More than 2.5 billion people live on less than $2 a day. This level of poverty is not only disconcerting as a human rights issue, but also threatens global and regional peace as well as economic stability. What people of limited needs require to emerge from the continuous cycle of poverty is access to capital.

A relatively new set of financial services called microfinance now provides what appears to be a sustainable way of supplying access to that capital. Microfinance institutions, or MFIs, have achieved public recognition mainly for making small loans (sometimes as little as $50) to people considered “unbankable” by the conventional financial sector—and for achieving remarkably high repayment rates on those loans (with top-tier MFIs reporting repayment rates as high as 97%). Over a few decades, some 600 million of the world's poorest people, previously left completely behind by the financial sector, have been provided with access to capital that has allowed them to build businesses and livelihoods. MFIs also provide other financial products and services, such as insurance and deposits, as well as business training and networking opportunities, designed for the economically active poor.

At present, microfinance is changing from a sector driven mainly by a commitment to a social bottom-line to one more responsive to the demands and interests of private capital and customers. Traditional NGOs dedicated to microfinance have begun to transform themselves into licensed banks and non-bank financial intermediaries to gain access to public funds or small savings deposits. At the same time, some established commercial banks and finance companies have recognized the potential of micro-credit to enhance their product mix and bottom line. Encouraged by the successes of MFIs, many credit unions have begun to reinvent, or at least reinvigorate, themselves and are seeking to regain their leading role as suppliers of a full range of financial services to the poor. Even more striking, the world's largest banks, including Citigroup, Deutsche Bank, Commerzbank, HSBC, ING, ABN Amro, and Morgan Stanley, are entering this “double-bottom line” industry.

Greater involvement of the capital markets is likely necessary for microfinance to reach its full potential. Estimates of MFI annual growth rates range from 15% to 30%, thus suggesting a demand of somewhere between $2.5 billion and $5.0 billion for portfolio capital each year in the immediate future, with $300 million to $400 million in additional equity required to support such lending. But even these estimates could be too low if expansion continues at the exponential rates seen recently in larger MFIs. In short, it is clear that microfinance will need significant amounts of financing in the coming years.

Much of the demand will come from a handful of institutions. According to the Consultative Group to Assist the Poor, there are now as many as 10,000 microfinance institutions worldwide. But less than 1% are considered economically viable, and just 150 to 200 are estimated to be serving the vast majority of clients. These top-tier MFIs, all of which could be described as having taken a “commercial approach,” share a number of other important features: A range of products developed specifically for their clientele; ability to operate in competitive environments; and consistent maintenance of a portfolio at risk of less than 5% and repayment rates of 97-98% or higher.

Securitization—the repackaging of loans into tradable securities—is likely to be the quickest route for the microfinance industry to gain investor acceptance as an asset class and access to mainstream capital markets. In April 2006, Morgan Stanley arranged the BlueOrchard Loans for Development 2006-1 transaction—an almost $100 million collateralized loan obligation (CLO) backed by unsecured senior loans to 21 MFIs in 13 developing countries in Latin America, Eastern Europe and Asia. The largest of its kind to date, and the first to be arranged by a major international investment bank, the BOLD transaction showed that standard securitization techniques can be used to allow the mainstream capital markets to invest in the microfinance industry.

The entire microfinance industry faces a number of challenges in sustaining its successful growth, and satisfying its potential market—a market that is estimated to grow from some $17 billion at present to $250 to $300 billion over the next decade or two. The first is human resource capacity. The microfinance model is an extremely intensive consumer of human resources, especially in the critical area of credit operations. When the model is rigorously applied, the results are impressive in terms of both social outreach and financial return. But the sustainable growth of MFIs will require a supply of skilled personnel that might be difficult to find even in economies with far higher levels of investment in education and training than will typically be the case.

The second key challenge is the allocation of capital within microfinance, and the most appropriate roles for the different potential suppliers of such capital, whether equity, debt, or grants. Consider, for example, what happens in a mature market such as the debt financing of small- and medium-sized enterprises in a Western economy. Here we find governments and their agents having very specific and targeted roles in addressing areas where markets often “fail”—notably, the financing of startups without collateral, or businesses in depressed areas or industrial sectors seen as higher-risk but strategically important. But the funding of mature, profitable businesses will typically be left entirely to the commercial sector.

This stratification of the market has yet to take place in the microfinance sector. Indeed, despite the recent proliferation of funding sources, there is still considerable disagreement within the industry about fundamentals such as the proper “mission” of the funders of MFIs. Should it be purely commercial or should it reflect the social objectives of an MFI in terms of, say, health and education improvements, while making allowance for the inevitable dilution of financial returns?

The microfinance industry is in such an early state that it is still possible to see the tectonic plates shifting. It is therefore not surprising that there are many uncertainties about strategy, and some fuzziness over the parts that various parties should play. For microfinance to flourish as an asset class, however, the leading participants in the market—issuers, investors, and intermediaries—must engage in a debate over the optimal allocation of scarce funding resources. In so doing, we can hope to move closer to something like a consensus about how much and what kind of support should come from private versus publicly subsidized capital, and where it is most appropriately allocated in the market. Only then will we see the full potential of this vital development tool for the 21st century.

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