Fizzling Subprime and Fizzy Microcredit

from Sify

Manreet Sodhi Someshwar / DNA MONEY

Grameen Bank, the pioneer of microcredit, has entered the US market at a time when the subprime crisis has the American economy reeling. Its first loans have been in the city of New York. A third-world bank lending to citizens of the world’s richest country - ironical yet illuminating. In the face of declining credibility of mainstream US banks hit by the mortgage meltdown, the Bangladeshi bank has stepped in to finance those on the fringe of the banking system. Muhammad Yunus, the founder of Grameen bank, has been honoured with a Nobel prize and hailed as “Banker to the Poor”. Will the microcredit techniques of Grameen Bank work in the US where subprime has fizzled out?

Both microcredit and subprime credit work on the fundamental principle of lending to people who historically did not have access to credit. Also interest rates are typically higher for micro and subprime borrowers than those for “prime” borrowers. Which begs the question: if the inherent principles at work for both types of credit are same, why did the subprime cookie crumble while microcredit hailed across South Asia, Latin America and Africa, is making forays into the developed world?

The microfinance revolution started in the 1970s with independent initiatives in Latin America and South Asia. Thus far, it has allowed 65 million poor people around the world to receive small loans without collateral in order to build up assets, and buy insurance. The emphasis is on increasing economic productivity. In their book The Economics of Microfinance Professors Morduch and Armendariz de Aghion cite the following as pillars for microfinance:

Social collateral (each borrower’s loan is guaranteed by other members of her group)

Peer-to-peer monitoring ndynamic incentive (zero defaults mean the next loan amount can be bigger)

Repayment in frequent instalments

The fulcrum on which microcredit institutions operate is relationship: between bank and borrower, and amongst the group of borrowers themselves. The institutions know their customers very well and maintain frequent contact with them. SKS, one of the fastest-growing microfinance institutions in India, keeps its default rate below 2 per cent by using software that provides real-time data. Vikram Akula, its CEO and founder, says that on spotting a red flag, “we’re on it like a swat team”. Mohammed Yunus explains it thus: the poorest of the poor, who take out microfinance loans, see this as their one shot out of poverty and they don’t want to blow it. Hence the lower rates of default.

Subprime credit, on the other hand, was for housing (unlikely to boost productivity); the loans amounts were large; and not lent to groups. Additionally, subprime loans were secured (which makes it possible for banks to leave the door open for defaults); microcredit loans, however, are secured by sweat collateral (where the recipient has to work to earn cash to enable repayment).

In the US, the loans themselves were “sold” to a third party with no direct connection to the borrowers. Since the lender-borrower relationship was devoid of constant follow-up and monitoring, trouble was not spotted quickly enough. This led to ballooning payments with interest rates in excess of 1500 per cent.

In the case of Grameen Bank, its success is closely tied to its particular customer base. While traditional banks have historically lent exclusively to men, women make up the bulk of Grameen’s borrowers - 95 per cent. This is not unusual since microfinance is about small businesses which most often involves self-employment in the informal sector - an area where women are a large and growing segment. Microfinance institution across the world have successfully replicated Yunus’s model: the social cost of defaulting for women is much higher and simply not considered as an option given the various practical domestic financial constraints. Will this strategy work for Grameen Bank in the US? Is the poor woman’s relationship with microcredit the same whether she be in Dhaka or New York?

The rich are different from you and me, said Fitzgerald, but perhaps the poor are same across the world? At least the poor women are. Professors Morduch and Armendariz de Aghion cite that from the standpoint of a microlender simply interested in maximising profits, women - relative to men - might be better clients. Among the poorest of poor of the world, women have the dubious distinction of being over-represented. In addition, they are more conservative in their investment strategies than men.

In the US, 28 million people have no bank accounts while 44.7 million have only limited access to financial institutions - these “unbanked” produce $1400 billion in annual income, as estimated by the Federal Deposit Insurance Corporation. Grameen Bank, leveraging off its understanding of its core customer - poor women - has made its first loans to groups of immigrant women in Jackson Heights in New York’s borough of Queens. It might just be on the right track.