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Jelmer Griepink
Fintech Consultant
Jelmer Griepink
Fintech Consultant

How a $27 loan transformed the lives of millions

by | Nov 18, 2017 | Knowledge | 0 comments

In 1974, Bangladesh suffered from the worst famine in decades. A combination of flooding, mismanagement, and failure to distribute foodgrain stocks led to food shortages in Northern Bangladesh. An estimated 450,000 people died of starvation. The poor, laborers and the landless were most affected. It was in this context that a 34-year-old Bengal economist started an experiment which would change the lives of millions of people. Muhammad Yunus gave a group of 42 women producing bamboo stools in the village of Jorba a $27 loan. No bank would lend these women the funds to buy the raw materials needed for the production of the stools. Therefore they were lending the money from traders, trapped in an agreement to sell the stools at a price barely higher than the cost of the raw materials. A $27 loan was what it took for them to escape the debt trap and sell their products for a fair price, thereby improving their living conditions. In 2006 M. Yunus received the Peace noble prize for his efforts to fight poverty. The Grameen bank (Bengal for ‘Village bank’) he founded in 1983 and led till 2011 has 9 million borrowers today, 97% of them being women. Based on the belief that every human being is a natural entrepreneur he started the microfinance movement, providing small loans to poor people ignored by the traditional banking system. His concepts were copied outside of Bangladesh to other parts of Asia, South-America and, in a later stage, to Africa.

Clever product design

Yunus provided a microfinance solution for the failures in the credit market of asymmetric information and high transaction costs that cause financial exclusion through clever product design: Group lending. This is a form of lending in which loans are provided to a group of borrowers, with the group taking up joint liability for repayment of the loans by individual members. In the Grameen model I, the group has weekly meetings to do repayments. It is peer pressure rather than monitoring and enforcement by the bank that ensures repayment of the loans. Because of close social ties and weekly meetings, failing to repay leads to loss of face. Group lending comes in many forms with different group sizes and variation in the type of social ties between the members, frequency of the meetings and details of the liability agreement. This video demonstrates group lending applied in Kabir-Kumar, India. Group lending reduces the cost of monitoring by using peer pressure rather than bank employees to enforce the loan contract. It also transfers the high risks associated with lending to the poor from the bank to the group, replacing the need for a collateral or credit history. Third, as the group members have social ties (for example neighbors or colleagues) they can assess the trustworthiness of lenders far better than the bank, reducing asymmetric information. Although group lending is a solution for asymmetric information and monitoring costs, it is far from perfect. First, the amount an individual can borrow is limited by the joint liability the group can take on. If a loan is needed to make a larger investment like buying property, a vehicle or other fixed assets, the maximum amount that can be lent through group lending might not be sufficient. Second, although monitoring costs for the bank are decreased the implied transaction costs for borrowers are high. The borrower will need to attend the weekly meetings. For an entrepreneur with a business to run and a family to support this may be too time-consuming. Moreover, the requirement of weekly payments may be too inflexible when income is irregular, with large deviations one week from the other. Lastly, transferring the liability for repayment from the bank to the group may not be a fair deal. After all, the bank is far better able to bear this liability than a group of village entrepreneurs.

Evolution

Group lending is, although an improvement, not the silver bullet. But Yunus inspired an important paradigm shift: He didn’t see the poor as people in need of aid and donations. Instead, he emphasized the opportunities of potential entrepreneurs. This vision inspired many to create an enabling environment, rather than provide direct aid. In the eighties, many NGOs started to offer microfinance products with the intention to use it as a tool to alleviate poverty. Group lending was just one possible solution for solving the failures of the credit market. Other financial products were designed to solve the specific problems the poor had to deal with.

Rapid growth

As microfinance gained traction, it received more and more attention from Wall Street: commercial investors seeing an opportunity to make a profit in unexplored markets. In the nineties the microfinance movement, which previously consisted mainly of ideologically inspired NGOs funded by donations, experienced an influx of commercial investment. Influential stakeholders such as CGAP, a global partnership organization for financial inclusion, emphasized the need for MFIs to be financially sustainable in order to maximize impact. They argued that the pool of funds coming from donations and development aid was simply not deep enough to make a structural change. Instead, MFIs were encouraged to focus on profits next to social goals. After all, to attract the large pool of commercial funding there should be some return on investment. The sector started to become more competitive. Sometimes this led to excesses, with customers taking on more debt than they could carry due to aggressive selling techniques, or extremely high interest rates of up to 85%. The Initial Public Offering (IPO) of Compartemos in 2007, oversold 13 times, led to raising eyebrows. The bank that started as an NGO in 1990 was valued at $467m dollar due to its high profits. Yunus commented that Compartemos was not setting priorities straight. In 2010, extreme stories of suicides caused by financial liquidity problems due to overindebtedness lead to the regulation by the Indian governmentSome countries established interest rate ceilings, although this may result in limited access to capital for people with a low income.

A maturing industry

The microfinance industry still struggles to find the right balance between focusing on profitability to attract commercial investment and the social mission to alleviate poverty. In response to the excesses mentioned above the sector started to pay more attention to consumer protection. Second, the growing trend of impact investment, investments intended to make a social or environmental impact next to a financial return. These investors require the organizations they invest in to report social performance as well as financial performance, incentivizing them to focus on their clients’ needs next to financial sustainability. Oikocredit, for example, developed the ESG-scorecard, which contains economic, social and governance performance indicators. These investors incentivize MFIs to commit to social targets next to profit targets. As microfinance matures, the term is becoming a household term. The world bank estimated that 200 million clients were served by MFIs in 2015. Not bad for a movement that started with 42 women in a village in Bangladesh.

Bright future

In the last decade, technology is causing a profound change in the Microfinance landscape. By lowering the cost to reach customers at distant locations through mobile platforms and offering innovative, less labor-intensive solutions to reduce asymmetric information they are transforming the industry. It is expected that progress in Artificial Intelligence, as well as Blockchain technology and further automatization of financial organizations, will speed up this process. FinTech companies, that started as technology companies rather than financial companies,  caused a new wave of innovation to increase financial inclusion. Due to the efforts of many in the financial ecosystem, we are getting ever closer to a world without financial exclusion. That would be a remarkable achievement of a movement that started with a $27 loan provided by a young economist in the mid-seventies.

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