Lending a hand in poor countries

Lending Strategy March 2010

Whenever we talk about microfinance and the concept of banking for the poor the first name that comes to mind is Dr Muhammad Yunus, founder of Grameen Bank and microfinance pioneer who in 2006 received the Nobel Peace Prize for trying to “create economic and social development from below”.

His work on structuring financing in Bangladesh revolutionised thinking on how to lend to the underprivileged. In many poor countries most people work in the agriculture sector, buffeted by unpredictable events and living in villages that lack infrastructure. This makes the cost of establishing a formal banking network prohibitive.

But microfinance is no longer the sole preserve of Dr Yunus. In 2003 a lecture he gave inspired the foundation of Kiva, a not-for-profit San Francisco-based facility that allows individuals to lend money via the internet to finance institutions in developing countries. They in turn lend the money to small businesses. Kiva is supported by loans and donations from its users and via partnerships with businesses.

Microfinance institutions around the world known as field partners can post the profiles of qualified local entrepreneurs on the Kiva website. The public can then browse and choose an entrepreneur they wish to fund.

Kiva aggregates loan capital from individuals and transfers this money to appropriate field partners to disburse to the entrepreneurs chosen by individuals who become lenders in their own right.

As entrepreneurs repay their loans field partners remit funds back to Kiva. As loans are repaid lenders can withdraw their principal or reloan it to other entrepreneurs. Field partners charge interest to their borrowers and lenders do not receive any.

Thanks to Kiva, lending to the poor is no longer constrained by national boundaries or financial institutions. Pretty much anyone with a keyboard can lend money to anyone else.

The previously excluded poor can become part of a functioning financial dynamic. With this comes the culture of borrowing and repayment crucial to the development of a successful economy

Here’s an example. A woman in Cameroon goes online seeking a $200 loan for her tailoring business. She makes her case and a man in Scotland lends her $25, someone in Sweden lends another $25 and the balance is covered by someone in Spain. The loan is made for a set period for a pre-agreed interest rate and she updates lenders on progress.

Since its foundation in 2005 Kiva has been a fantastic success story. By the end of 2009 it had distributed $110.67m in loans from 631,345 lenders. A total of 157,207 loans have been funded. The average loan size is about $400.

Kiva’s website now ranks in the top 15,000 on the internet. The cost of running the facility in 2008 totalled $4.7m and the user base released some $37m to low-income entrepreneurs.

So for every dollar spent on operations Kiva’s lenders made about $8 in loans. And unlike with aid, default rates are minimal. The current repayment rate is 98.13%. The previously excluded poor are thus made part of a functioning financial dynamic. With this comes the culture of borrowing and repayment crucial to the development of a successful economy. Small-scale banking to poor people has the capacity to generate enterprise and encourage growth.

Phoebus has decided to get involved with Kiva and try a bit of lending. Although the clients we provide software to loan billions of pounds every year we’ll be lending on a rather more modest scale. We will dip into our charity fund to the tune of £5,000 a year to finance ventures in less developed corners of the world.

In later articles we will update you the decisions we make and the progress of our borrowers.

Hopefully, our loans will be in good shape but don’t worry, we don’t plan on moving into the lending market. Although 90% of our staff have lending experience our focus remains on being a software provider.

Problems on the Ivory Coast
Even with all this experience on our side, lending through Kiva is not without its risks. In July 2008, it discovered that fraud had taken place with one of its field partners - an organisation based in Ivory Coast.

Activities with the organisation were suspended and after an investigation followed by the negotiated repayment of loans, Kiva cut all ties.
But which mortgage lender based in the UK can hold its hands up and say it has never been on the receiving end of a capable fraudster’s sharp practices?

Kiva’s extremely low defaults have also been called into question. A field partner may pay it for loans defaulted to the partner just to maintain good credit. Whether interest rates collected by field partners are enough to pay for significant defaults depends on local economic conditions.

Despite these problems some people, including Dr Yunus, have argued that the interest rates of many microcredit institutions are unreasonably high.

Dr Yunus says that microfinance institutions that charge more than 15% above their long-term operating costs should face penalties. For example, in 2009 micro loans from Kiva partners in Guatemala averaged 23.16% for the equivalent of $430 lent on average. This can be compared with the commercial Latin American BanRural rate of 24.5% for a loan of $635.

The inflation rate for Guatemala typically varies between 5% and 10% but it was just 0.62% in 2009.

Kiva defends its interest rates by saying its partners provide better rates than local alternatives and it must charge what it does because the costs of making a micro loan in the developing world are higher than for a larger loan in the West.

But given the increasing number of microlenders it is inevitable that the rates charged will become more competitive in time.