in the long run.
CFA: You mentioned how quickly the MFI industry has grown. From our understanding, most of that growth happened before the financial crisis of 2008. Is that correct?
von Stauffenberg: When you talk about percentage growth, yes, growth rates were higher before the financial crisis, and then dropped just as quickly as a result of the financial crisis. What I’m suggesting is that today the growth rates of MFIs are lower, but since the institutions are now much larger than they were ten or eleven years ago, a 10% growth rate today is much more money than a 40% growth rate back then.
CFA: Over the last twenty years, there have been hundreds of stories written about the downside of the group lending model. How much of that is being alleviated at this point? What percentage of the MFI community abides by that model of group lending?
von Stauffenberg: Group lending is a very large part of microfinance, and it’s particularly big in Asian countries with large populations of poor people. The scandals with group lending that happened in India were ultimately healthy, because they forced everyone to take a deep breath, and ask, “What are we doing?”
About fifteen years ago, Compartamos, an MFI in Mexico, floated an IPO that was successful beyond everyone’s expectations. Even though their motivation was to provide solid loans to poor entrepreneurs, shareholders became rich very quickly. This didn’t go unnoticed, and you then had imitators who wanted to show rapidly ballooning portfolios, and unfortunately, determining the integrity of the loans became secondary. In these situations there was a lot of pressure, then, to do whatever was necessary to avoid defaults. And that quickly became public and sort of forced a correction. As a result, investors then began to ask better questions about MFIs. — Who are they? What do they do? How do they operate? How are they motivated?
But I have to say that the majority of the MFIs we rate every year are really good, and getting better all the time.
CFA: MicroRate was the first to begin rating MFIs, and now most other rating agencies have entered this space. Besides your work and that of other rating agencies, what are you seeing as far as new legal and government oversight? What’s been helpful? What’s been harmful? And what is needed right now?
von Stauffenberg: The single best thing that donors and well-wishers of microfinance can do for that industry is to put a system in place that sets clear rules of the game, and more importantly, enforces those rules. In many places, it has taken time to craft legislation that properly regulates MFI activity. However, in the places where meaningful legislation, backed by solid enforcement, is put into place, we’re seeing a very positive, catalytic effect.
For example, back in the late 90s, President Fujimori of Peru was convinced of the power of microcredit loans. Instead of pumping large amounts of government money into microfinance, he compelled the Peruvian banking superintendency to train themselves in microfinance. At the same time, he passed the appropriate laws and regulations which that superintendency then enforced. This propelled Peru into the number one microfinance country in the Western hemisphere (which it remains today, though it is no longer the largest), and made it the most sophisticated microfinance sector anywhere in the world. But we have to remember that this success was hard earned after two decades of well implemented rules and effective supervision.
CFA: In a recent presentation, you brought up the problem of microfinance getting mixed in with consumer credit, especially at the smaller loan sizes. Is more of that being accounted for, or is the use of small loans to smooth over consumption still a significant problem?
von Stauffenberg: This is still a fairly significant problem, in part because competition has become quite fierce. In the developed microfinance market, it’s common to see a borrower not having just one loan, but multiple loans, all at the same time. And you really need a functioning credit bureau to sort through all of that. If you have too many MFIs too eager to lend, then those people who are already steeped in debt will not find it too difficult to obtain new loans to repay the old ones. And there will be a growing avalanche of clients trying to pay down the principal, while not managing to cover very high interest rates.
The bottom line is that even though best practices are improving and increasing within the world of MFI, because it’s more mainstream there’s now more competition, and that means there is greater potential for bad loans.
CFA: As you know, the Catholic Finance Association is not just a finance think-tank. As finance professionals, we are very serious about the ways in which our Faith, especially Catholic Social Teaching, can inform our industry. How does your faith play into all of these questions?
von Stauffenberg: If I can have a direct contribution in enabling these MFIs to be better funded and better managed, and as a result those MFIs have an impact on improving the lives of the poor, then that must be worthwhile… There are probably untold hundreds of thousands (and perhaps millions) who have in some way benefitted from well-managed MFIs, and if that is really the case, then that’s certainly worthwhile.
But I must admit that I initially looked at microfinance in a more ecclesiastical and clerical way, thinking that parishes should be directly involved in lending operations. I had to learn pretty quickly that a parish and lending usually don’t mix very well. For example, imagine a mother of three small children who can’t repay her loan, and she comes to the parish asking for leniency and more time. How do you manage the parish’s first responsibility to offer charity and spiritual assistance, while at the same time trying be financially solvent? You really are in an impossible position. So it’s healthy to leave the lending to the financial sector.
CFA: Pope Francis has mentioned microfinance before, and talks regularly about the preferential option for the poor. He even invited Muhammad Yunus, the father of microfinance, to the Vatican several years ago. What is your take on what the Pope has said in this regard? On the economy, on microcredit, and so on?
von Stauffenberg: Much of this emphasis on microfinance and the option for the poor started with Pope Benedict XVI, and the principles themselves were articulated well before that. In one of Pope Benedict XVI’s encyclicals, Caritas in Veritate, he said quite a bit about microfinance. Unfortunately, I’m afraid that it wasn’t informed by the sort of experience that I’ve been emphasizing. It was mostly informed by a “let’s help the poor” mentality, which is fine. That’s what we all want. But, in the long run the poor benefit most when they are served by efficient, client-oriented and financially sound MFIs, not by donor-oriented institutions which are absorbed in a never-ending hunt for subsidized funding.
The Church often ends up treating microfinance like a charitable endeavor. But microfinance now reaches hundreds of millions of people, and it only works if it’s financially responsible. Microcredit works if it gets repaid, and only if it gets repaid with interest. Unfortunately, the charitable mentality sees the problem as one of transferring wealth. In reality the challenge is to use loans in a way that unlocks the creativity of the borrower. It’s the borrower who creates wealth. The loan goes back, with interest, to where it came from.