Microfinance in Emerging Markets: The Effects of the Current Economic Crisis and the Role of Securitization

• Author: Jessica Deihl
• Position: Juris Doctor Candidate at the Washington College of Law
• Pages: 07

Jessica Deihl is a 2010 Juris Doctor Candidate at the Washington College of Law and received her Bachelor of Arts from Cornell University in 2005. Jessica is currently a Junior Editor for the Business Law Brief and will assume the position of Managing Editor next year. In 2008 she was accepted into the Summer Honors Program at the Securities and Exchange Commission and in 2009 will work as a Summer Associate for Nixon Peabody L.L.P.

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I Introduction

This past year has boasted the largest global economic recession in recent history. Like falling dominos, many large financial institutions are being forced into bankruptcy, one after another. The United States’ government and those abroad, are scrambling for solutions to brace their economies against the resulting financial effects. News circulates daily with somber stories of radical cuts in executive compensation and large-scale corporate layoffs. But, how deep into the global market are the effects of these falling dominos being felt? What have been the consequences to members of the world’s lowest income class and what can be done to brace their economic chances at a brighter future?

II What is Microfinance?

The term “microfinance” encompasses a large range of banking and financial services provided to low income and underserved communities, most often in developing countries.¹ In contrast to wealthier countries in which financial services are well established and refined, financial services in emerging markets have been comparatively sparse.² The poorest portions of the world’s population lack secure places to store the little money they do have and preventative services (including basic life and property insurance) are not accessible.³ Scarce sources of credit which are available, include local pawnshops and moneylenders who charge high interest rates and seek physical redress against clients who fail to pay on time.⁴

The origin of microfinance is often attributed to Muhammad Yunus, the founder of Grameen Bank of Bangladesh, who began making small loans to the poor in 1976.⁵ He subsequently received the Nobel Peace Prize in 2006 for expanding access to financial services for individuals and communities that traditional financial institutions did not service.⁶

Currently there are four categories of microfinance institutions which are recognized: informal financial service providers, member owned organizations, nongovernmental organizations, and formal financial institutions.⁷ This paper will focus on the final category, formal financial institutions, which are generally recognized to be the most expansive of the microfinance institutions in terms of delivering capital.

Formal financial institutions include the world’s largest banks and insurers. Their sophisticated systems and global networks enable them to raise large sums of capital in a way that local institutions cannot.⁸ However, all types of microfinance providers interact to satisfy current demands. For example, larger institutional players are able to reduce risks and increase the liquidity of smaller institutions through repackaging and selling their loans.⁹

The term “microfinance” encompasses a large range of banking and financial services provided to low income and underserved communities, most often in developing countries.

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III The Barriers Inhibiting Microfinance

In many developing countries, the pathways for institutions to provide financial services are blocked by non-ideal conditions, such as high inflation rates, incompetent governments, and deficiencies in the legal framework necessary to support such financial services.¹⁰ Most poor families have few assets that can be secured by a bank as collateral, and those who are fortunate enough to own land in the developing world may not have effective title to it.¹¹ Even those who do have legal titles to their land may be inhibited by property laws which make it unfeasible for low income borrowers to use their homes, which are likely their only asset, as collateral to obtain secured loans.¹² Many of the emerging markets are working to improve their current legal frameworks in the interest of attracting foreign investments and financial institutions. However, to ensure investor confidence, it is necessary that these markets effectively implement and enforce such legal reform.¹³

Though well intended, changes to a country’s legal framework may be hard to implement because local norms and customs are often deeply rooted within transition economies and date back through many generations.¹⁴ Unfortunately, there had not yet been sufficient research anlayzing the extent to which institutionally friendly legal reforms conflict with existing customary laws.¹⁵

One area that traditional customs are known to be in conflict with corporate objectives is within the Islamic culture. In accordance with religious teachings, Islamic law prohibits charging interest rates on loans.¹⁶ Such restraint undermines the profitability of lending money, thereby reducing the supply of loans. Similar limits are also found in non-Islamic emerging economies, such as Venezuela, Brazil, and Columbia. These countries impose interest rate ceilings that discourage new financial firms from entering the microfinance market and push existing firms to seek methods of evading such regulations.¹⁷

An additional barrier within many emerging markets is their lack of government deposit insurance policies similar to those of wealthier countries, such as the Federal Deposit Insurance Corporation in the United States.¹⁸ Thus, when banks in developing countries become bankrupt, depositors are often unable to retrieve any of their savings.¹⁹ The negative result is twofold; the poorest, those with the least to lose, end up suffering the greatest losses, and foreign investors become leery of depositing their money into a system with such high risks when safer alternatives are available.²⁰

Furthermore, basic public services (e.g. electrical power) are often unreliable, making it difficult to run computers and perform other basic business functions.²¹ Institutions that would otherwise wish to establish themselves within these developing countries are unable to set up shop without such capabilities.²² Indonesian banks that were willing to establish under these conditions circumvented the electrical shortages by using paper to record all of their financial transactions.²³ However, when a tsunami hit Indonesia in December of 2004, all the banks’ financial records were permanently destroyed.²⁴

If market hardships, combined with natural forces, do not completely discourage institutional investors away from microfinance, the likelihood of human brutality in response to a change in the status quo may close the deal. In poor countries, injecting available credit can result in social upheavals as the poor begin to have more opportunities. This possibility frightens the elite who fear they will no longer be able to monopolize with power based solely on family ties and inheritances. This turmoil has resulted in Islamic fundamentalists bombing branches of the Grameen Microfinance Bank in Bangladesh and India, and drug lords murdering the head of a large microfinance initiative in Afghanistan.²⁵ The bulk of microfinance borrowers are women, and for radical Muslims, extending credit to the poor enables women to create viable businesses and become independent, thus evading their traditional roles.²⁶ Afghan drug lords fear that credit extensions will enable local farmers, who previously depended on growing poppies to finance their crops, to have alternative options.²⁷

IV Does Microfinance Work?

The monetary needs of the world’s lowest income families can be divided into four categories: lifecycle needs (weddings, funerals, and childbirth), personal emergencies (sickness, injury, and theft), disasters (fire, flood, tornados, and war), and investment opportunities (expanding a business, buying land or equipment, and improving or repairing housing).²⁸ While there are creative and often collaborative ways to meet these needs though non-cash exchanges, loans offered through microfinance have been growing rapidly and have significantly helped the poor improve their lives.²⁹

According to the Senior Vice President of KFW, a government-owned Ger man Development bank, “[m]icrofinance has shown that

the working poor can create significant benefits for themselves with quite small loans.”³⁰ Numer ous success stories support his claim. In Bolivia, micro-entrepreneurs with access to microfinance loansPage 39 nearly doubled their income within two years while those unable to attain such loans were unable to achieve financial gains remotely close to that extent.³¹ A microfinance institution in Kosovo, ProCredit Bank, helped numerous families survive post-war crises by providing loans to rebuild their homes and businesses after the civil war.³² Finally, clients of BRAC, a microfinance institution in Bangladesh, were able to combat malnutrition in significantly higher numbers then non-clients.³³

In many developing countries, the pathways for institutions to provide financial services are blocked by non-ideal conditions, such as high inflation rates, incompetent governments, and deficiencies in the legal framework necessary to support such financial services.

The current market for microfinance institutions is continuing to grow. As many as 400 million potential clients worldwide lack access to financial services, a significantly greater number then the current industry could reasonably serve.³⁴ According to a 2007 report by Morgan Stanley, worldwide loan portfolios of microfinance...