What´s the difference between microcredit and subprime lending?

19 February 2010 at 06:00 3 comments

By Adam Kemmis Betty, KF10 Bolivia.

This post was prompted by a report by Oliver Wyman and the Fletcher School, The Future of Risk Management in Microfinance, available here. Many thanks go to Ross Frisbie at Oliver Wyman for his insights.

It´s a loan for someone who was unable to get a loan from a mainstream bank because they didn´t have the necessary paperwork or their income was too low or too volatile. The borrower is likely from a marginalized group, perhaps a migrant family. The loan costs more than a bank loan would cost, but the alternatives for this borrower are even more costly. The lending institution might hold these loans on their balance sheets, or they might sell them on to someone else…

So what are we talking about here, a typical Kiva loan or a subprime mortgage? Is there anything inherently different between the two?

Sure, there are differences.  Microfinance institutions (MFIs) normally have an explicit social mission, aiming to help the poor as well as maintain financial sustainability, unlike subprime lenders. MFIs typically have a close relationship with their clients, involving regular interaction with loan officers and perhaps formal training sessions – there is an element of borrower loyalty. Microcredits are often provided to groups rather than individuals, with each group member guaranteeing the others, which creates a social pressure to repay and helps avoid adverse selection. Loan terms are much shorter than subprime mortgages, often 6 months or less. And the loans themselves are destined for investment in the borrowers´ business, increasing their ability to pay back.

Well that, at least, was how it was. But as the microfinance industry evolves, many of those traditional methods of managing risk are being eroded. As competition increases in mature markets, such as here in Bolivia, it is increasingly common for borrowers to have loans with multiple MFIs, weakening customer loyalty and potentially creating problems of over-indebtedness. MFIs, in response to customer demand, increasingly offer individual credits with minimal paperwork or collateral. In Bolivia, none of the largest MFIs offer group loans. Loan terms are gradually getting longer and the loan use is evolving, with many MFIs offering loans for consumption (housing, health, education or general). And as for that social mission, many believe it is being eroded by the growing dominance of for-profit MFIs (which in Bolivia account for over 80% of the market).

Before you rush to cancel your Kiva account, it´s worth pointing out that most of these changes have been good for borrowers. Competition has brought down interest rates and increased access to credit. Individual credits are much less risky for the borrower – they no longer have to worry about 14 other people´s ability to pay. Recent analysis based on an extensive collection of “financial diaries” show that consumption loans may be more in tune with the poor´s needs than business loans. Finally, commercialization, while controversial, has undoubtedly contributed to the rapid growth in outreach of the microfinance industry.

Nevertheless, are MFIs heading down a slippery slope that could lead to much higher default rates in the future? Not necessarily, but as the microfinance industry changes, it is important that MFIs also adapt their approach to managing risk, in order to avoid the fate of subprime lenders. As they grow, it is critical that MFIs improve their data quality and upgrade their management information systems, so that if any problems in the portfolio arise, the MFI management is immediately aware. As competition increases pressure on pricing, it is likely that MFIs will need to develop a more differentiated approach to risk assessment, tying a customer´s interest rates to their level of risk. MFIs should maintain their commitment to simple products and promotion of financial literacy among borrowers, as the complexity of subprime mortgage products contributed to the levels of default. Finally, it is important that loan officers are not incentivized (e.g. through bonuses) to grow their portfolio at all costs (like subprime mortgage brokers), but consider also the social and risk aspects of the loans they make.

One likely consequence of the global financial crisis is that MFIs will be more closely regulated – in Bolivia, this process has already started with the supervision of NGO MFIs. Considering the changes in the industry, this is probably no bad thing. But it is also up to the industry to make sure it doesn´t sow the seeds for trouble further down the line.

Adam is a consultant at Oliver Wyman Financial Services and a Kiva Fellow at Pro Mujer Bolivia. To make a loan to a Pro Mujer borrower, click here. To join the Pro Mujer lending team, click here.

Entry filed under: Americas, Bolivia, KF10 (Kiva Fellows 10th Class), Pro Mujer Bolivia. Tags: , , , , , , , .

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3 Comments

  • 1. Antoine Stépane Terjanian  |  19 February 2010 at 07:49

    Mr. Kimmis, I am happy that we have people like you volunteering as KF’s. I enjoyed very much your article and also that of Ross Frisbie of Tufts U that you referred to.
    While I agree with your statement about the need to “tying a customer´s interest rates to their level of risk” (in fact that is what banks all over the world have always done – rich borrowers get an easier access to credit and at lower rates), I struggle with it: Did Kiva lenders enter Microcredit to make a profit, or did they join so they can help the poor break from the vicious cycle of poverty, lack of education, poor health and sanitation?
    The poorer a person, the less educated s/he is, the less healthy s/he is, the higher their risk for defaulting. Now suppose such a poor person comes-up with a good business plan to advance a little ( I am of course not talking of a consumer loan to buy a TV or yet another video game), if we increase the interest rate we charge this poor person, aren’t we in fact pushing her/him closer to risking to default?
    I commented in another column where the KF was attempting to justify interest rates of 3% per month. I really don’t know of any ‘legitimate’ business where one can make enough profit to pay back a loan at 3% per month.
    Thanks again for a very informative and thought-provoking article.
    AST

    • 2. adamkb  |  19 February 2010 at 09:58

      Antoine, thanks for your comment.

      As you say, risk-based pricing is a tricky one. The most obvious way of doing this is to reward customers who consistently pay back on time by giving them a lower interest rate: very few MFIs do this, and it´s something that established borrowers often complain about. On the other hand, by having a flat rate you make it easier for new borrowers – perhaps those most in need – to enter the system.

      Whatever the pros and cons of the approach, I think it´s something that MFIs will have to introduce as competition (particularly for “good” customers) intensifies, in order to remain financially sustainable.

      Does a higher interest make the borrower more likely to default? I don´t have any evidence to back this up, but my hunch is no, as long as the borrower understands the costs involved: for this reason it is important that MFIs keep their commitment to product simplicity.

  • 3. Jeff  |  19 February 2010 at 06:38

    That’s thought provoking. After a year of lending through Kiva I’ve come to realize that the social aspects of the MFI’s are a very important part of what they offer. As for the added risk you mention it seems that, for the lender, picking short-term loans is one response although longer terms often indicate a borrower’s greater need.


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