ROLE OF COMMERCIAL BANKS IN MICRO FINANCE SECTOR

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Management of Financial Institutions - MGT 604

Lecture # 21

ROLE OF COMMERCIAL BANKS IN MICRO FINANCE SECTOR

Microfinance in its broadest terms can be defined as provision of a range of financial

services such as deposits, loans, payment services, money transfers and insurance to poor

and low income households, and their micro enterprises (Source: Asian Development bank

report on microfinance development strategy). While a commercial bank is a financial

institution that offers a broad range of deposit accounts, including checking, savings, and

time deposits, and extends loans to individuals and businesses.

The decision as to whether the commercial banks be involved in microfinance is a sensitive

and debatable issue which requires a deep analysis of many factors.

Primarily, the microfinance customers are large in number, scattered in far-flung areas with

very minute transaction sizes. Only government or state bank alone cannot reach out to

millions of potential Microfinance beneficiaries; a whole well knitted network with almost

doorstep reach is required, which is only possible when the commercial banks will be

involved in microfinance. In Pakistan it is estimated that as many as 5.6 million households

need microfinance services but these services reach only to less than 1 percent, most

probably because of the absence of commercial banks from the microfinance sector.

(Source: Pakistan microfinance Network PMN) This way a poor person just need to visit his

local commercial bank to get access to microfinance benefits, which will help reduce many

economic problems.

One criticism over involving the commercial banks in microfinance is that commercial

banks will charge higher interest rates, further lower the standard of living and will exploit

the public. The ground realities are totally different; empirical evidence has demonstrated

that participants in microfinance programs have improved their living standards at both the

individual and household level, and that this has provided increased educational

opportunities for children. For example, the clients of the Bangladesh Rural Advancement

Committee increased household expenditures by 28% and assets by 112%. It was also

demonstrated that Bangladeshi children were sent to school in larger numbers and stayed for

a longer time almost all girls in Grameen Bank (A commercial bank!) client households

had some schooling, compared with the rate of 60% in non-client households. (Source:

World Bank group, 30 August 2005) No doubt on the other hand the loans provided by the

commercial banks to the microfinance beneficiaries are a bit expensive, its not to discourage

the poor but there is a sound reason behind it; Providing financial services to poor people is

quite expensive, especially in relation to the size of the transactions involved. A $100 dollar

loan, for example, requires the same personnel and resources as a $2,000 one thus

increasing per unit transaction costs. Loan officers must visit the client's home or place of

work, evaluate creditworthiness on the basis of interviews with the client's family and

references, and in many cases, follow through with visits to reinforce the repayment culture.

It can easily cost US$25 to make a micro loan. While that might not seem unreasonable in

absolute terms, it might represent 25% of the value of the loan amount, and force the

institution to charge a "high" rate of interest to cover its cost of loan administration.

If commercial banks are to be involved in the micro finance by no means it would be a

wrong decision for them as regard to their primary aim, profitability. Yes it can. Data from

the Micro Banking Bulletin reports that 63 of the world's top MFIs had an average rate of

return, after adjusting for inflation and after taking out subsidies programs might have

received, of about 2.5% of total assets. This compares favorably with returns in the

commercial banking sector and gives credence to the hope of many that microfinance can

be sufficiently attractive to mainstream into the retail banking sector. Many feel that once

Management of Financial Institutions - MGT 604

microfinance becomes mainstreamed, massive growth in the numbers of clients can be

achieved.

According to a recent analysis conducted by the Consultative Group to Assist the Poor

(CGAP), the compound annual growth rate of the world's leading microfinance providers

over the last five years has been a whopping 15%. Worldwide, these leading Microfinance

institutions are nearly twice as profitable as the leading commercial banks. The trend is not

new. In fact, in the last decade, microfinance has been a more stable business than

commercial banking in emerging markets. During Indonesia's 1997 financial crisis, for

example, commercial bank portfolios imploded, but loan repayment among Bank Rakyat

Indonesia's three million-plus micro-borrowers barely declined at all. During the more

recent Bolivian and Colombian banking crises, microfinance portfolios suffered slightly, but

remained substantially healthier than commercial bank portfolios, and the microfinance

institutions remained more profitable. (Source: The banker, 04 July 2005)

There are 70million savings and loan accounts in the world in micro finance sector and

about 80 percent of these accounts are savings rather than loans, suggesting that poor

entrepreneurs often have to save to accumulate capital for investment rather than the faster

if higher-route of borrowing it. Thus it's absolutely favorable for the commercial banks to

operate in the micro finance sector. For example in India ICICI bank, which has a large

network of local branches, entered the micro finance market in 2001 and increased its

portfolio from US $16m to US $63m in two years. (Source: Financial Times, 14 September

2005)

I see the commercial banks in micro finance in action, independently...without any

government back, mandate or subsidy.

On the whole microfinance is not an area commercial banks want to overtake. The majority

of commercial banks that undertook microfinance lending were because it was required of

them by their governments. Research findings came from in-depth interviews with over 40

bankers in 22 banks in India, the Philippines and Australia, and from speaking with 17 other

banks in the other seven countries covered in the study. A great deal of microfinance

undertaken by commercial banks was found, but it was undertaken because of government

mandates to lend to this sector rather than for business reasons.

(Source: The Role of Commercial Banks in Microfinance: Asia-Pacific Region Ruth

Goodwin-Groen, 1998)

The involvement of commercial banks in micro finance is important because all those micro

finance programs, which were directly run or backed by the government, faced a total

failure. Sustainability and scale in microfinance by commercial banks were only found in

the market-based programs when assessed on the basis of achieving both high portfolio

quality and significant scale of outreach to the poor, most of the commercial bank

microfinance programs that were mandated by governments can only be considered as

failures. The exceptions were those programs that charged a commercial rate of interest.

They had a higher portfolio quality than other programs but they were still not profitable.

This almost universal failure is not explained by the different policy contexts across the

Asia-pacific region. Further, because microfinance has not been a profitable business,

government mandates have been unsuccessful in encouraging commercial banks to become

involved in microfinance. The banks must have the incentive to design better products for

micro entrepreneurs, which can be profitable.

Management of Financial Institutions - MGT 604

A real world example of a successful micro finance commercial bank is of BRI's Unit Desa

system (its microfinance arm) has the best financial results of any microfinance institution

in the world. In 1996-97 it earned a profit of $170 million on loans of $1.7 billion to 2.5

million clients, with no subsidies. This is an approximate return on performing assets of 10

per cent a very competitive rate by commercial standards. The success of BRI's Unit Desa

systems can be attributed primarily to the fact that the system has adhered to the

fundamentals of banking and finance for the rural micro entrepreneurs, including the

provision of competitive savings services. The microfinance savings and loans of the Unit

Desa system perform consistently for BRI and continue to grow quickly. BRI's

microfinance business may not compete with the most spectacular returns, but it does

achieve these strategic goals. (Source: The Role of Commercial Banks in Microfinance:

Asia-Pacific Region Ruth Goodwin-Groen, 1998)

The types of commercial bank involvement in microfinance can be classified as;

government-subsidized lending programs channeled through the banks, government

mandated lending targets met by banks subsidizing interest rates, government-mandated

lending targets with banks charging commercial interest rates and microfinance as a

profitable business. Only the last one "micro finance as a profitable business" has seen

success. Thus the involvement of commercial banks in micro finance sector should not be

based on any government mandate, subsidy or target. The sole benefit of the society as well

as commercial banks is the adoption of micro finance as a business. (Source: The Role of

Commercial Banks in Microfinance: Asia-Pacific Region Ruth Goodwin-Groen, 1998)

Involving commercial banks in micro finance would be a step to take these services at the

doorstep of the potential customer, because if only some government agency or state bank is

involved the extensiveness as regard to area covered cannot be brought.

On the other hand commercial banks need not to make any special arrangements to cater for

micro finance operations. Only a new "micro finance" counter might be needed in the

existing branches. Thus there would be no high setup cost for the commercial banks to

venture into this sector.

In short I see micro finance as a very promising sector for commercial banks and on the

other hand simultaneously it would help the standard of living to rise; and attached with it

the literacy rate, employment level, socio-economic development would also take place.

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