Banks that ignore the huge numbers of people who remain outside the financial system may be missing an opportunity to improve their image and increase their profits. Silvia Pavoni reports.
Financial exclusion is seen as a purely developing world problem. It is not. In some developing countries, almost three-quarters of the population are unbanked and access to financial services is confined to the urban middle classes. But the number of people in mature economies who remain outside of the financial system is also shocking. In the US, 7.8% of the adult population (17 million) do not have a bank account. In the UK, this applies to 4% of the population (1.75 million adults). Other developed economies boast similarly ignominious statistics.
Should banks care? The smart banks have realised that reaching out to the marginalised can be profitable, and helps to nurture a client base for the future. In addition, it can also go a long way to improving a public image badly in need of repair for some banks in the wake of the financial crisis.
This potential is not lost on banks and many are now targeting the low-income sector, often as part of a broader corporate and social responsibility (CSR) programme. In April, for example, JPMorgan invested $10m in the LeapFrog micro-insurance fund. In May, Citi provided $1m in grants to three local microfinance institutions (MFIs) in Haiti, and Wells Fargo made a $1m equity-equivalent investment in non-profit microfinance organisation, Grameen America. It seems that the time is ripe for more of the world's banks to take up the challenge to bank the poor.
Developing need
In the developing world, the need is dramatic. A recent survey by CGAP, the independent policy and research organisation that aims to improve financial access to the world's poor, indicates that about 70% of adults in developing countries are excluded from the regulated financial system, despite years of growth in the financial sector and multiple programmes championed by the World Bank and regional development banks.
The banking system's failure to enfranchise the low waged begins in the remittance sector.
The World Bank estimates that remittances totalled $443bn in 2008, of which $338bn were sent to developing countries, involving about 192 million migrants that make up a staggering 3% of the world's population. According to remittance experts, as much as 40% of this traffic bypasses the regulated banking sector's remittance operations.
Many are critical about the failure of the banking world to capture a greater percentage of the remittance market, as well as the failure to convert those remittance customers who do use banks into account holders. If up to 60% of remittances are being sent through banks, credit unions or other types of deposit institutions, this means that every month, millions of recipients collect their money at bank branches with little effort being made to retain their services by offering even the most basic of financial services.
According to the Inter-American Development Bank (IDB), in the majority of transactions where banks do distribute remittances in Latin America, they serve only as a licensed distribution agent for a money transfer organisation. Remittance operations are largely kept separate from other bank operations - sometimes even physically separate from the teller queues available to account holders.
The banks are missing a trick, because where serious efforts have been made to turn remittance customers into deposit holders, programmes report a 30% conversion rate. Implemented region-wide in Latin America, this could easily result in more than 3 million new clients and $1bn in deposits year after year, says the IDB.
Stepping stone
Banks do seem to be finally waking up to the potential of remittances as the first step in establishing a banking relationship. The key issue, say bankers, is to understand how to tailor products and services to an entirely new customer group. "Banks traditionally have not handled the majority of remittances in the US," says Bob Annibale, global director of Citi Microfinance. "We need to understand what will make a product appropriate for a customer segment that we've never reached before."
But Citi hopes to change this dynamic. By developing a better understanding of remittance traffic through partnerships with local and regional banks, Citi is opening up significant opportunities to enfranchise family members at both ends of the remittance chain.
Citi knows which of its remittance customers in the US are unbanked, and through partnerships such as the one it holds with Ecuador's Banco Solidario to serve New York's large Ecuadorian population, it has been able to analyse transaction data to find out which recipients have no bank accounts in their home country either. "By refining a partnership, we often realise that we're working with two ends of an unbanked family," says Mr Annibale. And this provides an opportunity to turn these family members into a savings customer. "Someone who does a remittance is someone who saves," says Mr Annibale.
The failure to bank the poor has historically been driven by the perceived lack of profitability in this client segment. But evidence from the UK proves that this need not be the case. According to data from Spanish bank Santander, a growing force in UK retail banking, reaching out to the low-waged community is as much about creating the customers of the future as it is about social responsibility.
Santander offers a basic bank account to the low waged, and such accounts currently represent about 6% of its total UK accounts. Analysis of account data reveals a promising trend: the swift migration of customers from these so-called entry accounts to intermediate products. The bank says that over the past two years, 40% of basic bank account customers have moved to accounts with some access to credit and other services. This is vital proof that a basic banking product can quickly become a stepping stone into more sophisticated - and more profitable - financial services.
Working together: Santander UK chief executive António Horta-Osório says inclusion efforts must be coordinated
Government support
António Horta-Osório, chief executive of Santander UK, underlines the importance of government and regulatory efforts to encourage banks and ensure that those which increase financial inclusion do not end up paying a disproportionate cost.
"There has been significant progress made in the past few years, but further progress has to be made together with the government, banks and [non-governmental organisations]. Financial inclusion efforts have to be coordinated because otherwise this may create an asymmetry in the market," he says.
The importance of legislative support has been clearly demonstrated in Kuwait, where a local law has forced employers to use bank accounts to distribute payroll to all employees, including low-income expatriates. As a result, Commercial Bank of Kuwait (CBK) has been able to introduce a low-cost labour account dedicated to the low-income segment, which was previously ignored by the country's banks.
The average holder of the new accounts earns less than $100 per month, and typically has never had a bank account before, even in their home country. Because of this initiative, CBK has more than doubled the number of its accounts over a four-year period.
Push on microfinance
In broader terms, the push to bank the unbanked also includes the world of microfinance, where small loans are extended to borrowers without bank accounts or credit history.
Having achieved widespread recognition as a development tool, microfinance has been promoted by many national governments and multilateral agencies eager to bridge the financial inclusion gap. According to data from the Microfinance Information Exchange (MIX), between 2004 and 2008 the microfinance sector experienced average annual asset growth of 39%, accumulating total assets of more than $60bn and gross loan portfolios of more than $44bn by the end of 2008, the latest full-year figures available.
The sector's impressive performance means that it has moved beyond an early reliance on philanthropic donations, and has widespread support from commercial banks and growing access to the capital markets.
Compartamos Banco is a prime example of the sector's success. Established in 1990 to work in rural areas of Mexico, Compartamos - the largest MFI in the western hemisphere - listed on the Mexican stock exchange in 2007. The initial public offering (IPO) of 30% of Compartamos's equity was 13 times oversubscribed and the share price surged by 22% in the first day of trading. The IPO raised $458m for its original investors, including not-for-profit entities such as the International Finance Corporation, although one-third of investors were private.
This represented a return on the original investment (which was about $6m) of 100% a year compounded over an eight-year investment period, and was seen as a clear indicator to private capital of the money that could be made by lending to the poor.
Muhammad Yunus, Nobel Prize winner
Success with a price
The reason for Compartamos's robust equity market valuation is to be found in its staggering returns on equity, averaging more than 50% a year. And the reason for such startling returns leads to the controversy which increasingly surrounds the microfinance sector: Compartamos generates those returns by charging annual interest rates of about 72%.
Compartamos is not the most expensive lender. Another Mexican MFI, Te Creemos, has annual interest rates of 125%, which many suggest is one of the highest in the mainstream MFI industry. Neither compare well to the industry average. Based on the 1084 MFIs reporting to the MIX, the median interest rate was 31% (the average interest rate was 38%), with one-quarter of MFIs charging rates of less than 22%, and three-quarters of MFIs charging rates of less than 44%. By comparison, the average interest rate on a UK credit card is between 16% and 19%.
Many feel uncomfortable about such large returns being made on the back of loans to the very poor. Muhammad Yunus, who earned a Nobel Prize through his work pioneering microfinance with Bangladesh-based Grameen Bank, voiced his criticism of MFI interest rates earlier this year to a gathering of financial officials at the UN.
"We created microcredit to fight the loan sharks; we didn't create microcredit to encourage new loan sharks," Mr Yunus told his audience. "Microcredit should be seen as an opportunity to help people get out of poverty in a business way, not to make money out of poor people."
Mr Yunus has advocated rates of no more than 10% to 15% above the cost of borrowing, saying that higher rates are akin to loan sharking. Yet by this calculation, more than three-quarters of the MFIs reporting to the MIX would fail Mr Yunus's test.
High touch, high cost
According to the MIX's research, the bulk of the money from interest rates is used to cover operating expenses in what is a high-touch business, where the cost of reaching the most inaccessible poor is high. In addition, it costs much more to manage multiple small loans than a single big loan, and many industry practitioners argue that reducing costs, rather than attacking profit, is the best way to lower interest rates.
Carlos Danel, executive vice-president of Compartamos Banco, defends its rates, saying that customers make good returns and therefore are in a position to pay the interest rates it charges. "Our clients have on average a monthly return on equity of 50%, which means that they are able to repay the interest rates without a problem," he says. "There was a time when interest rates were above 100%, when we were smaller. Going public has allowed us to grow more, to drive cost down."
Mr Danel also says that Compartamentos does not set rates as high as it could, and neither do its investors encourage it to do so. "I have had many investors come to me asking: 'How are we going to lower cost and become more competitive?' The right kind of investor raises the bar for institutions to improve their performance and better service their clients."
He argues that the peculiarities of each market dictate what operating costs and business models are workable. "The only way to reduce the interest rates faster is to grow the loan amount; and if we do that, we would need to move away from our target: the lower income client. Or we would have to push money onto [our clients]; so if they need $300 we would try to give them $1000. We don't want to do this either. The difference between a good loan and a bad loan is that a good loan is one you can repay; a bad loan is one you can't repay. We don't want to over-leverage the client," says Mr Danel.
Compartamos has serious growth plans, however, to be funded by an expansion into retail deposits in Mexico and an ambitious capital markets issuance strategy. Its recent bond issues suggest there is growing appetite for MFI paper among investors, despite a difficult macroeconomic backdrop and the struggle by many MFIs to refinance existing loan portfolios. It began a 6bn pesos ($486m), five-year funding strategy with a 500m pesos bond issue in July last year, followed by a 1bn pesos bond in November, one of the largest MFI bond issues ever.
Manuel Méndez del Río Piovich,president of the BBVA Foundation
Mutually exclusive operations?
Commercial banks have taken to microfinance with increasing enthusiasm. But many argue that running microcredit alongside conventional banking is an uneasy relationship. Culturally, they are worlds apart, not least in the dramatic differences in levels of customer sophistication and the very different skill sets required.
Conventional mechanisms, such as the use of collateral in traditional lending, become unworkable concepts when applied to microfinance. "I don't like the idea of having microfinance in a commercial banking business, because the way you conduct the two is very different," says Manuel Méndez del Río Piovich, president of the BBVA Foundation, the banking group's CSR concern. "Traditional commercial banks have gained high efficiency by using collateral guarantees; their activities are based on [their] use, this is something poor people don't have."
Operational cost and intensity are other big differences. Mr Méndez del Río Piovich likens microfinance to project finance due to the level of due diligence required. "The amounts we're talking about are $300, $500, but the analysis you need to do [on every project] is the same that you would do on a large project, such as financing a highway," he says.
Similarly, recruiting people with the right skill set is a huge challenge for any microfinance operation. Analysing the ability of a client to repay a microloan is often based purely on 'soft' factors; for new customers there is rarely a credit history to refer to. Additionally, for microfinance to reach out to the rural poor, staff must be prepared to travel to often remote and difficult regions, carrying cash and relying on simple printed spreadsheets for loan calculations. "A loan officer in microfinance has to be out seeing customers, out in the sun and the rain, visiting villages, [meeting] in markets," says Kurt Koenigsfest, CEO of BancoSol, Bolivia's leading microfinance bank.
But Mr Koenigsfest argues that microlending and conventional banking work happily together at BancoSol. And having a large microfinance business has certainly not discouraged other depositors, he says. "[Many of] our depositors have $300 in their savings account, so they're the same [microborrowers] that we lend to," says Mr Koenigsfest. "But we also attract deposits from larger companies, such as insurance and pension funds, [which see ours as] safe deposit accounts."
Partnership model
Other banks have built microlending on partnerships within the local business infrastructure. This provides greater familiarity for borrowers and reduces risk for the bank, says Coenraad Jonker, head of Standard Bank's community banking unit.
Standard Bank has focused on creating partnerships with local retailers, which handle cash for clients on behalf of the bank. In a community of 500,000, say, the bank would typically have partnerships with 100 retailers, which bring the net cash positions of clients to the bank on a daily or monthly basis; others manage the entire position locally.
"This shifts the risk of handling and transporting cash from within the bank to the community - where people know each other - while dealing with a bank means dealing with people they don't know," says Mr Jonker. "In such a community, the bank would have six or seven ATMs, while with 100 retailers, acting as points of business, the risk per transaction is much lower."
To ensure that policies on interest rates and other areas are respected, retailers sign an ethical code stating that they cannot independently change interest rates. If the terms are not met, the partnership is terminated.
Technological challenge
One of the biggest hurdles for microfinance is the technological demands of gathering and maintaining management information, reconciling data on a timely basis, and giving customers access to bank accounts or an MFI branch in remote areas. In more developed markets, the provision of mobile telecommunications-based microfinance demands secure and reliable telecoms networks.
Many technology vendors are working on solutions that can potentially revolutionise microfinance business models. IBM is working on a solution that promises to dramatically reduce costs, something that may help MFIs to address criticism over high interest charges. "We saw that MFIs operating costs were 20% of overall loan value, while in traditional banks it would be 3%," says Ian Watson, director of microfinance at IBM. "Our solution will lower costs by five or 10 times."
Mr Watson says that IBM is focusing on a centralised back office for MFIs, which will go live in the fourth quarter of this year for Prisma, a microfinance institution based in Peru.
IBM has already teamed up with the Grameen Foundation in India to develop Mifos, a scalable, centralised, open-source banking platform designed to help Grameen gain better control of transaction and accounting information, in order to generate growth and obtain new funding. In areas where there is a reliable telecoms network, microfinance representatives visiting rural villages can enter transaction data into the Mifos system on the spot, accessing a centralised web-base repository holding transaction data from 46 bank branches.
Information that once took weeks to compile is now available in real time, so that Grameen can more easily shift resources to where they are needed. It allows MFIs to accurately predict cash requirements, freeing up capital to support greater lending activity. And it provides timely, accurate information to help raise new capital from global financial institutions.
Financial inclusion has come a long way, but as the figures of the unbanked reveal, it still has a long way to go. Banking the poor and making a profit remains an emotive subject.
But to provide an effective and sustainable service to the community, many argue that it must shed the remnants of its charitable roots. Ruud Nijs, director of Rabobank Netherlands' CSR unit, says: "Focusing on financial inclusion is not philanthropy."
