Microfinancing platforms help entrepreneurs in emerging economies borrow from lenders around the world who crowdfund their business startup loans.
The lenders don’t make money, and most microfinancing platforms are nonprofits. But to reach the borrowers, they use intermediaries in the field who charge interest on the loans to cover their costs. Those interest rates can be higher than 30 percent in some cases. A professor at Duke University's Fuqua School of Business has devised a mechanism to keep interest rates lower without removing intermediaries from the process.
Professor Bryan Bollinger discusses his research in this Fuqua Q&A.
If lenders aren’t compensated, and the platforms are nonprofits, why do field partner intermediaries charge interest?
The field partners have costs, and charging interest allows them to cover those costs. That’s perfectly reasonable. But using data from Kiva, one of the largest microfinance platforms, we found the interest rates suggest the field partners who set them are maximizing profits rather than behaving in an altruistic way.
Under the current system, there’s less risk to the field partner with microfinance if the borrower defaults on the loan. Higher interest rates are often correlated with higher default rates. However, since the field partners are not responsible for paying back the principle to the lenders if the loan defaults, they have a much lower incentive to prevent default. We demonstrate that by shifting much of the default risk to the lenders, microfinance creates an incentive for the field partners to increase interest rates.
Also, the interest rates do not affect lender decisions, which removes one of the disciplining mechanisms that can keep rates down. Essentially the field partners are able to monetize the altruism of everyone else involved. When the field partners are getting free capital from lenders – as they currently do from Kiva – and have no risk in recovering the principal, everything is gravy to them.
So lowering interest rates means changing the incentives of the field partners. How can that be done?
The idea is very simple. The main difference in our proposed mechanism is that the loan is not actually to the borrower. Instead, the loan is to the field partner, who is then responsible to pay it back regardless of whether the borrower defaults. Of course, the money is lent to the field partner contingent on them loaning it to the borrower.
It still provides that injection of capital into the system, which is very much a positive for consumers in the area, and more people will have access to loans because of microfinance. Separating the loan payback to lenders from the default removes the upward force on interest rates.
When the field partner is making the loan themselves, they are motivated to keep the interest rate lower so they can pay back the principal, even when setting rates to maximize profits.
Why wouldn’t it be easier just to eliminate intermediaries altogether?
Around the time we developed our model, an alternative microfinancing platform – Zidisha – entered the market. They do not use intermediaries, and their interest rates are much lower, around 10 percent. This highlights the dramatic impact intermediaries can have on interest rates.
That said, the field partners serve a valuable a role: they are the ones on the ground, identifying eligible borrowers, processing applications, disbursing the loans and collecting payments. That takes local knowledge, and it takes money. There’s nothing wrong with field partners charging interest, because those costs must be covered and people need to be paid for their work. But the current mechanism can lead interest rates to be higher than they would be for standard loans if microfinancing wasn’t even an option. By contrast, under our proposed system, the consumers and the field partners are both better off than they would be without microfinance.
Microfinance is seen as a key tool for alleviating poverty in developing world. It accounted for $25 billion in 2007 alone – more than a decade ago – and crowdfunding has exploded over the last decade, raising $2.7 billion just in 2012. I think microfinancing can play a really important role. But nonprofits like Kiva need to remain aware they are working with for-profit entities and should account for those entities’ incentives.