Microfinance, American style: Part 2, the good
By: David A. Smith
[Continued from yesterday's Part 1.]
Yesterday’s post opened the topic of payday lending as exploitive microfinance, designed not to maximize the borrower’s well-being but rather to hold that borrower on the razor’s edge of permanent default, as illustrated by this article from the Washington Post:
Meanwhile, big companies are muscling into a sector that has been dominated by independent operators, lured by the promise of a largely untapped $13 billion market. Wal-Mart, the world’s largest retailer, stepped up the competition earlier this year by slashing prices on its most popular financial services, such as check cashing.
Three years ago, I wrote about these ‘industrial loan companies,’ or banks by any other name describing them in favorable terms, although with a caveat:
“That’s caveat, not Cavett, as you know full well”
Pursuit of CRA investment test credit is a principal driver in LIHTC equity investment, leading to very high prices and resulting highly efficient use of government tax expenditures. And however much banks may tout their CRA performance, there’s no question it’s a burden to them, so if banks are competing against non-banks without a CRA obligation, they will be at a competitive disadvantage.
Consider then an entity that:
1. Has an enormous market capitalization.
2. Is active from coast-to-coast.
3. Takes deposits.
4. Makes loans and provides financial services to its depositors.
Is that a bank by any other name?
“O Romeo, that which we call a time-deposit, by any equivalent interest rate would yield as much.”
If it is, should it be subject to the CRA?
Ask Wal-Mart, as shown in this Economist article:
When Wal-Mart rolls into town, small shopkeepers quake. Now that the world’s biggest retailer wants to enter the financial business,
Industrial loan companies are a symbiotic species advantage – the ILC symbiotically lives inside the retailer, and provides the retailer’s customers with credit to buy the retailer’s products. That’s powerful competition, and we’re all for it – if it’s properly regulated (as to capital, transparency, and consumer protection) and provided it bears the same social responsibilities banks do – namely, CRA.
Beyond ILCs, we are seeing a rebirth of American microfinance (a business model that I believe was born in the USA just over a century ago:
Start-ups have emerged to offer lending to niche groups, such as Hispanic immigrants, at dramatically lower rates.
Niche lending is key to establishing a microfinance institution (MFI). Focusing on the niche gives the lender better touch on the customers, which reduces probability of default.
Even as non-banks are making small American microfinance loans, banks too are finding their way into the space:
Some credit unions offer short-term loans as an alternative to payday lenders. North Side Community Federal Credit Union in Chicago, manager Ed Jacob said, introduced a six-month, $500 loan with 16.5% interest several years ago.
Microfinance, American style, coming to you from the streets of
Five hundred bucks for six months? That’s the very definition of a normal microfinance loan worldwide.
Mohammad Yunus would be proud of you, NSCFCU
The credit union has since made 5,000 such loans, and it has become one of the most popular products.
Meanwhile, start-ups such as Progreso Financiero in
While we think of
With Progreso’s main Web site in Spanish, he probably doesn’t even have to translate the forms.
Financiero has made about 25,000 loans to its customers in
Let’s take him at his word, and return to that ‘usurious’ 36% interest rate. Convert that into 3% per month, apply it to a $500 loan and a six-month average duration, and you get a princely sum of $90 gross revenue per customer. Out of that must be paid costs of money, costs of administration, loan loss reserves, cost of collection, cost of marketing and advertising …
Hence the challenge of microfinance, American style. To make a profit from inception, you have to charge rates that seem very high expressed as a pure percentage. Then, even if you charge a rate that will take many people aback, you make so little per loan you need 100,000 customers to turn a profit.
To get the rates down, get the customer volume up
Jacob said the credit union doesn’t make any profit from its payday-loan alternatives.
Motivation matters. If you sell a drug to cure someone of addiction, that is very different from selling a drug to get someone hooked.
Too much payday borrowing
Instead, it hopes to boost members into good financial standing so they can then apply for profitable products such as auto loans.
Moving someone up the bankability pyramid makes the prospect profitable to you because you can lend them a larger sum for a longer interval. Lending profitability isn’t about interest rate so much as it is about the total ‘loan area’: Amount x Term.
Motivation matters. So does the lender’s use of profits, since that influences the lender’s orientation on rate compression – something to pursue, or to resist?
Some industry veterans are also moving into the sector. Just this year, Wal-Mart lowered the price of its prepaid debit card to $3 and its fee to cash checks to a maximum of $3.
The more nodes, the lower marginal cost
Finance scales. Like other network-based businesses, it has a substantial establishment cost of intangible and intellectual infrastructure. As those costs are shared across an expanding customer base, higher marginal profits ensue, allowing lower fees – which in turn expands the market further.
It also allows shoppers to pay many of their bills in stores. The giant retailer estimates that about 20% of its customers are unbanked.
20% of the people who buy there have no bank
Except on the historical context of microfinance born in the
“Our customers are living paycheck to paycheck and watching every penny,” said Jane Thompson, director of Wal-Mart’s financial services.
Wal-mart may be creating the Model T Bank.
The next global bank?
But perhaps the biggest hurdle the industry faces is improving customers’ financial literacy. Many are afraid of leaving their money in banks, do not have the documentation to open a bank account or have had accounts closed. They also may not understand how loans are structured.
There lies the regulatory and policy challenge – how do you distinguish between Bad and Good microfinanciers, when your prospective customer is unable to do so for himself?
D.C. resident Gregory Warf, 20, said he doesn’t want a bank account. He turns his savings over to people he trusts, like his brother, or hides it.
Familiarity dulls people’s risk sensitivity; we have many examples of unworthy siblings.
Oh, you can trust me, Simba
If he needs to cash a check, he goes to the nearest liquor store, which charges him a fee. And if he needs money – say, $10 to put on his SmarTrip card – he asks a friend.
Not trusting anyone dooms Mr. Warf to high transaction costs and cuts him out of the banking system.
“I’d rather have my money in my possession,” Warf said. “I don’t really trust anybody else.”
Except that those two statements are contradictory over time.
Write a comment