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MGT604 - Management of Financial Institutions - Lecture Handout 21

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Microfinance in its broadest terms can be defined as provision of a range of financial services such as deposits, loans, payment services, money transfers and insurance to poor and low income households, and their micro enterprises (Source: Asian Development bank report on microfinance development strategy). While a commercial bank is a financial institution that offers a broad range of deposit accounts, including checking, savings, and time deposits, and extends loans to individuals and businesses.

The decision as to whether the commercial banks be involved in microfinance is a sensitive and debatable issue which requires a deep analysis of many factors.

Primarily, the microfinance customers are large in number, scattered in far-flung areas with very minute transaction sizes. Only government or state bank alone cannot reach out to millions of potential Microfinance beneficiaries; a whole well knitted network with almost doorstep reach is required, which is only possible when the commercial banks will be involved in microfinance. In Pakistan it is estimated that as many as 5.6 million households need microfinance services but these services reach only to less than 1 percent, most probably because of the absence of commercial banks from the microfinance sector. (Source: Pakistan microfinance Network PMN) This way a poor person just need to visit his local commercial bank to get access to microfinance benefits, which will help reduce many economic problems.
One criticism over involving the commercial banks in microfinance is that commercial banks will charge higher interest rates, further lower the standard of living and will exploit the public. The ground realities are totally different; empirical evidence has demonstrated that participants in microfinance programs have improved their living standards at both the

individual and household level, and that this has provided increased educational opportunities for children. For example, the clients of the Bangladesh Rural Advancement Committee increased household expenditures by 28% and assets by 112%. It was also demonstrated that Bangladeshi children were sent to school in larger numbers and stayed for a longer time – almost all girls in Grameen Bank (A commercial bank!) client households had some schooling, compared with the rate of 60% in non-client households. (Source: World Bank group, 30 August 2005) No doubt on the other hand the loans provided by the commercial banks to the microfinance beneficiaries are a bit expensive, its not to discourage the poor but there is a sound reason behind it; Providing financial services to poor people is quite expensive, especially in relation to the size of the transactions involved. A $100 dollar loan, for example, requires the same personnel and resources as a $2,000 one thus increasing per unit transaction costs. Loan officers must visit the client's home or place of
work, evaluate creditworthiness on the basis of interviews with the client's family and references, and in many cases, follow through with visits to reinforce the repayment culture. It can easily cost US$25 to make a micro loan. While that might not seem unreasonable in absolute terms, it might represent 25% of the value of the loan amount, and force the
institution to charge a “high” rate of interest to cover its cost of loan administration.

If commercial banks are to be involved in the micro finance by no means it would be a wrong decision for them as regard to their primary aim, profitability. Yes it can. Data from the Micro Banking Bulletin reports that 63 of the world's top MFIs had an average rate of return, after adjusting for inflation and after taking out subsidies programs might have received, of about 2.5% of total assets. This compares favorably with returns in the commercial banking sector and gives credence to the hope of many that microfinance can be sufficiently attractive to mainstream into the retail banking sector. Many feel that once

microfinance becomes mainstreamed, massive growth in the numbers of clients can be achieved.

According to a recent analysis conducted by the Consultative Group to Assist the Poor (CGAP), the compound annual growth rate of the world’s leading microfinance providers over the last five years has been a whopping 15%. Worldwide, these leading Microfinance institutions are nearly twice as profitable as the leading commercial banks. The trend is not new. In fact, in the last decade, microfinance has been a more stable business than commercial banking in emerging markets. During Indonesia’s 1997 financial crisis, for example, commercial bank portfolios imploded, but loan repayment among Bank Rakyat Indonesia’s three million-plus micro-borrowers barely declined at all. During the more recent Bolivian and Colombian banking crises, microfinance portfolios suffered slightly, but remained substantially healthier than commercial bank portfolios, and the microfinance institutions remained more profitable. (Source: The banker, 04 July 2005)

There are 70million savings and loan accounts in the world in micro finance sector and about 80 percent of these accounts are savings rather than loans, suggesting that poor entrepreneurs often have to save to accumulate capital for investment rather than the faster if higher-route of borrowing it. Thus it’s absolutely favorable for the commercial banks to
operate in the micro finance sector. For example in India ICICI bank, which has a large network of local branches, entered the micro finance market in 2001 and increased its portfolio from US $16m to US $63m in two years. (Source: Financial Times, 14 September 2005)

I see the commercial banks in micro finance in action, independently…without any government back, mandate or subsidy.

On the whole microfinance is not an area commercial banks want to overtake. The majority of commercial banks that undertook microfinance lending were because it was required of them by their governments. Research findings came from in-depth interviews with over 40 bankers in 22 banks in India, the Philippines and Australia, and from speaking with 17 other banks in the other seven countries covered in the study. A great deal of microfinance undertaken by commercial banks was found, but it was undertaken because of government mandates to lend to this sector rather than for business reasons.

(Source: The Role of Commercial Banks in Microfinance: Asia-Pacific Region Ruth Goodwin-Groen, 1998)

The involvement of commercial banks in micro finance is important because all those micro finance programs, which were directly run or backed by the government, faced a total failure. Sustainability and scale in microfinance by commercial banks were only found in the market-based programs when assessed on the basis of achieving both high portfolio quality and significant scale of outreach to the poor, most of the commercial bank microfinance programs that were mandated by governments can only be considered as failures. The exceptions were those programs that charged a commercial rate of interest. They had a higher portfolio quality than other programs but they were still not profitable. This almost universal failure is not explained by the different policy contexts across the Asia-pacific region. Further, because microfinance has not been a profitable business, government mandates have been unsuccessful in encouraging commercial banks to become involved in microfinance. The banks must have the incentive to design better products for
micro entrepreneurs, which can be profitable.

A real world example of a successful micro finance commercial bank is of BRI’s Unit Desa system (its microfinance arm) has the best financial results of any microfinance institution in the world. In 1996-97 it earned a profit of $170 million on loans of $1.7 billion to 2.5 million clients, with no subsidies. This is an approximate return on performing assets of 10
per cent – a very competitive rate by commercial standards. The success of BRI’s Unit Desa systems can be attributed primarily to the fact that the system has adhered to the fundamentals of banking and finance for the rural micro entrepreneurs, including the provision of competitive savings services. The microfinance savings and loans of the Unit
Desa system perform consistently for BRI and continue to grow quickly. BRI’s microfinance business may not compete with the most spectacular returns, but it does achieve these strategic goals. (Source: The Role of Commercial Banks in Microfinance: Asia-Pacific Region Ruth Goodwin-Groen, 1998)

The types of commercial bank involvement in microfinance can be classified as; government-subsidized lending programs channeled through the banks, government mandated lending targets met by banks subsidizing interest rates, government-mandated lending targets with banks charging commercial interest rates and microfinance as a profitable business. Only the last one “micro finance as a profitable business” has seen success. Thus the involvement of commercial banks in micro finance sector should not be based on any government mandate, subsidy or target. The sole benefit of the society as well as commercial banks is the adoption of micro finance as a business. (Source: The Role of Commercial Banks in Microfinance: Asia-Pacific Region Ruth Goodwin-Groen, 1998)

Involving commercial banks in micro finance would be a step to take these services at the doorstep of the potential customer, because if only some government agency or state bank is involved the extensiveness as regard to area covered cannot be brought.

On the other hand commercial banks need not to make any special arrangements to cater for micro finance operations. Only a new “micro finance” counter might be needed in the existing branches. Thus there would be no high setup cost for the commercial banks to venture into this sector.

In short I see micro finance as a very promising sector for commercial banks and on the other hand simultaneously it would help the standard of living to rise; and attached with it the literacy rate, employment level, socio-economic development would also take place.