«Jonathan Conning & Jonathan Morduch April 8, 2011 Contributions to this research made by a member of The Financial Access Initiative. The Financial ...»
Microfinance and Social Investment
Jonathan Conning & Jonathan Morduch
April 8, 2011
Contributions to this research made by a member of The Financial Access Initiative.
The Financial Access Initiative is a
consortium of researchers at New York
University, Harvard, Yale and Innovations
for Poverty Action.
NYU Wagner Graduate School
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www.financialaccess.org Microfinance and Social Investment Jonathan Conning Hunter College and The Graduate Center City University of New York and Jonathan Morduch Wagner Graduate School of Public Service and the Financial Access Initiative New York University Abstract This paper puts a corporate finance lens on microfinance. Microfinance aims to democratize global financial markets through new contracts, organizations, and technology. We explain the roles that government agencies and socially-minded investors play in supporting the entry and expansion of private intermediaries in the sector, and we disentangle debates about competing social and commercial firm goals. We frame the analysis with theory that explains why microfinance institutions serving lower-income communities charge high interest rates, face high costs, monitor customers relatively intensively, and have limited ability to lever assets. The analysis blurs traditional dividing lines between non-profits and for-profits and places focus on the relationship between target market, ownership rights and access to external capital.
Key Words Financial intermediation, market development, pro-social behavior, corporate governance, social entrepreneurship, microcredit, leverage.
2. THE STATE OF PLAY IN MICROFINANCE
2.1 The microfinance schism, rekindled
2.2 Global financial data
3. CORPORATE FINANCE OF MICROFINANCE: A BENCHMARK MODEL
3.1 Strategies to expand financial frontiers
3.2 Monitoring agents with other agents
3.3 Limits to joint‐liability
3.4 Competition and over‐lending
4. SOCIAL INVESTMENT
4.1 What social investment does
4.2 The social investor’s dilemma
4.3 Should the goal be commercial microfinance?
5. REGULATORS AND INVESTORS
DISCLOSURE STATEMENTJonathan Morduch is a member of SafeSave, a microfinance cooperative that operates in the slums of Dhaka, Bangladesh. The authors are not aware of any other affiliations, memberships, funding, or financial holdings that might be perceived as affecting the objectivity of this review.
ACKNOWLEDGEMENTSFinancial support was generously provided by the Moody’s Foundation. We thank Emily Breza and Vidula Pant for valuable conversations, and Cecelia Tanaka for research assistance.
The views here are ours only and not those of Moody’s.
1. INTRODUCTION On December 30, 2010, an Indian financial institution registered under the acronym GFSPL completed its third securitization; 25,768 loans were pooled and issued as debt securities. The senior tranche was purchased by a large Indian mutual fund, and the subordinated piece was subscribed by the investment bank that arranged the transaction. Earlier that same year, GFSPL received $2.2 million in loan financing from a Dutch private fund and issued over $4 million in secured redeemable non-convertible debentures to a US-based private equity firm (IFMR 2010).
What is remarkable about this story is not the structures of these financial dealings but the identity and nature of the firms involved. Grameen Financial Services Private Limited, GFSPL, is the for-profit firm behind Grameen Koota, a microfinance service provider that almost exclusively serves poor female entrepreneurs and day laborers with incomes as low as $0.50 to $1 a day. GFSPL’s website (www.gfspl.in) describes their aim to bring “life-changing microfinance services to India’s working poor.” Launched as a nonprofit in 1999 with only $35,000 in seed capital, Grameen Koota transformed into a for-profit non-bank financial institution (NBFI) in 2007. By late 2010, it claimed 450,000 clients and plans to reach 2 million by 2012.
The investors and arrangers are notable as well. The private equity fund, Microvest I, is a $60 million fund founded in 2003, chaired by W. Bowman Cutter, a former managing director of the $25 billion venture capital firm Warburg Pincus. The three founding investors in Microvest, however, are non-profits: Mennonite Economic Development Associates; the humanitarian organization CARE; and a fund set up by the French Committee against Hunger and for Development. Such “social investors” seek to create positive social impacts alongside financial returns. (GFSPL’s reported return on equity was a modest 1.2% in 2008 and 2.6% in 2009 according to www.mixmarket.org.) What may be more remarkable is, in fact, how unremarkable this kind of mixing of social and financial goals has become. By the end of 2009, more than $6.2 billion of foreign capital was invested in microfinance through 91 specialized microfinance investment vehicles (MIVs), estimated to account for about half of foreign investment in the sector (CGAP 2010). While limited financial access has long been cited as a fundamental constraint to economic development (e.g., Galor and Zeira (1993)), the rise of institutions like GFSPL is rapidly democratizing access and connecting local micro-lenders to international capital markets. The idea of “microfinance” has now evolved beyond lending microcredit (small—often unsecured— loans) to include microsaving (entry-level saving accounts) and basic forms of insurance and transfer mechanisms. The idea of mixing social and financial goals is not new, nor is the attempt to democratize access to credit. But today’s supply-side expansion is unprecedented, and microfinance has become the leading example of a broader push for “social investment” in the health, education, and energy sectors (J.P. Morgan 2010).
Still, maintaining a balance of social and financial goals is tricky. By the start of 2011, the Indian microfinance sector was in a full-blown crisis, with politicians accusing micro-lenders of aggressive loan collection practices, over-lending to indebted customers, and exploitative interest rates (Rhyne 2010, Yunus 2011). State-level politicians responded with a tough microfinance 2 ordinance in October 2010. In January 2011, the Indian central bank stepped in with a broader set of rules whose effect (if not their intention) will likely shut down many micro-lenders serving the poorest customers (M-CRIL 2011).
This tension between social and commercial goals has run through the history of microfinance. Morduch (2000) characterizes a long-standing schism among leading microfinance proponents, centered on whether commercial transformation is the best strategy to expand financial services to poor families. The debate is often framed as involving for-profit versus non-profit strategies, but that is too simple and clouds the issues. Muhammad Yunus (2011), for example, asserts that it is “possible to harness investment in microcredit — and even make a profit — without working through either charities or global financial markets.” Yunus is right that neither a strictly philanthropic path nor a fully-commercial path has delivered institutions that serve most of the people most of the time. But neither theory nor evidence supports his assertion that charities and global financial markets should be side-lined. To the contrary, experience suggests that the future of microfinance rests with the ability to combine forces.
Finding the right path requires a more rigorous “corporate finance of microfinance.” So far, corporate finance has had relatively little to say about businesses that pursue social goals, and many economists are swayed by Milton Friedman’s (1970) argument that the primary social responsibility of business is a fiduciary responsibility to shareholders. Business and philanthropy should therefore not be mixed. But Friedman’s argument is most compelling when markets are complete. When market imperfections are rife – which is the fundamental premise of microfinance—the theoretical case emerges that mixing philanthropy and business may sometimes be necessary to build markets and increase economic efficiency (and not just reduce inequality). Understanding that possibility and its limits requires getting a handle on microfinance institutions’ internal incentives, financial structure, ownership, governance, and market context. The economics of microfinance has generated a steady flow of strong studies, but the ideas here are relatively unexplored in the academic literature. Our aim is to draw theoretical links and illustrate key ideas with new evidence. Section 2 details the landscape of microfinance, placed in the context of the Indian microfinance crisis of late 2010. Global data reveal a world that mixes socially-driven institutions and more narrowly commercial for-profit players. The evidence suggests that the institutions co-exist but are not always substitutes: their typical target
populations and financial structures often differ markedly. The evidence sets up the question:
how can financial intermediation frontiers be pushed out?
Section 3 begins the work of describing a corporate finance approach to microfinance. We draw on the workhorse corporate finance model of Tirole (2006) and the model of financial intermediation of Holmstrom and Tirole (1997), which highlights two elements important for understanding the structure and limits of microfinance: costly delegated monitoring and scarce intermediary capital. The setup helps to explain why financial markets tend to fragment into clusters served by formal and informal financial institutions. Borrowers with ample pledgeable income or collateral can gain access to traditional bank loans and other formal financial services.
Borrowers with little or no collateral have difficulty gaining access to these formal services but may have access to monitoring-intensive finance from informal sector providers and microfinance, or they may remain entirely excluded. In this context, we explain the rationale of “group lending” contracts that encourage peer-monitoring among microfinance borrowers.
Much of the literature on microfinance incentive mechanisms focuses on new monitoringintensive products and dynamic repayment incentives but goes no further. We show that these products are costly because they rely so heavily on costly monitoring to create and maintain their value. The products also create constraints that shape the capital structures and the ownership of the microfinance institutions. Section 4 explores these issues and turns to the role of social investors. We argue that the rapid expansion of microfinance would not have been possible without the support of philanthropic seed capital and policy entrepreneurs with pro-social motivations, even though--once they are established--many of these institutions can be run as profit-making institutions. We also clarify the fundamental trade-offs face by social investors, involving choices between who is served and how many are served. The section frames that choice, and explains why—counter to a strong push for commercialized microfinance—some profitable institutions may nonetheless want to continue as non-profits. In Section 5, these ideas are applied to the Indian microfinance crisis of 2010.
2. THE STATE OF PLAY IN MICROFINANCEThe challenge for “micro-lenders” is to create banking models that work for the unbanked and under-served. The potential demand is vast. Chaia et al. (2009) compile global data to count 2.5 billion adults without formal financial accounts (provided by regulated banks) or “semi-formal” financial services (provided by microfinance institutions and similar institutions regulated separately from banks). Most, nearly 2.2 billion of these unbanked adults, live in developing regions. There is no up-to-date count of the reach of microfinance (and much depends on definitions), but all credible estimates are between 100-200 million customers globally, falling far short of the total unbanked population. The broad question is: how can the gap be filled? By banks going “down-market”? By NGOs supported by donors? By state banks? By newly-created commercial microfinance institutions?
2.1 The microfinance schism, rekindled In the same week that the GFSPL securitization was announced, Bloomberg ran a story titled “Suicides in India Revealing How Men Made a Mess of Microcredit (Lee & David 2010 ).” The article cited a government report that claimed excessive debt, coupled with aggressive loan collection practices, had driven more than 70 people to kill themselves in the southern state of Andhra Pradesh between March and November 2010.1 The suicides spurred the state government to come down hard on microlenders, and an ordinance in October 2010 restricted the ability to meet with customers and approve loans. Within weeks, loan collection levels plummeted from 98 percent to under 20 percent.
The Bloomberg story highlighted India’s first microfinance IPO, completed in August 2010.
SKS Microfinance, with 7.8 million customers by September 2010, rose to become the largest
The Bloomberg article puts the debt-related suicide data into perspective: “Andhra Pradesh, where three-quarters of the 76 million people live in rural areas, suffered a total of 14,364 suicide cases in the first nine months of 2010, according to state police.” The article continues, “SKS [the largest microlender] says 17 of its clients have committed suicide, none because of loans being in arrears or harassment.”