Avoiding a Micro financial Crisis

Recent media coverage and debate about the credit meltdown has focused largely on big lenders in the developed world. But attention must also be paid to the developing world to prevent a potential parallel crisis in the microfinance sector. This vital industry provides access to basic financial services for millions of people in emerging countries including Brazil, Kenya, Bangladesh and India. If microfinance institutions suffer losses akin to big banks in the developed world, however, their clients could lose a vital lifeline: access to affordable credit.
Today, the microfinance sector appears solid, with high repayment rates of over 98 percent. But this doesn't mean that all is smooth sailing. The sub-prime market collapse has made many microfinance institutions nervous. And rightly so: like banks in developed nations, microfinance organizations were incentivized to expand rapidly in recent years, transforming the sector from an industry dominated by NGOs like Grameen Bank in Bangladesh to one led by for-profit companies including Compartamos in Mexico and SKS Microfinance in India.
This for-profit shift has boosted microfinance institutions' capital, enabling them to serve more of the world's poor, but it also pressures microfinanciers to provide competitive rates of return for their investors. Ultimately, increased competition between microfinance providers is good for the industry, although, as we learned from the sub-prime crisis, it is imperative that best lending practices aren't compromised as a result.
The good news is that evidence suggests the microfinance model has allowed many borrowers to start small enterprises that generate income. This provides the poor with a productive "hand up" rather than a short-term "hand out", and should continue to remain the focus of microfinance institutions and their investors in future.
Yet this progress does not come without risk, for microfinance CEOs know little about their loan recipients. There is a dearth of research and empirical evidence about the borrowing habits of the world's poor. In the absence of any formal credit bureau or co-operation between organizations to promote best lending practices, anecdotal evidence suggests that borrowers are taking loans from multiple microfinance institutions and other sources, such as loan sharks. Oftentimes, clients are using one loan to repay another. This could be destabilizing for the sector as a whole in the event that household incomes decline or the credit system contracts, which would prevent people from covering old debts with new ones.
For many clients, borrowing from multiple sources suggests that the currently low, fixed loans offered by microfinance institutions are simply insufficient to meet their businesses' credit needs. But other clients might just be falling deeper and deeper into debt. So several basic risk management questions - such as who should be receiving credit and how much microfinance institutions can prudently lend - still remain unanswered.
While these questions loom, the responsibility for ensuring that the microfinance sector learns from the painful mistakes made by financial intermediaries in the developed world, falls upon three groups: the microfinance institutions themselves, their regulators and the increasing number of investors who are active in the sector.
All three parties must take steps to strengthen and safeguard the microfinance sector. First, microfinance organizations should support both research and technology initiatives that will help them better understand the creditworthiness and spending patterns of their clients. Second, regulators should create an environment that encourages prudent growth, with the guidance of specialist teams that focus on microfinance as an independent sub-sector of the financial services industry.
Finally, investors should heed the lessons from the credit crisis and encourage microfinance organizations to better understand the true risks in their loan portfolios, whilst continuing to apply and develop best practices in lending to the world's poor.
Although microfinance may face similar perils as sub-prime lending did in the US, it is important to remember that they are fundamentally different markets. The vast majority of microcredit goes to productive uses that improve the lives of the poor. With this in mind, we should remain hopeful about the future of microfinance - and that the microfinance community will draw upon lessons learned from the global economic meltdown to protect and strengthen one of the most promising mechanisms for sustainably alleviating global poverty.