One silver lining of the COVID-19 pandemic has been the time to stop and reflect on matters we may have previously taken for granted. At the outset of the crisis, CGAP decided to focus on support to the microfinance sector as one of its priorities, reckoning that the sector was likely to come under significant strain. It has become evident over time that the economic fall-out is not going to be a hard, one-off shock, but rather a rolling series of crises that will play out over months and even years, as the disruption and uncertainty caused by the pandemic flow through the world’s economies. As we move into the autumn of 2020, the focus is shifting away from immediate liquidity needs and damage control to building a stronger and more resilient microfinance sector for the future. When discussing building back better, the need to digitize is reflexively offered as a solution. But rarely do we explore why this might be a solution, nor what it would take to bring microfinance more fully into the digital age. It also bypasses some uncomfortable conversations we might need to have about the microfinance business model and its durability in the digital age.
I would suggest that there has been a need for traditional microfinance to face the challenge presented by digital technology for some time: the pandemic has simply accelerated this process. In this essay, I will lay out why I think it is worth investing in digital transformation of traditional microfinance, and why it is imperative for the sector to take transformation seriously. I’ll also speak to the challenges of digital transformation and offer some ideas about the opportunity digital presents. Finally, I’ll discuss the role of different players in the inclusive finance ecosystem, as I think it is unrealistic to think that microfinance providers will be able to make this transition without external support.
Why Microfinance Institutions (MFIs) Matter
I interviewed a number of long-time industry observers in producing this essay and, when I explained what I wanted to explore, a common question was, “Why are you focusing on MFIs?” -- the implication being, “Why bother?” There are so many exciting things happening in the world of fintech, why would anyone care about MFIs? My short answer is that they matter in the lives of poor people. They matter in the same way that Community Development Finance Institutions (CDFI) matter here in the United States: they provide suitable financial services to low-income and excluded segments on affordable and responsibly delivered terms.
The subtext of the response from industry observers, of course, is that they feel there are digital challengers emerging that will overtake microfinance institutions and can simply do the job better. That may ultimately prove to be true, but in my view, it is currently too soon to tell. While we do have evidence that technology-enabled business models are nimbler and better able to scale, it is not yet clear that these digital challengers can deliver the same services responsibly, especially for the kinds of returns expected by their investors. Nor is it clear that they will reach the poor in any meaningful sense, particularly with products aimed at supporting sustainable livelihoods at the lower end of the income scale.
It is worth examining this question through the lenses of both scale and impact, because I would argue that MFIs have done a pretty good job on impact but have been less successful on scale. And digital challengers are easily achieving scale but may not be bringing the same kinds of services to the market, much less delivering them responsibly. But that situation may be changing, and that should be a wake-up call for traditional MFIs.
In the early days of M-Pesa, the buzz in the financial inclusion community was all about M-Pesa being a superior model to microfinance because it could achieve scale. But M-Pesa wasn’t delivering the same service as MFIs: M-Pesa was building a payment system. Traditional payment systems like Visa and MasterCard have many more customers than any one bank in their networks. They provide a large-scale networked service and leave other client services like loans and savings to their member banks. MFIs essentially fulfill a similar function to banks in this analogy, only they provide lending for productive purposes to people without collateral or credit histories. The problem for MFIs is that digital payment providers like M-Pesa are rapidly becoming platforms for the delivery of many other financial services by third party providers, and some of those solutions are starting to look a lot like digital microfinance. Companies like Aye Finance in India, TiendaPago in Peru, KopoKopo in Kenya and Konfio in Mexico are demonstrating how to do productive, cash flow-based lending in a more efficient, customer friendly and scalable way than traditional microfinance. And these companies have the APIs, the data, and the tech capabilities to do this at scale, adapting to serve the changing needs of their customers over time.
Scale is the elephant in the room for microfinance institutions, because it matters both for reasons of competitiveness and resilience. Todd Watkins recently produced an interesting analysis of data from the 2015 MIX dataset1 demonstrating that the average all-in cost of borrowing from a small or medium-sized MFI (up to 100,000 clients) is almost 60 percent higher than the cost of borrowing from a very large one (defined as over 1 million clients). And very large MFIs not only offer customers a better deal, their profit margins are around 2.5 times greater than for small and medium-sized institutions. Clearly, if MFIs wish to stay competitive and build their own institutional resilience, they need to get to scale. Unfortunately, only 560 MFIs from the MIX sample had over 100,000 borrowers and only 62 had more than 1 million. Scale remains a serious challenge in microfinance. And this means that product diversity, institutional resilience and cost to the customer remain sub-optimal in the vast majority of MFIs, which in turn makes them an easy target for digital challengers, which have scale and efficiency built into their business models from the start.
But are those new business models reaching the same underserved customers as MFIs? While new digital models have proven their efficiency and ability to scale, I think there is far less evidence that they are reaching the poor. The fintechs described above are likely reaching more formal parts of the micro and small enterprise (MSE) market, since their ability to reach small merchants who lack digital means of payment acceptance is limited. However, as platform-driven business models increasingly find ways to digitize and provide credit to small and informal merchants, this may change. MFIs would do well to observe these trends and find ways to incorporate them into their own businesses, either by building their own capabilities or partnering with fintechs, which often need a financial institution to underwrite their data-driven lending.
The bigger concern is whether these products are being provided responsibly. The explosion of high-cost, digital credit across much of Africa, and the predatory practices that have often accompanied it, provide a cautionary tale about the potential risks that can arise when high tech business models with hungry investors try to serve low-income and marginalized communities.
There will likely be a floor to what these new fintech models can accommodate in terms of serving low-income clients. But the risk is that over time, MFIs will be boxed in and left to serve increasingly marginal customer segments, which would keep them sub-scale, preventing them from growing and evolving with their best clients. If microfinance remains small and marginalized, then it will not only leave many poor people with few options other than high-cost digital consumer credit, but it also means that MFIs will remain vulnerable to crisis and dependent on external support. Some may not survive.
In this context, I see a strong case for redoubling our focus on the microfinance sector - which has a long track record of serving poor communities - and helping MFIs adapt and transform for the digital age. Microfinance represents an opportunity to build a community banking system that serves the poor rather than extracting value from them, much as CDFIs do for low-income and marginalized segments in the United States. For this reason alone, I think it is worth the continued investment in microfinance, at least until it becomes clear that challenger models are able to reach far down market and to do it responsibly. Will MFIs be wildly profitable? Probably not. But they can be self-sustaining, and they do have impact on poor people’s lives. Scale remains a real problem, and digitization is not a silver bullet. But by taking a long, hard look at business models and rethinking how MFIs operate, digitization represents an opportunity for the sector to retain a competitive position and to thrive by providing responsible services to their low-income customers.
What Have We Learned About Digital Transformation?
The task of bringing traditional microfinance into the digital age will not be a trivial one. As technology has shaken retail financial services to its core, microfinance seems mired in a quaint world of service delivery where nothing much seems to have changed. Many MFIs are based on a high-touch no-tech business model that was designed 50 years ago for simplicity and replication, not for adaptation and growth. There are many ways that technology can be used, but it is becoming increasingly clear that there are four main categories of change that are going to matter most as MFIs transform:
- Channels. One of the most important insights from the COVID-19 pandemic is a need to find new ways to reach and interact with customers, not just because we have to observe social distancing, but because even in normal times, people value convenience and services that reflect their needs. Many providers have by necessity started building alternative channels in response to the pandemic, including expanding the use of agent networks, remote customer on-boarding and enhanced use of call centers. This trend will continue, either through integration with larger platforms or building the institution’s own channels. When done well, it has the added benefit of lowering costs and expanding reach.
- Use of data. Data is increasingly central to financial services business models, and this trend will only accelerate. Yet MFIs have long struggled with digitizing and managing customer data. Their ability to gather and use relevant data is central to many of the changes they need to make to compete, from risk-based pricing to effective credit risk management, from new product design to customer relationship management, from improving operational efficiency to growing the portfolio over time. The longer MFIs take to build these capabilities, the further they will fall behind more nimble competitors.
- Product diversification. MFIs will either need to broaden the services they offer in a way that meets customers’ demands and enhances loyalty or find a way to make the services of third parties available without losing the customer relationship. There is a certain customer stickiness in offering a range of complementary services. But to achieve product diversification, MFIs need better data, as well as more sophisticated back-office capabilities and technology skills.
- Flexible core systems. Underlying all of this is a need to build more flexible core IT and data management systems, which have traditionally been a weakness for MFIs. The ability to evolve and adapt business models and their reflection in more agile IT systems is increasingly a defining factor in the digital age. With cloud computing and Banking as a Service (BaaS) providers now meeting this demand in the banking industry, shared IT solutions could become a game changer for the microfinance industry. MFIs would need to invest in some skills and infrastructure, but a vendor solution would require less investment than transforming on their own.
While the direction of travel is becoming increasingly clear, there are a number of challenges in traditional microfinance models that will be serious impediments to digitizing, many of which speak to fundamental weaknesses in the business model itself, including weak governance, difficulty attracting technical expertise, inadequate resources, rigid business models, and a heavy reliance on manual processes, to name a few. Over the last 10 years, many MFIs have experimented with digitization, but they have mostly done this using donor funds in ways that studiously avoided challenges to the core business model. One of the key learnings from this work is that it is hard to avoid examination of the core business model in a more digital future. An MFI may think it is just introducing a channel or a data scored credit product as a tweak to its business, but such changes are likely to ripple through the organization in unexpected ways. And so, the core business model must evolve.
How Should We Approach Digital Transformation?
Change is going to involve more than just investing in technology. It is necessarily going to involve a long hard look in the mirror. And that kind of change management is hard to do. Given this, I think a few conditions need to be in place for an MFI to even consider undertaking digital transformation:
- Understand customer needs. An MFI should ground its transformation in a solid understanding of what customers need and are willing and able to pay for. This should be the foundation of its long-term vision and will ensure that core customers stay with the MFI as it grows. Microfinance has been characterized by a business model that is simple and easily replicable, but successful MFIs have for the most part prospered by evolving over time to match their customers’ needs and aspirations.
- Clear strategy. Once an MFI has a clear idea of where it wants to go, it then needs to outline a business plan and the technology changes required to get there. It is not just a question of putting a technology solution on top of an inefficient business model. That is a recipe for perpetuating a sub-standard operating model. A clear-eyed view of the challenges and what it will take to overcome them is crucial. Based on this, a fully costed business plan should be developed and agreed with the board.
- Commitment and focus. Digital transformation is a massive exercise in change management and requires rock solid commitment from the board all the way down to loan officers. If key institutional stakeholders do not understand what the institution is doing and why, it makes it very hard to enact change. Alongside this comes a question of culture. The adaptive mindset that is required for digital transformation is completely counter to how most financial institutions operate. You can’t just tack a digital offering on top of a traditional bank and declare victory. The institution has to be willing to potentially cannibalize parts of its current operating model to make a transition to a new one possible. Similarly, an ability to stay focused on the long-term goal is crucial: many MFIs have embarked on digital projects only to have their focus shift elsewhere in the face of changing priorities. Focus and an adaptive approach that enables adjustment and improvement is imperative in achieving real transformation, as is the ability to stay the course.
- Skills. Strong digital skills are obviously going to be important and are often lacking in many MFIs. Having core staff with an ability to assess technology-driven solutions and guide their adoption will be important, and these skills are scarce and expensive. It is also worth reflecting whether the institution has other requisite skills that may be affected by a transformation, including risk management, treasury, and core IT skills.
Many organizations have had a taste of change in responding to the COVID-19 pandemic, moving rapidly from face-to-face models to incorporate remote service functions. And many have come to understand that complacency is no longer an option. The trick will be to maintain the momentum. There is not a single path to introduce digital to a business, nor is it a one-off undertaking. It is a constant journey of adapting and changing, so it is worth investing in the skills and knowledge to do it now and well into the future.
Funding Transformational Change
If the prospects for transforming MFIs are daunting, there is an equally formidable question of how we are going to pay for it. Let’s start with two obvious, but often overlooked points. First – serving the poor is hard and it is hard to make money if you are doing it responsibly. The good news is that technology can help lower the cost of delivery. But that brings me to my second obvious point: technology costs money. And requires technical expertise to deliver. If we agree that the microfinance sector plays a crucial role in serving the poor but needs to digitize to remain competitive, the money has to come from somewhere. I would argue that this requires a re-examination of how the sector is funded.
Historically, funding has come from three main sources: commercial impact investors and MIVs, development finance institutions (DFIs), and donors. The balance has shifted among them over time, away from heavy reliance on donors and towards more commercial sources of finance. And that’s a good thing: it demonstrates that the sector is financially sustainable. But if we want to transform the industry, it is going to require additional investment and taking risks, and to achieve that, the funding ecosystem for inclusive finance needs to start playing like a team again.
In the early days of microfinance, different groups of funders had differentiated roles: donors provided start-up capital and technical assistance, funded public goods like the MIX and de-risked commercial investments through blended facilities; DFIs built markets by creating apex institutions and stimulating local investment into a growing MFI sector in Latin America, underwriting bond issuances in India and investing in greenfield MFIs in Africa; commercial investors built specialized MIVs to efficiently invest commercial funds into MFIs. More recently, there has been an increasing convergence in roles. If you have ever seen a group of five-year-olds play football, you know what this looks like: they all chase around after the ball like a swarm of bees; they don’t have differentiated roles. If we are going to keep developing the inclusive finance sector, we need to go back to playing like a team – with strikers, mid-fielders and defenders. What does this mean for different funders? Focusing on what each can uniquely contribute.
MIVs should encourage greater resilience through their commercial investments. They should demand more from their investees in terms of risk management and reporting capabilities and think creatively about using loan covenants to incentivize a focus on enhanced resilience. Equity investors have more influence through their role in institutional governance and should encourage continuing the digitization journey begun as a result of the COVID-19 shock. There is a role for specialized equity funds to invest in MFIs that have compelling digital transformation plans in place. And strategic investors can also play a role in driving change, as BBVA Foundation is doing with its network of MFIs in Latin America. In addition to financial and impact data, investors should consider adopting key performance indicators that reflect improved operations, greater efficiency and institutional resilience.
DFIs need to resume their role of pushing out the frontier of inclusive finance. They played a transformational role in building the microfinance industry. There is now a need for them to push the sector further by embracing digital transformation. DFIs can inject lessons from fintech into traditional MFIs and back their technical advice with investment funding. They can build solutions to the really hard problems, like making local currency facilities more available in tough markets through blended finance instruments, guarantees for local currency lending by local banks and helping to underwrite local currency bonds. For digital transformation to happen, they will have to lean in and accept some of the costs and risks that it entails, leveraging their donor relationships to help support riskier investments.
Finally, donors have a unique role to play. In recent years, returnable capital has become a priority for many donors seeking to make their aid budgets go further. But donors can take risks that no one else can. The more donors focus their limited resources on mimicking what investors are doing, the less they can invest in the vitally important undertakings that help build an inclusive finance sector. Donors can play a unique role, with potentially large multiplier effects, by:
- Rethinking public goods. The India stack has shown just how powerful public good market infrastructure can be, but few countries have the resources that India has. Donors need to understand and invest wisely in new technology-driven market infrastructure. There is also a role to play in supporting regulators, who will inevitably play a role in any public-private solutions.
- Exploring shared services. Although this is a very new space, donors could help encourage BaaS providers to bring their services to emerging markets. Expertly delivered shared services based on cloud infrastructure and data could be an important point of leverage for the inclusive finance industry.
- De-risking the hard parts. Foreign exchange risk remains a big challenge for investors in emerging markets. DFIs have the skills to put together hedging solutions, but they often need donors to come in to help mitigate the risks and make hedged instruments affordable. In markets where hedging is too difficult and expensive, donors could potentially help establish local currency lending facilities that are replenished and managed locally.
- Investing strategically in digital transformation. Donors for years have funded experiments in digitization, usually requiring a nominal in-kind contribution. This almost guarantees that institutional commitment is marginal, as are any gains. Donors should invest in MFIs that are willing to put their own money on the table, either from their balance sheets or as part of an external investment. Donors should also think about augmenting transformation funds or supporting technical assistance tied to targeted digital investments through DFIs with advisory arms like the IFC.
Despite hype to the contrary, building inclusive financial systems is hard and requires focused attention and investment. Digital innovation has shown us what is possible, but in the coming years we need to make sure it works for the benefit of the poor. Financial inclusion is not about the number of accounts we open – it is about what those accounts are able to do to improve and advance poor people’s lives.
The purpose of this essay is not to advocate for rescuing the entire microfinance sector from the fallout from COVID-19, nor is it to suggest that the only response to the pandemic is for every microfinance institution to invest in digital transformation. Rather it is to show that digital finance has yet to live up to its full promise, microfinance continues to play an important role, and it does have a place in the inclusive financial system of the future. But it will need to adapt and evolve or it may not survive, and that will have profound implications, both for the industry and for the poor customers that is serves. It will require hard work to make the industry more resilient and ready to face an increasingly competitive digital future. But it is an investment worth making.
1 Watkins, “Microfinance Industry Concentration and the Role of Large Scale and Profitable MFIs”, from The Future of Microfinance, Lieberman et al, 2020.
This is a much needed roadmap for the next few years of inclusive finance that should be extensively discussed by the main stakeholders: investors, donors, development agencies and the like so as to make sure all share the same broad outlook and priorities... and eventually team up