Microfinance should become mainstream

Professor Moorad Choudhry, Visiting Professor at the Department of Mathematical Sciences, Brunel University
Tuesday, 8 Oct 2013 | 2:05 AM ET
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The concept of "microfinance" doesn't exist in the developed world, in the way that it does in developing economies. Yes we have Credit Unions, but their share of the market is tiny, and they don't have an impact on the lower-income sector of the population in any meaningful way.

But in emerging economies, microfinance has helped transform society. Perhaps the best, and certainly the best-known, example is Grameen Bank in Bangladesh, which earned its founder Professor Muhammad Yunus a Nobel Prize and was the driving force behind the empowerment of thousands of the rural poor, and particularly poor women, to set up their own businesses and break out of the cycle of poverty. Microfinance and microcredit is a proven business model.

In fact, Microfinance does exist in developed economies. However the suppliers aren't banks, but so-called Payday Lenders. A sure sign of an economy in recession, or emerging from recession, is the rise in companies advancing small loans to consumers, often at exorbitant rates of interest. A good example in the UK is Wonga.com, a payday lender that has a high profile and a business model that emphasises its flexibility, ease of access and instant response over the internet. It also charges, as it points out on its website, a representative interest rate that comes close to 5,000% APR in many cases.

(Read more: Payday lenders: Is the 'clock ticking'?)

In a recessionary environment, companies like Wonga benefit because a larger share of the population find themselves unable to access mainstream banking facilities, perhaps because of poor credit history and/or unemployed status, and so turn to payday lenders. Often the need is for a small loan, under £1,000, and for only a short period of time (say, four-six weeks). Mainstream banks, even where the customer is considered an acceptable credit risk, do not offer such facilities.

That's a pity. The microfinance loan is a legitimate and customer-friendly product. The profit-making success of companies like Wonga - they are a UK Premiership football club shirt sponsor, to the tune of several millions a year, implying they have cash to spare – demonstrates that this segment of the loan market is a viable business proposition, but the requirements of business model itself are not beyond a bank's capabilities.

(Read more: Payday Loans Cost Economy $1 Billion in 2011: Study)

Default rates among this customer franchise may not necessarily be higher than the prime lending market. Obviously the key to banks being seen as providers of choice for consumers would be a much lower interest rate. And this is where banks' existing size and balance sheet strength comes in. Banks can afford to make a lower return on capital (RoC) than the likes of Wonga on this lending, because it wouldn't be their primary line of business. The risk-weighted asset value will be material, but microfinance would be a small part of the balance sheet overall. The aggregate increase in regulatory capital requirement would not be expected to be unbearable. So this asset class is not unviable for banks.

But above all, it would be a valuable service to society. Banks represent the communities they serve. It isn't in their – or society's – interest for there to be a significant percentage of the community that is "non-banked" and cant access credit. By taking microfinance into the mainstream, banks achieve one of those rare things in business: a genuine win-win.

Professor Moorad Choudhry is Visiting Professor at the Department of Mathematical Sciences, Brunel University and author of The Principles of Banking (John Wiley & Sons 2012).