The Economy: Reviving and Rebuilding

Scaling microfinance is a prime need

Over the years, the microfinance sector in Bangladesh has undergone significant transformation. PHOTO: AFP

Microfinance—which started as microcredit after independence—now covers a range of financial products and services, such as savings, credit, insurance, payments, and money transfers. The core, however, still refers to offering and servicing small loans to the poor, provided to borrowers or groups who would otherwise have no access to financial services. Banks and formal financial institutions usually do not extend loans to those with little or no assets or collateral, especially in the small amounts typically involved in microfinance.

For microfinance institutions (MFIs), the "credit for target group" approach results in a focus on providing loans in specified quantities and earmarked for specific purposes. This operational approach translates into "supply-leading finance." Generally, the target group can only be partially and temporarily reached due to the failure of the supply-based approach. The emergence of the "pushing the financial frontier" view highlights the importance of permanent financial relationships for rural households and, thereby, the permanence of financial institutions. The adoption of "cost-covering interest rates" for MFIs (instead of subsidised interest rates) is a significant step toward achieving such permanence.

The emergence and expansion of MFIs have been greatly facilitated by financial liberalisation in Bangladesh since the 1990s. This has meant a reduced role for the government in the allocation of capital, less interference with financial institutions, and new opportunities for banks and MFIs to engage in the central function of financial institutions: intermediation between savers and borrowers.

ILLUSTRATION: ZARIF FAIAZ

At present, there seems to be a consensus on the broad objectives of microfinance—outreach to low-income people and financial sustainability. Given these two objectives, MFIs need to address two central issues in their day-to-day operations: (i) the information issue: how to establish borrowers' ability and willingness to repay; and (ii) the cost issue: how to handle small financial transactions cost-effectively, which are generally required by low-income people.

The first requires screening, monitoring, and enforcement procedures that comply with the specific circumstances of low-income people, which deviate widely from usual practices. The second requires operating with transaction costs that necessarily lead to interest rates well above commercial bank rates but are still competitive and attractive for MFI clients.

MFIs generally experience a trade-off in their operations between these two objectives: a focus on somewhat better-known clients who require larger loans, which eases the cost issue and brings financial sustainability closer, but leaves smaller clients outside the financial frontier. Conversely, a focus on new clients brings them inside the frontier but also involves more costs and risks. This trade-off between the two objectives is critical for MFIs.

Despite these dilemmas, Bangladesh's microfinance sector has created a unique space as important financial intermediaries with significant value propositions to their client base and the national economy. MFIs extend financial products, including basic social services, to clients, especially in rural and remote areas, through their widespread network and infrastructure. This has enabled MFIs to gain valuable experience in providing financial and human development services to extremely poor populations and offering microenterprise loans to credit-hungry cottage and microenterprises (CMEs), especially in the rural economy.

Through innovation and close work with target populations and enterprises, MFIs have also gained several strengths, such as ready access to an established client base, experience in cash management in small lots, well-functioning internal audit and monitoring systems, experienced field staff and local branches, client insights for new product development, and experience in client relationship management.

As of June 2023, the total number of MFIs—licensed under the Microcredit Regulatory Authority (MRA)—stood at 731, with more than 25,000 branches and 200,000 employees. These MFIs provided financial and human development services to more than 40 million low-income members and microenterprises, with a total outstanding loan of Tk 2,493 billion and a savings portfolio of Tk 621 billion. The credit services of the microfinance sector are categorised into six groups: (i) general microcredit for small-scale self-employment-based activities; (ii) microenterprise loans; (iii) loans for the ultra-poor; (iv) agricultural loans; (v) seasonal loans; and (vi) loans for disaster management. Loan amounts up to Tk 50,000 are generally considered microcredit, while loans above this amount are classified as microenterprise loans.

The concentration ratio of the microfinance sector is relatively high in Bangladesh. Overall, the 20 largest MFIs control nearly three-quarters of the market share, while the two largest MFIs (BRAC and ASA) control half in terms of both clients and financial portfolios.

Bangladesh’s microfinance sector has created a unique space as important financial intermediaries with significant value propositions to their client base and the national economy. PHOTO: ICAB

Structural transformation of microfinance: Over the years, the microfinance sector in Bangladesh has undergone significant transformation, evolving from group-based, limited-scale microcredit operations to individual microenterprise operations to create widespread and sustainable development impacts. Over time, microcredit has graduated from its mainstream activity of supporting the basic needs of the poor to nurturing broader farm and nonfarm activities and microenterprises for graduating microcredit borrowers and microentrepreneurs. The focus on "appropriate" finance—scaling up credit to meet the threshold level of activities for sustainable livelihoods, targeting extremely poor groups and remote areas, mobilising the poor to promote social development, creating awareness of health, education, women empowerment, and other social issues, and fostering green and climate-resilient activities—has provided MFIs with a unique opportunity to emerge as key development partners in Bangladesh.

Over the decades, the sources of financing for MFIs' operations have broadened to include loanable funds from several sources, such as members' savings, cumulative net surplus, borrowing from banks, concessional loans (e.g., from Palli Karma-Sahayak Foundation), loans from large MFIs, loans from non-institutional sources (e.g., board and client members), and other sources like reserve funds, staff security funds, and loan loss provision funds. The most important sources of funds for MFIs are the savings of their members/clients (43 percent), followed by cumulative net surplus (31 percent) and borrowings from banks (19 percent).

Overall, MFIs have contributed significantly to expanding access to microfinance services for poor and low-income households. In Bangladesh, microfinance—especially for poor women—is widely regarded as a virtuous tool and is seen as valuable for poverty reduction efforts. Microfinance is also considered a relatively efficient means of assisting the poor. Although interest rates on micro-loans are relatively high, they serve as a positive mechanism for rationing the limited volume of microfinance to borrowers who can earn sufficient returns to cover costs. In practice, this self-selection process is far from perfect, as the poor may borrow in desperation and become locked in a cycle of indebtedness. Moral hazard problems may also arise.

VISUAL: SALMAN SAKIB SHAHRYAR

The controversy surrounding the effectiveness of microfinance in poverty reduction in Bangladesh runs deep. A comprehensive assessment of its capacity to reduce poverty requires an economy-wide framework. While microfinance can provide short-term relief from poverty, it is unlikely to serve as a long-term solution, especially for households with small amounts of land or productive assets. Modern agriculture's strong positive economies of scale are difficult for small farms to leverage effectively. Similarly, nonfarm economic opportunities may remain limited without strong economic growth and technological innovation.

A more important aspect of microfinance, however, is its role in enhancing the status of women and their bargaining power within families, as most micro-loans in Bangladesh are given to women. Although some studies show that increased access to microfinance does not necessarily improve women's health and education or enhance their role in household decision-making, these findings may be context-specific. The overall picture in Bangladeshi society is more positive, as many women have been empowered and have become successful microentrepreneurs using microcredit as their stepping stone.

Extrapolating the effects of microfinance on individual households to the rural economy provides insights into its broader impact. Increased individual capacity to deal with shocks reduces the effects of covariant shocks on the rural population as a whole, particularly when a substantial share of the population is within the financial frontier. Furthermore, increased savings in financial assets shift wealth away from low-productivity assets, aiding financial deepening and reducing inequality while raising the incomes of poorer segments of the population.

Financial deepening has direct relevance for microfinance in rural areas, as providing rural households with access to savings and credit is its core objective. Its effects go beyond individual MFI-household links, as the availability of capital for new, productive clients fundamentally affects economic relationships in rural areas. Enlarging microfinance to include a substantial share of the rural population enhances its positive effects.

Over the years, civic organisations (e.g., NGOs) have worked with local government institutions (LGIs) in Bangladesh to achieve transformative changes at the grassroots level, creating linkages upward—not just with government initiatives, but also to transform underlying behaviours and ideas that underpin social development. These micro-efforts and their macro-level transmissions provide a powerful stimulus for rapid social outcomes in Bangladesh.

Challenges of microfinance: Despite significant achievements, a major challenge for MFIs is their high transaction costs. Supporting a large volume of small transactions results in high costs with low returns per transaction.

For the poor in Bangladesh, there is a need to redesign conventional financial products to reflect their specific requirements and demands. In this context, MFIs are well-equipped to serve the poor effectively. Moreover, MFIs must find the right balance between financing income-generating activities for the poor and deprived groups and financing CMEs through larger loans.

MFIs must also focus on designing innovative financial products and services with terms and conditions suitable for vulnerable and risk-averse poor households. These products should emphasise creating multiple income sources, accumulating productive assets, and adopting risk-minimising techniques (e.g., microinsurance). In addition to appropriate supply-side policies, demand-side interventions are necessary to ensure that poor and low-income households are financially literate and capable of using services productively.

Policy implications are twofold: (i) the government's policy attention for rural finance is validated, not to provide capital directly but to enable financial institutions to mediate between savers and borrowers; and (ii) policies need to encourage financial institutions (including MFIs) to push the financial frontier to include new, low-income rural households by tackling information problems through innovative screening, monitoring, and enforcement procedures.

VISUAL: collected

Microfinance and digital financial services: To increase access and perform more efficiently, MFIs need to capitalise on rapid advances in mobile communications and digital payment services (DFS) to connect poor households to affordable and reliable financial services. For the poor, access to financial services helps them successfully adopt new farming technologies, invest in new business opportunities, or find new and more productive jobs. At the same time, access to DFS prevents a large number of people from falling back into poverty or into deeper poverty due to health problems, financial setbacks, and other shocks. Simple yet powerful innovations, such as digital wallets and other innovations, help reach a greater number of poor people and drive down transaction costs. Although Bangladesh still has a long way to go to take full advantage of digital finance, the country is moving rapidly to build the required ecosystems and remove barriers to ensure progression from payments to solutions "beyond payments."

To exploit digital technology both effectively and efficiently, key issues for MFIs are to ensure that: (i) financial products and services are tailored to the specific needs of different customer groups; are transparent and secure; and provide an optimal balance between different features of products and their prices; (ii) DFS are introduced through adopting well-sequenced and well-coordinated policies to nurture in-house technological innovation and ensure that financial operations become more efficient and diversified; (iii) to harness the widespread transformative power of digital technology, MFIs need to identify both opportunities and challenges so that management is prepared for both the rewards and risks of digitising financial services and reaching members of financially excluded groups; (iv) in digitising financial services, MFIs must place emphasis on designing customer-centric financial products and services, especially suited to low-income and financially excluded individuals and enterprises.

For MFIs, adopting a customer-centric approach is instrumental in bridging the "access-usage gap" in digital technologies. Although more than 90 percent of MFI borrowers are women, less than 20 percent of digital finance users are women. This shows the existence of a significant gender divide in access to DFS, which has strong repercussions on the uptake of digital technology by MFI members.

For successful digitisation, MFIs need to resolve a number of issues in creating an inclusive digital landscape, such as where to start, how to judge the readiness of a particular MFI to undergo digital transformation, what challenges and risks should be considered before embarking on transformation routes, and similar issues.

In Bangladesh, many MFIs have undergone digital transformation successfully, enabling them to evolve, scale, and compete more efficiently in the rapidly changing financial landscape. The expectations of customers are also changing rapidly, increasingly shaped by their experiences with smartphone apps, fintechs, and social media. For MFIs, digitising operations will no doubt emerge in the coming years as one of the most credible ways to meet the changing expectations of their customers in Bangladesh.

In reality, it is true that not all MFIs are ready to digitise to the same extent or at the same speed. The need for MFIs is to prioritise the processes for digital transformation based on their current and desired level of digital maturity. Based on available best practices, a framework may be used to deepen understanding of digital transformation by specific MFIs, identify digital transformation objectives and maturity for adoption, and take steps towards adopting successful digital transformation.

For CMEs, the adoption of digital technologies by MFIs can help address specific challenges in the value chain—especially those that need financial service solutions, and where traditional finance has limitations in fully addressing demands in the rural market. This is often due to high infrastructure costs and a lack of incentives to adapt products to the unique needs of these enterprises. Digital finance also offers a way to expand access to the formal financial system, taking advantage of the rapid growth of digital and mobile telephone infrastructure and the advent of agent banking. These factors have a direct link to increasing microentrepreneurs' income and wellbeing.

Designing MFI business models: Business models, to a large extent, determine the costs incurred to deliver financial products/services on one hand and the value generated on a sustainable basis, on the other. This in turn determines whether the provision of financial products and services will be sustainable. As such, designing efficient business models is a key determinant of the successful delivery of financial services by MFIs. It also needs to be recognised that business models are inspired and motivated by various factors. Usually, MFIs adopt diverse strategic approaches to product development, including roll-out and scale-up. The key for MFIs is to adopt pragmatic approaches towards developing business models, recognising both operational, regulatory, and policy challenges as well as practical difficulties in reaching customers.

One of the key concerns for developing business models of MFIs is the challenges that emerge from traditional small transactions, completing paperwork, and other complexities. For MFIs, the microfinance value chain involves multiple players, which allows several business model alternatives. In fact, MFIs can potentially emerge as intermediaries with a significant value proposition to their client base, extending financial products through their existing and innovative digital infrastructures in remote rural areas.

Innovation drivers for MFIs: The innovation drivers of MFIs need to encompass both push and pull factors. The push factors come from external sources outside the microfinance sector that motivate MFIs to develop innovative financial products and services to expand outreach to currently excluded and low-income groups. Internal factors act as pull forces, coming from within MFIs, encouraging them to develop internal capacities for delivering better-suited and efficient services to these groups.

The most important push factor is the government's determination to rejuvenate the financial sector to overcome the deep scars of past mismanagement and corruption, and make the sector more inclusive. In this context, MFIs may follow a three-pronged approach: (i) expand capacity and enhance the confidence of potential customers regarding the efficient delivery of tailored financial products and services; (ii) provide information and education on access to and use of DFS by the microfinance sector; and (iii) encourage the delivery of a variety of financial products and services using digital and more efficient mechanisms in line with the needs and demands of different target groups. The MRA, as the key regulator, may design specific measures in these areas.

In the coming decades, the priority for MFIs will be to provide their services in more efficient and sustainable ways facilitated by a better understanding of local communities, adopting innovative service design and delivery models, and lending techniques. Furthermore, new innovations may also be explored in the existing MFI models.

MFIs may explore the feasibility of developing partnerships with other financial service providers for performing some of their activities, e.g., accepting repayment instalments and micro-savings, releasing micro-loans to microcredit/microenterprise borrowers, providing microinsurance, and other services by creating access points for financial services in locations where MFI branches are not available.

MFIs may also explore several options to enhance and sustain their activities to meet emerging challenges: (i) build long-term relationships with banks for the supply of funds for lending; (ii) design new and digital financial products/services, particularly long-term housing loans and multiple loans including emergency loans and risk-minimising microinsurance products; (iii) implement human resource development programmes, both through training existing staff and recruiting adequately skilled personnel, especially in digital technologies; (iv) enhance security of funds, especially in relatively less accessible areas; (v) ensure access to information technology for complete documentation of members and borrowers using information from the credit information bureau for the microfinance sector; (vi) use the right skills and information for selecting borrowers/microenterprises and providing services; and (vii) explore options to mobilise voluntary and term deposits.

Repositioning microfinance: MFIs have already emerged as major players in providing financial services to the poor and disadvantaged in Bangladesh. More than 40 million individuals exist under the microfinance network, and about 2 million small businesses are lateral entrants into MFIs' credit network. Most of these clients are part of the "missing middle" in the formal bank credit market. Over time, the horizon of MFIs has also expanded; microloan products have diversified to include both financial and non-financial products.

Moreover, the regulations of MFIs have contributed to a structural shift in the microfinance market, signifying a move toward microenterprise-based higher loan sizes, creating intense competition for loans between microenterprises and traditional household-based activities. On the other hand, with an emphasis on sustainability, MFIs have also targeted their activities with a renewed focus on transaction costs and risk-minimising approaches. Coverage of poor members under the MFI financial network has been facilitated by the availability of subsidised funds, the institution of risk-minimising informal microinsurance (e.g., credit, livestock, and health insurance), and programme-induced and targeted lending activities. However, the shift towards microenterprise-based lending activities may have affected the loan portfolio of extreme and moderately vulnerable poor households, at least to some extent.

At present, there are three major targeted clientele groups for MFIs: (i) vulnerable poor, including extreme poor and moderate poor; (ii) graduating microcredit members; and (iii) lateral entrants of small businesses, e.g., microentrepreneurs. This has also led MFIs to adopt two major mechanisms to deliver financial services to clients: (a) relationship-based lending to individual microentrepreneurs and small businesses; and (b) group-based lending under which several small borrowers come together to apply for loans and other services as a group. The group-based model represents an approach under which poor and near-poor households can have access to a range of appropriate financial services, including not just credit, but also savings, microinsurance, and fund transfers.

Some evidence shows that, for MFIs, the default rate is higher in relationship-based microenterprise lending than in group-based lending. Moreover, since the average size of microenterprise loans is much higher than in group-based loans, even a low default rate in the former loan causes a bigger liquidity constraint for MFIs. On the other hand, net returns are higher for microenterprise loans as these loans generally have low administrative and supervision costs. Thus, there is a dilemma, and the need for MFIs is to strike the right balance between the two types of loans and minimise the risks of microenterprise loan defaults. Additionally, while meeting the demands of these clientele groups comprising the "missing middle" is undoubtedly important, supporting excluded vulnerable and extreme poor households is also critical toward fulfilling MFIs' social mission.

Over the years, the interplay of both external and internal factors has motivated MFIs to develop innovative financial products and services to expand outreach and create internal capacities for delivering better microfinance services in Bangladesh. The government's policy and institutional reforms have also facilitated the development of innovative delivery techniques and appropriate products. Since its establishment under the Microcredit Regulatory Authority Act 2006, the Microcredit Regulatory Authority (MRA) has been working toward creating policy, regulatory, and institutional frameworks for the integrated development of the microfinance sector, which is both socially beneficial and profitable. In addition to traditional microfinance products, a wide variety of financial products and services is now available that are more accessible to the poor, better suit their cash flow challenges, and help address future spending needs.

The presence of a wide network of MFIs and other financial service providers (FSPs) has also created significant opportunities for increasing access to financial services in Bangladesh. Obviously, the gaps that presently exist in universal financial inclusion provide both a challenge and an opportunity to ensure effective access to and use of financial products and services by all residents of Bangladesh.

In fact, the double bottom line of fulfilling the social mission and providing financial services in a profitable and sustainable manner has been guiding the new generation activities of MFIs in Bangladesh. The MFIs are adopting more effective and innovative business models to ensure financial viability, supported by innovative loan collection techniques and monitoring and supervision methods.

In short, the operational characteristics of the microfinance market in Bangladesh show that: (i) around 58 percent of extreme poor households still do not have access to the microfinance market; (ii) around 53 percent of moderate poor do not access financial services of MFIs; (iii) female-headed households have lower access to microfinance services; and (iv) there seems to exist a recent trend of rising flows of credit to non-poor households who are graduating members and lateral entrants belonging to CMEs.

Considering these realities, three aspects of the financial operations of MFIs need attention in the coming years: (i) explore innovative and sustainable measures to ease binding financial constraints to provide financial services to target populations/business groups; (ii) develop appropriate financial products/services (including housing, business scaling-up and enterprise development, technology adoption, and emergency loan products) to meet the needs of different groups of excluded poor households/CMEs; and (iii) ensure more efficient and cost-effective MFI operations through the adoption of digital and modern technologies and resolve the asymmetric information problem of excluded households/enterprises.

In addition, capacity building of MFIs needs to be prioritised to meet the demands of different segments of targeted populations by addressing problems like lack of skilled and trained staff, inaccessibility to haor, hilly, and remote areas, limited access to technology and information, inadequate information flows to excluded households/enterprises, and limited financial education to manage financial resources more productively and efficiently.

Despite significant positive achievements, the challenge for MFIs is their high transaction costs needed to support a large number of small transactions, which are unique features of their operations. To overcome the challenge, the adoption of digital technology is a major enabler, which is proven, scalable, secure, cost-effective, and likely to be sustainable. Although MFIs still remain unchallenged in serving the poor and low-income segments, the urgent need is to dream for a digital future.

MFIs need to search for a roadmap towards that future, to grow and expand their mission to issues like supporting climate adaptation and mitigation efforts as well in Bangladesh. The key is to learn how MFIs can leverage technology to grow their business, deliver value to their customers, and embark on a digital future. Although Bangladesh still has a long way to go to take full advantage of digital finance, the country is moving rapidly to build the required ecosystems and remove the barriers through creating an enabling policy and regulatory environment.

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Scaling microfinance is a prime need

Over the years, the microfinance sector in Bangladesh has undergone significant transformation. PHOTO: AFP

Microfinance—which started as microcredit after independence—now covers a range of financial products and services, such as savings, credit, insurance, payments, and money transfers. The core, however, still refers to offering and servicing small loans to the poor, provided to borrowers or groups who would otherwise have no access to financial services. Banks and formal financial institutions usually do not extend loans to those with little or no assets or collateral, especially in the small amounts typically involved in microfinance.

For microfinance institutions (MFIs), the "credit for target group" approach results in a focus on providing loans in specified quantities and earmarked for specific purposes. This operational approach translates into "supply-leading finance." Generally, the target group can only be partially and temporarily reached due to the failure of the supply-based approach. The emergence of the "pushing the financial frontier" view highlights the importance of permanent financial relationships for rural households and, thereby, the permanence of financial institutions. The adoption of "cost-covering interest rates" for MFIs (instead of subsidised interest rates) is a significant step toward achieving such permanence.

The emergence and expansion of MFIs have been greatly facilitated by financial liberalisation in Bangladesh since the 1990s. This has meant a reduced role for the government in the allocation of capital, less interference with financial institutions, and new opportunities for banks and MFIs to engage in the central function of financial institutions: intermediation between savers and borrowers.

ILLUSTRATION: ZARIF FAIAZ

At present, there seems to be a consensus on the broad objectives of microfinance—outreach to low-income people and financial sustainability. Given these two objectives, MFIs need to address two central issues in their day-to-day operations: (i) the information issue: how to establish borrowers' ability and willingness to repay; and (ii) the cost issue: how to handle small financial transactions cost-effectively, which are generally required by low-income people.

The first requires screening, monitoring, and enforcement procedures that comply with the specific circumstances of low-income people, which deviate widely from usual practices. The second requires operating with transaction costs that necessarily lead to interest rates well above commercial bank rates but are still competitive and attractive for MFI clients.

MFIs generally experience a trade-off in their operations between these two objectives: a focus on somewhat better-known clients who require larger loans, which eases the cost issue and brings financial sustainability closer, but leaves smaller clients outside the financial frontier. Conversely, a focus on new clients brings them inside the frontier but also involves more costs and risks. This trade-off between the two objectives is critical for MFIs.

Despite these dilemmas, Bangladesh's microfinance sector has created a unique space as important financial intermediaries with significant value propositions to their client base and the national economy. MFIs extend financial products, including basic social services, to clients, especially in rural and remote areas, through their widespread network and infrastructure. This has enabled MFIs to gain valuable experience in providing financial and human development services to extremely poor populations and offering microenterprise loans to credit-hungry cottage and microenterprises (CMEs), especially in the rural economy.

Through innovation and close work with target populations and enterprises, MFIs have also gained several strengths, such as ready access to an established client base, experience in cash management in small lots, well-functioning internal audit and monitoring systems, experienced field staff and local branches, client insights for new product development, and experience in client relationship management.

As of June 2023, the total number of MFIs—licensed under the Microcredit Regulatory Authority (MRA)—stood at 731, with more than 25,000 branches and 200,000 employees. These MFIs provided financial and human development services to more than 40 million low-income members and microenterprises, with a total outstanding loan of Tk 2,493 billion and a savings portfolio of Tk 621 billion. The credit services of the microfinance sector are categorised into six groups: (i) general microcredit for small-scale self-employment-based activities; (ii) microenterprise loans; (iii) loans for the ultra-poor; (iv) agricultural loans; (v) seasonal loans; and (vi) loans for disaster management. Loan amounts up to Tk 50,000 are generally considered microcredit, while loans above this amount are classified as microenterprise loans.

The concentration ratio of the microfinance sector is relatively high in Bangladesh. Overall, the 20 largest MFIs control nearly three-quarters of the market share, while the two largest MFIs (BRAC and ASA) control half in terms of both clients and financial portfolios.

Bangladesh’s microfinance sector has created a unique space as important financial intermediaries with significant value propositions to their client base and the national economy. PHOTO: ICAB

Structural transformation of microfinance: Over the years, the microfinance sector in Bangladesh has undergone significant transformation, evolving from group-based, limited-scale microcredit operations to individual microenterprise operations to create widespread and sustainable development impacts. Over time, microcredit has graduated from its mainstream activity of supporting the basic needs of the poor to nurturing broader farm and nonfarm activities and microenterprises for graduating microcredit borrowers and microentrepreneurs. The focus on "appropriate" finance—scaling up credit to meet the threshold level of activities for sustainable livelihoods, targeting extremely poor groups and remote areas, mobilising the poor to promote social development, creating awareness of health, education, women empowerment, and other social issues, and fostering green and climate-resilient activities—has provided MFIs with a unique opportunity to emerge as key development partners in Bangladesh.

Over the decades, the sources of financing for MFIs' operations have broadened to include loanable funds from several sources, such as members' savings, cumulative net surplus, borrowing from banks, concessional loans (e.g., from Palli Karma-Sahayak Foundation), loans from large MFIs, loans from non-institutional sources (e.g., board and client members), and other sources like reserve funds, staff security funds, and loan loss provision funds. The most important sources of funds for MFIs are the savings of their members/clients (43 percent), followed by cumulative net surplus (31 percent) and borrowings from banks (19 percent).

Overall, MFIs have contributed significantly to expanding access to microfinance services for poor and low-income households. In Bangladesh, microfinance—especially for poor women—is widely regarded as a virtuous tool and is seen as valuable for poverty reduction efforts. Microfinance is also considered a relatively efficient means of assisting the poor. Although interest rates on micro-loans are relatively high, they serve as a positive mechanism for rationing the limited volume of microfinance to borrowers who can earn sufficient returns to cover costs. In practice, this self-selection process is far from perfect, as the poor may borrow in desperation and become locked in a cycle of indebtedness. Moral hazard problems may also arise.

VISUAL: SALMAN SAKIB SHAHRYAR

The controversy surrounding the effectiveness of microfinance in poverty reduction in Bangladesh runs deep. A comprehensive assessment of its capacity to reduce poverty requires an economy-wide framework. While microfinance can provide short-term relief from poverty, it is unlikely to serve as a long-term solution, especially for households with small amounts of land or productive assets. Modern agriculture's strong positive economies of scale are difficult for small farms to leverage effectively. Similarly, nonfarm economic opportunities may remain limited without strong economic growth and technological innovation.

A more important aspect of microfinance, however, is its role in enhancing the status of women and their bargaining power within families, as most micro-loans in Bangladesh are given to women. Although some studies show that increased access to microfinance does not necessarily improve women's health and education or enhance their role in household decision-making, these findings may be context-specific. The overall picture in Bangladeshi society is more positive, as many women have been empowered and have become successful microentrepreneurs using microcredit as their stepping stone.

Extrapolating the effects of microfinance on individual households to the rural economy provides insights into its broader impact. Increased individual capacity to deal with shocks reduces the effects of covariant shocks on the rural population as a whole, particularly when a substantial share of the population is within the financial frontier. Furthermore, increased savings in financial assets shift wealth away from low-productivity assets, aiding financial deepening and reducing inequality while raising the incomes of poorer segments of the population.

Financial deepening has direct relevance for microfinance in rural areas, as providing rural households with access to savings and credit is its core objective. Its effects go beyond individual MFI-household links, as the availability of capital for new, productive clients fundamentally affects economic relationships in rural areas. Enlarging microfinance to include a substantial share of the rural population enhances its positive effects.

Over the years, civic organisations (e.g., NGOs) have worked with local government institutions (LGIs) in Bangladesh to achieve transformative changes at the grassroots level, creating linkages upward—not just with government initiatives, but also to transform underlying behaviours and ideas that underpin social development. These micro-efforts and their macro-level transmissions provide a powerful stimulus for rapid social outcomes in Bangladesh.

Challenges of microfinance: Despite significant achievements, a major challenge for MFIs is their high transaction costs. Supporting a large volume of small transactions results in high costs with low returns per transaction.

For the poor in Bangladesh, there is a need to redesign conventional financial products to reflect their specific requirements and demands. In this context, MFIs are well-equipped to serve the poor effectively. Moreover, MFIs must find the right balance between financing income-generating activities for the poor and deprived groups and financing CMEs through larger loans.

MFIs must also focus on designing innovative financial products and services with terms and conditions suitable for vulnerable and risk-averse poor households. These products should emphasise creating multiple income sources, accumulating productive assets, and adopting risk-minimising techniques (e.g., microinsurance). In addition to appropriate supply-side policies, demand-side interventions are necessary to ensure that poor and low-income households are financially literate and capable of using services productively.

Policy implications are twofold: (i) the government's policy attention for rural finance is validated, not to provide capital directly but to enable financial institutions to mediate between savers and borrowers; and (ii) policies need to encourage financial institutions (including MFIs) to push the financial frontier to include new, low-income rural households by tackling information problems through innovative screening, monitoring, and enforcement procedures.

VISUAL: collected

Microfinance and digital financial services: To increase access and perform more efficiently, MFIs need to capitalise on rapid advances in mobile communications and digital payment services (DFS) to connect poor households to affordable and reliable financial services. For the poor, access to financial services helps them successfully adopt new farming technologies, invest in new business opportunities, or find new and more productive jobs. At the same time, access to DFS prevents a large number of people from falling back into poverty or into deeper poverty due to health problems, financial setbacks, and other shocks. Simple yet powerful innovations, such as digital wallets and other innovations, help reach a greater number of poor people and drive down transaction costs. Although Bangladesh still has a long way to go to take full advantage of digital finance, the country is moving rapidly to build the required ecosystems and remove barriers to ensure progression from payments to solutions "beyond payments."

To exploit digital technology both effectively and efficiently, key issues for MFIs are to ensure that: (i) financial products and services are tailored to the specific needs of different customer groups; are transparent and secure; and provide an optimal balance between different features of products and their prices; (ii) DFS are introduced through adopting well-sequenced and well-coordinated policies to nurture in-house technological innovation and ensure that financial operations become more efficient and diversified; (iii) to harness the widespread transformative power of digital technology, MFIs need to identify both opportunities and challenges so that management is prepared for both the rewards and risks of digitising financial services and reaching members of financially excluded groups; (iv) in digitising financial services, MFIs must place emphasis on designing customer-centric financial products and services, especially suited to low-income and financially excluded individuals and enterprises.

For MFIs, adopting a customer-centric approach is instrumental in bridging the "access-usage gap" in digital technologies. Although more than 90 percent of MFI borrowers are women, less than 20 percent of digital finance users are women. This shows the existence of a significant gender divide in access to DFS, which has strong repercussions on the uptake of digital technology by MFI members.

For successful digitisation, MFIs need to resolve a number of issues in creating an inclusive digital landscape, such as where to start, how to judge the readiness of a particular MFI to undergo digital transformation, what challenges and risks should be considered before embarking on transformation routes, and similar issues.

In Bangladesh, many MFIs have undergone digital transformation successfully, enabling them to evolve, scale, and compete more efficiently in the rapidly changing financial landscape. The expectations of customers are also changing rapidly, increasingly shaped by their experiences with smartphone apps, fintechs, and social media. For MFIs, digitising operations will no doubt emerge in the coming years as one of the most credible ways to meet the changing expectations of their customers in Bangladesh.

In reality, it is true that not all MFIs are ready to digitise to the same extent or at the same speed. The need for MFIs is to prioritise the processes for digital transformation based on their current and desired level of digital maturity. Based on available best practices, a framework may be used to deepen understanding of digital transformation by specific MFIs, identify digital transformation objectives and maturity for adoption, and take steps towards adopting successful digital transformation.

For CMEs, the adoption of digital technologies by MFIs can help address specific challenges in the value chain—especially those that need financial service solutions, and where traditional finance has limitations in fully addressing demands in the rural market. This is often due to high infrastructure costs and a lack of incentives to adapt products to the unique needs of these enterprises. Digital finance also offers a way to expand access to the formal financial system, taking advantage of the rapid growth of digital and mobile telephone infrastructure and the advent of agent banking. These factors have a direct link to increasing microentrepreneurs' income and wellbeing.

Designing MFI business models: Business models, to a large extent, determine the costs incurred to deliver financial products/services on one hand and the value generated on a sustainable basis, on the other. This in turn determines whether the provision of financial products and services will be sustainable. As such, designing efficient business models is a key determinant of the successful delivery of financial services by MFIs. It also needs to be recognised that business models are inspired and motivated by various factors. Usually, MFIs adopt diverse strategic approaches to product development, including roll-out and scale-up. The key for MFIs is to adopt pragmatic approaches towards developing business models, recognising both operational, regulatory, and policy challenges as well as practical difficulties in reaching customers.

One of the key concerns for developing business models of MFIs is the challenges that emerge from traditional small transactions, completing paperwork, and other complexities. For MFIs, the microfinance value chain involves multiple players, which allows several business model alternatives. In fact, MFIs can potentially emerge as intermediaries with a significant value proposition to their client base, extending financial products through their existing and innovative digital infrastructures in remote rural areas.

Innovation drivers for MFIs: The innovation drivers of MFIs need to encompass both push and pull factors. The push factors come from external sources outside the microfinance sector that motivate MFIs to develop innovative financial products and services to expand outreach to currently excluded and low-income groups. Internal factors act as pull forces, coming from within MFIs, encouraging them to develop internal capacities for delivering better-suited and efficient services to these groups.

The most important push factor is the government's determination to rejuvenate the financial sector to overcome the deep scars of past mismanagement and corruption, and make the sector more inclusive. In this context, MFIs may follow a three-pronged approach: (i) expand capacity and enhance the confidence of potential customers regarding the efficient delivery of tailored financial products and services; (ii) provide information and education on access to and use of DFS by the microfinance sector; and (iii) encourage the delivery of a variety of financial products and services using digital and more efficient mechanisms in line with the needs and demands of different target groups. The MRA, as the key regulator, may design specific measures in these areas.

In the coming decades, the priority for MFIs will be to provide their services in more efficient and sustainable ways facilitated by a better understanding of local communities, adopting innovative service design and delivery models, and lending techniques. Furthermore, new innovations may also be explored in the existing MFI models.

MFIs may explore the feasibility of developing partnerships with other financial service providers for performing some of their activities, e.g., accepting repayment instalments and micro-savings, releasing micro-loans to microcredit/microenterprise borrowers, providing microinsurance, and other services by creating access points for financial services in locations where MFI branches are not available.

MFIs may also explore several options to enhance and sustain their activities to meet emerging challenges: (i) build long-term relationships with banks for the supply of funds for lending; (ii) design new and digital financial products/services, particularly long-term housing loans and multiple loans including emergency loans and risk-minimising microinsurance products; (iii) implement human resource development programmes, both through training existing staff and recruiting adequately skilled personnel, especially in digital technologies; (iv) enhance security of funds, especially in relatively less accessible areas; (v) ensure access to information technology for complete documentation of members and borrowers using information from the credit information bureau for the microfinance sector; (vi) use the right skills and information for selecting borrowers/microenterprises and providing services; and (vii) explore options to mobilise voluntary and term deposits.

Repositioning microfinance: MFIs have already emerged as major players in providing financial services to the poor and disadvantaged in Bangladesh. More than 40 million individuals exist under the microfinance network, and about 2 million small businesses are lateral entrants into MFIs' credit network. Most of these clients are part of the "missing middle" in the formal bank credit market. Over time, the horizon of MFIs has also expanded; microloan products have diversified to include both financial and non-financial products.

Moreover, the regulations of MFIs have contributed to a structural shift in the microfinance market, signifying a move toward microenterprise-based higher loan sizes, creating intense competition for loans between microenterprises and traditional household-based activities. On the other hand, with an emphasis on sustainability, MFIs have also targeted their activities with a renewed focus on transaction costs and risk-minimising approaches. Coverage of poor members under the MFI financial network has been facilitated by the availability of subsidised funds, the institution of risk-minimising informal microinsurance (e.g., credit, livestock, and health insurance), and programme-induced and targeted lending activities. However, the shift towards microenterprise-based lending activities may have affected the loan portfolio of extreme and moderately vulnerable poor households, at least to some extent.

At present, there are three major targeted clientele groups for MFIs: (i) vulnerable poor, including extreme poor and moderate poor; (ii) graduating microcredit members; and (iii) lateral entrants of small businesses, e.g., microentrepreneurs. This has also led MFIs to adopt two major mechanisms to deliver financial services to clients: (a) relationship-based lending to individual microentrepreneurs and small businesses; and (b) group-based lending under which several small borrowers come together to apply for loans and other services as a group. The group-based model represents an approach under which poor and near-poor households can have access to a range of appropriate financial services, including not just credit, but also savings, microinsurance, and fund transfers.

Some evidence shows that, for MFIs, the default rate is higher in relationship-based microenterprise lending than in group-based lending. Moreover, since the average size of microenterprise loans is much higher than in group-based loans, even a low default rate in the former loan causes a bigger liquidity constraint for MFIs. On the other hand, net returns are higher for microenterprise loans as these loans generally have low administrative and supervision costs. Thus, there is a dilemma, and the need for MFIs is to strike the right balance between the two types of loans and minimise the risks of microenterprise loan defaults. Additionally, while meeting the demands of these clientele groups comprising the "missing middle" is undoubtedly important, supporting excluded vulnerable and extreme poor households is also critical toward fulfilling MFIs' social mission.

Over the years, the interplay of both external and internal factors has motivated MFIs to develop innovative financial products and services to expand outreach and create internal capacities for delivering better microfinance services in Bangladesh. The government's policy and institutional reforms have also facilitated the development of innovative delivery techniques and appropriate products. Since its establishment under the Microcredit Regulatory Authority Act 2006, the Microcredit Regulatory Authority (MRA) has been working toward creating policy, regulatory, and institutional frameworks for the integrated development of the microfinance sector, which is both socially beneficial and profitable. In addition to traditional microfinance products, a wide variety of financial products and services is now available that are more accessible to the poor, better suit their cash flow challenges, and help address future spending needs.

The presence of a wide network of MFIs and other financial service providers (FSPs) has also created significant opportunities for increasing access to financial services in Bangladesh. Obviously, the gaps that presently exist in universal financial inclusion provide both a challenge and an opportunity to ensure effective access to and use of financial products and services by all residents of Bangladesh.

In fact, the double bottom line of fulfilling the social mission and providing financial services in a profitable and sustainable manner has been guiding the new generation activities of MFIs in Bangladesh. The MFIs are adopting more effective and innovative business models to ensure financial viability, supported by innovative loan collection techniques and monitoring and supervision methods.

In short, the operational characteristics of the microfinance market in Bangladesh show that: (i) around 58 percent of extreme poor households still do not have access to the microfinance market; (ii) around 53 percent of moderate poor do not access financial services of MFIs; (iii) female-headed households have lower access to microfinance services; and (iv) there seems to exist a recent trend of rising flows of credit to non-poor households who are graduating members and lateral entrants belonging to CMEs.

Considering these realities, three aspects of the financial operations of MFIs need attention in the coming years: (i) explore innovative and sustainable measures to ease binding financial constraints to provide financial services to target populations/business groups; (ii) develop appropriate financial products/services (including housing, business scaling-up and enterprise development, technology adoption, and emergency loan products) to meet the needs of different groups of excluded poor households/CMEs; and (iii) ensure more efficient and cost-effective MFI operations through the adoption of digital and modern technologies and resolve the asymmetric information problem of excluded households/enterprises.

In addition, capacity building of MFIs needs to be prioritised to meet the demands of different segments of targeted populations by addressing problems like lack of skilled and trained staff, inaccessibility to haor, hilly, and remote areas, limited access to technology and information, inadequate information flows to excluded households/enterprises, and limited financial education to manage financial resources more productively and efficiently.

Despite significant positive achievements, the challenge for MFIs is their high transaction costs needed to support a large number of small transactions, which are unique features of their operations. To overcome the challenge, the adoption of digital technology is a major enabler, which is proven, scalable, secure, cost-effective, and likely to be sustainable. Although MFIs still remain unchallenged in serving the poor and low-income segments, the urgent need is to dream for a digital future.

MFIs need to search for a roadmap towards that future, to grow and expand their mission to issues like supporting climate adaptation and mitigation efforts as well in Bangladesh. The key is to learn how MFIs can leverage technology to grow their business, deliver value to their customers, and embark on a digital future. Although Bangladesh still has a long way to go to take full advantage of digital finance, the country is moving rapidly to build the required ecosystems and remove the barriers through creating an enabling policy and regulatory environment.

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