Microfinance

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GLOBAL INVESTOR FOCUS <strong>Microfinance</strong>—22 Ernst A. Brugger // Your life is over by then… Hernando de Soto // That’s right. So the result is the creation – and we also don’t like the word “informal” – of the extralegal market. But anyhow, a big part of the problem is constraints, and they’re absolutely useless. In other words, it’s simply government disorder. It’s collateral damage to a great extent – a result of the fact that the government churns out about 28,000 ordinances a year. That’s about 106 a day, and nobody knows whose hand is in whose pockets and which law is really effective. Viewed from the perspective of the poor, which is what we’re trying to do, there is a grass-roots base from which we can create a constituency for change. It’s no longer an imported American issue (or neoliberal program), the poor themselves want to do it. It’s something that stifles the poor, and so you create a constituency for change that every politician should like. Anyhow, the idea is that, yes, you’ve got this other system that we were talking about, you’ve got all these other rules. The problem with these other rules is that it’s not one system of rules, it’s a thousand systems of rules: each community has one, you can go three blocks, you can go fifteen blocks, each community has it’s anarchy. But anarchy is not chaos, anarchy means a variety of little systems as you had in Switzerland before Eugen Huber put all these things together. Walter B. Kielholz // It sounds very familiar; all industrialized countries were developing nations at some stage and have gone through this process at some time. Giles Keating // You’re talking about collateral, but mind that at times a lot of microfinance is being done on the basis of trust and a kind of peer pressure. Roshaneh Zafar // That’s a good point. It’s actually the way the market is created. You have poverty lending programs in Asia that usually have loan sizes of up to 300 to 500 dollars. Lending in Latin America goes up to 1,000 or 1,500 dollars. When you’re talking about poverty lending programs, mostly these are based on credibility. How is credibility gauged? There are several models that work. There are so-called solidarity lending programs, where you build groups and these become the unit of transaction. There are many reasons behind this: one is to lower the cost of transaction, which means, for example, that we use 25 women as one unit of transaction, which means all their loans are recorded as one, and that cuts down on supervision and monitoring. Ernst A. Brugger // Do you also do individual lending? Roshaneh Zafar // Our organization does solidarity lending and individual lending. It depends on the loan size: when loan sizes increase to USD 800, we begin to look at collateral. How do you do collateral with poor people? Since there is no efficient market mechanism for collateral, we take co-guarantors. These are people who actually have income tax statements or are salaried workers. We use them as proxy collateral. And the next thing we do is also look at property titles. And as Hernando pointed out, people didn’t want property rights. When we told them that we were willing to transfer title to them, that we would walk them through the process and negotiate a transaction for them, they were still not interested. They didn’t want to get caught up in the tax net and didn’t want to be documented. And, of course, there are good reasons for that, because there is corruption, there is nepotism, there is collusion, there are other transaction issues, and the poor are scared. These are crucial problems in my part of the world. Litigation is very common. It’s a very litigious society, and litigation usually centers on two things, property or personal feuds, family feuds. Those are the two reasons. People are very scared of the law. Hernando de Soto // We must remember, they reject the legal system, not the property rights, because the system is what takes 17 months to enter, it’s what requires 549 days to register a business. So, of course they don’t want it. It’s the fact that none of these various property titles helped you to get into the formal economy to begin with, so they make no sense. If the title is just for taxing, but titleholders are not connected to the banks, then why should they want titles. Roshaneh Zafar // And so, in our case, credibility is built over time. It’s like credit-card operations. As I see it, microfinance is very similar to a credit card; you have a limit, you repay a loan, your limit is raised. In some ways we are documenting these people. And recently in Pakistan we decided to set up a credit bureau for microfinance institutions. The government is not doing it. So we decided to engage with the private sector, and we emulated, for example, the case of the Bolivian market, where a credit bureau does exist. So in some ways people are documented, but again, it’s not formal. Hernando de Soto // But it’s a logical first stage. It gradually evolves to encompass those who are more adventurous, other types of legislation, and then later you start doing the formal lending. So there is always this 20- to 30-year period before you actually get to the formal sector in the developing countries. Walter B. Kielholz // I wanted to come back to this element of trust or credibility mentioned before. It is actually nothing other than the sole criterion for a successful allocation of capital. Why? Otherwise what are the criteria? There are no files, no numbers, no collateral, and so on. The only thing is trust. That’s why I think the question in microfinancing is about the front side and the cost involved. What’s important is that the individual decision at the front end is right, because if that decision is wrong, the system is corrupted and the money flows into the wrong channels. Hernando de Soto // May I just add something there? One of
GLOBAL INVESTOR FOCUS <strong>Microfinance</strong>—23 “The existence of the extensive extralegal market is the result of constraints because of an improper system. It’s simply government disorder. It works against the poor. So you have to create a constituency for change.” // Hernando de Soto the ways to look at the issue is that to a great degree it is based on trust, reflected in the fact that the English word credit comes from the Latin word “credere,” meaning “I believe in you because you have something to lose.” We found out that a lot of the poor do have assets, have something to lose, but it doesn’t mean that they can use them as collateral. It means that they possess an asset that can be developed, but until you dismantle all these extralegal, dispersed structures that allow people to deal with each other at a local level, trust cannot be fostered. Ernst A. Brugger // Let’s continue with this important train of thought. Two questions: First, how do you ensure that you make the right decisions at the front end? Second, isn’t it the case that poor people cannot afford not to pay back a loan, because if they don’t repay they risk falling into this really illegal sector with its very high costs? Roshaneh Zafar // I will answer the first question. If I were a bank and wanted to lend to the poor, my biggest problem would be asymmetry of information. How do I know who’s credible and who isn’t? The way we do it, and it’s something that has been tested, you let the community decide. It’s a principle of involvement and participation and the principle of self-selection. If you’re running a solidarity lending program, what you do is let the group decide who comes into the group. Then you have a second way to verify. We use what engineers call a triangle of information: you collect the same data from three different points. I think any researcher would do that too. So you first let the community decide, then you go to their houses and you see that they are genuinely credible and actually live there, and the third person you go to is someone from the community who is not linked to them. Usually you would go and check that information with the local grocery store. Because that’s where they have lines of credit. And you know instantly who’s been paying their credit and who hasn’t. Ernst A. Brugger // So it’s like social engineering… Roshaneh Zafar // Absolutely. We are basing our entire credit decision on the person’s reputation. We’re not basing it on the business proposition. Ernst A. Brugger // And the result? Roshaneh Zafar // In our case, and in most microfinance instances, if it’s done right, the recovery rate is above 99%. So obviously we are doing something right with the principle of self-selection. That’s if you’re talking about credibility or solidarity in generating social capital; you can’t do it without ownership. Now, coming back to the issue of costs. You know the transaction cost or the cost of delivery becomes very important, and that’s a big challenge. If you look at the alternatives on the market, there is another option: it’s the moneylender. We’ve done a lot of research to discover what moneylenders do right. They’re the tougher ones. They provide the client immediate access. The moment you need money, they will put it in your hands. But they are charging something like 200% or 360% interest per year on their loans. It is completely outrageous. Walter B. Kielholz // The important part is the decision-making, and that’s why it has to be done properly. The moneylender is actually spending a lot of money trying to recollect the loan, by all kinds of means. Roshaneh Zafar // That’s right. But if you compare their pricing with our service charge or interest rate of 20%, the household finds this to be very economical. At the same time, we have to charge that rate because it costs us on average 15%. For every dollar that we lend in the market, it costs us 15 cents to recover the money. So it’s a very labor-intensive, cost-intensive service because it’s small tickets and high volume. And because you are offering service delivery; you are going to the client. Ernst A. Brugger // So it’s about efficiency and professionalism in microcredit. We have about 5,000 microfinance institutions in the market, and I would place only about 10% of those in the top tier of professionally managed financial institutions, which probably serve around 50 million people. The rest are largely working in a development-aid mode, subsidized by aid money. Jane, would you agree with these estimates? Jane Nelson // That’s roughly correct. My sense is that there are obstacles to overcome in learning the best practices of the more commercially oriented and sophisticated microfinance institutions. I think part of the reason probably is that there have been more aid-driven initiatives and fewer major commercial banks coming through. Ernst A. Brugger // Can you imagine, Walter Kielholz, that this could become a mainstream banking business? Walter B. Kielholz // Maybe one day, but it will take a very long time. I think there was a monetization in society in the nineteenth century which took place because there was a rural exchange community here in Switzerland. It took a very long time. It’s principally not a funding problem, but rather a question of how to bring it to the forefront. It reminds me really of the Raiffeisen movement. However, the increasing demand for financial services in developing countries will further advance this development. That’s also the reason we have joined with other financial institutions to provide a platform for microfinance investments for our clients. Of course, this is only a small step, but it shows that there are possibilities to act as a financial intermediary and to contribute to bridge the gap between the financial markets and developing countries. >
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Microfinance

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