Muhammad Yunus and Grameen Bank received the 2006 Nobel Peace Prize for pioneering the Microfinance revolution. Visionaries such as Fazel Hasan Ahmed of BRAC, who was recently knighted, and John Hatch, the founder of FINCA and the creator of Village Banking (not surprisingly, Grameen also means Village) were also the forerunners in this revolution. Though the word Microfinance does encompass microsavings and microinsurance, the focus of the initial efforts for nearly two decades in 1980s and 1990s was on microlending that involved microloans as small has $50 or $100.
What is remarkable about the various microlending models is the fact that the small loans are made to entrepreneurs without any physical collateral and despite the lack of physical collateral, the repayment rates have been unusually high -- over 95% in many cases. Despite such high repayment rates, it has proved extremely difficult to create self-sustaining and economically viable models of microlending that do not rely not some form of explicit or implicit subsidy by governments, charitable organizations and socially conscious individuals who are willing to sacrifice their time and talent at levels of compensation that are way below what they could earn in many other jobs available to them.
Three questions come to mind. Why use debt (as opposed to, say, equity)? Why are repayments rates high despite any lack of collateral posted by borrowers? Why has it been difficult to make money or even break-even despite such remarkably high repayment rates?
The answers to these three questions, it turns out, are related. Equity-type contracts require that entrepreneurs pay a fraction of what they make to their financiers. But that requires the financiers both observe what entrepreneurs are making and be able to enforce the stipulated terms of the equity contracts (these arguments were exposited in seminal papers by Professor Robert Townsend and Professor Douglas Diamond of the University of Chicago). If costs of such verification are very high, as they are likely to be for small loans, it would make no sense to write such contracts. Debt contracts are simple because they do not require financiers to audit what the entrepreneurs are doing with their money but be able to impose a sanction if the entrepreneurs fail to repay the principal and a pre-determined interest on the loan. For microloans, even the costs of enforcement, as a proportion of the loan amount, can be extremely high, which explains why interest rates charged often seem unusually high (read my blog and one by Beth Rhyne on this). The only way out then is to rely on contracts that are self-enforcing, in other words, create incentives so that entrepreneurs want to repay on their own without requiring any external enforcement.
It is often argued that if you create a system in which borrowers who default on their debt contracts are denied further credit in the future, it would provide an incentive to repay their loans. That argument is incomplete because unless the borrower had a prospect of borrowing more than what she was supposed to repay in principal and interest, her incentive to default are great because she could, in effect, default and become her own financier. But even the ever-increasing loans do have to reach a maximum at which point the incentive to default is great and working backwards, the argument falls apart. One possible reprieve from this hopeless conundrum is if the borrower begins to build some assets as she borrows ever-increasing amounts which she can eventually use as collateral when she "graduates" from borrowing from the microlender who does not require a collateral.
To make this work, then, two conditions seem necessary. One, design micro-contracts that do not require expensive monitoring or enforcement. Two, create an incentive, perhaps the possibility of being able to borrow at a low rate eventually when the entrepreneur "graduates" from micro-financing phase. But, if we are going to rely on self-enforcing incentives, we do not need to insist on debt contracts. Equity-like contracts would work just as well because we would rely on self-reports by entrepreneurs in the first place. Welcome Microequity!
Marco Lucioni, CEO of Confianza-USA, appears to be following a model that is similar in spirit to what I describe. He finances entrepreneurs in Los Angeles who directly pay a fraction of their credit-card sales to him. This makes it an equity-like contract. However, until recently, this was still, what he described, as "high-touch" business requiring substantial monitoring which in effect raises financing costs substantially. But recently he partnered with Opportunity Fund which finances relatively larger loans at reasonably low interest rates. Bingo! Now, if his "high-touch" customers could be given an incentive that they can graduate to larger loans funded by Opportunity Fund, perhaps it would alleviate the need for expensive monitoring. This is what we discussed at the Microfinance USA 2010 conference in San Francisco recently that I was invited to by Eric Weaver, CEO of Opportunity Fund.
At the conference, I also met Shivani Siroya, Founder and CEO of InVenture Fund, who appears to be converging to a similar model. Dylan Higgins, co-founder and CEO of SaveTogether, Lisa Kant and I brain-stormed at the conference and figured that if InVenture could help entrepreneurs save and build assets and partner with a bank that the entrepreneurs could graduate to, InVenture's microequity model might work as well.
There are a number of attractive features of microequity over microloans. First, microequity automatically provides microinsurance to the entrepreneurs. If business is down and sales are low, the entrepreneur's repayment burden is automatically reduced. Thus, it aligns the interests of entrepreneurs with interests of financiers. Also, in many countries practicing Islamic finance, payment of fixed interest rates is prohibited and thus microequity offers a viable alternative to serving the needs of small, poor entrepreneurs. It is time for both academics, like myself, and practitioners, such as Marco and Shivani, to fine-tune the theory and the practice, and explore the promise of Microequity.
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