A recent article by Gregory Chen at CGAP (a microfinance arm of the Word Bank) explores why many believe the microfinance sector will implode considering rising default rates in recent months. The ambitions of the microfinance sector are alluded to those of Icarus, the Greek mythological creature who died after attempting to fly too close to the sun, ignoring the vulnerability of his waxen wings.

Similarly, it has been agreed upon that the repayment crises (PAR30 over 7% and aggressive loan write-offs) experienced by microfinance institutions (MFIs) in several markets are the result of their high-growth. Chen looks at the result of several case studies conducted in Pakistan, Nicaragua, Bosnia and Herzegovina, and Morocco, which reveal specific problems faced by microfinance providers as they get allured by impressive growth rates and ignore traditional management wisdom:

Rapid growth can strain MFI systems and controls, and as a result, vulnerabilities in three areas emerge:

Rapidly adding larger numbers of staff in a short amount of time – averaging 40% annual staff growth in the four countries

New pressures on middle management to manage growth

Internal controls which are not suited to keep pace with the growing scale or the complexity of operations

Rapid growth can harm the ‘credit discipline’ of an MFI. Conservative credit practices are replaced with risky decisions to compete better and satisfy shareholders who push for profits and growth (dual mission of MFIs). Problems in three areas arise:

Rapid increases in loan sizes and the introduction of new credit products

Gradually ceding control of credit processes to informal agents who are not employees of the MFI

Blunt staff incentive schemes which reward short-term growth but do little to promote long-term client relationships

It’s interesting to note that India, the fastest growing market for microfinance, has been spared because of prudent decisions by the Reserve Bank of India, such as the setup of a microfinance credit bureau. Despite other problems, microfinance has managed to bear the economic crisis with strength. However, profit-minded investors may lead to the demise of this sector as they push MFIs to ‘fly too close to the sun’:

• Microfinance banks will suffer greater losses as a result of higher default rates and loans write-offs, and
• To offset this risk, the already-high interest rates will be pushed higher, as a result of which,
• The poor will not only be captured in lethal debt-traps, but
• Poverty rates will rise further.

Interestingly, microfinance is the only field where the seller aims to diminish the size of his/her market by improving the living standards of buyers/borrowers. But misguided business practices will ruin this grand vision.

You can read other articles about the microfinance theory and practice, as well as the impact of the economy on microfinance as a sector.