Unlike previous crises that the microfinance industry weathered successfully, Covid-19 has created significant challenges for both the demand side – low-income borrowers struggling to repay their microloans – and the supply side – providers facing their own funding pressures.
A recent Economics Observatory article analysed the impact of Covid-19 on the banking sector. Here, we focus on microfinance institutions (MFIs), which cater to hundreds of millions of low-income households across the world.
For households, lockdown meant shuttering of the microbusinesses and day-labour opportunities on which they rely on for daily consumption and the income to repay loans. For MFIs, lockdown immediately interrupted the ability of microlenders to conduct normal operations, especially to collect repayments.
It is unclear to what extent the status quo ante can return as and when lockdowns ease. Borrowers will be likely to need some relief from the debts they incurred before the pandemic, but MFIs may not be in a position to give that relief without receiving assistance themselves.
While many MFIs have the reserves to survive months of non-repayment, there are serious concerns about the long-term effect on the ‘high-touch’ business model on which they rely to achieve high repayment rates, and what that means for the capital structure of the industry and its regulatory frameworks. The future success of the industry will require revisiting the trade-offs between profitability and subsidy, financial inclusion, regulation and consumer protection.
Why does microfinance matter to low-income households?
While the aspirations of the microfinance industry to make a substantial dent in poverty rates have been substantially tempered by a series of impact evaluations finding that, at the margin, the average impact of microcredit is quite small, the inclusion successes of microfinance should not be dismissed. The modern microfinance movement – and broader efforts to promote financial inclusion – have been incredibly successful at bringing low-income households into the formal financial system.
As recently as 2010, estimates suggested that ‘half the world was unbanked’. The most recent data from the World Bank’s Global Findex suggest that those numbers had been cut by nearly a billion people by 2017, leaving just 31% unbanked.
A fundamental feature of poverty around the world is substantial volatility of income and expenses, which makes access to reliable and affordable financial services both very important and hard to come by (Collins et al, 2009). The microfinance industry has successfully found a business model that allows for offering credit (and, to a lesser extent, savings and insurance) at significant scale to customers that the traditional banking industry could not and would not serve. This has enabled poor households to engage in the kind of ‘consumption smoothing’ that allows them to cope with their volatile incomes.
Remarkably, the industry has survived, and even thrived, through significant previous crises that have caused major disruptions to more established parts of the financial system, such as the Asian financial crisis and the 2007/08 global financial crisis. While there have been localised repayment crises (Andhra Pradesh, Nicaragua, Bosnia) and epidemics (Liberia, Sierra Leone), the industry and most providers have managed to cope without much damage.
But as with so many things, the Covid-19 pandemic is different: no longer can MFIs trumpet the ‘99% repayment rates’ that have historically been so fundamental to their marketing pitch.
How has the pandemic affected microfinance customers?
The pandemic and lockdown have had a major negative impact on the typical low-income microcredit borrower. Most microcredit contracts require weekly repayments from customers, who have little in the form of savings and for whom the sharp drop in economic activity would have meant almost immediate defaulting on their loans. In response, regulators allowed a deferral of loan repayments in dozens of countries, including India, Pakistan, Bangladesh, Kenya and Nigeria (collectively covering more than a hundred million borrowers).
We conducted a survey of microcredit borrowers in Pakistan about a week after lockdown began. The intuition driving the repayment moratoria policies was confirmed: borrowers’ reported income had fallen by about 90%. Surveys in Bangladesh showed a 60-80% drop in income, with 70% of borrowers saying they could not make their next loan payment (Malik et al, 2020).
Similar stories have come from around the world. Lockdown caused a sharp drop in income for microcredit borrowers, and a concomitant inability to make repayments.
How have the payment moratoria and lockdown affected microfinance providers?
The payment moratoria were necessary: borrowers could not repay and would have been significantly harmed if they had had to scrape together the cash to attempt to make full repayments. But the relief for borrowers comes at a cost.
Clearly no lender can survive indefinitely if repayments stop, but the liquidity situation of lenders seems to be fairly strong so far. Some recent analysis finds that in a sample of large MFIs, more than half did have the financial reserves to cover more than six months of operating expenses without any repayments or other inflows (Rozas, 2020).
But the challenges of lockdown, social distancing and payment moratoria are potentially much more severe for MFIs than just a temporary halt to repayment.
Microfinance’s ‘high-touch’ business model, which has allowed for such rapid global growth and scale, is dependent on several features that have been disrupted. Many lenders keep costs low by having groups of borrowers meet together at a regular time and place each week to make repayments.
It is unclear how this system could work under lockdown or social distancing regulations. Most lenders around the world have dropped the ‘group liability’ contract that was a prominent part of early microfinance models, but the groups themselves still exist, a necessary mechanism that cuts the costs of customer service. They have a potentially massive downside though: when it is time for regular repayments to resume, members of the groups will see if others are repaying or not. The groups can as easily accelerate a ‘contagion of default’ as they can spread the virus.
The disruption to regular meetings also has implications for borrowers’ incentives. Indeed, this was a primary concern of microfinance leaders that we surveyed as part of our study in Pakistan. They expressed anxiety that messages from the government or from other microfinance lenders about not needing to make payments would be garbled or misunderstood by customers. That could lead to borrowers essentially going on a repayment strike either through confusion or strategic default. Without being able to issue new loans, lenders recognised that they lacked a credible threat to induce repayment of current outstanding balances.
CGAP (Consultative Group to Assist the Poor), a World Bank organisation that exists to support financial inclusion, is conducting a global survey of MFIs to assess the situation. While the majority of MFIs state that they do have enough liquid reserves to continue operations for six months or more without a resumption of repayments, the median MFI executive reported that the stress their institution was under was ‘severe’.
Across the world, ‘portfolio at risk’ (loans on which a payment has not been made for 30 days or four repayment cycles) is creeping up above 5%. That may not seem very high, but it reflects the fact that the moratoria – loans with no scheduled payment – are not being included. It is impossible to tell how many of those loans will resume repayment once moratoria are lifted. With a loan portfolio featuring rapid repayment and relending, a default rate of just 10% could quickly bankrupt an MFI (Rosenberg, 2009).
Past crises have faded without much damage to the industry, so why is this one a concern?
Microfinance’s expansion in terms of customers is often noted, but just as notable is its expansion in terms of capital. The industry has successfully tapped into global capital markets, in part based on evidence of a low correlation between the sector and the broader global economy. Investing in microfinance has thus been seen as a possible way to diversify investment portfolios. As noted, in the Asian financial crisis and the 2007/08 global financial crisis, which significantly affected major economies and financial institutions, the microfinance sector performed remarkably well.
Historically, there has been little connection between global capital markets and the economic lives of microfinance borrowers. When there were disruptions at the local level (for example, because of natural disasters) global capital markets were obviously unaffected – if an MFI had to forgive loans or forgo repayments, they could easily find investors to recapitalise. And when there were disruptions in global capital markets, the day-to-day economic lives of poor borrowers were similarly unaffected – the regular flow of repayments meant that the sector could just carry on until the crisis passed.
The Covid-19 pandemic has, for the first time, affected both global capital markets and local economies down to the poorest neighbourhoods. What that means is that in contrast to prior crises, the industry cannot count on one side or the other of the equation (global capital markets or local repayment) to cover shortfalls.
So while it seems that many MFIs can survive the short-term crisis, the long term is more concerning. Provided that lockdown ends and economies begin functioning again, MFIs may find it difficult to recapitalise. The capital structure of the industry relies to a significant extent on social investors who have been ‘crowded-in’ to the industry via explicit or implicit guarantees from development finance institutions (DFIs), such as the International Monetary Fund and the World Bank, and bilateral aid agencies. Those social investors in turn are crowding-in more profit-oriented investors.
The pandemic exposes the fragility of that capital structure. The DFIs and aid agencies are themselves going to be stretched (because of much higher demand for capital, plus uncertain inflows from the governments that fund them). That will put the social investors at risk, which will in turn cause for-profit investors to reassess the risk-return trade-off that the industry offers – particularly in the context of uncertainty about future repayment rates. While social investors have been pushing for coordinated action to address the issues, they cannot do it on their own and the DFIs have been slow to engage (Rhyne, 2020).
Could microfinance simply shift to a digital model?
One suggestion often heard is that the microfinance industry should just shift to mobile money and digital financial services (DFS) in order to cope with bans on in-person meetings. There are many challenges to doing so, which are significant enough that a digital transition by itself cannot be a solution.
First, many of the customers of MFIs are not yet users of digital financial service, including those who are illiterate. That presents a huge challenge: how can MFIs effectively teach their customers to use DFS, including good security practices, which are a challenge even for the well educated and technologically savvy?
The microfinance leaders in our survey did not even trust that communications via text message would be useful for and consistently understood by their customers. Some said that low literacy rates led to a risk that a text about payment deferral could be interpreted as a loan write-off and default of the MFI, with rumours quickly spreading on social media platforms.
Second, digital transitions are expensive for providers, requiring significant investment in information technology systems and running expenses for maintaining equipment and cybersecurity. In the current environment, it is unlikely that many would be able to make the necessary investments and recoup the costs before they run out of operational cash.
Other challenges include the unknowns about the effect of moving away from face-to-face transactions and what that might mean for repayment rates and loyalty, as well as the difficulty of competing with fintech companies and mobile money providers with more experience with the requisite technologies.
What should regulators and central banks do?
While regulators moved quickly to protect borrowers, there has been less certainty and consistency about what actions (if any) they should take to protect the microfinance industry itself. That is a consequence of the implicit bargain that the industry has made to enable its business model: the industry successfully argued that since the primary business of MFIs is to lend small amounts to otherwise unserved customers, a light regulatory touch was sufficient.
That light touch has been important because it keeps operational costs low and therefore allows workable business models while lending at (relatively) affordable rates.
So while in many countries regulators and central banks took steps to ensure the stability of the traditionally regulated banking system, MFIs were usually left out of programmes such as access to a liquidity backstop or borrowing windows.
In Pakistan, for example, in addition to the moratorium on debt repayment, the central bank was quick to introduce refinance schemes to help small and medium-sized enterprises (SMEs) to pay wages on time and a credit sharing facility on loans given to SMEs. It is worth noting that these facilities were only available for SMEs and not micro-enterprises that typically have very few (if any) full-time employees, or non-enterprise borrowers of microfinance that form the bulk of microfinance clientele and are often poorer. Further, few customers seem to be aware of these options (Pakistan Microfinance Network, 2020).
The pandemic has called into question the long prevailing consensus on regulation of microfinance. MFIs need support from central banks and regulators to survive the crisis and rebuild. This raises questions about what prudential regulation of the sector should look like. The uncertainty about customer protection in the face of payment moratoria and other policies to protect borrowers argues for stricter regulation in that domain as well.
At the same time, we have learned over the last decade that microfinance plays an important role in the financial lives of poor households, although it is a different one than had been imagined. Access to microcredit is important for households to manage liquidity so that they can smooth consumption and make big purchases. Microcredit also plays an important role in allowing households to move in and out of casual labour markets to protect incomes and consumption (Breza and Kinnan, 2018; Bauchet et al, 2015).
Protecting the liquidity and consumption of vulnerable households should be a key goal of regulators and central banks, which argues for concessional support for the microfinance industry. At the same time, it also argues for consumer protections that ensure that borrowers have the capacity to repay loans safely and reliably.
We are far from having a playbook that allows for regulators to thread the needle between regulation that protects the soundness of the banks for the poor, protects those customers and enables the industry to thrive. We will learn a great deal about those trade-offs in the years following the pandemic.
Where can I find out more?
Covid-19 and debt moratorium conundrum: The case of microfinance: Giorgia Barboni and Misha Sharma discuss the likely effects of debt moratorium for MFIs in India.
How are Indian households coping under the Covid-19 lockdown? Key findings: Marianne Bertrand, Kaushik Krishnan and Heather Schofield document the effects of lockdown on the income of households in India.
Urgent: A rescue plan for the microfinance sector: Ira Lieberman and Paul DiLeo draft key principles and structures to help the microfinance sector survive the Covid-19 recession.
Banking on human capital: What financial institutions need to do – now – to enable a Covid-19 recovery: Elisabeth Rhyne lays out guiding principles for financial institutions to recover from the Covid-19 crisis.
FinDev Gateway Covid-19 hub: A resource hub for microfinance and the global financial community.
Microfinance and Covid-19: A framework for regulatory response: CGAP summarises the six key steps for microfinance policy-makers.
FinDev data – tracking the global response to Covid-19: Covid-19 response data relevant for microfinance and financial inclusion compiled by FinDev Gateway.
Who are experts on this question?
- Timothy Ogden, Managing Director, Financial Access Initiative
- Jonathan Morduch, Wagner Graduate School of Public Service, New York University
- Elisabeth Rhyne, Financial Access Initiative
- Greta Bull, CEO of CGAP and director at the World Bank
- Daniel Rozas, European Microfinance Platform