Microfinance has proven to be an important tool in helping lift people out of poverty by providing low-interest loans to those who don’t have access to traditional lending. Many studies have looked at the outcomes for loan recipients, but few have examined how microfinancing organizations raise capital, especially in times of political and economic turmoil in a country. In their latest research, Wharton management professors Tyler Wry and Adam Cobb, along with Indiana University professor Eric Zhao, focus on funding for microfinance organizations.
Wry and Cobb recently talked with Knowledge at Wharton about their paper, “Funding Financial Inclusion: Institutional Logics and the Contextual Contingency of Funding for Microfinance Organizations,” and its implications.
An edited transcript of the conversation follows.
Knowledge at Wharton: In this research, you were looking at funding for microfinance organizations. What were the key questions you were trying to answer?
Tyler Wry: Adam and I have been looking at microfinance in different capacities for a while now, and Eric has as well. One of the things that is a little bit surprising about the space is that you’re making loans to poor people. But the money used to finance those loans, it’s not like a typical bank where they mobilize their deposits to then lend out the money. In microfinance, you count on upstream funders, and the microfinance organizations themselves are more of a flow-through. No one had really looked at how this upstream funding works. We managed to get access to really great data through the Microfinance Information Exchange, and it gave us a chance to look at how the upstream funding works as a way to analyze downstream impact.
The literature suggests that microfinance in a nation works best when you have a really robust ecology of different kinds of microfinance lenders. You want to have big, established, more commercial, profitable organizations. But you also want to have smaller, less profitable organizations that aren’t quite financially sustainable yet [because] maybe they’re doing a little bit more outreach. You need to have funding go to all of these organizations to ensure you’re getting sustainable outreach, good competition and a healthy sector overall. So, we were looking at how funding flows to these different types of microfinance organizations and who the different funders are. It turns out, about $30 billion a year that we can track flows into microfinance around the world each year. It comes primarily from two sources. One is commercial lenders, mostly in Western Europe and the United States, and they have commercial goals. They want to get their money back. They might want a little bit of a social return on the investment as well. But really, this is risk capital. They’re going to lend this money out, but they want to see it returned. On the other hand, you have development banks and multilateral aid agencies. They’re more interested in funding development in the sector.
When things are working well, you have the commercial lenders funding the big, established commercial microfinance organizations, and you have the public organizations funding the smaller, not-yet-sustainable ones. No one had analyzed this. So, our top-line analysis was just to see if this held up in practice because some people suggest it doesn’t. What we found is, in fact, it does. In a steady state, you see this ecology work the way it should. It all kind of lines up nicely. But when you start to look at uncertainty in a country — political uncertainty, financial uncertainty, when things get volatile and it’s a little less clear how previous investment strategies are going to work — you see all of the funders retreat to a safe harbor in the largest microfinance organizations. This is public and commercial funders, and this is tied to a lot of very adverse outcomes in the microfinance sectors of a country. This is really the gist of the paper and the big thing that we uncovered.
Knowledge at Wharton: You started out with a number of hypotheses about microfinance organizations and how they’re funded. Some of them held up, and some of them held a little bit of surprise. Tell us about the key takeaways from this paper.
Adam Cobb: One of the things that was a takeaway for me is that it wasn’t so clear whether this would map out the way we expected. In particular, there is a little bit of work, mostly anecdotal evidence, that suggests that there’s a lot of competition between these more public funders and these commercial funders, and that they are both targeting really large, sustainable, profitable organizations. If you look at the microfinance literature right now, the evidence suggests that they’re targeting the same types of microfinance lenders. At least in a steady state, that doesn’t seem to be the case. Just uncovering that was a nice thing to discover. They’re actually doing what they professed to do and probably what they should be doing. But at the same time, even things that are a little bit further away or of higher level, like political uncertainty or financial uncertainty, are affecting these decisions being made by these commercial and public funders half a world away. They’re actually paying attention to these things and making conscious strategies. That wasn’t exactly what a lot of people would expect.
“Anything that microfinance lenders can do that make them appear less risky is going to help ensure that the microfinance lending structure holds in place during times of uncertainty.”–Adam Cobb
We got a chance to talk to some of these people, and they said, “Yeah. This is totally what we do. It doesn’t make a lot of sense to invest in these smaller, less sustainable microfinance lenders if the economy’s really turning poorly and these entities might disappear anyway. It fulfills our social mission.” Another surprising thing is that they still feel like they’re holding to this social mission even though they’re changing their lending strategy, which is something that we wouldn’t expect. That’s seen as more of a change in your ideology or a change in your strategy. They don’t see that a change in investment behavior is tied to a change in strategy. They see those two things being compatible.
Knowledge at Wharton: But does this change in investment behavior have implications for people who receive loans or to the organization itself? In terms of this paper, what are some of the practical implications? If I’m a microfinance organization, especially if I’m a smaller one or one that is located in an uncertain climate, what can I do?
Wry: There’s the implications for the organizations, and there’s what they can do and what they should do. Building on what Adam was saying, one of the really striking things about our finding is that under these conditions of uncertainty, if you were a small microfinance organization, even one that’s managed well and turning a reasonable return on your investment, there’s a good chance that if things become uncertain, you’re going to lose this funding. And it’s going to put you in a really precarious position.
At the same time, these forms of political and economic uncertainty are also things that are likely to put people who are on the edge of poverty into poverty. What this means is that as this is happening, as people are more likely to be desperate and very poor, the organizations that are the ones that are most targeted to addressing their needs are the ones that are going to have their funding dry up first. This is a big issue, and there’s no easy answer to what should happen here.
In the paper, we talk about a couple of different things. One is on the policy side. Government should probably make provisions to step in and have emergency capital reserve funds, something to restore the funding to the organizations that are having it dry up when things become uncertain. That is going to be the way that you ensure the money keeps flowing to the people who need it, as well as ensuring that you have the basis for a healthy microfinance sector once things calm down again. Beyond that, seeing as size seems to be the big driver of investment decisions under uncertainty, we speculate that maybe the smaller, not-yet-sustainable microfinance organizations could band together. They could work together, merge, do other things to get some of the advantages of size in order to compete for loans that are progressively moving up-market.
Cobb: Another thing we’ve found — it’s not emphasized quite as strongly in the paper — is that with these microfinance lenders, better and more transparent financial reporting seems to help a little bit. That is something that’s relatively low-cost for them to employ. It does suggest that a lot of this is about risk, so anything that microfinance lenders can do that makes them appear to be less risky — more transparency, anything government can do that can guarantee loans, other things — is going to help ensure that the microfinance lending structure holds in place during times of uncertainty.
“These forms of political and economic uncertainty are also things that are likely to put people who are on the edge of poverty into poverty.”–Tyler Wry
Knowledge at Wharton: If these smaller microfinance organizations do things to make themselves more attractive in uncertain times, they also have to keep in mind how that could impact their social outreach. Larger organizations are maybe doing social outreach differently. As organizations become larger, the way the organization is administered changes. It seems like this paper also has a bit of advice to microfinance organizations. If they’re small, they’re trying to become larger in order to stave off these effects that are caused by uncertainty. They also have to keep in mind, how does this affect how I’m reaching out to people? How does it affect how I’m bringing in clients?
Wry: There’s definitely that aspect to it. In the paper, we look at what the implications are of the money going to larger organizations as well as the social outreach of larger versus smaller microfinance organizations. Your question really speaks to a bigger point: There is this relationship between trying to grow a microfinance organization from something that might be a little bit smaller, more focused on outreach, maybe a little bit more of a boutique operation, to something that is larger, more financially self-sustaining and can attract commercial capital.
When you want to play in that world, the bottom line really does become important. It’s not just size, it’s also your performance. One way to get your performance up is to sacrifice social outreach in some ways. So, it’s important, especially if it is going to be an uncertain environment, if you’re taking these steps to try to ride out the storm, that you think about the implications this has downstream. It’s one thing to get yourself in the market for commercial capital, but if this means that you’re moving away from the social mission and it really isn’t helping the health of the microfinance sector as something that addresses poverty, there’s some bigger macro-implications that definitely deserve attention.
Cobb: Part of the reason that this context is interesting to people in our field is, there is this tension between financial performance and social outreach. A lot of work has been trying to untangle that tension and examine under which conditions are organizations more likely to do one versus the other. What happens when you’re trying to trade off these two things? You might have, in the same organization, those that are really interested in the financial performance and others that are really interested in the social outreach. How do you balance those interests inside organizations? That’s one of the really neat things about studying the context.
At the same time, there’s no easy answer. if you’re totally focused on social outreach, if there are things like financial or political uncertainty, maybe you just go out of business. And that doesn’t do any good. But if you’re too focused on financial performance, then at least aspirationally what microfinance is supposed to do is help those who need it and help those who are being left out of the financial sector and can’t obtain loans. So, there is a balance that these organizations have to seek. It’s not to say that there’s one right way that they all have to do it. But hopefully what you have is sort of an ecosystem of microfinance lenders in a country that span the spectrum. Some that are maybe a little more focused on the financial performance, and some that are more focused on the social outreach. Then across the spectrum, they’re able to reach different parts of the population.
Wry: One of the things we hoped to highlight in this paper is that by showing that the psychology breaks down as uncertainty ramps up, hopefully this is enough to get people who are in the sector thinking about this stuff and the implications it has. What can they do to stay true not just to their narrow mission, but their broader goals of supporting the sector in its entirety?
Knowledge at Wharton: What misperceptions are dispelled by this research?
Cobb: I think one misperception that is dispelled by this research is this notion that public and commercial funders are crowding each other out. More specifically, there is this big concern in the microfinance literature that these public funders don’t need the same kind of rate of return on capital, so they’re offering loans to really big, stable, good-performing lenders in these countries and able to offer better rates and better loan terms. It’s actually not enabling the infrastructure, the ecosystem to grow. So, there’s this big push to get these public funders to go and invest in the smaller, less-sustainable organizations. At least at the baseline, our results do not indicate that this is as big of a problem as some of the anecdotal evidence suggests. I think that’s definitely one thing.
Wry: I think that’s absolutely right. The finding that Adam’s talking about caused quite a bit of turmoil in the microfinance community, with the idea that the public funders weren’t being faithful to their mission. They espouse lofty goals of fostering development in the sector. If they were just investing in the largest, safest organizations, trying to make their organizations look good, make their investment team look good, this would have been a big problem. And it certainly is out there in some instances in microfinance in different countries.
“One way to get your performance up is to sacrifice social outreach in some ways.”–Tyler Wry
But I think one of the things that is valuable about our finding is to put some boundary conditions around this. Part of what led us do this was access to more complete data. The findings that were out there that were showing this crowding-out effect were based on a limited sample of lenders in a limited sample of countries. It was really just looking in Latin American countries. Now, with this broader data looking at the capital flows around the world, we really get a much fuller sweep of what’s going on. In doing that, we can see that there are contexts where crowding out takes place, and there should be action taken to address that. But it really seems to be linked to political and financial uncertainty in a country. Whereas under steady state, these organizations are acting in ways that are faithful to their mission. It’s just that their mission changes a little bit under uncertainty. There are a lot of good, rational reasons for why they’re behaving that way.
Knowledge at Wharton: What sets this research apart from other research being conducted about microfinance?
Cobb: A lot of research on microfinance is looking at the lendee-borrower relationship and whether or not microfinance helps get people out of poverty. That’s always been the promise of microfinance. People haven’t really looked at this funder-microfinance lendee relationship yet. The fact that microfinance lenders don’t operate like banks, so they don’t mobilize their own deposits and they are dependent on these other organizations for them to get the capital necessarily to lend out, is something that I imagine if you talk to the person who just has a casual understanding of microfinance, they might not even know that’s how they get their money. How that money flows in and the terms have a big impact downstream on the lendee-borrower relationship. I think that was one of the big appeals to me to take part in this research. It just really hasn’t been explored. I think this is a good first step to looking at the importance of the funder-lendee relationship. Not to say that the borrower-lender relationship isn’t important, but we really need to be looking at the entire supply chain.
Knowledge at Wharton: What’s next for this research?
Wry: We’ve been talking about a bunch of different ideas. It’s fun to think about where it might go. We’ve been talking about looking at the effects that different forms of capital have on the behavior of the organizations. In this research, we were looking at how the funders behave. In follow-ups, we’re thinking about taking that to the microfinance organization level and looking at how the composition of capital in a country affects the behavior of the organizations.
Getting back to a question you asked earlier about the effects of this in terms of the organization’s behavior on the ground, doing their work, trying to lend to poor people. We’re starting to look at how these organizations make lending decisions in terms of how they apply the screens when they’re deciding what organizations to invest in. What sort of pressures does this put on the organization, both directly and indirectly? How does having different pots of capital available in a country allow for different types of organizations to flourish? Or how it might just have the whole ecology implode on itself, like what we see under uncertainty in the funding relationship. To the extent that this speaks about issues of social finance, it potentially has implications for understanding how we affect positive outcomes, not just through corporate social responsibility and social action, but also how money comes into corporations more broadly. We’d like to be able to show some boundary conditions around when social investment has positive versus negative outcomes.
