Microfinance has failed to live up to its early promise as a tool to fight poverty. In this three-part blog series, we discuss the three major issues with current microfinance and how the Balloon model has addressed these.
Microfinance was hailed as a remarkable innovation because it was seen as a way to jump start development through offering financial services to those who previously had no access to them. The provision of a loan to purchase a productive asset could transform poor people’s lives.
The award of a Nobel Prize to the father of microfinance, Mohammed Yunus, as well as the UN declaring 2005 as the year of micro-credit, testify to the hope placed upon the innovation to bring about change.
However, following a series of high quality evaluations the impact of microfinance has been brought into question. Indeed, one report concluded “We advise against the promotion of microfinance as a means to achieve the Millennium Development Goals”.
As Balloon offers financing to entrepreneurs we are often called a microfinance organization. However, we have taken the underlying concept of microfinance and innovated to avoid some of the common pitfalls. The differences between Balloon’s model and traditional MFIs are sizeable. In this blog series, we clarify what those differences are.
Microfinance Institutions and Mission Drift
Microfinance institutions (MFIs) typically generate revenue through loans (either through interest payments or grants/funding based on loans). In essence this creates tension between acting in the interest of the MFI and its beneficiaries.
In many cases this can result in the organization drifting from its original mission. That is, chasing growth and therefore revenues rather than focussing on combatting poverty.
Three groups of practices are particularly problematic:
- Interest rates are hidden or set too high
- Repayment terms are constraining in terms of length, frequency and/or how soon they begin after the loan
- Multiple loans are often given to the same individual
High Interest Rates
If MFIs’ revenue is derived from loans, there is an incentive to set interest as high as possible. Interests rates have been documented at anywhere between 10% and 100% with anecdotal reports of interest set at over 100% up to almost 200%. Regardless of the ethics of such levels of interest, it is unreasonable to expect that any impact resulting from increased access to finance would persist after such inflated interest payments. An idea that has been supported through research.
Constraining Repayment Terms
A second problem is that repayment schedules are often designed with the MFI rather than the customer in mind. Repayment terms are often constraining either in length, frequency or how soon they begin after the loan, presumably because of concerns about repayment.
However, the rigidity and immediacy of payments usually means that the loaned amount rarely can be used for experimentation. This incentivises a copycat culture where entrepreneurs stick to what is tried and tested rather than doing something different and new. Ultimately, this limits the chances of success as replication means a race to the bottom, with price being the only differentiator.
A third issue is the provision of multiple loans to the same individual. Evidence suggests that over-indebtedness is strongly linked to a failure to repay loans. However, restricting loan availability to those who are debt free in the developing world would reduce the total addressable market to a tiny proportion of the overall market, meaning little incentive to do this. Thus, once again, if number of loans issued is linked to revenue the benefit to the beneficiary is diminished.
Overall, mission drift (as illustrated above) has been a sizeable problem in the sector. Such accusations have been levied at organizations including Compartamos Banco in Mexico and SKS in India, two of the largest players in the industry.
Decoupling revenue from loans at Balloon
Appreciating these challenges, Balloon’s revenue model is different to traditional MFIs. The main sources of revenue are separate from entrepreneurs. Instead, revenue comes from volunteering programmes sponsored by universities, the UK Government, and corporates. This significantly reduces problems associated with mission drift mentioned above. Growing faster means recruiting more volunteers which allows Balloon to achieve its purpose faster, rather than compromise on it.
As a result of this decoupling, Balloon loans have many advantages compared to traditional MFI loans. Loans are usually interest free and unsecured. Regarding repayment terms, there is a one-year repayment term however entrepreneurs are free to recommend their own terms (amount, frequency, and duration) within this one year.
Furthermore, as Balloon is not dependant on loans for revenue it can be picky with who it loans to. Loans are not issued to individuals with existing loans (but they can still work through the programme receiving the added support), thus avoiding the issue of over indebtedness. Furthermore, loans are used exclusively for the development of a business to ensure that this capital has the greatest impact (as opposed to consumption loans).
An added benefit is that because we are accountable only to ourselves regarding loan performance, we can afford to take greater risks with the capital on offer. We have therefore taken a conscious decision to have a large risk appetite when it comes to backing entrepreneurs.
Ultimately, these considerations mean there are fewer pressures pushing Balloon away from its mission. Instead it focusses on giving the entrepreneur the maximum chance to grow their business. Feedback from our entrepreneurs suggests that they highly value finance offered in this way.