The determinants of the success of microlending: a comparison of Iraq and the United States.

Rubach, Michael J. ; Bradley, Don B., III ; Brown, Justin Eric 等

INTRODUCTION

Microfinance institutions (MFIs) have become fixtures of the international community. For over thirty years, MFIs have successfully supported entrepreneurship by lending money to needy people all over the world (Richardson, 2009). The growth of the microfinance and microlending has spawned considerable research interest in this industry and its international growth. Much of the prior research has examined the product and service offerings of MFIs, management best practices, MFI clientele, and policy issues and their impacts (see Brau & Woller's (2004) literature review of microfinance). Brau and Woller (2004) found that scholarly inquiries into microfinance and microlending have generally lagged behind industry developments.

In Iraq, the United States government through the U.S. Agency for International Development (USAID) has successfully created programs that have provided more than 132,000 microloans worth a combined value of over $300 million. The loans have averaged $1500 at 1518% interest rates with a repayment rate of over 98%. (US Federal News Service, 2009). The microfinance loans from MFIs working with USAID have resulted in more than 130,000 jobs being sustained or created (Iraq Microfinance Industry (IMFI), 2010). In contrast, microfinance and microlending, while achieving considerable success internationally, have not generally succeeded in the United States. Microlending in the US has experienced high default rates, failures in meeting program goals, and a general lack of self-sufficiency or sustainability (Richardson, 2009). Sustainability as used herein refers to survivability, not the social responsibility focus that sustainability has begun to assume.

This article will examine the factors that contribute to the success and failure of microlending efforts, and compare the specific reasons for the success of the USAID programs in Iraq and the general failure of microlending and microcredit efforts in the US.

DETERMINANTS OF MICROLENDING SUCCESS/FAILURE

Microfinance generally refers to the informal and formal arrangements that offer financial services to the poor (Brau & Woller, 2004). While it has existed for centuries, microfinance came on the international scene during the 1970s as a serious effort to create and formalize financial services for the poor (Richardson, 2009; Brau & Woller, 2004). Domestic use of the terms "microenterprise" and "microfinance" did not appear for another decade (Burrus, 2005).

A microenterprise is a business with five or fewer employees. Many of these businesses have no employees other than the owners (Burrus, 2005). The purpose of microfinance is to provide economic opportunities, including financial capital and services, to the poor in the hope that the cycles of poverty can be broken through new business development (Crabb, 2008). Microfinance offers people living in poverty access to basic financial services, such as loans, savings, money transfer services, and insurance needed to run their businesses (Consultative Group to Assist the Poor (CGAP), 2009). At best, commercial banks in developing countries serve only 20% of the population (Richardson, 2009). MFIs have stepped in to fill this void, lending to individuals that traditional lenders have ignored due to high transaction costs and risks (Richardson, 2009). There are now thousands of MFIs servicing 100-200 million of the world's poor (Brau & Woller, 2004). The individual amount of the microloans in developing countries ranges from $10 to over $1000 with durations usually of less than two years. Borrowers are not usually required by microlenders in developing countries to put up collateral or undergo credit checks (Richardson, 2009).

Since the 1970s, MFIs in developing countries have been very successful, while those in the United States have seen limited success. Defining success for MFIs has been problematic. MFIs normally have dual objectives of financial development and social improvement. Financial success can be measured by the attainment of two standards: self-sufficiency and sustainability, i.e., operating without outside resources and subsidies. Whether an MFI meets the needs of microentrepreneurs or creates social improvements is more difficult to ascertain.

Theoretically, capital should flow to the poor and the microfinance industry should not be necessary (Schmidt, 2009). However, the realities of investment risk, asymmetric information for both lenders and debtors, high transaction costs, and the presence or absence of legal institutions and systems, all work to present challenges for offering microcredit by commercial financial industries (Schmidt, 2009). These challenges are compounded by over-emphasis by many financial institutions on the need for collateral, a tendency to ignore the debtor's willingness or ability to pay, a poor culture of repayment, lack of coordination and support between MFIs, business organizations and the government, and the divergent aims of microfinance itself (Knight, Hossain, & Rees, 2009).

There may be many causes for the reluctance of conventional financial institutions to serve the poor (Schmidt, 2009). There may be socio-psychological reasons, such as social prejudice, stubbornness and ignorance. More likely it is because poor borrowers are not perceived as profitable. The risk of lending to them is too high. The costs of the lending transaction are too great. The borrowers often have no collateral and no credit history. The costs to enforce the loan agreement may even exceed the amount of the loan itself (Schmidt, 2009).

Faced with exclusion by conventional banks or exploitation by loan sharks, the poor can gain access to credit through microfinance institutions: non-governmental organizations (NGOs), charitable institutions, self-help institutions, or public banks, organizations that often pursue objectives other than just making a profit. The common feature of these institutions is the pursuit of both economic (profitability) and social (impacting the lives of their clients) endeavors (Schmidt, 2009).

MFIs in developing countries have been recognized for their innovative means of delivering credit. Group lending is one way to ameliorate the problems arising from asymmetric information. Network theory recognizes that parties cooperate by virtue of the mutual benefits they will receive and reciprocate. Among networks there is a high commitment to cooperate among the interdependent parties (Scott, 2003). Under group lending, the borrowers monitor themselves, eliminating the need for providing risk information to the lender. The group networking and peer-mentoring associated with group lending add to its success (Richardson, 2009). In addition to group lending, innovations in microfinance in developing countries include flexible repayment schedules, public repayments, and flexible collateral (Armendariz de Aghion & Morduch, 2005).

Institutional theory highlights how rules enable and/or constrain organizational decisions. The theory recognizes the importance of history in shaping the rules, routines and processes that structure an organization's behavior (March & Olsen, 1989). Rules of operation are history-dependent and can include both formally codified standards and informal routines or norms. Rules are embodied in the policies, procedures, routines, and conventions around which activities are constructed (Scott, 2003). The rules can cause institutional inertia, which along with path dependency, can inhibit innovation by financial institutions and economic expansion in developing economies (Pei & Xiangping, 2009).

Financial markets have particular characteristics which shape, and are shaped by, the transaction costs paid by both consumers as buyers and financial service providers as sellers. Transaction costs are often hard to measure in practice, and will vary uniquely for each buyer-seller exchange (Porteous, 2004). They take two main forms: 1) Ex ante costs, which include the costs of search (for both buyers and sellers) as well as the costs of contracting; and 2) Ex post costs, which include monitoring the contract during its term and enforcement of contractual rights (Porteous, 2004).

Using transaction cost, network, institutional, and competition theories, we have identified some differences between the microlending industries in Iraq and the US (see Table 1). These differences and their effects on the success or failure of MFIs are discussed in the next sections of the paper.

US-LED MICROLENDING IN IRAQ

Microlending is a relatively new industry in Iraq (USAID-Tijara). Before 2003, there was no microfinance industry in Iraq. While loans were made to state-run enterprises and some small businesses during the Saddam Hussein regime, financial capital was often available only to those loyal to the regime. Entrepreneurs without political connections had no sources of capital except loan sharks who charged usurious interest rates (IMFI, 2010).

Between 2003 and 2006, there were only three MFIs in Iraq and those were operated by international NGOs. The Cooperative Housing Foundation, ACDI/VOCA and Relief International were the sole providers of microfinancing in the country at that time (USAID-Tijara). Currently, there are ten microfinance institutions (MFIs) operating in Iraq's 18 governorates. The loans to micro and small business enterprises range from $500 to $25,000 in size with an average duration of 12 months. Interest rates vary depending on loan size and the business's location (IMFI, 2009).

The USAID began the Izdihar project in 2005; it was terminated in March 2008. The Izdihar project began the efforts to create a sustainable microfinance industry, bank lending for small and medium size enterprises, business development services and training, investment promotion, and trade reform (USAID-Tijara). In 2006, the Izdihar project, in conjunction with the US military, created and funded the first indigenous Iraqi MFIs: Al Bashaer in Baghdad and Al Aman in Kirkuk. When the Izdihar project was terminated in 2008, six additional MFIs had been established (USAID-Tijara).

The Iraqi MFIs are located in different parts of the country (see Figure 1). They adapt their financial services to local borrowers' requirements. Some Iraqis have complained about the charging of interest on loans, a violation of the Koran. In response, the MFIs have offered murahaba Islamic loans. The major difference between a conventional loan and an Islamic loan is that a conventional bank charges interest while an Islamic lender does not. Under the murahaba loan, a service charge is levied instead of interest, allowing the lender to make a profit. For example, instead of lending a home builder $10,000 at 12 percent interest to purchase building materials, the Islamic lender will buy $10,000 worth of materials for the builder and then sell him those materials for $11,200. The lender still earns a 12 percent profit on the transaction. The final result is the same in both the conventional and murahaba loans. The latter differs only in that it follows the Koran's prohibition against charging interest (IFMI, 2009).

Since July 2003, when the first MFI working with the USAID began operation, some 200,000 loans worth more than $370.7 million have been made (IFMI, 2009). Over 75% of the microloans were made to start or improve businesses in production, services, agribusiness, and trade. The remaining loans were for home improvements which supported home-based and cottage industries. Private residences are often the locales for many neighborhood businesses, such as barbers, cosmetologists and seamstresses (USAID-Tijara)

Microloans make differences in peoples' lives. The following stories are not uncommon, but are more the norm for modern day Iraqi businesses.

Adla Saleh Azez in the city of Dohuk used three microfinance loans to create the Havel Academy of Sewing where Adla teaches professional sewing skills to Iraqi women. "These women come to me to learn how to make a living sewing," explains Adla. "Most return to their villages to set up their own businesses." Adla plans to apply for a fourth loan which she will use to purchase patterns and equipment in Turkey to make wedding dresses. She adds: "The [MFI] loans ... have made a real difference in the lives of dozens of women, myself included." (IFMI, 2009).

[FIGURE 1 OMITTED]

Muthana Idan Kabul is an Iraqi citizen who owns and operates a tea cafe in the Karkh area of Baghdad. During the worst of the sectarian fighting, insurgents would steal his cafe's furniture and even set his shop on fire. This did not stop him from operating his business. He received a $2,500 (US) loan from a USAID-backed MFI to improve his business. He has since opened a bigger shop and bought new tables and chairs (Block, 2009).

Hamzi Abid Ali grows grapes in the town of Balad. He has grown grapes there for many years, starting during the time under Saddam Hussein. He stated that his income has more than quintupled since receiving a $2,400 (US) loan from the Al-Baydaa Centre, a US-backed microcredit institution. He was able to buy a new irrigation system and well pump that has allowed him to expand his business operations and help him speed up repayment of the loan

(Fifield, 2009).

In 2008, the Tijara project became the successor to the USAID's Izdihar project. Tijara means trade in Arabic. The Tijara project is a three to five year program funded by the USAID to promote private enterprise growth and employment in Iraq. The project focuses on Iraqi communities and provides services that will stimulate businesses and provide greater access to loans and financial services (USAID-Tijara). The mission of the Tijara project is: "to promote economic growth and employment in Iraq by increasing private sector access to finance, in particular for micro, small and medium enterprises. This objective is fulfilled by stimulating microfinance institutions and private banks to increase loan volume and diversify their services and clients; by creating and supporting indigenous providers of business development services; and by working with the Government of Iraq to develop an improved enabling environment for increased trade and investment in the private sector." (USAID-Tijara).

USAID-Tijara and the Iraqi government have created Small Business Development Centers (SBDCs). The SBDC services range from offering microloans to develop new businesses to offering basic business training courses to help educate the Iraqi citizenry about how to manage a business. The SBDCs have created a voucher system to provide individuals with the financial resources to pay for the business education programs. The SBDCs also offer assistance for creating business plans and help entrepreneurs develop businesses from the ground up in areas that vary from taxi drivers to new hospitals (Small Business Development Centers in Iraq). Further, SBDCs sponsor business conferences, host trade fairs, and provide business and consulting services. While the SBDCs have not attained sustainable status, this is a long-term goal. The most critical service SBDCs perform, however, is linking aspiring and struggling entrepreneurs with microfinance institutions and banks that have capital to invest in the local business economy. It is interesting to note that in the Frequently Asked Questions section of SBDC's website, the agency was asked if there was an age limit on receiving assistance from the SBDC. The response was intriguing: "We would expect that a person who wants to create a business or has an idea should be 15 years of age or older." (Small Business Development Centers in Iraq).

To reduce risk and ensure repayment, Iraqi MFIs often require borrowers to provide a guarantor, who usually is a government employee. This safeguard has caused many of Iraq's poorest citizens to be excluded because they lack friends within the government. To include more borrowers and reduce transactions costs, MFIs working with USAID-Tijara program offer group loans. These loans are structured so that a borrower can receive a small loan (typically $650) by forming a group wherein each member serves as a guarantor for the others. During a four month period of 2009, 8,345 Iraqis (of whom 17% were women) received group loans collectively totaling $8.9 million (IMFI, 2009). In order to help the very poor, microfinance institutions in Iraq now are offering solidarity group loans to eight people or fewer. The group's collective promise, that every person will repay his or her loan, serves as the collateral for the loan. Group loans have been made to women's groups, handicraft associations and people referred from Iraq's 12 SBDCs that are supported by USAID-Tijara and Provincial Reconstruction Teams (IMFI, 2009; USAID-Tijara).

The Iraqi government has recognized the need to grow a strong private sector. The government understands that a modern free market economy and a favorable legal environment are necessary for Iraq to join the global economy. There has been substantial progress in the government's efforts to establish a business climate conducive to economic growth (USAID-Tijara).

As of February 2010, there are 58,852 outstanding microfinance loans in Iraq with a total value of $82,855,717 (US) (USAID-Tijara). The primary goal of the Iraqi microfinance industry is to provide quality financial services, mostly through loans, that will stimulate economic growth and create new and higher-paying jobs. The Tijara program assists in these endeavors by providing business development services and creating a sustainable microfinance industry (USAID-Tijara). Despite operating under the challenges of an insecure political environment, including continued sectarian violence, inadequate sources of human capital, and an underdeveloped legal and regulatory schema, MFIs in Iraq have displayed significant portfolio growth and high loan repayment rates--they are succeeding.

MICROFINANCE IN US

Despite the success that microlending has experienced internationally, efforts to support entrepreneurship of poor people in the US have been generally less successful (Burrus, 2005). US MFIs have been neither efficient (they have failed to become self-sufficient), nor effective (they have reached less than 1% of US microentrepreneurs) while suffering higher default rates than their international counterparts (Richardson, 2009).

US microlending began in the 1980s modeled after the programs established in the international context. Microfinance is a relatively young industry with most MFIs being created since 1995. The industry is very fragmented with many smaller lenders (Burrus, 2005). US MFIs are typically not-for-profit organizations (NFPs) that make loans usually for under $25,000 with the average loan about $10,000. The demand for microlending services in the US far outweighs the suppliers (Burrus, 2005). There are over 13 million microentrepreneurs in the US. Most are self-employed individuals who have no or few employees (Burrus, 2005). Many cannot obtain loans from traditional commercial banks due to the requirements of those institutions for a credit history or collateral. Unlike their international counterparts, US microfinancers usually do not make group loans, thus failing to utilize the benefits of networking (Richardson, 2009).

The US MFI industry is usually broken into two types: either credit-led--primarily offering credit and financial services, or training-led--primarily offering training and technical services. Training-led MFIs are concerned with business plan creation (Burrus, 2005). Training-led organizations often offer courses for feasibility studies, business plan development, and general individual preparation for operating a business. Additionally, classes or one-on-one assistance in tax preparation, marketing, technology utilization, and finances are available (Burrus, 2005).

While the need for microfinance in the US may never be greater, traditional financial institutions have not provided loans to microentrepreneurs. Most commercial banking institutions will not lend to individuals who lack a credit history or collateral. The US microfinance industry has been characterized by scale economies; larger lenders are more efficient and cheaper to run. However, MFI inefficiency, as measured by the lack of MFI self-sufficiency and sustainability, also characterizes the industry (Burrus, 2005).

While most not-for-profit microlenders in the US are unregulated--the only restrictions are general prohibitions within the Internal Revenue Code, state corporations laws, or consumer protection acts--US commercial lenders are highly regulated. These regulations increase transaction costs. The US microlending market suffers from both high ex-ante and ex-post transaction costs. It is expensive to gather the necessary information on potential borrowers, as well as to monitor and enforce loan repayments. The norm for US banks is to require borrowers to provide collateral, credit histories, and/or business plans in order to secure loans. These policies and procedures increase transaction costs. Information asymmetries occur on both sides of transactions. MFIs lack information about borrowers, an ex-ante cost, and borrowers have limited knowledge of or experience in financial or credit markets. US MFIs have failed to adequately address the information deficiencies of borrowers (Richardson, 2009). The lack of collateral affects both types of costs. Ex-post transaction costs are also quite high in the US. The costs to enforce a loan agreement through the court system in the US can be prohibitive. Further, state usury laws prevent lenders from charging higher interest rates to offset these expenses. The limits on interest rates limit lenders' returns and have adversely affected MFI sustainability (Richardson, 2009).

Further, the regulatory schema is severely restrictive. Under capital holding requirements, banks are required to hold portions of their capital against each loan they make. "The more risky the loan, the greater the amount of capital the bank must hold." (Richardson, 2009: 932). These requirements make it more difficult for conventional financial institutions to make microloans.

Previous research (Richardson, 2009; Dyal-Chand, 2005) has attributed the differences in the success of MFIs between developing countries and the US to differences in market structures. MFIs in developing countries have had greater success because the markets in which they are located are "less formal"--lacking in entry barriers and market saturation. The informality allows entrepreneurs to transact business more cheaply, i.e., without extensive transaction costs. In contrast, US markets are more mature in structure and in product offerings. US entrepreneurs need more market information and are required to perform more analyses, especially of the feasibility of their business models.

Lastly, government support for the US MFI industry has been previously mixed. There has been a general lack of federal funding for MFIs due to budget deficits. Plus, the Bush administration was criticized for its general lack of interest in microlending (Burrus, 2005).

The transaction costs present in US MFI industry together with regulatory restrictions on financial institutions have hampered the development of MFIs. While there have been calls for regulatory reform (Richardson, 2009), due to the structural and operational norms of financial institutions, MFI success in the US has been spotty.

CONCLUSION

The United Nations declared 2005 as the International Year for Microcredit to promote and increase the public's understanding of microfinance and microlending (UN, 2005). Muhammad Yunus and his Grameen Bank, a microlender in Bangladesh, won the Noble Prize in 2006 (Nobel Prize, 2006). Microfinance and microlending are now mainstays of international finance (Richardson, 2009). While microlending has positively affected the lives of hundreds of millions of people, there are still many more who have had no access to the services of MFIs (Crabb, 2008).

There are substantial differences in the operations of MFIs in Iraq and the US, ranging from how each approaches transaction costs and innovation to differences in their markets and the presence of governmental support. In Iraq, MFIs appear to have achieved considerable success. The experience of MFIs in Iraq supports the theory that a factor in the success of microlending is the presence of free markets (Crabb, 2008).

A study by the United Nations found that Iraqi men between the ages of 15 to 29 faced an unemployment rate near 30%. Microfinance loans made through the joint efforts of USAID-Tijara and Iraqi MFIs were instrumental in creating or sustaining 130,000 jobs. The study found that people with jobs did not join militias. Many of the group loans were held by former members of the Mahdi army who were able to earn more money as business owners than they did serving religious extremists (IMFI, 2010).

Despite the prior lack of government interest and support for microlending in the US, government support for microlending in Iraq stands in sharp contrast. Structural differences in markets are not the only answer. US regulation of financial lending institutions severely restricts microlending. The need for regulatory reform is great (Robertson, 2009). The current recession should provide opportunities for microlenders as the declines in the job market have forced many laid-off individuals to seek self-employment as a solution. However, the operational and regulatory structures of the US MFI industry have impeded its efficiency and effectiveness.

Microlending globally has positively affected many lives (Crabb, 2008). "We make around 220 loans a month that are collectively worth about $228,000," says Al-Mosaned

Executive Director Wakkas Noori. "Our loans keep widows in their homes and allow young men to turn their dreams into businesses." However, Wakkas Noori observed that the biggest difference between microfinance and banking is one of social responsibility. For him, "[b]anking is all about money, [but] [m]icrofinance is about people." (IMFI, 2009). While much has been done, there are still many more people who have no access to the services of MFIs. This will continue to be the challenge for both Iraq and the US on both the operational and policy levels.

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Michael J. Rubach, University of Central Arkansas

Don B. Bradley III, University of Central Arkansas

Justin Eric Brown, University of Central Arkansas

Table 1
Differences between US and Iraq Microlending Industries

                           United States                 Iraq

Formality of Lending           Formal                  Informal
System                  Highly Regulated for         Unregulated
                        Banks and Commercial
                          Lenders (CDFIs)
                        Unregulated for NFPs

Economic Freedom                High                     Low

Transaction Costs               High                     Low

Ex-ante                 Individual Business          Group Loans
                               Loans

Risk Avoidance             Business Plan         Peer Recommendations
                             Collateral
                           Credit History

Ex-post Enforcement            Costly             Societal Pressures

Regulatory Regime      Usury Laws / Interest          Innovative
                           Rate ceilings
                          Capital Holding
                          Requirements for
                         Commercial Lenders
                            Conservative

Markets (Dyal-          Formal (structurally    Informal (structurally
Chand, 2005)            developed)--Need for       under-developed)
                          more competitive
                              analysis

Government Support             Mixed                    Strong