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Enthusiasm for microfinance has surged since Professor Muhammad Yunus and his Grameen Bank shared the Nobel Peace Prize in 2006.

This November, APEC finance ministers will be asked to adopt an initiative on “financial inclusion” when they meet in Kyoto.

Unfortunately, this coincides with a wave of financialization of micro-lending, a phenomenon Yunus deplores.

As events unfold, micro-lending may come to provide an uncomfortable analogy, in terms of credit bubbles and systemic damage, with subprime home mortgage lending. APEC should avoid endorsing negative aspects of financialized microcredit.

Thinking about financial services for the poor has evolved since the 1980s, when Yunus pioneered micro-lending.

During the 1990s, the emphasis shifted to microfinance, seen as a range of financial services — deposits, transfers, remittances, even micro-insurance, as well as credit. Recently the idea of financial inclusion — access to formal services for all — has taken hold.

The arrival of a new class of for-profit investors, attracted by the high interest rates and low nonperforming loan rates of well-managed microfinance institutions, is transforming the industry.

Financialization in micro-lending takes forms familiar to mainstream capital markets, including creation of specialized microfinance investment vehicles (MIVs) and the use of securitization, collateralized debt obligations and structured finance, among other risk management tools.

Rating agencies support the industry and successful IPOs are occurring, increasing the allure of for-profit investment. Microcredit in developing countries has become a new asset class for metropolitan and domestic investors.

Data provided by the Consultative Group to Assist the Poor, a World Bank affiliate, suggest that at the end of 2008, the return on assets for microfinance institutions in many developing countries was higher than for commercial banks.

About 75 percent of microfinance investment vehicles (MIVs) dealt entirely or mainly in fixed-interest investments.

Some were socially focused and accepted lower returns; others offered structured products with a range of risk/return options.

Average gross yield on debt held by MIVs was a respectable 9.5 percent. Other MIVs were private equity funds.

This newest class had the highest rate of asset growth among MIVs. More than 100 MIVs held total funds under management of $6.6 billion at the end of 2008.

The negative impact of all this includes looming credit and private equity bubbles in at least one of the most advanced micro-lending markets, India.

There, according to a CGAP/JP Morgan analysis, equity deals by microfinance institutions are being done at up to six times historical book value.

This will surely have negative consequences for excessively leveraged institutions and over-indebted households.

Even more damaging in the long term is the shunning of domestic savings that financialization engenders. Access to investment funding disinclines microfinance institutions from seeking deposit-taking status, or from exploiting that status fully.

Many find it easier and cheaper to rely on external resources.

When financial institutions don’t mobilize savings, financial intermediation is hobbled.

Local deposits are a platform for grassroots financial development, and greater reliance on deposits reduces microfinance institutions’ vulnerability to external shocks.

Growing reliance on external resources may void these benefits. For poor households, the absence of deposit facilities denies important benefits to the self-employed, including vital learning and opportunity to acquire financial identity.

Savings offer them a buffer against misfortune, permitting consumption smoothing and management of lumpy income flows.

To the extent that it neglects or represses savings, investment in micro-lending does nothing to meet this complex bundle of needs.

There are advantages in borrowing from local banks. Loans are generally in local currency and such banking relationships may grow deeper over time.

Alliances with commercial banks may promise microfinance institutions financial services they cannot themselves provide, including savings or ATMs.

However, if domestic for-profit investment causes mission drift, or if it represses savings in particular sectors or social strata, there are compelling reasons to object.

Financially inclusive policy frameworks may offer poor societies an escape from contradictions posed by foreign-funded micro-credit, as could “distributed” financial institutions and systems.

Distributed financial systems, comprising financial “microgrids,” with self-sufficient local power centres and drawing capital from local communities, offer prospects for greater financial inclusion.

Distributed institutions, growing through savings accounts and local capital markets while offering responsible lending, could underpin a diversified and durable financial system.

For microfinance institutions in developing countries, this model poses a credible alternative to current preoccupations with cross-border financing.

The APEC Business Advisory Council should comprehend this alternative, among whatever others it considers, in its campaign for financial inclusion in APEC economies.


John D Conroy is a participant in the Advisory Group on APEC Financial Sector Capacity Building.

East Asia Forum