In the early 2000s, a few pioneers started to experiment with the microfinance model in Western Europe. Faisel Rahman, fresh from managing a $120 million World Bank microfinance program in Bangladesh, was one such social entrepreneur. He had worked with 200 microfinance institutions (MFIs) in Bangladesh, creating the first microenterprise fund to grow businesses in rural areas. The experience opened his eyes to the similarities between financial exclusion in the developed and developing worlds.
Rahman’s family immigrated to London in the 1970s, escaping the war in Bangladesh. As a youth, he grew accustomed to moneylenders’ insidious role in his neighbors’ daily financial survival and saw how mainstream financial services often failed the poor. He came to believe that microfinance might play an important role in the United Kingdom. Intuitively, he felt that what held back the poor both in the United Kingdom and Bangladesh from accessing mainstream financial services was a perceived rather than actual ability to save or repay debts.
“The overarching problem is that the poor are perceived as second-class citizens,” says Rahman. “The provision of financial credit needs to draw inspiration from the original meaning of the world credo—I trust.”
When Rahman made his first microcredit loan, London was almost virgin territory for MFIs. He knew that he would have to experiment. Rahman set up an office in the basement of a friend’s charity and started to make affordable loans to women in East London, using an overdraft facility and his credit card as well as philanthropic and government funding. Between 2000 and 2005, he made more than 300 loans to women.
The experiment helped Rahman learn how the traditional microfinance model created for the developing world needed to be adapted for the developed world. First, potential clients in the developed world often struggle with severe indebtedness, so Rahman’s model included debt advice. Second, he realized that the peer-to-peer lending approach that worked in Bangladesh would not work in London. That was because communities were not particularly close-knit, and peer-to-peer groups, although good at building networks and relationships, proved less good at supporting entrepreneurs. Rahman realized that his service needed to work more like a community bank, with loan officers dealing directly with clients and offering training to those creating startup businesses. Third, he learned that there was significant demand for small personal loans.
In April 2005, Rahman launched Fair Finance as an industrial and provident society, a nonprofit structure with charitable goals, and opened its first office in Stepney, East London, employing five people, including two debt advisors. Rahman’s success was beginning to convince skeptics that microfinance was an appropriate model for the United Kingdom. His tactic was to provide evidence—from his work as well as other local microfinance providers—that financial exclusion was a reality and that the poor could repay their debts. In 2004, he set up a steering group of more than 60 community, housing, and private sector organizations in East London to tackle the problem of financial exclusion collectively.
Rahman’s efforts were well timed. Tony Blair’s Labour government had created a $190 million Financial Inclusion Fund to improve access to banking services, affordable credit, and money advice. In 2006, Fair Finance secured just over $900,000 from the fund for lending and to build its operations. Over a two-year period it nearly doubled its income and staff, and the debt advice portion of its work mushroomed. But in 2008, the government decided not to renew funding; the volume of loans Fair Finance delivered fell short of its target, despite high performance in loan accessibility, speed, and default rate.
Fair Finance found itself in a situation familiar to MFIs in the developing world. To reach scale, it needed to end reliance on public subsidy and raise commercial investment, much as Banco Compartamos did in Mexico and SKS Microfinance did in India. In April 2011, Fair Finance closed the first commercial investment deal in Western Europe, securing $3.66 million of debt from one retail and two investment banks as well as $1.17 million of social investment to expand its operations. Fair Finance had four branches, 3,000 customers; it had lent $4.7 million with a repayment rate of 92 percent since 2005. With the additional capital it aimed to open eight more branches and make about $22 million of additional lending available to some 50,000 Londoners over the next five years.
To reach scale, Fair Finance needed to end reliance on public subsidy and raise commercial investment, much as Banco Compartamos did in Mexico.
Although these numbers are tiny relative to the global microfinance market, Fair Finance’s role is significant. It is leading the expansion of the small, fragmented, and heavily subsidized microfinance sector in Western Europe. Its commercial banking deal is an encouraging sign of growing interest by mainstream banks in the application of microfinance in developed countries. Other signs include the setting up of a separate microfinance unit by Spain’s La Caixa bank in 2007 and the funding of Qredits, a new microfinance foundation in the Netherlands, by three prominent mainstream banks in partnership with the government. The deal also illustrates that although public subsidy and philanthropic support will still be required for some of the ancillary services needed to support microfinance in wealthy countries, such as business training and debt advice, it is possible for these MFIs to develop a financially sustainable and commercially investable portfolio of loans.
By tracing the history of Fair Finance this article explores the emerging microfinance sector in the developed world. It reveals the large number of people who are poorly served by traditional financial services providers, and why the need for alternative loans and services is acute. It explains how the traditional package of microfinance loans and services must be adapted to serve the needs of a different type of customer. And it explores the challenges of creating a sustainable and impactful MFI.
THE NEED FOR MICROFINANCE
Kevin K. came to Fair Finance needing a $2,000 loan to start a business trading and repairing clocks. He was starting to feel hopeless; he had been turned down by several banks, despite having strong experience in his field. What he did not have much of was income, and the high transaction costs for the small loan he required made him unattractive to banks.
Kevin is a typical Fair Finance client. He has a bank account, but limited collateral. His income and capital requirements are too small and his risk level too high to be desirable for a commercial bank. In 2007, Fair Finance granted him a $4,500 loan over three years to buy tools, which he is repaying monthly without difficulty. Kevin is lucky: There are tens of thousands of people with his financial portrait who cannot find a microfinance provider. The Aspen Institute estimates that only 2 percent of potential US microfinance customers are being served, compared to the 17 percent being served in the developing world.1
Changes to the banking industry, accentuated by risk aversion brought on by the recession, have made it much harder for entrepreneurs in developed countries to get small business loans. With the increased number of mergers and acquisitions and the closing of local bank branches, standardized credit-scoring techniques have replaced relationship banking and heightened competitive pressures. The result is that less profitable loans are avoided. Banks are moving away from making loans of less than $30,000 and from investing in startups, instead focusing on large loans to established businesses. When banks are lending to startups, an increasing reliance on collateral makes it harder for less affluent entrepreneurs to secure financing.
The community development finance institution sector in the United Kingdom and the United States, although valuable in supporting housing and small and medium-size enterprises, does not generally provide microbusiness loans. Neither can poorer entrepreneurs turn readily to their credit cards or overdraft facilities to manage cash flow or capital. The difficulty in getting small business loans is particularly acute for women, blacks, Asians, and other minority groups, for people receiving income-related benefits, for those with criminal records, for residents of deprived communities, and for recent immigrants.
There is, in short, a significant need for the type of microbusiness loans that Fair Finance is providing—startup loans with an average size of $4,500 and an interest rate of between 17 and 19 percent, and loans to existing microentrepreneurs of an average size of $7,500 with an interest rate of 15 to 17 percent. To date, 70 percent of Fair Finance’s business loans have been lent to startup businesses and 80 percent to people from minority ethnic groups.
The need for microfinance in the developed world, however, lies not just in small business loans. Personal microfinance as well as counseling and education around indebtedness have become part of the microfinance provision. Customers might need cash until payday, a loan to buy a car, or money for a funeral or to pay overdue bills. Often, clients also need to be advised on how to manage their debts and how to get out of the spiral of indebtedness. Fair Finance offers personal loans with an average size of $750 at an interest rate of between 32 and 39 percent. The potential market for these types of loans is significant, as illustrated by the size of the doorstep lending and payday loan markets. The UK government estimates that annually 4 million people use doorstep collectors and 2 million use payday lenders; in the United States, the payday lending industry was estimated to have revenues of around $40 billion in 2010. Although financial exclusion in developed countries is far less severe than in the developing world, there are still a surprising number of people who are “unbanked” (those who lack a bank account) and “underbanked” (those who are excluded from mainstream bank lending and credit cards because of bad credit scores or irregular incomes). In the United Kingdom more than 1.5 million people lack bank accounts,2 and in the United States 7 percent of households are unbanked and 21 percent are underbanked.3 When the unbanked and underbanked want to access credit, they often turn to loan sharks, doorstep lenders, or payday lenders who charge exorbitant rates of interest—300 percent APR and upward.
MFIs offer an alternative to these predatory lenders. They help job and business creation, which in turn take people off benefits, increase family income, and create sustainable businesses. On the personal microfinance side, counseling helps clients to manage indebtedness, reduce rent arrears, and prevent evictions, and more reasonable credit relieves poverty through reduced interest payments, builds credit history, and increases financial inclusion.
The Aspen Institute estimates that there are nearly 800 microfinance organizations across the United States.4 In a high-profile move, Grameen America set up its first branch in New York City in 2008 and has since opened several new branches and lent $24 million to 7,100 borrowers. It has plans to expand microcredit across the United States. Its US growth might well create a wave of innovation in the sector. In Western Europe, the MFI sector is smaller and more fragmented, with most lenders distributing fewer than 50 loans per year.
Operating as an MFI in developed countries is difficult. First, loan provision is a much more costly business than in the developing world. More direct and expensive communication between the loan officer and client is required. In addition, the vast majority of loans are to start businesses, requiring MFIs to provide business training to clients. The lack of an entrepreneurial and aspirational culture among low-income groups, the bureaucratic hurdles in setting up a business, and the existence of the welfare state mean that clients thinking about starting businesses need support to make the leap, which again translates into high education and counseling costs. Meanwhile, the problem of indebtedness and the need to increase financial literacy and counsel clients add to operational costs. And the stronger regulatory environment means there are often caps on interest rates, so it is hard to price a loan to cover its cost. Last, only banks can take deposits, which means that the more financially sustainable microfinance model of having savers and borrowers is unavailable to nonbank MFIs like Fair Finance. Nonetheless, Fair Finance managed to hurdle these challenges, becoming over a two-year period increasingly efficient, innovative, and professionalized without compromising its social mission.
EFFICIENCY AND FINANCIAL SELF-SUSTAINABILITY
For the first two years of its existence, Fair Finance grew as a result of Rahman’s energy and persistence, as well as fortunate timing that enabled the nonprofit to secure money from the newly launched Financial Inclusion Fund. But by 2007, a culture change was required if Fair Finance was going to advance. Financially savvy board members started to play a central role. Mark Hannam, chair of Fair Finance and a former investment manager in London, remembers that the Fair Finance board felt like the board of a nonprofit. “The level of financial sophistication was inadequate, and the board didn’t seem to be asking itself: How are we going to raise money? How do we think about leveraging ourselves?” says Hannam.
“We have a very different message from other lenders’—not that easy credit is a phone call away, but that you can’t afford that car,” says Rahman.
One of Hannam and Rahman’s first moves was to bring onto the board Neil Stanley, who had worked at Goldman Sachs for 11 years and excelled as an Internet entrepreneur. A finance committee was formed to clarify the cost of each loan and to determine whether current interest rates were covering that cost. They were not, so the board decided to roll out price increases across the loan book. Although some board members were initially resistant, because they supported subsidizing the cost of loans to disadvantaged groups, a consensus to raise rates was reached. In June 2008, the price of Fair Finance’s personal loans increased from 21 percent to 39 percent for new clients and to 32 percent for repeat clients, with an additional 5 percent up front arrangement fee for loan approvals. Despite the steep rise in interest rates, Fair Finance continued to grow. As high as the new rates were, they were still a tenth of what doorstep lenders, payday lenders, and loan sharks were charging.
The Fair Finance board also spent significant time thinking about how the organization could be more productive. Better Internet technology systems were developed, a chief operating officer was hired, and staff were divided into personal loan, business loan, and debt advice units. Throughout these changes, Fair Finance was determined not to sacrifice social impact. It set a maximum rather than a minimum number of loans each officer should process each month, to drive home that clients came first. “We think it is important to have a rich engagement with our clients, to go through budgeting skills,” says Hannam. “This whole way of dealing with our customers led us to come up with the concept of a private banker for the poor. A mainstream banker wants you in and out, but private bankers want to talk to you. They want a proper relationship with you.”
Nor was Fair Finance tempted to increase loan volume by engaging in riskier lending and tolerating a higher default rate. “We have a very different message from other lenders’—not that easy credit is a phone call away, but that you can’t afford that car,” says Rahman. Ultimately, Fair Finance’s approach worked. It found that its customer service led to more responsible lending, better repayment rates, and more repeat business from clients. It also created a more financially sustainable organization.
By early 2009, Fair Finance had taken major steps to change the balance of non-earned income revenue to earned income revenue. In 2005, grants accounted for 40 percent of its income; four years later grants accounted for just 4 percent of income. It opened its second permanent office in the London borough of Dalston as well as two temporary offices in Islington and Redbridge, and it increased its staff to 15. The board and Fair Finance team focused on an ambitious growth strategy framed by three core objectives: to preserve the organizational culture that had been a powerful contributor to the MFI’s success; to maintain the customer-rich experience, including personalized loan decision making; and to be accessible to all financially excluded Londoners.
Expansion planning included determining how fast Fair Finance wanted to grow its loan portfolio and its number of loan officers; what the productivity of its loan officers might be; and what type of loans it wanted to make (the likely product mix, duration of loan, size of loan, mix of new vs. repeat business, and bad debt rate). A sophisticated financial model was built to test the sensitivity of assumptions and to determine when Fair Finance might reach breakeven. It was clear that a significant injection of external capital would be required to grow at the speed desired. Analysis suggested that with organic growth, Fair Finance’s personal loan business would not be self-sustainable for 20 years. With outside capital, it could be achieved in five.
The team decided to go for it. Fair Finance’s expansion strategy included coverage of London by 2015, with 12 offices and nearly 50 staff. By 2015, Fair Finance would make more than 8,000 personal loans and 366 business loans per year. To implement the growth strategy for the personal loan portfolio, Fair Finance estimated it would need $5 million of external capital, including $3.9 million of secured debt capital to fund the shortfall in the loan account and $1.17 million of patient capital to fund the shortfall in the net cash flow of the personal loans business. For the expansion of the microcredit loans product, Fair Finance would need $1.25 million of patient capital and $3.1 million of debt financing.
The disruptive nature of Fair Finance’s business model—lending to the very people banks were turning away—confused bankers.
A revelation that came out of the development of this strategy was the need for corporate restructuring, to separate the different risk profiles and sustainability dynamics among the product lines and to make individual financing of business units possible. Clifford Chance, a leading law firm, provided advice pro bono. Within a holding company, separate business units were created for each of three subsidiaries: personal loans, business loans, and debt advice. The restructuring enabled the capital financing, which would be most suitable for a mainstream bank lender, to be separated from the financing of operating costs and working capital at the holding company level, which would be most suitable for investors with a higher risk appetite.
RAISING CAPITAL DURING THE FINANCIAL CRISIS
Armed with a sophisticated financial model, a good track record, and a convincing case for investment, in mid-2009 Fair Finance started to approach investors with its personal loan expansion proposal. Yet two years would pass before Fair Finance was able to line up the growth capital. Raising expansion capital during the postcrash credit crunch certainly was difficult, but an added problem was that mainstream investors and banks found it hard to reconcile Fair Finance’s social mission with the prospect of financial returns.
Private equity and venture capital investors seemed to interpret Fair Finance as a subprime business, and they wanted a much more aggressive growth strategy. Rahman and the board knew that they needed to preserve the quality of their operations and loan decisions. They maintained that Fair Finance’s magic ingredient was its rootedness in the East London communities and the specialized training it provided loan officers from these communities. Rahman and his board refused to sacrifice elements of their model to expand at the rate that private equity and venture capital wanted. Eventually, they decided that these equity and venture capital investors were not a good fit.
Retail banks were also reluctant to invest in Fair Finance. Retail bankers deemed it impossible to lend sustainably without charging exorbitant interest rates. The disruptive nature of the business model—lending to the very people these banks were turning away—confused the bankers. They could not understand that because of Fair Finance’s successful application and adaptation of microfinance principles, and its community rootedness and personalized loan decision-making process, it was able to provide affordable loans with high repayments to the most disadvantaged and financially excluded customers. Although retail banks had community banking and financial inclusion teams, they saw Fair Finance’s work as largely charitable and without potential for profit.
Fair Finance did, however, have an easy time raising capital from impact investors. After just two meetings, it raised $1.25 million of patient capital from 10 high net worth people seeking social as well as financial returns, and from Venturesome, a leading UK social investment fund. Rahman and his team structured a financial product that offered investors an annual return of up to 5 percent and a commitment to repay when Fair Finance was cash positive. The ease with which Fair Finance attracted money from these investors perhaps says more about the lack of viable and investment-ready targets for social investors than the maturity or depth of the UK’s social investment market.
By mid-2010, discussions with mainstream retail banks had foundered, and Fair Finance realized it needed to change direction to obtain market-rate debt. “We pushed in every direction with our financing plans,” remembers Stanley. “Like any entrepreneurial business, we stopped pushing when the door was closed.” Next they approached investment banks already involved with microfinance in Latin America, Asia, and Africa. They reached an agreement with two French banks—Société Générale and BNP Paribas—the leadership of which was able to envision how microfinance could work in the United Kingdom. In addition, the Spanish retail bank Santander came into the deal along with the United Kingdom’s Big Society Finance Fund, to provide the debt portion for the expansion of the personal loans portfolio. Santander provided $1.56 million of financing, Société Générale and BNP Paribas provided $1.56 million, and the Big Society Finance Fund committed a further $550,000. After being turned away by so many retail banks, Fair Finance was gratified that Santander had bought into the idea. Rahman believes this is because Santander is what he calls a “big local retail bank” and one of the few expanding in the United Kingdom that have a real focus on increasing customers. And financial inclusion is part of Santander’s business.
After a long and difficult process, Fair Finance had achieved its financing goals, becoming the first MFI in Europe to secure commercial funding from mainstream banks to expand its operations. The precedent was powerful. If more social enterprises like Fair Finance develop—and partner with commercial banks—financial services for disadvantaged people in the developed world could change dramatically.
THE ROAD AHEAD
There are huge implementation challenges ahead for Fair Finance, particularly in the recruitment of qualified and suitable loan officers and in ensuring that expansion does not affect the quality of the loan decisions or the organization’s social impact. The collapse of ShoreBank in the United States provides a salutary reminder of how successful financial services institutions working with disadvantaged groups can be destroyed by external shocks. (See “Too Good to Fail” by James Post & Fiona Wilson, Stanford Social Innovation Review, fall 2011.) The good news for Fair Finance is that its repayment rate has risen during the recession, unlike many other European MFIs, which in 2009 experienced a 20 percent drop in the average repayment rate.5 Fair Finance is also in advanced discussions with impact investors and banks partnering with the government to provide the growth capital for the expansion of its microcredit product line. Fair Finance hopes it will have secured the additional $4 million of commercial and government funding to grow the business loan book by the end of 2011. It has been earmarked for approximately $3 million of funding from a partnership between the UK government, the Co-Op/Unity Bank, and the community development finance sector, which is offering half of the expected $100 million shortfall in this sector to fund business startups in the next three to four years. Fair Finance also will raise additional social investment from European and UK investors.
What lessons can be learned for Fair Finance’s success? “Ultimately, this is about leading the way toward a banking industry that is better able to serve the poor,” says Rahman. “Arranging the financing has required specialist help, legal support, advisors, and a really strong board. We’ve had to bend ears, pull favors, and find ways of keeping up morale when every door kept shutting in front of us. It has meant understanding in the most minute detail how the business worked, how we were going to scale it, and how we could find the right skills to deal with becoming a much more complex organization.” Rahman hopes Fair Finance’s success will inspire other MFIs in wealthy countries to approach commercial lenders for growth capital. If more do so, they will need to balance three goals. They will need to make their loan book financially sustainable, build models to reach the poorest of the poor, and produce a positive net gain for society in economic growth or poverty reduction. Fair Finance is proof that a locally rooted, innovative, and entrepreneurial organization can meet this triple goal through partnering with mainstream commercial lenders.