Three Secrets of Safe Microfinance

Like sex, microfinance can be safe if practiced responsibly. Recently, however, we've seen that not all participants in the microfinance industry are practicing safe microfinance. As happens with that other risky activity, the players in microfinance face temptations that lure them away from healthy long term relationships. One need look no farther than Andhra Pradesh, India, where the temptation for lenders to grow very fast in order to win market share, prestige and profits caused them to woo many clients into excessive debt -- with predictably bad consequences for both clients and lenders.

Safe microfinance rests on a handful of operational practices that remain just as valid today as they were before the crisis in Andhra Pradesh. These practices emerged in an early form at the start of microfinance in the 1980s. They were then honed by subsequent experience as the field matured. Proven across continents and decades, the three principles I am about to describe underpin microfinance operations around the world that maintain healthy relationships with clients.

Choosing the right "partners" (sound underwriting) First and fundamental is sound credit underwriting. Safe microfinance requires a credit underwriting process that effectively assesses a client's ability and willingness to pay. Loan officers in safe microfinance operations spend time talking with a client at her place of business, using her answers to analyze the cash flow of the business and household and using their own experienced eyes to determine whether a client's answers are consistent with plain sight observations. They assess willingness to pay during the interview and by checking with a client's friends or neighbors. This method, introduced as early as 1984 by Bank Rakyat Indonesia, works wonderfully well when clients have existing microbusinesses and are not already highly indebted. But in places where multiple partners -- I mean providers -- have emerged, safe microfinance requires an additional dimension: checking for existing indebtedness, both through detailed questioning of clients and through credit bureaus. Most countries in South America now have well-functioning credit bureaus that help prevent the kind of overindebtedness that occurred in Andhra Pradesh, where no credit bureau operates.

People with a passing exposure to microfinance often think it only uses group lending, and, indeed, group lending helped jump start microfinance. It was a good solution -- until it wasn't. In Latin America a wholesale shift from group toward individual lending occurred in the late 1990s. Clients expressed their strong preference for one-on-one relationships while lenders realized that under stress (as in a recession), group solidarity tended to unravel all at once. For the most part, microfinance in India and Bangladesh has not made this shift, in part because it requires more highly skilled loan officers (see third secret below). In other parts of the world many group lenders are now incorporating repayment capacity assessment into their procedures and offering individual loans to more trusted clients.

Deepening the relationship (providing savings) Second, and possibly still more fundamental, institutions who hook up with clients around the lasting value of savings will have stronger relationships than those who are in it only for the lending. For clients, savings are the beginning of asset accumulation; for providers, savings accounts are the anchor of a permanent client relationship. Credit unions got savings right from the beginning, but the message has not fully penetrated the microfinance sector, partly because the non-profit origins of many microfinance institutions (MFIs) disqualified them from deposit-taking. Today some of the world's leading MFIs -- like Bank Rakyat Indonesia and Equity Bank in Kenya -- are full-fledged commercial banks that offer flexible voluntary savings products. They serve more savers than borrowers (both profitably) and do not depend on international capital markets for funds. Although they have grown fast, they have avoided overindebtedness. It's my bet that being a savings-led institution is strong protection against the temptation to over-lend.

Putting "partners'" needs first (training staff in client service) Third, a trained and motivated staff makes it all possible. Since its transactions are tiny, microfinance requires staff to handle large client caseloads. At the same time, staff must be sensitive to the needs of low income people, who may need support to overcome cultural or linguistic barriers, limited literacy and other challenges. Safe microfinance institutions recruit the right kind of staff (in terms of values, education and personality traits), train them carefully in both the hard core (credit analysis procedures) and soft core (corporate purpose, people skills) of the business. Motivating staff by a sense of mission works well for many NGOs, especially smaller ones. Monetary incentives can also work well, as long as they only reward staff for growth if they produce safe loan portfolios. Incentive payments must link to client outcomes. When institutions grow too fast, it is difficult to recruit people with the right profile, hard to ensure that they internalize the values and processes of the institution, and hard to monitor their performance. In some recent cases, MFIs outsourced the recruitment of borrowers to paid commission agents -- a practice that is just asking for trouble.

Successful microfinance is built on these three open secrets. But too-rapid growth and increased competition can seriously test, and sometimes breach, an MFI's adherence to these principles. To make sure such principles hold under pressure, MFIs need more than just good intentions. Perceiving a need to replicate strong client protection practices developed by some of the world's best-run MFIs, microfinance industry leaders from around the world established the Client Protection Principles, and in October 2009 they launched the Smart Campaign to put the principles into action. Today the Campaign is a global effort with over 1,500 signatories, a wealth of tools and resources and an ambitious action agenda.

Institutions that practice the secrets of safe microfinance are already on their way toward fully implementing the Client Protection Principles. An institution that seriously follows the three secrets of safe microfinance is likely to benefit clients and be a healthy provider for years to come.