Income Smoothening – a possible solution to a genuine problem

The poor lack the array of options we take for granted in wealthy nations, and are more vulnerable to shocks. Their incomes and expenses may be more volatile. Insurance services are limited, and a comparatively minor medical emergency, or such interruption to their lives, can have a major adverse impact. We are familiar with the arguments. Financial services can offer protection against this volatility.

A recent article by Chris Dunford suggested distinguishing between microfinance which alleviates poverty by providing income smoothening services; and that which reduces poverty by enabling the poor client to build an astonishingly profitable enterprise and be miraculously catapulted out of poverty. The latter is euphemistically described as “the minority”.

This is a valid point, and not the first time this has been made. The book Portfolios of the Poor revolves around such principles; Dan Rozas has written eloquently on the topic; chapter 2 of Roodman’s Due Diligence is a must-read.

I wish to discuss how we can easily offer the poor what they want. In fact we already have the product and technology well developed. I will then suggest reasons why we have failed to do this to date.

The ideal product is simply an instant-access savings account with an overdraft facility. This is the standard banking product of the developed world. It pays a paltry interest rate on savings, perhaps enough to cover inflation. I can deposit as much as I want, whenever I want, and when I need funds I have instant access. When I need additional funds, perhaps because of higher than expected expenses, lower than expected income, or to pounce on some investment opportunity, I have an overdraft facility that I can dip into. This limit is set periodically depending on an analysis of my capacity to repay, credit history, income and wealth etc., similar in concept to the analysis performed by MFIs.

When I need funds I first use my own funds, depleting savings. This is my cheapest source of capital – it merely costs me the interest foregone on my savings. When I need additional funds I use the overdraft facility, and I pay only for the money I borrow, for the days I borrow. As soon as I have available excess cash I begin repaying the overdraft, reducing my interest expense immediately, and eventually I start accumulating savings once again. If my savings ever reach a sufficiently high level (disappointingly rarely) I can take a proportion to a fixed-term savings product where I forego instant access in exchange for an elevated interest rate. If I require a longer-term loan, or a loan that exceeds my overdraft facility, I apply for precisely such a loan, if and when I need it (also rare, thankfully).

This is an extremely useful product for me, and appears to well meet the income smoothening needs of the poor. It is possibly one of the simplest retail banking products in the entire developed world, but denied to the poor. It is not perfect, clients in cash-based commercial businesses will likely keep much of their float outside a bank simply to avoid endless trips to the bank to deposit and withdraw funds, but it is merely one of an array of products we need to offer the poor, but currently do not.

MFIs in fact offer the precise opposite to such an account. They prefer locking clients into longer-term, fixed repayment loans. If income smoothening is the problem we need to solve, why oblige a client to take out a 6-month loan if they only need the money for a short-period? Sure, if the loan is to be used for a longer-term investment then a microfinance loan may be wiser, but as noted above, the majority of microfinance is not used for such investments. Indeed, most MFIs charge penalties for early-repayment of loans – precisely the opposite of a current account. Some do offer instant access savings accounts, which I applaud, but the majority of MFIs are not regulated to take deposits from the public, and if they do, tend to offer savings that are not instant-access, and may in fact be impossible to withdraw during the life of the loan – forced savings for example, or savings used as a “guarantee”. Again, this is the precise opposite of a reasonable current account that many of us use each day.

Indeed, if a client needs financing for a week or two, it may be rational and preferable for the client to go to an illegal moneylender and pay an APR of 200% p.a. for a fortnight rather than go to an MFI for a 6-month loan at an APR of 100%. Moneylenders still operate abundantly in microfinance zones, and a current account product could actually be a more viable tool for eliminating such predatory lending.

Given the prevalence of the savings account with an overdraft facility across the developed world, why could this product have been so slow to arrive in the hands of the poor? The technology and know-how clearly exists. There are 4 key reasons:

  1. Longer-term, fixed repayment loans generate more interest income for the MFI than an overdraft facility, and are therefore more profitable. When clients suffer a short-term crisis necessitating additional liquidity the ability to dip into their own savings is a missed opportunity to the bank, who could otherwise have offered a nice 6-month fixed rate loan to cover the one week or one month dip, and given that this may be the only source of quick credit available, the poor have little choice. It’s perhaps not surprising that the evil moneylenders still exist, in part to plug this precise gap in the market.
  2. MFIs prefer fixed term savings as they are less volatile for the MFI, who can on-lend these funds at high interest rates. Instant access savings accounts require the bank to maintain a larger cash buffer to cope with unexpected withdrawals by clients. Thus adding flexibility to the clients reduces flexibility to the MFI. Instant access savings are less profitable for the MFI.
  3. Instant, or near-instant access to savings is a direct expense to the MFI, depending on the method of access: passbooks require a branch visit, ATM withdrawals require investing in cards and cash machines, or paying fees to use an existing network. Mobile technology can potentially reduce this cost further, as M-Pesa has demonstrated, but while this reduces the cost to the MFI to offer such access, the other reasons cited prevent the MFI from leaping at these products. They are not as profitable for the MFI.
  4. Offering such a product requires the MFI to be regulated in most countries. This is an expensive process to undergo, incurs increased ongoing operating expenses, and applies additional scrutiny to the bank from the regulator. MFIs, and indeed most players in the entire microfinance sector, are weary of regulators. Thus the fascination of self-regulation – formal regulation is a hassle and may limit profitability.

The astute reader will note these four points are actually identical: offering such a product to the poor may better meet their actual needs, but it is less profitable to the MFI.

A fifth reason, less related to the MFIs or product per se: banks that mobilize substantial local savings are less dependent upon external funding from microfinance investment funds (MIVs), and it may be in the interests of the MIVs to not push such activities, as they reduce their own income streams in the process. Isn’t it strange that Banco Compartamos, one of the most profitable (and vulture-like) MFIs on Earth, with such massive ROE as to be able to launch almost any product it wishes, does not offer a single savings product at all?

The poor with savings become ever so slightly more autonomous. Those with loans become enslaved.

Look at the evolution of almost every developed country financial sector – they generally began with savings and loan co-ops. Roodman’s third chapter is an excellent summary of the historical origins of the financial sectors of such countries. Savings were integral in the evolution of many European, American, British and Canadian banking sectors and structured as co-ops. We now seem to believe that savings are barely necessary: credit-only institutions (many of which are privately owned and for-profit) still dominate the entire microfinance sector. Is this what Ha-Joon Chang would refer to as Kicking Away the Ladder?

Indeed, it is likely that those best suited to offer such a loan product, who may in fact already offer such a product to their wealthier clients, are the commercial retail banks. They have the regulatory structure and technology/back-office in place to manage such a product. A principal justification of microfinance, if I recall correctly, was a consequence of the hesitance of precisely these banks to lend to the poor, forcing them into the arms of the evil moneylender. If the commercial banks could further downscale their operations into the microfinance segments this problem may be solved, and this is precisely what we observe in some countries currently. Look at Banco Guayaquil and Banco Pichincha in Ecuador, CrediScotia in Peru etc.

We know microfinance did not eliminate the evil moneylender, but perhaps these commercial banks downscaling and offering suitable products (which already exist) to the poor could eliminate the evil MFI? Wouldn’t that be a huge success? Good products offered to the poor at fair rates by commercial, regulated banks? Indeed, surely the goal of the microfinance community is to make itself redundant?

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4 Responses to Income Smoothening – a possible solution to a genuine problem

  1. Phil says:

    Excellent post, Hugh, on an issue which has been troubling me for quite some time. To expand upon your points just a bit: Isn’t it so that the better-suited service (an instant-access flexible-payments savings product with overdraft facility), which matches clients’ complicated needs, above all goes against the *simplicity* on which most MFIs have premised their financial success, or their entire operating model? It appears that the infrastructure and management, indeed the sheer thought going into such a product, would have to be far greater than that for the simple one-size-fits-all products which have defined microfinance so far. It may just well require such a thing as a locally-owned ROSCA or Credit Union to function properly; incidentally those things which have only been rediscovered as part of “microfinance” since the failures of the mainstream microfinance model have become so obvious. Finally, it appears above all that offering this sort of service would be *riskier* to the capital provider, particularly clear in situations like natural disasters, when everyone suddenly needs their savings so the bank simply ceases to exist. To a community-owned institution that wouldn’t matter; the co-op entirely fulfils its purpose entirely when it can be “cashed in” in times of need. However, for a shareholder-owned MFI – as your text indicates – it’s failure. Shareholders lose their money. So for them it’s better to make legally-binding loans and (like Grameen in Bangladesh after the cyclone 2007) just hand out new extra loans. Perfect maintenance of cashflow in the short term for all involved, but really utter lunacy in the long term.

    … I think you’ve opened up a long-overdue discussion which, if pursued properly, shoudl prompt some serious questioning.

    • Thank you Phil,

      I’m not sure what goes through their little minds, but simplicity is certainly questionable. Some MFIs disguise their interest rates so thoroughly as to require a PhD to decipher the actual cost of a loan. The product I propose is the bread-and-butter of the mainstream retail banking sector, so is not too cumbersome to adopt. I should add that this is not the ONLY product an MFI should offer, but as with other retail banks, it is a base product. I do not have any evidence for this, but I guess (note speculation here) that such current accounts earn Barclays, Lloyds, ABN Amro, ING, Deutsche etc. relatively small returns for the effort and volumes involved, and their profit arises from cross-selling other products on the back of a core current account. The question is simply “why doesn’t the microfinance sector offer such an account?”. It clearly aids in income smoothening, and the sector is constantly whining about the problems of volatile income and expenses.

      However, on the risk front, this dovetails with my general pro-regulation stance – a stance that the microfinance sector abhors but most living in the post financial-crisis universe have some sympathy for. I’ll use Ecuador as an example. A regulated bank in Ecuador has to pay a fee to the regulator based on saving balances, for which its clients receive deposit protection up to $31.000 per person. Given the average depositor in Ecuador is unlikely to exceed this (>5 times annual GDP/head), in practice this means that 99.999% of Ecuadorians are covered by formal governmental deposit insurance, as we take for granted in Europe/US etc. The banks absorb the cost of this, and compete in an open market on interest rates to attract savers. Ask Icesave, Anglo Irish or Northern Rock depositors what they think of deposit insurance.

      Once again we have a case of the poor at last benefitting from legislation that we take for granted in our countries: basic consumer protection under an effective regulator. Self-regulation is a joke. Aggressive, incompetent or corrupt regulation is also a joke, but the microfinance investment community in particular seem rather hesitant to embrace formal regulation, preferring self-regulation hosted and financed by insiders. I am sure Wall Street would prefer regulation run by Goldman Sachs also – the question is whether this is beneficial to the client.

      Indeed, continuing the Ecuador example, the government has placed interest rate caps (30.5% APR) and a tax on external capital encouraging the sector to seek local funding where possible, regulated savings deposits being an obvious first choice, and the result is largely positive. Naturally very few MIVs will openly approve the Ecuadorian model, and likely brand Correa as a leftist extremist Marxist communist or whatever. The MFIs moan at not being able to charge higher rates, of course, but none have collapsed. Indeed, I would suggest that Ecuador is a fascinating case study of regulation in microfinance. It is not perfect, but it sheds important light on how we can possibly clean up some of the mess of the current global microfinance sector, and perhaps achieve better results than the current “zero”, to quote Roodman once again.

  2. Bart First says:

    Blueorchard Microfinance Fund down for a second month and year to date -3.6%.

    What is happening? Really sinking?


    • Thanks for this BF, I hadn’t spotted it. You are referring to the following document I assume:

      I assume you read the exellent article by Dan Rozas on the subject:

      The document is interesting. I almost couldn’t believe the negative returns in only two months, mainly on account of Andhra Pradesh apparently. It’s surprising that wasn’t provisioned previously. Even the 5-yr return is pretty mediocre, 0.76% in CHF and double in USD/EUR. What I also find quite alarming is the exposure to Peru, easily the biggest single country, 6.38% in MiBanco alone. There are some early warning signs of over-heating there. Mexico is another country to watch, and thankfully BO have minimal exposure there.

      Regarding a prognosis, is it really sinking? About half the portfolio is falling due within 6 months. The NAV of the fund fell from $287m to $274m in a month ($12m), and the total disbursements increased from $1.169bn to $1.182bn, so they are still disbursing ($13m this month in 5 deals, average deal size of $2.6m, lower than their historic average). Could this be a controlled winding-down of the portfolio? I guess they wouldn’t be disbursing if this was the intention, but it would be nice to know if this was new investments or roll-overs. Frankly, I don’t have any more information than that published on their website, but something is clearly happening. From Jan to Feb the number of countries increased from 40 to 41, and the number of MFIs from 76 to 78, so I suppose only 3 of these 5 loans could be roll-overs. They are still doing new deals.

      They seem quite upbeat: “We are confident that no further negative impacts on performance shall result from existing positions classified as ‘substandard, doubtful or loss’”, so I guess only time will tell if this is a valid assessment. Thanks for pointing this out, and let’s keep an eye on this. Cheers, Hugh

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