Generating income, the micro-credit way

When we imagine giving loans for income generating activities we feel happy that there are companies (MFIs) that are filling such a dire need for the poor.  We are happy that micro-credit is helping them buy goats or cows, start a tiny kirana shop, a cycle repair shop and in some cases help farmers buy inputs during their crop cycles.  But are these really “business loans” the way we like to imagine them?

How much of the loans go for Income Generating Activities?

All information that I have come across tells me that the % of micro-credit loans that go towards income generation activities being only around 30-40%, with another 30-40% going towards life-cycle events such as marriage, death, health emergencies and the rest (approximately one-third) towards purely consumption activities.

Loans for Income Generation

Regardless of the percentage, when we imagine giving loans for such activities we feel happy that the loans are helping the poor buy goats or cows, start a tiny kirana shop, a cycle repair shop and in some cases help farmers buy inputs during their crop cycles.

Let’s pause and compare these “business” loans to mainstream businesses: What happens when you or I need a loan for a business activity?

A mainstream startup, when it seeks capital in any form (loans, equity and any combinations of the two) has to submit a detailed business plan explaining why it thinks it will be profitable and sustainable over time.  In other words, the lender (or investor) tries to form an informed opinion about the financial viability of my business.  On top of that, based on cash flow projections, s/he will also try to understand my ability to pay back the loan in time.

In other words, when a startup or small business applies for a loan from a bank, their business and their financial accounts are scrutinized from two perspectives: a) Their ability to pay back the loan, b) the financial viability of the activity itself.

In contrast, when MFIs give loans for income generating activities, typically the only thing they check is the repayment ability.

Can we really call a loan that is given without any attempt at understanding the business, a business loan? Or is it just a personal loan under a different name?

For any micro-loan given to buy a goat or equipment for a cycle repair shop, do MFIs develop an informed point-of-view about the profitability of the planned income-generating activity?  Do they have loan officers specializing in “business loans” who have been trained in scrutinizing P&Ls and business plans, like banks do?

Repayment Terms

Thirdly, any real business loan would take into account the repayment cycle given the nature of the business.  If I gave a working capital loan to a business I will want to know the average time between procurement and sales, which will give me a good idea of the time-frame when I can expect to get my money back.  If I am giving loan to a farmer, I might design a loan which has no repayments until the crop matures. Even “college loans” in countries like the US, have a very minimal (or no) repayment requirement while the student is in college and revert to higher “EMI” upon graduation. That is any loan given as capital or investment is designed with a repayment timing that takes into account the natural cycle of the activity in question.

But almost all MFIs have a fixed repayment schedule that starts immediately after loan disbursements.  So if farm input loans have “EMIs” that begin the week after loan disbursements, how is that different from a personal loan for buying a plasma TV?

So what?

You might say, well we are just debating semantics.  Why does it matter whether we call the loan a business loan or a personal loan.  Hold that thought for a moment…

If we continue with the logic, it implies that when thinking about micro-loans for income generating activities, a good MFI should ask itself:

  1. What % of loans are actually being used for income generating activities or business?
  2. How are the approval criteria for income-generating activities different from any personal loan? (In other words, how do we learn about the business being undertaken?)
  3. How are the repayment terms for income-generating loans different from any personal loan?

One consequence of apply such a logic will be that we will have a truer picture of which loans are truly being seen by the lender as business loans versus personal loans.

Now let’s say I am running an MFI.  I realize that if I apply the above criteria, I hardly have any loans that are truly business loans. Let’s say I develop the capability to do #2 and #3 above.  What then?

More likely than not, I will find that all these “businesses” like sheep rearing and cycle repair shop are not going to be profitable (or perhaps even break-even).  What then? Some of them may be “fixable” through easy measures and a bit of advise.  But what about the rest?  Do I no longer give them credit if they still insist on undertaking the activity against my advise?  Or for such activities, I revert to giving them personal loans with the fixed EMIs and terms of personal loans, knowing very well that this activity may not generate enough income to even cover the investment, let alone provide additional income.

Or here’s an even more scary thought:  Have all MFIs reached this conclusion already?  That all these micro-businesses are never going to make any money. So why pretend that they are anything but personal loans.  I will still categorize them under “income-generation” because that is what the lenders and the rest of the world expects from me.  But at the bottom of my heart, based on all my analysis, I know that these businesses are never going to generate any real income.

Rationally speaking, based on what I have learnt about micro-businesses in the last year and a half, I would say most of them are bound to fail.  Even mainstream start-ups have low success rates (by some measures only 10% survive the 3rd year).

And, one thing most people forget is that businesses need a lot more than just money to succeed.  They need good business skills – to make good decisions about which business to enter and which to avoid, how to run their “operations”, how to manage finances, etc.  And as Ela Bhatt (SEWA) has said recently: the poor need more than loans to be successful entrepreneurs.  They need business and financial advice as well.

Coming back to micro-credit for income generating activities, this means that perhaps we should add a fourth element to our list of questions:

  1. What % of loans are actually being used for income generating activities or business?
  2. How are the approval criteria for income-generating activities different from any personal loan?
  3. How are the repayment terms for income-generating loans different from any personal loan?
  4. How can we link the poor with experienced entrepreneurs who have started similar small businesses and succeeded in generating income over “long” periods of time? Or, failing that, what alternative methods can I deploy to help them build financial and operational skills needed to run a business?
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This entry was posted in Financial lives of the poor, Micro-enterprises & rural businesses, Microfinance and tagged , , , . Bookmark the permalink.

2 Responses to Generating income, the micro-credit way

  1. We had advanced warned that it would be a free fall for SKS:

    Micro-Finance to Face Slow Painful Death. SKS Share to enter Free Fall. Sell, Sell, Sell! 7/11/10
    Read more: http://devconsultgroup.blogspot.com/2010/11/micro-finance-to-face-slow-painful.html

    SKS Micro-Finance drifting into a firm Bear Grip 14/11/10
    Read more: http://devconsultgroup.blogspot.com/2010/11/sks-

  2. Babu Rahman says:

    Dear Richa,
    Good questions. So, I challenge you, what are the answers? What should the answers be (i.e. to #1)? What are the next steps? If I’m one of the well-wishers on the other side of the world looking to create income-generating activities, possibly with MFI support, what criteria should I be looking for? Are there MFIs that you would recommend working with because they ask the tougher questions and aren’t scared of the inconvenient truths?

    I’m particularly interested to hear your thoughts about the 2nd half of #4: “what alternative methods can I deploy to help them build financial and operational skills needed to run a business”. As you know, part of what Agami strives to do is facilitate that infrastructure in which income generation can occur. Any advice (Bangladesh specific?) would be welcome.

    Thanks!

    Babu

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