To profit or not to profit (part I)

After two months here, it's about time I got around to explaining what this microfinance stuff is all about. This is going to require several entries, so bear with me. There are a plethora of models around in the microfinance world so in the interests of ease, here's a stab at classifying them. Perhaps the most contentious division and that which splits the microfinance world in two (not in terms of 50% of assets fall into each camp, more in terms of two very different points of view), is the for-profit vs non-profit model. Each model has its proponents with varying justifications as to why their world view is better. Each model also has a range of incarnations with varying service levels and product offerings. But let's make one aspect clear at the outset: they all charge interest, and they all expect the loan capital to be paid back. Helping the poor microfinance may be, but charity it ain't.

Let's start with the non-profit version. ECLOF Peru, whose offices I work in, are of the non-profit mould. Thus interest is charged on loans, but there is no profit taking out of this interest. All proceeds are used to pay operating costs and whatever is left over is capitalised and used to make further loans. ECLOF International in Geneva is the head office of the ECLOF empire. It is an organisation that was set up after the Second World War to help in the reconstruction of churches bombed by various parties. In 1971, after its primary mission had been completed, it transformed itself into a development organisation. In part due to ECLOF's roots in the Christian faith its view of how to implement microfinance in practice is grounded in values of support, justice and humanity. This means that whilst charging what almost anyone in the developed world would consider at first glance a seriously steep interest rate, when viewed in context the reality is that ECLOF Peru's clients are actually getting a decent bang for their buck.

When people from the impoverished parts of Peru with few assets and no home ownership walk into a Peruvian retail bank (Interbank, Scotiabank, Banco Continental, Banco de Credito) and ask for a loan, they'll politely be told that their financial situation disqualifies them. End of conversation. So the next place to turn to might be a loan shark in the street, happy to lend money to all and sundry at his attractive interest rate of 100% p.a. or higher. Step in the microfinance institutions (MFIs). Even the for-profit types charge far better rates than this. These might range up to 60%. Still high, but more manageable. ECLOF Peru's policy is to charge 2.5% per month. Annual equivalent rate 34.49%.

The story does not end there however. Even in the non-profit space, the range of services provided by the MFIs varies from the warm and cuddly to the cold and distant. A characteristic of the microfinance client base which I had failed to appreciate prior to arriving here is a lack of what in the developed world we take for granted: an understanding of the most basic financial instruments. Many of the people who want to borrow money have never encountered the fine print of a loan agreement. Overdrafts and credit cards, means by which most of us become acquainted with the pleasant minutiae of compound interest are non existent in this segment of Peruvian society, where even holding a bank account is a rare thing indeed.

Thus ECLOF Peru provides financial and business training to all of its loan clients. This takes the form of workshops run by ECLOF Peru's analysts attended by anywhere from five to twenty new clients. This service is free, or the price is included in the interest rate charged on the loan, however you want to view it. On top of this there's a significant amount of hand-holding, particularly with clients taking out their first loan. Reminders are hand delivered a week in advance of a repayment date and analysts are available on the end of a phone or in the office to resolve any problems. No six option automated phone lines here. On the other hand, some of the non-profits simply hand over the cash and say "let's have that back in six months please with 40% annualised interest" and on to the next client. The ECLOF Peru approach of hands-on service yields one very positive financial benefit: default rates across the portfolio of less than 2%. By contrast the biggest microfinance player in Peru (one of the two beasts of the market with a loan pool of $345 million at the end of 2006 versus ECLOF Peru's $2.2 million), Banco del Trabajo, has a write off ratio above 10%.

The effect a default has on a client's borrowing potential at this end of the income spectrum can be devastating. Even an organisation like ECLOF Peru which seeks to help the least enfranchised at the "base of the pyramid" (on oft-used phrase in development circles) has to keep its financial risk wits about it. Lending to individuals with no assets to use as collateral, nor much in the way of income, with a previous black mark, or several, against their name is not going to prove a solid foundation to building a sustainable lending business.