Microfinance
by Kathleen Lucia, EAU Vice-President

Time to think small?
The death of “free market capitalism” has now been so widely proclaimed that it is safe to discount it as tosh. People have not changed and therefore the reason why markets exist has not changed. You and I will continue to try to fulfil our desires with minimum effort and these desires will remain limited only by our imagination.

But an equally safe assumption is that governing elites around the world will be looking to interfere in our socio-economic lives with even more vigour. They will tell us, some sincerely, that this will be for our own protection and, certainly, we may feel we need some protection from the predations of a paralysed banking and financial services system that is not longer willing to lend even to the most demonstrably robust businesses. Yet governments are unlikely to offer any solution apart from propping up the existing imploded system with the money the rest of us provide. There are, though, some potential answers, none of them new, but all tried and mostly tested, which are already being revisited by those whose livelihood could well depend on them.

One idea, whose time may have come more positively than before, is microfinance. This is the system by which the poor are advanced very small loans that they can afford to raise and service. One big attraction may simply be that it is so remote from the incomprehensible world of derivative financial instruments that laid the fatal fire beneath the world’s financial systems. But does it really give impetus to the entrepreneurial spirit, or is it merely a dangerous distraction from the essential business of powering real economic growth?

Microfinance could be seen as banking returning to its roots in pre-history in that something like banking and like microfinance is nearly as old as settled humankind. Credit based banking flourished throughout much of the Mediterranean by the fourth century BC and banking administration and financial regulations were well developed in Ancient Rome, along with such sophisticated practices as the charging of interest on loans and payment of interest on deposits.

Then, as now, banking is fundamental to the smooth operation of an economy. Businesses, even the least sophisticated, cannot function effectively without it, hence the drama of the credit crunch. But possibly the biggest difference between then and now is the sheer scale and complexity of our financial institutions, so vast and pervasive that their collapse can bring down whole national economies with them. In today’s climate it is not surprising that there is a strong and growing sense that a return to smaller banks and basic banking– simply taking deposits and lending them –is much to be encouraged.

Microfinance, big business
And it is worth remembering that the world’s beleaguered borrowers and savers are in a relatively small minority. Around the world there are millions of people who have no access to the financial services that most people in the developed world take for granted: no loans, no savings accounts; certainly no mortgages or longer term lines of credit.  

Yet microfinance is already big business and has been for several centuries. The idea does have some obvious attractions: simplicity, practicality and moral acceptability, despite the charging of interest rates that, at first sight, appear usurious. Further, its long history, should, one would think, ensure its robustness in practice over time. In Modern times, Grameen Bank is probably the best known microloan institution, founded in 1983 by economics professor Muhammad Yunus. He found that tiny loans, originally to a group of around 40 families, was enough to lift them out of poverty and enable them to pay back the loan reliably. He famously proclaimed that all people were entrepreneurs. Since then, a global movement has developed, sucking in investment from the likes of Citigroup, the venture capital fund, Sequoia Capital and private equity group, Helios Capital, among many others. And, to crown this success, the United Nations declared 2005 the International Year of Microcredit. There is an estimated $25 billion of loans outstanding around the world to up to 150 million customers. And it is a highly profitable business, hence the interest of Big Commerce.

According to Financial Times writer Tim Harford, writing in the paper’s weekend magazine last December, microfinance lenders can often charge interest at very high annual percentage rates, frequently well in excess of 30 per cent, because small short-term loans are costly to advance. For example, he points out, a $50 dollar loan over four months at 50% APR would yield only around $5 in interest payments. Nevertheless, high volume and low overheads amount to good profits. The drive toward commercialisation has, though, split the world of microlending. Yunus, in particular, favours the socialised, not-for-profit model that he considers is the only way to reach the very poor. Others, who argue that it is glaringly obvious that not everyone can be an entrepreneur, believe that the commercial approach, which correctly factors in risk and reward judgements, will reach more people and be more successful over time. We are back to the fundamental arguments about the human condition and the nature of markets.

Poor people save
Moreover, nobody has determined so far exactly when microfinancing works or why. The fact is that poor people tend to be savers rather than borrowers, but they need safe, well regulated, well governed institutions to take their deposits. Deposit taking is a much more complex and expensive market for microfinanciers to enter, making it unlikely that many will. But if they do they are unlikely to find it impossible to raise the deposit–based capital needed to make fresh loans – in other words they will become retail banks as we used to know them.

But it is savings, not loans that are vital to economic growth, argues Croatia-based professor of economics, Milford Bateman. He sets out an ‘iron law of microfinance’ that states: “to the extent that local savings are intermediated through microfinance institutions, the more that country or region or locality will be left behind in a state of poverty and under-development”.

The effect of a focus on microloans, he says, is to produce a shortage of funds for the small and medium sized companies that have far greater growth and development potential. In Serbia, he says: “there has been an accelerated proliferation of informal-sector microenterprises, so the country is now chock-full of traders, kiosks, shops, street-traders and subsistence farms. The base of the economy is quite simply being destroyed”. And Bangladesh, where Yunus’ project took off, continues to rely on foreign direct investment because so much domestic investment is channelled into microfinance. Conversely, the brilliant East Asian ‘tiger’ countries directed much of their savings into sustainable growth-oriented businesses and continue to benefit from them. Savings are critical to economic development, he argues, but equally they must be invested in growth and productivity enhancing projects.

In the end, some basic propositions need reconsideration. They are that:

Mutual interests
An alternative approach is similar and, again, a return to the first principles of private investment: that wealthy individuals invest directly in businesses that they understand and are interested in helping to grow. The “investment angels” system of direct investment by the affluent (though not necessarily very wealthy) in small business was particularly popular in the UK in the 1980s, when there were special tax breaks on relatively small direct investments in small, usually start-up businesses. But when these tax breaks went, so did the investors, and left the field open to the big private equity firms and venture capital funds – who are far less interested in risking clients’ money on small firms and start-ups. Latterly, successful private equity firms have much preferred the management buyout route to taking over medium sized and larger companies with clear growth potential. This was because their principal clients, institutional investors, needed very large repositories for their vast investable wealth. Private equity and venture capital firms may well change tack again in today’s stormy economic weather. But now, through the power of the Internet, it may well be possible to bring small investors and small businesses together again for their mutual profit, tax breaks or no. After all, there remain many affluent individuals looking for good returns on their spare cash for which they are willing to take on some risk. Web sites are already springing up that connect hard pressed small businesses with potential direct investors.

Another widely touted option is the return of “mutuality” – the revival of savings and loans organisations, like old-style building societies and, on a smaller scale, loan clubs, that are owned by their members. Although they lend only what their members hold in savings, their capital available for lending can still be adequate to support investment in small to medium sized businesses.

But these emerging responses to the credit crunch are truly “grass roots” movements inspired by the need for individuals simply to get on with their lives. It is increasingly clear that it is not governments, but people, with their limited time and unlimited desires, that are driving solutions. And, in the end it may be that the surest way back to successful businesses and strong economies, is simply to encourage basic, straightforward, plain vanilla banks and good, old fashioned equity investors who can read both character and balance sheets.