The Missing Middle in Micro-finance

Savita Shankar, associate professor at Keio Business School, Japan, shares her research in a 2-part article on how to address the needs of millions of micro entrepreneurs who form the ‘missing middle’ as their financing needs are met by neither micro-finance institutions nor commercial banks.

The missing middle

Anika, Babar, and Saba met during a festival organised by their village community hall and hit it off straight away. All three had a dream to start their own business selling local snacks and specialties to the business people and merchants of the area. They had no capital, only their passion and expertise in cooking, and the motivation to offer their snacks to people in the village and beyond. Luckily, they had heard of a micro-finance bank in the nearest big town some seventy miles away and, after convincing the lender that their business idea was worth it, they became the happy beneficiaries of an initial Rs25,000 ($384) loan – enough to set them up in a stall near the market place and pay for the ingredients for their first snacks. Business boomed and Anika, Babar and Saba, naturally encouraged by the signs, wanted to grow and add an area in front of their stall where customers could sit and eat their snacks and engage in conversation. So they returned to the micro-financer and obtained another loan – this time for Rs50,000 ($768). The stall grew, and the quality of their snacks and passion for service spread by word-of-mouth further and further afield until they realised that the opportunity for yet another venture was there to be explored – a food truck. So once again they returned to the micro-finance banker who, very pleased with the regular repayments and slight margin he gained from the youngsters’ business success, announced that he was ready to accord them a grand Rs100,000 loan, equivalent to $1,536. Now this might have been enough to purchase a very old van, but certainly not a reliable and newer van as well as all the outlay required for ingredients, petrol and wages for the two people they wished to hire as driver-sellers of their famous snacks. But when they mentioned this, the lender sadly shook his head – he could no longer help them because his type of bank could not lend over the limit of Rs100,000. It was the law. Thanking the lender for the help already given, undeterred and believing in their dream, Anika, Babar, and Saba decided to go and see a commercial bank in the city for a bigger loan. The commercial banker listened with interest to their story and congratulated them on their success and entrepreneurial spirit. But then, when they had finished explaining their case and fell silent for the banker to make them an offer, all she did was sadly shake her head – she could not, unfortunately, grant them a loan. No – the smallest amount she was allowed to grant was Rs1 million – and that was for targeting small-to-medium enterprises, not informal start-ups. Anika, Babar, and Saba looked at each other in disbelief. Little did they know, but they had just become victims of what might be called the microfinance graduate syndrome or missing middle.

The context and issues

Savita Shankar, professor at Keio Business School, Japan, decided to research the phenomenon of the missing middle in three key countries for micro-finance – India, Bangladesh, and Pakistan. The term missing middle is generally used to describe the disproportionately small number of SMEs in relation to the number of micro or large enterprises in developing countries. In her research, Prof. Shankar uses the term more specifically to refer to the lack of financing options for enterprises whose needs fall in between the typical loan sizes offered by micro-finance institutions and commercial banks – exactly the case of our young heroes Anika, Babar, and Saba. They were successful ‘graduates’ in their entrepreneurial venture but capped on the amount of micro-financing required to grow further, and too small to benefit from the size of loans offered to SMEs by the commercial banks: almost like striding across a series of stepping stones only to find, mid-river, several of them missing and the other side of the river heart-achingly out of reach. This problem creates something of a conundrum for millions of fledgling entrepreneurs in developing countries. But there is hope.

Financial exclusion and the growth of micro-finance

‘In recent times, financial inclusion has been on the policy agenda of many developing countries,’ states Prof. Savita Shankar. This implies availability of a continuum of financial services for all income groups, the idea of an inclusive financial system being to ‘provide credit to all bankable individuals and firms, insurance to all insurable individuals and firms, and savings and payment services for everyone,’ she continues, quoting the United Nations definition of financial inclusion.

The figures speak for themselves. In India, Bangladesh and Pakistan – the three countries analysed in Prof. Shankar’s research – financial exclusion is widespread. According to the World Bank’s Global Findex database (2014), only 56.3%, 35% and 13% respectively of individuals in those countries above the age of 25 years possessed a bank account while only8.8%, 13% and 2% respectively had a formal borrowing account.

However, spurred by the UN, the willingness to promote financial inclusion helped pioneers such as the Grameen Bank in Bangladesh and hundreds of others who followed to grow. The result today, is that the microfinance sector, having reached maturity, sees the need for successful micro-financed entrepreneurs to aim for higher loans that don’t actually exist. Hence, the ‘missing middle’ – those whose needs are neither met by microfinance institutions nor commercial banks. Indeed, India, Bangladesh and Pakistan have sizable missing middle segments with considerable employment potential. ‘And as employment generation is an important goal for all three countries,’ she asserts, ‘catering to the missing middle is a priority. This means that it is firmly on the policy agenda.’

Microfinance and the challenges

Prof. Shankar based her research on interviews with key personnel from the microfinance and banking sectors in each of the three countries. Thirty-two interviews were conducted in all, with at least ten interviews conducted in each country, mostly with chief executive officers of microfinance institutions and banks including stars such as BRAC, Grameen Bank and the Basix Group.

She found that the biggest challenge faced in lending to the ‘missing middle’ firms in the three countries is the high degree of informality of their operations. In India, a large urban-based NBFC-MFI, Janalakshmi Financial Services, surveyed 13,177 potential missing middle customers with surprising results: 90% of them had never filed an income tax return, 67% had not maintained a book of accounts, and 65% had no enterprise registration of any form. ‘This informality,’ states Savita Shankar, ‘is a primary reason for their financial exclusion, as banks typically ask for various documents and records before lending.’

These entrepreneurs also miss out on finance for another reason: they are unable to offer collateral – security pledged for the payment of a loan – to lending institutions. ‘And even if they do have property,’ explains Prof. Shankar, ‘often the accompanying papers and documents may not be complete, making it hard for lenders to create a title and mortgage it.’ As a result, lending to them has to be based on an assessment of their cash flows. But this isn’t easy. Try gaining a clear picture of a small company’s accounts and transactions when most of their business is cash-based. It makes it tough for financial institutions to obtain a clear picture of their volumes.

Continue to Part 2 of Prof. Savita Shankar’s feature article – The Next Leap forward for Micro-finance: Bridging the gap.

Food for thought: Having seen the challenges, what solutions do you think could be found to overcome these? Compare your ideas with part 2 of the article this coming Thursday!

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