Nothing too small about it: The role of MFIs in financial inclusion

The emergence of modern microfinance, coupled with the advent of nano finance, opened many opportunities for the under-served sections of society. However, the COVID-19 pandemic is likely to significantly delay the goal of achieving 100% financial inclusion.

 In this article, we will examine the current state and the future of microfinance in an increasingly globalized economy.

Towards an inclusive future

Financial inclusion is the process of ensuring access to the full suite of financial services (deposits, lending, payments, insurance, etc.) at an affordable cost, as and when needed by historically excluded groups. These groups can mean small businesses, women, and other low-income groups. This under-served group enjoys only limited access to traditional banking channels due to many reasons. The most important reasons are the lack of collaterals and/or credit history, irregular income patterns, remote locations, lack of financial literacy, and small ticket sizes (typically less than 100 USD). This segment - estimated at ~1.7 billion by the World Bank - is forced to borrow from loan sharks at exorbitant interest rates. Quite naturally, such borrowings become a significant hindrance in their journey towards economic upliftment.

Not being able to address the needs of this excluded segment has meant that about 10% of the world’s population still lives in extreme poverty, i.e. on less than US$ 1.90 a day. The global recession triggered by COVID-19 will impact this segment the most as they are largely daily wage earners, with no safety net and negligible savings to fall back on.

The UN has listed poverty elimination as its number one priority, in its Sustainable Development Goals (SDG) target, set for 2030.

To support this initiative, the World Bank and IFC have set a target of universal financial access (UFA) for a billion people by 2020 so that they can have access to a transaction account as the basic building block to manage their financial lives. While the goal was already running behind schedule, COVID-19 has ensured the target date will have to be pushed out significantly. For true financial inclusion, the transaction accounts will need to be active. But, as per World Bank’s Global Findex survey report, as many as 50% of the accounts in developing countries are dormant.

Microfinance could offer a solution to this challenge.

Microfinance: Serving the un(der)served

Microfinance is a category of financial service products which target individuals and small businesses that lack access to traditional banking services. A recent offshoot of microfinance is nano finance, which offers loans of the smallest ticket sizes to individuals, especially to women. This practice is like the daily prepaid packs offered by telecom operators.

Microfinancing activities play a significant role in enhancing the financial inclusion of the under-served segment. They act as a bridge to enable ‘last-mile connectivity.’

Microfinance addresses the problems of the under-served population by:

• Enabling inclusive participation in the economy, thus helping in poverty reduction
• Creating an atmosphere of responsibility through features like group lending
• Looking at the first steps for expansion for urgent, short-term capital needs of home-based/small businesses
• Helping them with emergency or unplanned expenses like hospitalization, home repairs, education, etc.

The size of a typical loan to an individual would be of the order of $20-$50 ($2-$20 in the case of nano finance), with a loan duration up to a couple of months. Loans to small businesses range between $500-$1000, with weekly repayments scheduled over the loan duration. These loans are largely unsecured for individuals and tailored for small businesses.

Microfinance is now available in most of the developing world, with the most extensive consumer base being in South Asia (led by the Bangladesh Grameen bank model). Mobile wallets (M-Pesa in Kenya) are leading the penetration drive in Africa, while East Asia is leading on the technical innovation (Mimos in Malaysia) front.

A report by PwC pegged the global microfinance industry at an estimated worth of $120 billion. It also noted that the sector had impacted the lives of 139.9 million borrowers worldwide. 80% of such borrowers are women, and 65% are from a rural background.

The current state of affairs

One of the principal challenges of microfinance lies in providing small loans at an affordable cost. With an average annual interest rate of 25% at the end of 2017 (a reduction from 28% at the end of 2015), the price of microfinance services (cost of credit) remains significantly high as compared to traditional banks. These costlier rates are due to the high servicing cost (agents) relative to the loan size, and the costs of covering the risk of default while still ensuring a reasonable return for investors.

Some of the established players are leveraging alternative delivery channels (ADC) such as an extensive network of physical agents (sometimes one of the borrowers), mobile vans, satellite (BRI Indonesia), floating branches (ships), virtual teller machines, and ATMs to increase their outreach.

Loan disbursal powered by data

Innovations in alternative credit scoring models bridge the gap for lenders to be able to take credit underwriting decisions using proprietary algorithms. Lenddo, in the Philippines, uses non-traditional data like digital footprint obtained from social media and mobile phone usage to calculate a credit score. Psychometric evaluations (being used by Janalakshmi in India) to assess an applicant’s integrity, beliefs, loan repayment behavior, business acumen, and ethics are being leveraged for the assessment of propensity to pay off borrowers.

How can regulators help?

Financial regulators are now working with innovators in the private sector to promote test-and-learn approaches. However, they will also need to keep a level playing field for established players (like banks) as well as new-age fintechs to enable broader participation. Standards for the sharing of credit history and data among players have to be formulated by regulators on a war footing. In the light of several recent high-profile data breaches, there is a need for stringent data privacy practices. A proper channel for complaints recourse must be established, while also laying down some norms to protect microfinance institutions (MFIs).

Amid the crisis, an opportunity

The specter of a looming recession triggered by the COVID-19 pandemic will place a heavy burden on the global financial system. This, in turn, will impact the flow of credit from banks who are the primary source of funds for MFIs. Loss of earnings due to unstable jobs will lead to a default on repayments from borrowers. Lockdowns and social distancing norms will ensure even the collections (whatever little) remain low. The governments will need to roll out stimulus packages for MFIs to enable them to remain solvent. MFIs on their part will need to look at easing the terms of debts for borrowers, may need to even go slow on new customer acquisitions. Central banks should be prepared to recapitalize microfinance institutions, so that they are in a position to lend again once the crisis recedes.

Due to increased competition for capital, microfinance institutions will need to raise efficiency, lower transaction costs for clients, and expand outreach to new markets. Cultivating partnerships with technology providers who have expertise in big data, AI, mobility and IoT will become crucial. MFIs can leverage tools based on big data and AI to scale up the scoring models for increased adoption of services. On the other hand, IoT can be used to track borrowers and field agents.

Microfinance institutions must roll out simple products with flexible limits and durations. They will also need to enhance trust using high-tech mobile-based intuitive apps. These services should also enable them to educate the consumer and ease their transition into a digital model.

As financial literacy increases, there will be a shift of loyalty towards the MFI from loan officers (agents), which will help increase outreach. It will also help in lowering the risk of over-indebtedness for borrowers. Being mobile-ready and incorporating future-proof tech solutions will go a long way in simplifying the loan disbursal process as well as offer avenues for better client engagement.

One small step at a time

In short, microfinance and nano finance are poised to play an important role in ensuring the sustained financial well-being of the under-served sections of society. Global trends have shown that extending financial services to include those in the marginalized sections will spur entrepreneurship among them and lead to the accelerated economic growth.

The onus, then, is on microfinance institutions to adopt modern and future-proof digital technologies with strategic partnerships so that they can equip themselves to serve their customer base as seamlessly as possible.