Covid-19 represents crisis for microfinance in low-income communities

ISLAMABAD: The COVID-19 pandemic has created immediate challenges for institutions that serve affected communities, a study says.

It was prepared by six academics associated with prestigious educational institutions of the world. They included Kashif Malik, Assistant Professor, Economics Department of the Lahore University of Management Science (LUMS), Simon Quinn, Associate Professor, Department of Economics, University of Oxford, Muhammad Meki, Lecturer, Department of International Development, and Oxford Centre of Islamic Studies, University of Oxford, Jonathan Morduch, Professor, Robert F Wagner Graduate School of Public Service, New York University, Timothy Ogden, Managing Director, Financial Access Initiative, New York University, and Farah Said, Assistant Professor, Lahore School of Economics.

The study focused on implications for local microfinance institutions (MFIs) in Pakistan, a country, it said, with a mature microfinance sector, serving a large number of households. It conducted rapid response phone surveys of about 1,000 microenterprise owners, a survey of about 200 microfinance loan officers, and interviews with 20 senior representatives of microfinance institutions (MFIs) and regulators in the sector. These surveys were run starting about a week after Pakistan went into lockdown to prevent the spread of the coronavirus.

“We find that, on average, week-on-week sales and household income both fell by about 90 percent. Households’ primary immediate concern in early April became how to secure food. As a result, 70 percent of the sample of current microfinance borrowers reported that they could not repay their loans; loan officers anticipated a repayment rate of just 34 percent in April,” the study said.

It argued that COVID-19 represents a crisis for microfinance in low-income communities and has disrupted both the client-facing and the capital-facing sides of microfinance simultaneously.

The profound crisis is sufficient to make it highly likely that a significant number of MFIs globally will not survive. It presents both the necessity and the opportunity to reconsider the innovations and compromises that have shaped the modern microfinance movement. That reconsideration is vital to guide policy responses to the present crisis and its aftermath in Pakistan and elsewhere.

The study framed the reconsideration around six points, designed to stimulate discussion in the microfinance policy community.

First, the industry must reconsider how microfinance is used by most of its customers. “We are far from the first to point out the mismatch between the standard microcredit loan and the rhetoric of business investment. For most clients, microcredit is primarily a tool for managing liquidity, for households and microenterprises to match their volatile cash flows to their money management needs. The concerns of the microfinance CEOs we surveyed were not consistent with those of investment banks but with those of markets that depend on liquidity – the kind of financial markets (such as overnight lending) that central bank authorities in the United States and Europe stepped in to backstop first. Recognising that microfinance is primarily about managing liquidity has many implications, especially for regulation and oversight.”

Second, the idea that non-deposit-taking institutions could be exempted from prudential regulation because customers would not be hurt by failure or insolvency (and perhaps could even be helped) is highly questionable if the primary use of the product is managing liquidity. When investment loans become unavailable, growth is certainly a casualty and recession is likely.

But, the study said, when sources of liquidity dry up, consequences can be much more severe in a much shorter time frame and with devastating effects for both sides of a market. That is a different rationale for prudential regulation of microfinance and its role in the economy of lower-income households and microenterprises. While microfinance institutions are quite diverse, there may be some common need for regulation and supervision due to the similar roles the institutions play in the financial lives of their customers, and the overlap in the customer base.

Specifically, the surveys point to significant near-term and, absent action to provide future access to financial services including borrowing, long-term suffering of most microfinance customers. That is a powerful argument for regulators and central bank authorities to quickly expand their efforts at stabilising the financial sector to include all forms of microfinance. Emergency liquidity facilities and recapitalisation must be considered to allow MFIs of whatever stripe to forbear or forgive current loans and be in a position to extend liquidity management products when the pandemic is under control.

Third, now is the time to extend regulation and supervision beyond financial oversight to consumer protection. While such regulation would not have prevented the current crisis, the depth and seriousness of the crisis requires it sooner rather than later to protect customers from even more harm.

The MFI CEOs surveyed during the study shared concerns about the behaviour of field staff; loan officers and customer reports showed they were right to be concerned. When a product plays such a large role in poor households’ financial lives, it behooves governments to ensure that those households are protected from exploitation by the providers of that product. Governments should consider taking consumer protection principles developed within the industry as voluntary guidelines and making them mandatory regulations.

Many governments, like Pakistan, have imposed moratoriums on repayment – some with forbearance on interest, others not. Regardless, as survey participants noted, it is unclear whether borrowers will ever be able to fully repay these loans, especially absent new lending. What does consumer protection and responsible lending look like in the aftermath of a pandemic?

Letting individual MFIs decide for themselves may not produce optimal outcomes for the lenders or for the borrowers (see point six below for more discussion of this issue).

Fourth, the global microfinance business model may need to be significantly rethought – and additional innovation may be needed. While it’s clear that MFIs face a liquidity crunch, and absent bailouts may quickly face insolvency, it is unclear what happens next. Even if bailouts are forthcoming, capital markets may be much more wary of investing in MFIs now that there is experience of how quickly normal operating procedure can turn into insolvency.

Given that there is uncertainty as to how the pandemic will play out, including possible recurrences of COVID-19, or of other epidemics or pandemics (there have now been three coronavirus epidemics in 17 years), there should also be uncertainty that the way microfinance has been funded for the last 40 years will remain viable. On the customer side, additional regulation and supervision imposes costs.

There is a trade-off between the amount of regulation and who gets served – more regulation means higher costs, which means that the most marginalized and poorest (read, most expensive to serve) will likely find that they are no longer part of the target market of many institutions (which may in turn struggle to find funding if they can’t make the case they are serving the most excluded).

Fifth, the current crisis illustrates just how far there is to go before digital financial services change operating procedures in the industry (with obvious heterogeneity from country to country). Deploying technological solutions is capital intensive – both in terms of financial and of human capital. That’s why the leaders in digital financial services tend to be either well-funded existing corporations with a steady revenue stream (like mobile network operators) or fin techs with access to large amounts of risk capital.

Sixth, and finally, two of the most important, but intangible assets built up by microfinance - trust and social capital - are at risk. MFIs, with exceptions, of course, have built up a great deal of trust with their customers by following rules-based processes and providing reliable services in environments where both are often lacking.

Without collective action – from MFIs, regulators and supervisors, and investors – that trust could be destroyed by the present crisis.