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What can social finance learn from microfinance?

Thirty years ago, Professor Muhammad Yunus founded the Grameen Bank in Bangladesh, creating a new way to provide credit and banking services to the rural poor. Yunus’ work was fundamental in proving that the poor could be reliable borrowers. His new system, known as microfinance, now has a global reach. According to the Charities Aid Foundation, there are some 3,500 microfinance institutions in more than 40 countries around the world—and more than 150 million families have received a loan.

For many years, microfinance has been the poster child of international development, heralded by some as the key to eradicating poverty. However, some commentators are concerned that certain microfinance agencies have lost their way. In one extreme example last autumn, as many as 30 people committed suicide in the Indian province of Andrha Pradesh as a result of the aggressive debt collecting practices of local microfinance agencies. These agencies were providing loans at rates that were too high for the borrowers, and they were not providing borrowers with the support they needed to repay those loans.

According to the All-Party Parliamentary Group of Microfinance, microfinance cannot be seen as a ‘universally positive social force’. In fact, if done in the wrong way, microfinance has the potential to cause problem debt and even to damage lives.

Social finance: the new poster child?

The question mark hanging over the microfinance model has paved the way for a new poster child to emerge in the charity sector over the past few years: social finance. Where microfinance increases access to credit for poor families in the developing world, social finance gives charities and social enterprises access to finance that delivers both social and economic returns to investors.

In many ways, social finance finds itself in the same place as microfinance was 15 years ago. A small group of social finance intermediaries are proving that the concept works. They are showing, to some extent, that you can lend to social organisations and get your money back. However, as the social investment fund CAF Venturesome has put it: ‘The market remains fragile and the actions of practitioners in the field could still damage this emerging industry either through carelessness or misdirected effort.’

This is a crucial time for social finance in the UK. Late 2011 will see the launch of the Big Society Bank, which will act as a wholesale investor for social investment and champion the sector to the public, stakeholders and investors. Using £350m in unclaimed assets from bank accounts, it will invest capital in intermediaries so that they are able to invest in frontline organisations.

So how can the Big Society Bank and social finance intermediaries make sure that social finance is still thriving ten years from now? How can they avoid a scenario where hundreds of social organisations have unmanageable debt and even face bankruptcy as a result of inappropriate borrowing? What can they learn from the experience of microfinance?

Lesson 1: Provide the right type of capital

Some microfinance agencies have run into trouble in recent years because they have charged interest rates of up to 40%. As the suicides in Andhra Pradesh so tragically illustrate, when borrowers cannot generate enough income to repay these loans, they fall into a spiral of debt.

Social lenders must be realistic about what financial returns they can expect and what investees can achieve with their money, particularly if they are high-risk borrowers. In terms of social finance in the UK, loans need to be provided on terms that reflect the returns that can realistically be achieved by charities and social enterprises. Many social finance intermediaries say it is hard work making loans at commercial rates, for a variety of reasons. NPC’s recent research forNESTA (the National Endowment for Science, Technology and the Arts) reinforced that message. It found that few intermediaries are lending at fully commercial rates. Investors looking to make a large profit will probably not find social finance the best option.

Social finance intermediaries need capital that is soft (charging below commercial interest rates, especially given the risk) and patient (lent over long periods—typically five to ten years). This is not the sort of money that banks are willing to lend. There are early signs that the people designing the Big Society Bank have got this message, and their plans state that the bank will make investments that support the development of the market. They will be long term, not very remunerative, and risky. Intermediaries are not going to start turning huge profits overnight, and commentators in the sector must remain vigilant, making sure that social finance does not get too expensive for charities and social enterprises.

Lesson 2: Support investees to get ‘investment ready’

When microfinance goes wrong, it is usually because money is lent to people for the wrong reasons (for example, to pay off another loan) and it does not come with proper support. Without a decent business plan, micro-entrepreneurs struggle to generate profit with their loan, making repayment difficult.

Our research for NESTA found that social finance intermediaries work hard to get charities and social enterprises ‘investment ready’—that is, they help them to develop a decent plan for using and repaying an investment. For many charities and social enterprises, which have long been dependent on donations, grants and public sector contracts, this is a new and challenging idea. Social finance intermediaries need subsidies to do all this capacity-building work, as the interest on loans does not provide enough income to cover these costs.

Early signs indicate that the Big Society Bank will not provide this sort of support. However, without it, the market will be slow to develop—you can’t lend £350m without a nice pipeline of organisations ready for investment. Profits that are channeled into the bank’s own charitable foundation will come too late, so subsidies to help charities and social enterprises get ready for investment will probably need to come from elsewhere (for instance, from trusts and foundations). This funding could be complemented by other low-cost support. For example, UnLtd and Social Business Trust are both organisations that provide advice to social enterprises and supply professionals who provide pro bono support to investees.

Lesson 3: Focus on social impact

The Grameen Bank was firmly rooted in the belief that social impact must come before profiting from the poor. Many of the organisations that have helped replicate and spread microfinance have retained this focus on social impact. However, some commentators are concerned that recent entrants to the microfinance market are focused more on generating profit than on reducing poverty. Even for lenders whose aim is primarily social, too few know what their social impact is. This makes it difficult to weigh up the risks and return of potential investments, and to judge the success of previous investments.

Social finance intermediaries must raise their game on measuring the social impact of loans, with the support of the Big Society Bank. Although plans for the bank do mention the need for social performance metrics, they do so only in passing. AtNPC, we would have placed greater emphasis on this. Understanding social impact is central to growing the market successfully and making sure it is having a positive social benefit.

Final calculations

The troubles in the microfinance world have taught us that the formula ‘finance + social purpose = positive impact’ is far too simplistic. In microfinance, this formula was so engraved on some people’s minds that they forgot that microfinance only reduces poverty under certain conditions: with the right interest rates, support for investees and a focus on poverty reduction. These three lessons should be transferred to the social finance world.

It is important to remember that money thrown at a social problem can have unintended consequences. We need more in-depth research to investigate the impact—both positive and negative—that social finance can have on charities and social enterprises.

The social investment market is developing fast, but it is still fragile. If we are to avoid some of the challenges that microfinance currently faces, we need to step back and reflect on where it is going so that we can find the most effective ways to reduce poverty in the UK and beyond.

For more resouces on this topic, please follow the link to the New Philanthropy Capital website, where this item was originally posted.