by Jeffrey Erfe - Trends/Challenges -

MICROCAPITAL PAPER WRAP-UP: Microfinance on the Rise, by Arthur D. Little

Written by Arthur D. Little and based on the firm’s previous industry research, released on November 13, 2008 as a “Financial Services INSIGHT,” 4 pages, available on November 26, 2008 at: http://www.adl.com/reports.html?view=329.

Arthur D. Little (ADL), an international management consulting firm, released on November 13 a report entitled “Microfinance on the Rise,” which analyzes the current factors broadly affecting the demand and supply of microfinance and outlines the core operational components of a good microfinance practice. The report is an interesting analysis of the industry’s state of affairs and a strong prediction that microfinance is poised to become a new asset class for traditional investors.

Established in 1886, ADL was founded in Cambridge, Massachussetts, by two MIT chemists and has since grown to become largely a management consulting firm that currently holds the 33rd spot on Vault’s list of the most prestigious management consulting firms. Today, the company employs about 1,000 people in 20 countries, and in fiscal year 2006 the company brought in USD 239 million in revenues. Although ADL does not claim any unique contributions to microfinance, the organization holds at least partial responsibility for developing a number of modern innovations, including operations research, word processing, synthetic penicillin, LexisNexis, and NASDAQ.

What follows is a summary of the report:

Microfinance Demand and Supply

Across the world, low-income clients typically comprise the majority of microfinance’s customer segment, and ADL argues that demand from this segment will only continue to grow. On the first page of ADL’s report, Figure 1 shows the relative percentages of the total population that low-income consumers make up among various European countries. These proportions range from ten percent in the Netherlands to 21 percent in Greece; the average over 15 EU countries is slightly over 15 percent. A subsequent figure on page two illustrates the growth in the purchasing power and net income of low-income consumers over a ten-year period. Net income per capita across the region rose from USD 5.5 million (EUR 4.2 million) in 1996 to USD 9.8 million (EUR 7.6 million) in 2006, a pace faster than the average population segment’s, which indicates to ADL an increase in the purchasing power and credit worthiness of potential low-income borrowers (p. 1). Accompanying this strong demand surge, notes ADL, are market constraints on the supply of capital from conventional creditors (p. 2).

Untapped demand for microlending, claims ADL, outpaces the current supply of microfinancial services. The firm’s estimates indicate that of the roughly 2.8 billion people in the world who live on less than USD 2 per day, approximately 500 million can be considered microentrepreneurs in need of credit (p. 4). Assuming an average loan size of USD 500, this translates into a global demand of USD 250 billion today. Only about USD 25 billion in loans are outstanding globally, a mere 10 percent of total global demand; in this environment, it seems only inevitable that traditional investment institutions will begin to create new assets to fill at least part of this gap, claims ADL (p. 4). Other pull factors encouraging the involvement of traditional finance are the high returns on equity (i.e. over ten percent at the median) of MFIs older than eight years and microfinance’s low correlation with conventional capital markets, rendering it a strategic portfolio diversification tool (p. 4). In sum, argues ADL, the chasm between global demand and supply and the favorable risk-return and niche diversification characteristics of microfinance create a setting ripe for its emergence as a new asset class in the coming decades (p. 4).

Good Microcredit Business Models

ADL highlights the fact that many contemporary microfinance institutions (MFIs) rely largely on small subsidies, a habit they most slowly wean themselves from if they are to achieve self-sufficiency since these small monetary amounts are unlikely to ever completely cover the cost of providing microcredit to all of an organization’s clients (p. 2). Furthermore, MFIs intent on achieving self-sufficiency must maximize operating efficiency and employee productivity. ADL draws attention to the following core components of successful microfinance, as divided into three categories: customers, lending processes, and structure and organization (p. 3).

Customers

  1. Small loans, primarily to women: Improving the livelihoods of these often-creditworthy borrowers improves not only their socioeconomic positions but also that of their children.
  2. Peer and progressive lending: Successful programs finance loans for small groups of people, each of whom assumes equal rights and responsibilities for each loan. These arrangements facilitate risk-sharing and improve market access for group members and can be scaled-up to include more people or more services over time.
  3. Target poor microentrepreneurs: Loans must reach the economically active among the poor.

Lending processes

  1. Simple and quick lending process: Application and lending processes must achieve quick turn-around times, ideally within two weeks or less.
  2. Commitment to training: Many successful programs teach clients about accounting, customer services, and marketing to strengthen these clients’ micro-businesses.
  3. Strong monitoring mechanisms: Microfinanciers must monitor a number of operational statistics, including their repayment rate, the success of their target microenterprises, and self-sustainability. “Hand-holding” of clients and monitoring clients’ businesses is also encouraged.

Structure and organization

  1. Supportive regulatory framework: A supportive regulatory framework that promotes the expansion of MFIs affects the reach and sustainability of microcredit programs.
  2. Appropriate interest charged: Successful programs typically charge an “appropriate” level of interest. ADL does not define this level other than by saying it is higher than that of a traditional bank and lower than that charged by a money-lender or loan shark.
  3. Well-trained staff: The recruitment, training and retention of productive staff are crucial.

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