Downscaling

When Commercial Banks Move into Microfinance

For many years, connecting microfinance with regular commercial banking activities was seen as a nearly impossible challenge. And in the few instances where it was done, it was usually in a fairly indirect way, such as partnerships between NGOs and commercial banks that prepared microentrepreneurs to “graduate” (as they used to say) to regular commercial banks. Even though this type of operation still exists to some extent, it is clear that microfinance is increasingly becoming a part of mainstream finance, attracting new and major interests.

Three trends (at least) can be seen as heralding this evolution: the accelerating emergence of more investment funds dedicated to connecting microfinance institutions to capital markets, the upscaling of many microfinance institutions to either regular commercial microfinance banks or specialized (and regulated) microfinance institutions (MFIs) and, last but not least, downscaling.

Downscaling is the practice of regular commercial banks moving into microfinance. As part of last year’s Forum on Microenterprise in Santa Cruz, Women’s World Banking (WWB) and Federation of Latin American Banks (FELABAN) hosted a seminar to present a paper they co-produced on this topic. Titled “Banking for the Majority,”[2] this paper offers a framework which, as argued by Nancy Berry, “shares knowledge on how to enter the market and how to do it right.” Combined with another WWB document, titled “Expert Group + 10—Building Domestic Financial Systems That Work for the Majority,” “Banking for the Majority” offers an excellent discussion of why commercial banks may decide to move into microfinance, the risks this move may entail and, most important, the strategies that can be used in such a move.

To put it simply, there are three major reasons a commercial bank may move into microfinance: the bank realizes that microfinance markets may present huge opportunities for expansion and good returns if done well; working its way into microfinance would most likely improve the bank’s image; and microfinance could be a key sector for future developments, such as remittances, which have attracted a lot of attention lately.

Benefits and risks

In moving into microfinance, commercial banks have some advantages and some weaknesses when compared with traditional microfinance players. Advantages may include better and cheaper access to capital (including the ability to develop savings products), a superior banking (and system) infrastructure and well-known names (favoring a brand effect). Weaknesses may include the tendency of a bank to underestimate the competition in this market, and the need to adapt infrastructure and practices and to adjust to a different business culture. This is probably the most important lesson that came out of the WWB/FELABAN seminar in Santa Cruz: when entering microfinance, banks should always keep in mind that microfinance has been developing for more than 30 years, and the fi eld has accumulated knowledge on how to do microfinance right. Therefore, if banks want to be part of it, they should make sure that they fi rst assimilate this knowledge and don’t try to reinvent the wheel. This implies many key factors, chiefl y: a decentralized methodology (where credit advisers are key to success), a close relationship with clients (adopting languages, procedures and facilities compatible with microfinance practice) and a foundation in family and business cash fl ow analysis (not on business plans).

It is necessary for commercial banks to understand that in order to be successful they must build close relationships with their clients, the way MFIs have done for the last 30 years. Indeed, not all commercial banks are well-suited for the daily realities of microfinance. As mentioned in Santa Cruz and in a February 2006 seminar in Amsterdam hosted by International Netherlands Group (ING), “Downscaling in microfinance is to be done by local banks and certainly not by ‘global banks.’ ”[3] That doesn’t mean there is no room for global banks in microfinance, but that they are better suited to working at other levels, such as developing partnerships with existing microfinance institutions (i.e., developing “remittance products and services”) or working as second-tier institutions.

There are also risks for commercial banks entering microfinance. The first risk is oversimplifi cation, which tends to make everyone believe that “now that even banks are coming into microfinance, it is clear that this fi eld is no longer a part of development strategies, and that commercial microfinance is going to fulfi ll all the needs of the sector.” Believing this would be a big mistake. Even though commercial microfinance has proven extremely positive in some contexts, it doesn’t yet fulfi ll all the fi nancial service needs of microentrepreneurs and their families. Therefore, there is still much room for different institutions and innovations to fi ll the remaining gaps. It should be remembered that microfinance is still a young fi eld.

Another major risk is when banks entering the market choose to strongly modify methodology by confusing microcredit with consumer credit practices. This would result in unfair competition, which, as experienced in Bolivia some years ago, could damage part of the market and the traditional microfinance clients and institutions within it.

The third risk is for the banks themselves. In some cases, as noted by Liza Valenzuela, the involvement of commercial banks in microfinance turns out to be short-sighted, and a “revolving door syndrome” is observed.[4] Banks enter with high expectations and leave disappointed, sometimes fairly rapidly, for not having been able to make the type of profi ts they initially expected. Microfi nance can sometimes be done on a commercial basis as a fairly profi table business, providing great services to its customers, but only when it is done right and within an appropriate framework. Of course, this suggests the proper handling of many parameters, including product design, interest charged, cost management, collateral requirements, monitoring practices, human resource management, decentralized decision process, and adequate structure.

A Question of Structure

A recent paper by Glenn Westley, of the Inter-American Development Bank, analyzes this last issue in detail: What type of structure should a commercial bank adopt if it wants to enter microfinance? This question has no easy answers. However, based on previous experiences, some points can be made. Westley considers these cases: an in-house microlending unit, a service company, and either a lightly or heavily regulated subsidiary. Working in two steps, he fi rst considers when to do microfinance internally and when to favor external solutions. He then considers the advantages and disadvantages of various external structures (when to go “external”). These issues are complex and cannot be summarized in a few words. However, a key issue is to fi nd the “right” structure to “do microfinance right.” And, as Westley says, it “comes down to the specifi c circumstances of how much more freedom the external organization is likely to enjoy and how much greater its incentives are to be effi cient and profi table, versus how much cheaper and faster to start up and cheaper to run the internal unit is likely to be.”[5]

Downscaling in microfinance carries a lot of potential to vastly increase the size of the industry. However, it also carries its share of risk. Therefore, there are grounds to argue for a cautious approach, capitalizing on what has already been learned about the way to “do microfinance right.”

References

[1] Centre de Recherche Warocqué, Université
de Mons-Hainaut (Belgium), Marc.Labie@
umh.ac.be

[2] WWB (2005). « Bancarización para la
Mayoría », borrador, Santa Cruz de la Sierra,
WWB & FELABAN seminar, October.

[3] Nyenrode Business Universiteit (EIBE),
(2006), “A Billion to Gain? A Study on Global
Financial Institutions and Microfi nance,” ING
microfinance support, February 2006.

[4] Valenzuela, L. (2002), chapter 3 in Drake
& Rhyne (eds.), “The Commercialization of
Microfi nance: Balancing Business and Development,
Kumarian Press.

[5] Westley, G. (2006). “Strategies for Commercial
Banks to Enter Microfi nance,” IDB,
Washington, draft.