American Offshoots: Will Microfinance Ever Really Take Root in the U.S.?Published: June 17, 2011 in Knowledge@Wharton
Microfinance institutions have been compared to many things, from loan sharks to saviors. But Tayyeb Shabbir, a finance professor at California State University in Dominguez Hills and an adjunct finance professor at Wharton, prefers to think of them as plants. He notes that if you take a plant native to a country like Bangladesh and put it in the ground in a similar climate, it's likely that it will thrive. But if you uproot it and replant it in the colder climate of, say, Philadelphia, the plant will probably die, unless it was given special attention or a new hybrid species was created.
The same is true of microfinance institutions (MFIs) in the U.S. "It's going to be very interesting to see how these very innovative institutions grow in the American context, which is very different [from their counterparts in developing countries] in terms of complexity and dynamics," Shabbir says.
Today, the U.S. is home to 362 MFIs in the country -- some imported and others that are homegrown. Whether these institutions can thrive in the U.S. by providing small-dollar loans and other banking products remains to be seen. With an entirely different regulatory environment and cultural context than in the developing countries where MFIs have their roots, small-dollar lending to the very poor in the U.S. is tricky for all parties involved.
Microfinance-like operations have been around in the U.S. since the 1980s, starting with institutions including ShoreBank in Chicago and Women's Economic Development in Montana that provide financial services to the poor. But it took several years after their arrival for the industry to take shape. Gradually, regulations were honed to improve how community-focused financial institutions operated.An important turning point was in 1991 when Accion International, a pioneer of microfinance in Latin America, opened its doors in the U.S., eventually becoming the country's largest microlender with some 19,500 small business loans worth a total of more than $119 million as of January 2010.
In the past few years, microfinance in the U.S. has turned yet another corner. In 2008, Grameen Bank -- the Bangladesh-based pioneering MFI -- opened its first branch of Grameen America in Brooklyn, N.Y. The following year, Kiva, an online peer-to-peer micro-lending service launched in San Francisco in 2005 but targeted at microfinance institutions in developing countries, began setting up partnerships with U.S. MFIs.
But why is microfinance coming of age at this point in time in the U.S.? The easy answer is the stop-start economic recovery. As traditional financial institutions continue tightening their overall lending, small business owners with limited financial track records are losing out. Additionally, "people have turned to self-employment" and require capital to fund their entrepreneurial enterprises, according to Caitlin McShane, communications manager of Opportunity Fund, a San Jose, Calif.-based MFI.
Aside from the economy, Sam Mendelson, microfinance director at the Center for the Study of Financial Innovation (CSFI), a London-based think tank, notes that there is growing awareness nationwide of the vast number of "unbanked," low income Americans with no access to financial services. According to a hallmark study in 2009 by the Federal Deposit Insurance Corporation (FDIC), nearly nine million U.S. households (or approximately 8% of all households) are unbanked, while another 21 million are "underbanked," with little regular access to mainstream financial services. Findings such as those have been spurring MFI investment by large foundations and funders that now keep many MFIs afloat.
To be sure, microfinance is a fraction of overall lending in the U.S. In 2008, MFIs made some 9,100 loans with a total value of $100 million, according to the Microenterprise Census from the Microenterprise Fund for Innovation, Effectiveness, Learning and Dissemination (FIELD). That is dwarfed by the 6.2 million small business loans totaling $206 billion from mainstream financial institutions during the same year.
The size of individual loans from U.S. MFIs is another noteworthy difference. For example, loans from Accion in the U.S. average about $7,000, compared with $200 elsewhere. Of course, one explanation for that difference, as Shabbir notes, is that $1 stretches much further in less developed countries like Peru or India than in the U.S.
But although U.S. loan sizes are relatively high,regulations across the country prevent MFIs from charging the high interest rates for which micro-lending in developing countries has become known. The rate on Grameen Bank's standard entrepreneurial loan in Bangladesh is 20%; many other MFIs outside the U.S. charge as much as 50%. In the U.S., interest rate caps vary widely from state to state, ranging from 7% in Michigan to 45% in Colorado.
Consequently, start-up costs in the U.S. are high, and exponentially more grants and donations are needed to sustain MFIs. While Accion subsidiaries in other parts of the world have become self-sustaining through the income they generate from loans, it's a different story in the U.S. Laura Kozien, Accion USA's director of communications, says that micro-lending alone will not make the institution self-sustaining. "We lose money on every loan," she states. "As lending volume increases, we lose less per loan. But it would take a rapid increase in loan volume coupled with revenue-generating activities to be self-sustaining."
Culture is another consideration. Grameen Bank in Bangladesh is among the many MFIs requiring that its customers (who are generally women) form local groups and jointly guarantee the loans made to others in that group. Much social baggage, or social collateral, is attached to those loans. For a Grameen borrower, defaulting doesn't just mean running afoul of the lender, but also potentially being ostracized from the community -- a key reason, experts believe, why repayment rates are very high and underwriting costs are low in developing countries where peer lending is widespread.
But Shabbir notes that peer lending models are not common in the U.S. With fewer close-knit communities than in developing countries and more focus on individuals, "there's not the same kind of social bonding that is the hallmark of more traditional societies," he points out. In response, some MFIs -- including Accion USA and Opportunity Fund -- do one-to-one lending with thorough underwriting for each loan. (Grameen America, however, has stuck with the peer lending model of its parent, as have several other MFIs.)
Another difference is that MFIs tend to have a lower profile in the U.S. According to Opportunity Fund's McShane, that makes reaching potential borrowers -- and gaining their trust -- more of a challenge.
U.S.-based MFIs also face more competition from a range of providers offering small, short-term loans, including "payday lenders" -- which provide loans to help borrowers make ends meet until their next paycheck -- and credit card companies. "Unlike the developing world, entrepreneurs in the U.S. are likely to have income from other sources and other alternatives to credit," according to Wharton management professor Keith Weigelt.
The Real Bottom Line
Experts, however, stress that microfinance -- whether in the U.S. or elsewhere -- is about more than the money changing hands. "Giving loan after loan without any support is just folly and a positively destructive way to live," CSFI's Mendelson notes.
"In the U.S., the financial element is a little less important [since] you can 'max out' your credit card and there are other sources of financing," adds Shabbir. So microfinance "is not just about providing financing, but [also] education, entrepreneurial skills and leadership." According to the FIELD census, most MFIs provide some sort of training, such as teaching borrowers how to create a business plan and market it, and technical support in the form of, for example, how to prepare cash flow statements. Accion's Kozien says her organization takes great pains to ensure that borrowers in the U.S. understand the entire lending process, from receiving credit scores to managing debt wisely.
As MFIs mature and establish credibility on the ground, the future of the industry in the U.S. looks much brighter today than in previous years. "This is our moment, and not just because of the state of the American economy, but also because there are effective microlenders out there with long track records and people are starting to have faith in it," notes McShane.
Additionally, the Obama administration is throwing its support behind micro-lending. Under the American Reinvestment and Recovery Act of 2009, $50 million was set aside for the Small Business Administration to lend to microenterprises, which are defined as businesses with five or fewer employees seeking individual loans that do not exceed $50,000. A provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 also sets up a loan loss reserve fund to encourage micro-lending among community development financial institutions.
However, increasing the number of MFIs will not necessarily make the industry stronger, experts say. Healthier for the industry would be investing in existing MFIs to enable them to achieve greater economies of scale and keep operating costs down, according to Kozien. "One of the problems bringing microfinance to scale is a lot a fragmentation," she says.
No matter what the scale, many observers don't see microfinance in the U.S. having the reach and impact that it has in other countries. Rather, microfinance will remain niche financing for entrepreneurs in certain markets. "I don't think it's going to be the impetus for a social revolution like in Bangladesh," Wharton's Weigelt notes. "But it's important that it's here, and I'm glad it's here."