The financial crisis and microfinance: Risks and rewards

March 18, 2009    

Recent evidence so far indicates that the global financial crisis will stress the microfinance sector and its clients, but the sector is fundamentally robust and may emerge even stronger than before. The crisis has highlighted the role of local sources of funding for microfinance. As international funding dries up, local deposits are becoming even more critical to fuel microfinance institutions’ lending.

“Low-income clients are feeling the effects of the global crisis, and microfinance institutions are under stress,” says Elizabeth Littlefield, CGAP CEO and a co-author of The Global Financial Crisis and Its Impact on Microfinance. “But deposit-based institutions that do not depend on international capital markets for their funding are less exposed to the fallout in the international banking sector.”

Littlefield and co-author Christoph Kneiding point out that poor households that were already reeling from the increased cost of food are now being affected by the drop in remittances from family members abroad as job losses mount in Europe and the United States. These households are sometimes struggling to repay loans to microfinance institutions, but although there has been an increase in short-term arrears, there have been no defaults.

Refinancing risk is a more immediate concern for microfinance institutions than loan defaults. And it is those institutions that depend on international capital markets for funding that are feeling the pinch most: “Microfinance institutions have become more integrated into the mainstream financial system, and so they are more vulnerable to market shifts like credit contractions than they were in the past,” says Littlefield.

Near-term Challenges
In the near term, institutions will face nearly unprecedented challenges. For example, research suggests that remittances are declining noticeably at a time when many family budgets in developing countries are already under pressure from higher food prices—the legacy of the price shocks of the first half of 2008. Remittances will continue to decline in five out of six developing regions this year and next, according to the World Bank. That said, some report increases in remittances because home markets are seen by workers abroad as safer than foreign markets. Also, the strong dollar can mean more local currency for each dollar sent.
Many microfinance institutions who borrow in foreign currency are facing both interest rate hikes and currency depreciation due to a strong U.S. dollar. Currency dislocation will challenge institutions’ ability to raise financing and match assets to short-term liabilities, which are predominantly priced in hard currencies.

In Africa, some European banks have asked microfinance institutions to prepay loans, and some international banks have been pulling out of the sector altogether. Because much of the financing of these small lenders matures in one or two years, the real extent of the squeeze may not be evident until 2010 or 2011. Microcredit financial institutions that anticipate a sharp downturn in available credit may begin taking actions to protect themselves by limiting lending to their current clients, by extending smaller loans, or by not renewing loans at all.

Although this approach might make sense in the near term, Littlefield and Kneiding argue that these steps could well backfire on lenders—their borrowers may decide to default on their existing loans if they feel there is little chance of future credit.

This is where the support of donors and investors becomes critical. They should continue to stand by well-managed microfinance institutions that are facing liquidity shortages, helping them reschedule loans or, if necessary, providing emergency funding to viable institutions to help them through the crisis.

Governments in developing countries can play a critical role in supporting the microfinance sector through effective regulation and legislation. But while legislators in poor countries are rightly concerned about ensuring that their citizens have access to financial services, responses such as loan forgiveness or interest rate caps would be shortsighted and could, in the long run, hinder poor people’s access to sustainable financial services.

Back to Basics
The message for the microfinance institutions navigating the crisis, meanwhile, is “back to basics.” “We’ve seen phenomenal growth in microfinance in recent years,” says Littlefield. “And while the slowdown will have costs for individuals and could curb widespread expansion of access in the short term, in the long term the microfinance sector could emerge from the crisis stronger. Slower growth, more attention to efficiency gains to cut costs, a greater emphasis on communications and caring for customers, and even consolidation of weaker institutions into stronger ones would all be good outcomes that would strengthen and shore up microfinance in the long term.”

In particular, the global financial crisis may accelerate long overdue consumer protection measures that will shape the future of responsible lending. Most importantly, the crisis has revealed the value of deposit-taking by microfinance institutions as deposits provide a stable funding source and at the same time provide much needed deposit services for poor households.