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Microfinance 101 Session 1 - Dr. Stephen Conroy


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Microfinance 101 Session 1 - Dr. Stephen Conroy

  1. 1. Microfinance 101 Session 1 Stephen J. Conroy, Ph.D. Associate Professor of Economics University of San Diego
  2. 2. I. Overview and Learning Objectives <ul><li>What is microfinance? </li></ul><ul><li>What is the formal lending institutions’ perspective? </li></ul><ul><ul><li>In-Class Exercise (Three Cases) </li></ul></ul><ul><li>How do MFIs differ from banks? </li></ul><ul><li>Interest Rates and Lending Practices </li></ul><ul><li>Stylized Facts about MFIs </li></ul>
  3. 3. I. Overview and Learning Objectives <ul><li>Banker to the Poor: Muhammad Yunus </li></ul><ul><ul><li>In-Class Exercise #2 </li></ul></ul><ul><li>Creating a World Without Poverty: Muhammad Yunus (Part 2) </li></ul><ul><li>BRAC—A Different Model </li></ul>
  4. 4. II. What is Microfinance? <ul><li>From Armendariz and Morduch (2005 ): “(A) collection of banking practices built around providing small loans (typically without collateral) and accepting tiny savings deposits. . . .” </li></ul><ul><li>From U.N. International Year of Microcredit 2005 Web page: “Microfinance refers to loans, savings, insurance, transfer services, microcredit loans and other financial products targeted at low-income clients.” </li></ul><ul><ul><li>“ Microcredit is a small amount of money loaned to a client by a bank or other institution. Microcredit can be offered, often without collateral, to an individual or through group lending. .” </li></ul></ul>
  5. 5. II. What is Microfinance? <ul><li>From : “To most, microfinance means providing very poor families with very small loans (microcredit) to help them engage in productive activities or grow their tiny businesses. Over time, microfinance has come to include a broader range of services (credit, savings, insurance, etc.) as we have come to realize that the poor and the very poor who lack access to traditional formal financial institutions require a variety of financial products.” </li></ul>
  6. 6. II. What is Microfinance? <ul><li>Mission Statement from Grameen Bank: [“Grameen Bank provides financial services to the rural poor of Bangladesh. Those services include loans, saving accounts, pension plans and loan insurance. The overall goal of Grameen Bank is the elimination of poverty.”] </li></ul>
  7. 7. II. What is Microfinance? <ul><li>Mission Statement from Compartamos:!ut/p/c1/04_SB8K8xLLM9MSSzPy8xBz9CP0os_gADwNLcw93IwP_UHcXAyNjR6cgIy9TY29jM_1wkA6zeAMcwNFA388jPzdVvyA7rxwAsAPlcQ!!/dl2/d1/L2dJQSEvUUt3QS9ZQnB3LzZfUEgwOTdIRzIwT1VHRDAyM0FCUjJKNTNLSjM!/?mosHist=1 [We are a social enterprise committed to people. We create development opportunities in popular market segments that are based on innovative and efficient models, distributed on a massive scale and on important values that foster an external and internal culture. In this manner we are able to achieve permanent relationships based on trust and that contribute to a better world.] </li></ul>
  8. 8. III. In-Class Exercise <ul><li>In-class exercise: Business Loan Cases </li></ul><ul><li>Divide into small groups </li></ul><ul><li>Read each case and decide whether you will make the loan—and under what circumstances. </li></ul>
  9. 9. III. In-Class Exercise <ul><li>Bank: </li></ul><ul><li>Assume you are a small bank. Each loan you originate costs you $10 to “wire” in the loan capital from another bank, $50 in labor and overhead, loan capital costs of 5%, plus the original amount of the loan. </li></ul><ul><li>Each loan will generate the following revenue: a small origination fee to the borrower of $10, plus you can charge the client his/her expected return as interest rate. You should consider the risk of default in your decision (e.g., a 10%, 50%, 90% and 95% prob. of repayment). </li></ul>
  10. 10. III. In-Class Exercise <ul><li>Case #1: </li></ul><ul><li>My name is Iwhiwhu and I live in Abraka town, delta State, Nigeria. I am a 34-year-old mother of three children. I have no formal education, though I was trained in domestic chores and farming as a girl. I have training in hairstyling, though, and used to own my own hairstyling business from 1991 – 2001, but was unable to make much progress due to an unpredictable power supply. I got started selling fruits on the roadside for an initial investment of US$56. I want to rent a shop someday, however in the meantime, I would just like to expand my offering of fruits which will require additional capital. I would like a one-year loan for US$64. I have no collateral to offer. I expect a 20% return on my investment. </li></ul><ul><li>Will you give me a loan? </li></ul>
  11. 11. III. In-Class Exercise <ul><li>Case #2: </li></ul><ul><li>My name is Nancy and I am a 40-year-old entrepreneur who is living her dream of owning her own business. I have been in business for 10 years running a party supply retailer (supplying everything from party hats to helium tanks). I have a college degree. I have 10 years worth of financial data that show that I had a rough start, but have generated profits in excess of $150,000/year for each of the past five years. Located in Escondido, I would like to expand my business to include an offering of inflatable “jumpers” for little children that can be rented out by the hour. This will cost me $50,000 and I am requesting a loan for $40,000 (with $10,000 to be financed from my own pocket). I am able to put up my two delivery vans (each worth $20,000) as collateral for the loan. My FICO credit score is 723 (this is the median FICO score from Fair Isaac ) and I expect a 25% return on my investment. </li></ul><ul><li>( ) </li></ul><ul><li>Will you give me a loan? </li></ul>
  12. 12. III. In-Class Exercise <ul><li>Case #3: </li></ul><ul><li>My name is Adonis and I live in San Diego, California. I am a 32-year-old Greek immigrant. I notice that the olives and olive oil here in California are not nearly as good as those in my native country. I would like to start importing olives and olive oil from Greece and sell them here in farmers markets. I have some business experience when I was in Greece, but I have no credit history in the US and only a little bit of cash ($5,000), which I want to put into my new business. I would like a one-year loan for $20,000 to start my business. I do not have any collateral, though, as I said, I am putting every cent I have of my own into this business. I have no FICO credit score. I expect a 10 percent return on my investment. </li></ul><ul><li>Will you give me a loan? </li></ul>
  13. 13. III. In-Class Exercise <ul><li>Bank Decisions? </li></ul><ul><li>Why? </li></ul><ul><li>Why not? </li></ul><ul><li>Factors considered? </li></ul><ul><li>What if the loan origination fees were reduced to $0? </li></ul><ul><li>What if clients’ risk profiles were known with certainty? </li></ul>
  14. 14. III. In-Class Exercise <ul><li>See spreadsheets for each case </li></ul><ul><li>Discuss different assumptions </li></ul>
  15. 15. III. In-Class Exercise <ul><li>Take-Home Points from Exercise: </li></ul><ul><ul><li>Banks prefer higher interest rates . . . at least up to a point (look at Case 2) </li></ul></ul><ul><ul><ul><li>**With the higher interest rate (25%) in Case 2, Scenarios 3 and 4 generate positive net revenue for the bank. [Note: Even if loan amount were only $4,000, Scenario 3 would still generate a $250 profit.] </li></ul></ul></ul>
  16. 16. III. In-Class Exercise <ul><li>Take-Home Points from Exercise: </li></ul><ul><ul><ul><li>From borrower’s perspective: higher interest rates would reduce profits and increase the risk of business failure, possibly attracting very risky ventures for loans—“ adverse selection ”. </li></ul></ul></ul><ul><ul><ul><li>Adverse selection—the selection of the worst “types” of individuals into a market (e.g., highest-risk clients for insurance policies, highest-risk borrowers for loans, used car sellers with “lemons” </li></ul></ul></ul><ul><ul><ul><li>“ Akerlof’s Lemons” paper—asymmetric information </li></ul></ul></ul>
  17. 17. III. In-Class Exercise <ul><li>Take-Home Points from Exercise: </li></ul><ul><ul><li>Banks prefer lower-risk clients. </li></ul></ul><ul><ul><ul><li>The higher risk of borrowers—i.e., lower probability of loan repayment—the less likely the bank will be able to generate positive net revenue. Note that defaults usually result in default on both the principal and interest—a double-cost for lender. </li></ul></ul></ul><ul><ul><ul><li>**In none of these three cases does a probability of repayment < 0.90 result in positive net revenue, even in Case 2 </li></ul></ul></ul>
  18. 18. III. In-Class Exercise <ul><li>Take-Home Points from Exercise: </li></ul><ul><ul><li>Banks prefer larger loan size. </li></ul></ul><ul><ul><ul><li>Because of fixed costs, larger loan sizes can generate larger revenues. </li></ul></ul></ul><ul><ul><ul><li>**Take, for example, Case 2, Scenario 3: Ten loans of $4,000 each would generate only $250 * 10 = $2,500, compared to $2,950 for one loan of $40,000 [this is due to fixed costs </li></ul></ul></ul>
  19. 19. III. In-Class Exercise <ul><ul><li>So . . . Why would banks want to lend to clients at (a) relatively low interest rates with (b) high risk, and (c) in very small increments??? </li></ul></ul><ul><ul><li>[The short answer is: they wouldn’t!] </li></ul></ul>
  20. 20. III. In-Class Exercise <ul><ul><li>Further . . . Access to formal financial institutions may be hindered by: </li></ul></ul><ul><ul><ul><li>Government monopolies in the financial sector </li></ul></ul></ul><ul><ul><ul><li>Gender discrimination </li></ul></ul></ul><ul><ul><ul><li>Racial discrimination </li></ul></ul></ul><ul><ul><ul><li>Religious discrimination </li></ul></ul></ul><ul><ul><ul><li>SES/Class discrimination </li></ul></ul></ul>
  21. 21. III. In-Class Exercise <ul><li>Case #1: Actual Outcome: </li></ul><ul><li>Actual Outcome: </li></ul><ul><li>With this loan, Iwhiwhu was able to expand her business, followed by subsequent loans of US$96, $120, $200 and $240. In 2007, she made US$40/week in profits and saved $1.60/day through Olidara, an itinerant savings collector. ( Source: State of Microcredit Summit Campaign Report 2007, Sam Daley-Harris) </li></ul>
  22. 22. III. In-Class Exercise <ul><li>Case #2: Actual Outcome: </li></ul><ul><li>Actual Outcome: </li></ul><ul><li>Okay, this is a hypothetical story . . . but . . . say Nancy failed to consider that several other jumper rental companies, with lower overhead, were able to lower their prices and keep her from being able to make this a viable part of her business. She closed down the business and had to forfeit her two delivery vans, which had been run down by delivering jumpers and were only worth $10,000/each. </li></ul>
  23. 23. III. In-Class Exercise <ul><li>Case #3: Actual Outcome: </li></ul><ul><li>Actual Outcome: </li></ul><ul><li>The agency loaned $5,000 at around 10%, which he paid off within the first year. In 2007, the client had a $10,000 loan at 12% (interest rates went up slightly), with 11 employees and vendor booths at farmer’s markets. He also supplied hotels, restaurants and casinos with olives and olive oil from Greece. His sales were still growing, despite a slowing economy. He also had a FICO credit score in the mid-600’s in 2007. ( Source: personal communication with local MFI—thought name has been changed.) </li></ul>
  24. 24. IV. Difference of MFIs from Banks? <ul><li>How do MFI’s differ from traditional lending institutions (banks, savings and loans, credit unions)? </li></ul><ul><ul><li>Smaller average loan size (high transactions costs—e.g. origination fees—associated with microloans generally made them unattractive to banks) </li></ul></ul><ul><ul><li>Lack of collateralization requirements (poor clients generally do not have wealth, hence, no collateral . . . So generally these loans were denied by traditional lending institutions.) </li></ul></ul>
  25. 25. IV. Difference of MFIs from Banks? <ul><li>What innovations have overcome these two obstacles (high transactions costs and lack of collateral)? </li></ul><ul><ul><li>Group lending [creates social accountability and increases repayment rates—a social capital collateral, addressing “risk” issue and “transaction cost” issue—one “group” origination.] </li></ul></ul><ul><ul><li>Early Repayment [Begin repayment of loan right away reduces risk.] </li></ul></ul><ul><ul><li>Progressive lending [increasing the loan size over time to the same clients establishes a “track record” with client—essentially what a credit rating (e.g. FICO score) does, though with only one source—the MFI itself addressing “risk” issues and larger loan size addresses “transaction cost” issues.] </li></ul></ul><ul><ul><li>Public repayments [creates social pressure and reduces risk of default.] </li></ul></ul><ul><ul><li>Emphasis on female clients [associated with higher repayment rates addresses “risk” issues. Also addresses social justice issues.] </li></ul></ul>
  26. 26. V. Interest Rates and Lending Practices <ul><li>If microfinance targets poor clients, then interest rates must be low. </li></ul><ul><li>Answer: Not exactly. . . . </li></ul><ul><li>Returns by microbusinesses range between 117 and 847 percent in studies from India, Kenya, Philippines—see International Year of Microcredit 2005 Web page. </li></ul><ul><li>Doubling the riskiness of borrowers (in terms of default rates) will lead to more than a doubling of the interest rate due to loss of principal (see example from Armendariz and Morduch, Ch. 2, p. 31) </li></ul><ul><li>Subsidized rates below (informal lender) market may be disruptive (political favorites receiving loans in Philippines case—see Armendariz and Morduch, p. 10) </li></ul>
  27. 27. VI. Stylized Facts <ul><li>Now some stylized facts about microfinance institutions around the globe—and their reach </li></ul><ul><li>Source: State of the Microcredit Summit Campaign Report 2009 , Sam Daley-Harris </li></ul>
  28. 28. VI. Stylized Facts—Progression over Time of Total Clients Year Institutions Reporting Total Number of Clients Reached Number of Poorest Clients Reported 1997 618 13,478,797 7,600,000 1998 925 20,938,899 1,221,918 1999 1065 23,555,689 13,779,872 2000 1567 30,681,107 19,327,451 2001 2186 54,932,235 26,878,332 2002 2572 67,606,080 41,594,778 2003 2931 80,868,343 54,785,433 2004 3164 92,270,289 66,614,871 2005 3133 113,261,390 81,949,036 2006 3316 133,030,913 92,922,574 2007 3352 154,825,825 106,584,679 Source: Daley-Harris, 2009, Table 5
  29. 29. VI. Stylized Facts—Poorest Clients <ul><li>Microfinance Summit Campaign reached their goal on Dec. 31, 2007 of serving > 100 million poorest borrowers during the year. (Some of this is due to existing MFI’s serving more of the poorest borrowers; some is due to new MFI’s reporting.) </li></ul>
  30. 30. VI. Stylized Facts—Poorest Clients by Size of Institution Size of Institution (in terms of poorest clients) No. of Institutions Combined No. of Poorest Clients Percent of Total Poorest 1 million + 7 28,098,014 26.36 100,000 - 999,999 54 17,184,064 16.12 10,000 - 99,999 313 8,525,154 8 2,500 - 9,999 572 2,608,463 2.45 Fewer than 2,500 2,364 1,454,464 1.36 Networks 6 48,714,520 45.7 Source: Daley-Harris, 2009, Table 6
  31. 31. VI. Stylized Facts--Gender Of the 106.6 million poorest clients reached in 2007, 83.2 percent (88.7 million) are women .
  32. 32. VI. Stylized Facts—Regional Distribution Region No. of Programs Reporting No. of Clients in 2007 Asia and Pacific 1,727 129,438,919 Sub-Saharan Africa 935 9,189,825 Latin America and Caribbean 613 7,772,769 Middle East and North Africa 85 3,310,477 Developing World total 3,360 149,711,990 North America & W. Euro 127 176,958 Eastern Euro & C. Asia 65 4,936,877 Industrialized World total 192 5,113,835 Global total 3,552 154,825,825 Source: Daley-Harris, 2009, Table 7
  33. 33. VI. Stylized Facts—Regional Distribution
  34. 34. VII. Banker to the Poor (Muhammad Yunus) <ul><li>In-Class Exercise #2 (Read the excerpts from Banker to the Poor) </li></ul><ul><li>Who is Sufiya Begum? </li></ul><ul><li>Describe the cycle of poverty Sufiya was locked into. </li></ul><ul><li>How much money did she need? </li></ul><ul><li>How much was the total amount needed to free 42 people from this cycle? </li></ul><ul><li>What doesn’t Yunus give her the money right there? </li></ul>
  35. 35. VII. Banker to the Poor (Muhammad Yunus) <ul><li>How much does Yunus set up the loans for? </li></ul><ul><li>Power of compounding example. </li></ul><ul><li>Why group lending? </li></ul><ul><li>Why do borrowers need to pass a test? </li></ul>
  36. 36. VII. Banker to the Poor (Muhammad Yunus) <ul><li>Yunus’ background </li></ul><ul><li>Sufiya Begum—stoolmaker of Jobra, Bangladesh, stuck in a poverty trap in1976 (pp. 46 – 50) </li></ul><ul><li>Banker’s concerns: </li></ul><ul><ul><li>Small loan amounts won’t cover costs of the loans </li></ul></ul><ul><ul><li>Illiterate borrowers—can’t fill out forms </li></ul></ul><ul><ul><li>No collateral </li></ul></ul>
  37. 37. VII. Banker to the Poor (Muhammad Yunus) <ul><li>Grameen Bank is . . . born . . . sort of! </li></ul><ul><li>Repayment rates: > 98% repayment rate in Grameen; “The poor know this credit is their only opportunity to break out of poverty. They do not have any cushion whatsoever to fall back on. If they fall afoul of this one loan, they will have lost their one and only chance” (p. 58) </li></ul><ul><li>“ Grameen assumes that every borrower is honest. There are no legal instruments between lenders and borrowers” (p. 70). </li></ul>
  38. 38. VII. Banker to the Poor (Muhammad Yunus) <ul><li>Group lending model (p. 63) (support—emotional and financial if loan is not repaid) </li></ul><ul><ul><li>Center chief </li></ul></ul><ul><ul><li>Group chairperson </li></ul></ul><ul><ul><li>Transparency (all group transactions in the open) </li></ul></ul><ul><li>Serial lending—small loan cycle, gradually increasing over time. </li></ul><ul><li>5% savings mandated with all loans. </li></ul>
  39. 39. VII. Banker to the Poor (Muhammad Yunus) <ul><li>Tests about the program—orally given to deal with illiteracy issue. </li></ul><ul><li>“ When she finally receives the twenty-five dollars, she is trembling. The money burns her fingers. Tears roll down her face. She has never seen so much money in her life” (p. 64). </li></ul><ul><li>Borrowers not told what to spend the money on. If Grameen knew what to spend the money on, they would have done it themselves instead of lend it. </li></ul>
  40. 40. VII. Banker to the Poor (Muhammad Yunus) <ul><li>Terms of loan (see p. 68) </li></ul><ul><li>Women in Bangladesh (Purdah— “a range of practices that uphold the Koranic injunction to guard women’s modesty and purity” (p. 74). In the strictest sense, it forbids women to leave their homes or be seen by men except their closest relatives. </li></ul>
  41. 41. VII. Banker to the Poor (Muhammad Yunus) <ul><li>Why lend to women??? </li></ul><ul><ul><li>“ Not only do women constitute the majority of the poor, the underemployed, and the economically and socially disadvantaged, but they more readily and successfully improve the welfare of both children and men. Studies comparing how male borrowers use their loans versus female borrowers consistently show this to be the case” (p. 73) </li></ul></ul>
  42. 42. VII. Banker to the Poor (Muhammad Yunus) <ul><li>Grameen is a sustainable business model . . . Very successful, financially ($100 million in loans by 1998). </li></ul>
  43. 43. VIII. Creating a World Without Poverty--Yunus <ul><li>Social Business: two kinds: </li></ul><ul><ul><li>A for-profit business whose mission is to provide a social benefit, not to be a profit-maximizing business (PMB). In fact, Social Businesses should not earn profits. Any retained earnings should be used to expand the reach and scope of the business. </li></ul></ul><ul><ul><li>A for-profit business whose mission does include profit-generation, but whose owners are the poor or disadvantaged. </li></ul></ul>
  44. 44. VIII. Creating a World Without Poverty--Yunus <ul><li>Why not a non-profit business (NGO)? </li></ul><ul><ul><li>Because these businesses are generally not sustainable—they rely on external donations. </li></ul></ul><ul><li>Why not for-profit? </li></ul><ul><ul><li>CSR is not sufficient to address needs of the poor </li></ul></ul><ul><li>Why not government? </li></ul><ul><ul><li>Ineffective, corrupt </li></ul></ul>
  45. 45. VIII. Creating a World Without Poverty--Yunus <ul><li>Grameen family of companies, including Grameen Danone. </li></ul><ul><li>Cross-subsidies from the for-profit side of Grameen . . . To subsidize risky social business ventures . . . And provide microfinance zero-interest “loans” (grants) to beggars. </li></ul>
  46. 46. IX. BRAC—A Different Model <ul><li>Ian Smillie’s book about BRAC: Freedom from Want </li></ul><ul><li>BRAC model is to create income-generating business opportunities for the poor. </li></ul><ul><li>Microfinance plays a supportive, not central, role, i.e., to help start-up BRAC businesses and assist when there are shocks (disease, weather, etc.). </li></ul>
  47. 47. IX. BRAC—A Different Model <ul><li>Chicken business </li></ul><ul><ul><li>Feed (Need growers and processors of chicken feed) (200,000 women involved in this program by 1992) </li></ul></ul><ul><ul><li>An army of “health workers” to vaccinate chickens </li></ul></ul><ul><ul><li>Eggs </li></ul></ul>
  48. 48. IX. BRAC—A Different Model <ul><ul><li>“ In its search, BRAC revolutionized the poultry business in Bangladesh. Over the years, more than 1.9 million women have joined BRAC’s poultry program, but BRAC day-old chicks and feed have served a much wider community as well. In 2006, its feed mills produced just under 40,000 tons of poultry feed, and in 2008, its hatcheries turned out 12.8 million day-old chicks. The business has helped poor women, and it has earned money for BRAC as well” (Smillie, p. 99). </li></ul></ul>