I mentioned in an earlier post that I have been thinking about profitability as a possibility for microfinance institutions. A commentator on this blog mentioned a recent article in the Economist about this issue. Unfortunately, you have to pay to read it on-line, so I didn’t, but here’s my semi-informed opinion on the matter:

Sustainability and Profitability: A Beginner’s Guide

If you want to understand the debate between non-profit and for-profit microfinance you need to understand why microfinance is even necessary in the first place, and why it has been almost entirely dominated by non-profit institutions. This is more complicated than it might seem.

You see, according to one of the hallowed laws of economics: the law of diminishing returns, we should never have needed microfinance. The idea is that the more capital you have, the less profit you get from each additional infusion of capital. Thus well-financed corporations get less profit from each additional dollar of capital (technically you should be thinking machines, not money when I say capital, but here it is just as useful to think of a loan as what the business would buy with the loan). On the other hand a poor entrepreneur with no capital whatsoever should make very high profits from each dollar.

Theoretically, this should mean that poor entrepreneurs can afford to pay high enough interest rates to draw money from rich banks. Capital should be flowing toward poor countries and poor businessmen like it was rolling downhill. The problem is, it doesn’t. Banks don’t want to loan to poor people, despite the fact that they should be able to gain more from every dollar of capital.

The reason is more complex than this, but basically, banks have no way of knowing who is a safe borrower and who is a risky borrower. Since they can’t know this, they offset costs and deter risky borrowers by demanding collateral. Poor people don’t have collateral (or at least not in amounts large enough to offset the cost of a defaulted loan). Microfinance, starting with Muhammed Yunus and Grameen bank in Bangladesh, combated this problem primarily by loaning to groups instead of individuals. This group contract opened up finance to poor entrepreneurs, and was effective enough that the idea has spread around the world.

And it all started with a non-profit institution. Grameen bank and its imitators have all started with the goal of fighting poverty, not making a profit. But wouldn’t services spread faster if you could make use of the most powerful incentive known to (neo-classical economist) man? Given that MFI’s generally achieve repayment rates in excess of 90 to 95% it would seem that this would be possible. But I’m not sure it’s that simple.

The fact that the microfinance innovation happened first in the world of non-profits should be one clue that profitability is difficult to achieve.  The fact is that non-profit MFIs do in fact strive toward profitability, but under a different name: sustainability.  Sustainability broadly defined means that the institution is able to cover its costs.  One important point is that if an institution reaches full financial sustainability (defined as the ability to cover both its operations costs and the cost of borrowing funds) it will theoretically offer the exact same interest rate as a profit-maximizing corporation operating under perfect competition.  This is because competition pushes profit to zero.

In other words, MFIs are actually pushing toward profitability in order to cover their costs and ensure that they can offer services to their clients without requiring massive subsidies which may dry up when microfinance loses its fad status.  Only the minority of MFIs have reached full sustainability.

The problem is that it is cheaper to cover larger loans.  You have higher costs per dollar when you loan to very small borrowers.  So the pressure as MFIs try to become sustainable is to service larger and larger loans.  Though they are still covering an under-served market, they tend to drift away from helping the poorest.

This is why I do not think that profitability is the ultimate answer.  I think the free market can and should efficiently serve the less-poor with financial services, but  there is less profit to be made from the most poor. I am certain that for-profit microfinance will expand in the future and I am relatively certain that this is a good thing, but it will not likely reach the very poor.  Because of this, I think non-profit organizations with a strong sense of mission will still be needed.

Also, the market needs constructive competition to ensure that the customers receive services at the lowest possible cost.  Compartamos in Mexico has received much press recently because it went for-profit.  Compartamos reportedly charges interest rates around 100% annually.  By way of comparison, Esperanza charges 30% annually.  I am certain that with stiff competition cheaper services could reach the consumer, but this would need to be constructive competition, i.e. an effective credit bureau needs to be established in order to assure that bad borrowers to not bury themselves in debt from competing institutions.  Unregulated competition nearly destroyed BancoSol in Bolivia because of this problem.

So that’s my opinion.  I know it’s really long, so I guess some more stars are in order for anyone who actually read the whole thing.  Geez I’m long-winded.  Anyway, if you know something about microfinance weigh in.  Stephen, I hope that answers your question.