Microfinance investments in German retail banking

Opportunities for poverty reduction and portfolio diversification

Bachelor Thesis 2009 53 Pages

Business economics - Investment and Finance


Table of Contents


Table of Abbreviations

Table of Figures

1 Introduction

2 The emergence of microfinance as an asset class
2.1 Historical developments
2.1.1 Micro-credit activities before 1900
2.1.2 The 20th century: The cradle of modern microfinance
2.2 Current state of the industry

3 Accessing commercial microfinance investment
3.1 Direct engagement
3.1.1 The domestic capital markets
3.1.2 Deposits and local equity
3.2 Indirect investment
3.2.1 Securitizations
3.2.2 Investment funds Open-end funds Closed-end funds

4 Financial utility of microfinance investment
4.1 Microfinance investment in a portfolio context
4.2 The relationship of microfinance and the formal economy
4.2.1 Correlation of microfinance with the international economy
4.2.2 Correlation of microfinance with the German economy

5 Is microfinance investment for German retail banking clients?
5.1 Market segmentation
5.2 Legal environment
5.3 Financial regards
5.4 Social aspects
5.4.1 Social return on investment
5.4.2 The potential impact on poverty reduction

6 Conclusion




Microfinance or the concept of providing small-sized loans to the unemployed poor through recent decades has transformed into an asset class that attracts commercially oriented investors from all over the world. While the majority of them still consist of institutional investors and high net worth individuals, large numbers of people who could potentially profit from a microfinance engagement lack access to appropriate investment products. Simultaneously, only a small fraction of the global funding demand of the microfinance industry is currently being met. This paper demonstrates that, for several reasons, German retail banking clients should be provided with opportunities to engage in this emerging asset class. It is shown that this client group not only can have a significant impact on poverty reduction by closing parts of the immense funding gap, but moreover it is able to gain advantages in terms of portfolio diversification from a microfinance engagement.

Table of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

Table of Figures

Figure 1: Commercial microfinance investment

Figure 2: A microfinance CLO structure

Figure 3: Performance of DMCF and its LIBOR benchmark over a period of 8 years compared

Figure 4: Bravais-Pearson correlation coefficients of the analyzed relationships

Figure 5: German private-client banking market segmentation by size of disposable fortunes

Figure 6: Comparison of dimensions for the assessment of MF and traditional investments

1 Introduction

Since the 1990s, the concept microfinance and its advanced commercialization provide various types of investors with the chance to participate in a newly created asset class[1]. By facilitating refinancing of microfinance institutions (MFIs), individual and institutional investors alike are able to support the provision of micro-loans with the help of which poor micro-entrepreneurs, their families and the whole community they live in are able to escape extreme poverty. The microfinance (MF) industry has seen a tremendous growth since its inception in the latter half of the last century. Expectations for the future do not lack behind.[2] Up to this time, the vast majority of the commercially raised MF capital has been provided in individual investment sizes that cannot be met by most German savers. While in other European countries average households were provided with an opportunity to take advantage of MF as early as 1998, in Germany just recently legal constraints, that kept the financial industry from creating a mass-market MF investment product, have been erased. However, up to this time, German retail banking clients (RCs) are still waiting for a Germany-initiated investment vehicle that facilitates them in taking advantage of an asset class, which on the one hand could generate advantages in terms of an improved asset allocation and on the other hand could allow them to make a contribution to the fight against global poverty.

The following analysis reveals that this second, social aspect of MF investment might turn out to be of particular relevance for distributing MF investment products in German retail banking. Moreover, light is shed on the environment for small-scale MF investment, market actors in Germany are currently being confronted with. It is evidenced that a potentially soon created MF investment product is able to generate financial and social utility for German RCs.

This paper is structured as follows. The following section describes the history of MF and introduces the principles and objectives of the underlying concept. Moreover, it critically assesses the current state of the MF industry and discloses obstacles to overcome in the process of effectively contributing to the success of MF in the attempt to alleviate poverty. Section 3 investigates currently available investment products that allow a 100 % commercial participation in the MF industry. Section 4 integrates utility aspects of financial nature that, from a theoretical perspective, arise. For this, it explores the relationship of MF and the formal economy. Section 5 analyses the appropriateness of MF investment products for German RCs. It elaborates on legal, financial and social concerns that essentially need to be considered in the evaluation process. Particular attention is drawn on the impact on poverty reduction German RCs could have. Section 6 concludes.

2 The emergence of microfinance as an asset class

2.1 Historical developments

For centuries, poor households lacked the opportunity of smoothening their consumption curve throughout the economic cycle by taking advantage of formal financial markets. This was due to the economic unviability inherent in providing financial services to the poor which, to a large extent, is caused by a characteristic intrinsic in any relationship between borrower and lender: Asymmetrically distributed information for ages undermined the principle of diminishing marginal returns to capital.[3] According to this, investors should prefer micro-businesses, in which relatively little capital is invested – in theory, allowing them to generate higher returns on capital over a large-capitalized cooperation. Due to information asymmetry, the reality looks different. Investors favor well-established businesses, because they can reduce information asymmetry with relatively few resources. The poor were unable to compensate for incomplete information by the provision of collateral. Also, the obstacles of enforcing contracts in weak judicial systems for centuries allowed adverse selection and moral hazard to appear as insuperable problems that prevented capital from reaching small-capitalized businesses. High transaction costs and the nature of the services which poor households demanded, prevented formal markets from integrating this client group for a long time. Nonetheless, the poor always needed to be able to call on savings and facilities that help them secure their livelihoods during economically harsh times, like for example, when suffering from a poor harvest. For a long time, informal sources of capital like savings and credit groups, family members, landlords and professional moneylenders, which charge interest at a level that prohibits profitable business operation[4], were the only resources that filled the gap to formal financial markets.[5] However, the means of these informal sources were very limited and on the large scale always failed to enable the poor to escape poverty. With the establishment of institutions especially designed to overcome the particular constraints of extending loans to poor clients, their need of access to formal financial markets slowly started to become accounted for. The concept of micro-credit (MC) was the first to acknowledge that, while from the perspective of traditional formal markets there were objections, the provision of loans to this unique client group can be a profitable business if conducted properly.[6]

2.1.1 Micro-credit activities before 1900

The roots of MC can be traced back to the 18th century, in which the Irish Loan Funds (ILFs) granted micro-loans to tenants reacting to the impoverishment of the country. Inspired by the Irish novelist Jonathan Swift, the British government helped Ireland through its potato famine-plagued history until the 1960s by extending micro-loans through the ILFs.[7] Those represent an early form of Microfinance Institutions (MFIs) operating within a financial system that lacked accessibility for large parts of the society it served.[8] Funded through interest-incurring deposits and retained earnings in addition to donations and interest-free loans the Irish Loan Funds provided an opportunity to participate in the social and financial returns of a poverty reduction program.[9] According to a documentation of the ILF-system by Piesse (1841)[10], in 1747 Swift and other individuals inspired by him were the first to engage in the ILF bearing at least partially commercial objectives in mind and thereby provided the basis for the following development of MF as an asset class in its own right. With the engagement of the Dublin Music Society, which invested profits from their musical performances into the ILF, non-individual MF investment had already occurred by the mid-eighteenth century.[11] From 1747 until 1844 the invested profits, excluding any kind of additional charitable member donation, enabled the ILF to grant 11,732 loans to struggling tradesmen and manufacturers, each with a size in between GBP 2 and GBP 4, helping to secure the livelihood of a total estimate of 57,250 people. Like Hollis and Sweetman (1997)[12] point out, large parts of the contemporary MF literature does not credit the ILF-system for embodying the foundation of all later MC activity. Considering their outreach, their impact on poverty reduction and the large number of individuals who due to their existence were able to avoid starvation and life-threatening diseases either immediately as a loan-receiver or indirectly as a family member, this appears unjustified. By the 1840s the ILF-system had expanded to a network of about 300 individual funds, which at their peak, were extending loans to 20 % of all Irish households annually.

In the 19th century throughout Europe, various kinds of credit unions (CUs) or savings and credit co-operatives of larger and more formal type were set-up aiming to serve the rural poor. Initiated by Friedrich Wilhelm Raiffeisen and Herman Schultze-Delitzsch, CUs from 1870 onwards, spread rapidly, in particular over Western parts of the German empire and soon expanded their activities to other Northern European countries.[13] The concept of CU stipulated these institutions to reach a high level of financial sustainability and, in contrast to the ILF-system, envisioned them to be owned by the people they were supposed to serve.

Twenty-five years after the inception of the first German CU in Indonesia, The Bank Perkreditan Rakyat or People’s Credit Bank was established.[14] Embodying the first formal financial institution that was serving the poor in a developing country, the BPR later developed into the largest Indonesian MF system which at its peak consisted of 9,000 individual institutions.

2.1.2 The 20th century: The cradle of modern microfinance

The conceptual framework of MF in its current form emerged from two pilot projects independently run in Asia and Latin America in the 1970s. In Latin America the MF network ACCION International focused on the reduction of urban poverty, whereas, the roots of MF in South Asia tackled with the issue of rural poverty, which especially female villagers of this region faced at that time.

After becoming a formal MFI in 1973, ACCION International to this day fights the lack of economic opportunity that the urban poor face after migrating either voluntarily, tempted by the prospect of industrial employment or, by force of armed conflicts to major Latin American cities. From Brazil, where it began with the extension of 885 loans that created jobs for 1,386 people, in the 1980s ACCION International expanded over fourteen Latin American countries maintaining an average repayment rate on their micro-loan portfolio of 97%. This was realized through charging interest rates, which in addition to compensating for the full risk incurred, covered all the lending process associated costs while simultaneously still allowing micro-entrepreneurs to maintain their business on a profitable basis.[15]

In large parts of the literature, the creation of modern MF is connected with the 2006 Nobel Peace Prize winner Muhammad Yunus[16]. In 1976 he discovered in a self-experiment, that it was possible to enable the families of 42 Bangladeshi female villagers to lift themselves above the poverty line[17] by providing access to USD 27 worth of capital without any collateral.[18] After successfully extending the outreach, the first modern Asian MFI evolved from Yunus’ micro-lending project and became established as a formal bank under Bangladeshi law in 1983.[19] Under the name of Grameen Bank it was the first to offer financial services to the hardcore poor including beggars and non-farm households that even lacked the opportunity of maintaining their livelihood by engaging in any kind of agricultural activity. By doing so, it pioneered in neglecting to focus lending activities on male farmers, which in many developing countries did not represent the poorest stratum of society. Instead, it heavily concentrated on the extension of micro-loans to groups of female villagers that were held jointly liable. Thereby, Grameen Banks’ concept utilized the fact that women did not only proof to be more reliable debtors but also are more likely than men to let others in need like their children take advantage of achieved resources. This way, it was ensured that with the given resources as many needy individuals as possible were able to cross the poverty line.

Imitating the successful example of Grameen Bank, further MFIs were established throughout the developing world in the 1980s. By then, the industry still relied heavily on private donation and subsidies for funding. When it became evident that these funding structures caused MFIs to operate inefficiently, market actors changed their mindset on MC. Instead of providing subsidized loans that supposedly fostered agricultural development, MFIs started to offer a full range of financial services that, in addition to loans and savings, included fund transfer services and insurances.[20] With this, the provision of MC became sub-discipline of what from the mid-1990s on is called microfinance (MF).[21] The goal of achieving long-term financial sustainability was formulated and with the foundation of the worlds’ first fully commercial MFIs in 1992 put into practice.[22] Bolivia’s BancoSol pioneered in transforming the concept of MFI from the NGO-driven model into regulated financial institutions, similar to commercial banks, which was soon replicated by MFIs from across the world.

2.2 Current state of the industry

Today, MFIs operate in 110 developing and developed economies utilizing a variety of approaches that include group- and individual-based lending.[23] As of May 2009, the Microfinance Information Exchange Inc. (MIX)[24] lists 1,397 MFIs amongst which competition since the beginning of this century started to become an issue. Newly founded MFIs that commence operations as regulated institutions straight away skipping the NGO-stage increasingly compete with local commercial banks, affiliates of large multi-national financial services providers and the first generation of modern MFIs. With the application of information technology, the MF client base began to overlap with those of traditional commercial banks for example regarding their businesses that are concerned with money transfer services and consumer finance.[25] As a positive consequence, markets that remained previously untapped became served. With this, the industry has become attractive for providers of commercial capital, without whose help, the current number of almost 100 millions micro-entrepreneurs[26] could not have been achieved.

With the declaration of the year 2005 as the International Year of Microcredit by the United Nations, public attention on the MF industry further increased, which assisted in making private sector enterprises and foundations more comfortable with the idea of dedicating money to the MF industry.[27] Although the underlying motives for providing funding in this context might have been altruistic to some degree, for the private sector these investments provided the chance to gain experiences with MF as an asset class and therefore opened doors to large-scale entirely commercial engagements. To this the MF industry presents itself attractive, featuring default rates in micro-loan portfolios from 1 % to 3 % percent. Slowly, financial markets started to accept that the world’s poor pay back their debts, often more reliably, than non-poor bank clients do. Substantiations for what has been an unexplainable issue for many MF critics throughout the time modern MF exists, might lie in this client groups’ dependency on the possibility to be granted further micro-loans in order to secure their livelihoods. The absence of social security systems in many developing economies forces micro-entrepreneurs to maintain profitable self-employment to provide for their families. This requires access to further capital that in many regions is at economically reasonable conditions exclusively available at MFIs. The fear of not being granted subsequent micro-loans encourages a high level of discipline. Despite the fact that a micro-loan is not secured by any from of collateral, the mechanisms of group lending and the commonly applied small installment sizes induce a high quality of MFIs’ loan portfolios. Also, these exhibit a high level of diversification as micro-loans are extended to a large number of small borrowers.[28]

On the other hand, the commenced commercialization of the MF industry causes MF funding to be unequally channeled to the top two percent of the existing MFIs. These are mostly large regulated entities featuring strong operational and financial performance. According to the World Bank’s Consultative Group to Assist the Poor (CGAP)[29], in 2005 82% of commercially raised funds flew to the 50 most profitable MFIs. Smaller, not yet profitable institutions that often focus their activities on post-conflict areas and other disadvantageous settings, increasingly lack funding opportunities. If a MFI of this type, due to a lack of funding, is forced to discontinue its operation, it leaves a large number of unserved hardcore poor, whose chances of escaping poverty vanished. In order to ensure that the MF industry strives to achieve its initial objective – that is, to alleviate poverty amongst the poorest of the poor – a close eye needs to be kept on indicators such as the average size of a micro-loan that a MFI grants and the regional distribution of the commercially raised capital.[30] While the former, to some degree, welcomely rises naturally with decreasing poverty the borrowers of a MFI face the regional fund distribution undoubtedly indicates whether or not MF on the large scale is sticking to its initial targets. The United Nations Millennium Development Goals[31] adopted in the year 2000, which by integrating various dimensions, define targets for the reduction of poverty by 2015 and name the access to formal financial services as a key component for their achievement. In order for MF to be a vital part of this process, recent developments that have led to regional concentrations of commercial MF funding favoring Eastern Europe, Central Asia and Latin America and particularly discriminating against Africa and the remaining parts of Asia, need to be corrected.[32] Moreover, it needs to be considered that funding stability advantages the MF industry for a long time benefiting from non-commercial investors with long-term strategic objectives enjoyed with increasing commercialization and consequentially increasing interdependency with international financial markets, are going to cease.[33]


[1] The literature lacks a formal definition of the widely used term asset class that is universally agreed on. However, Vöcking et al. (2002) and p.12 ff. and Greer (1997), p.86-91 demand four minimum requirements that should be met in order to constitute an asset class in its own right. Like it is demonstrated in the following, Microfinance has achieved a state, which qualifies it as an asset class as it inheres (i) specific institutional characteristics, (ii) a specific risk-return profile, (iii) a low correlation with other asset classes and (iv) positive returns when a “buy & hold” strategy is applied.

[2] Cf. Dieckmann (2007), p.7 ff..

[3] Cf. Armendáriz de Aghion and Mordoch (2007), p.5-8.

[4] Cf. Bhaduri (1973), p. 173 ff., Bhaduri (1977), p. 341-352 and Yunus (1997), p. 47-48 and p.95.

[5] Cf. Sundaresan (2008), p.3.

[6] Cf. Armendáriz and Mordoch (2007), p.21.

[7] Cf. Hollis and Sweetman (2004), p.2.

[8] Cf. Hollis and Sweetman (1997), p.5.

[9] Cf. Hollis and Sweetman (2004), p.4.

[10] Cf. Pisse (1841), p.9.

[11] Cf. Thom (1844), p.399.

[12] Cf. Hollis and Sweetman (1997), p.1.

[13] Cf. Prinz (2002), p.4 ff.

[14] Cf. Mann (2006), p.1-2.

[15] Cf. ACCION International: http://www.accion.org/Page.aspx?pid=506 (as of May 23rd, 2009)

[16] Cf. Norwegian Nobel Institute: http://nobelpeaceprize.org/ (as of May 23rd, 2009). The 2006 Nobel Peace Prize 2006 was jointly awarded to Prof. Muhammad Yunus and Grameen Bank.

[17] A World Bank study by Chen and Ravallion (2008) on the appropriate level of an international poverty benchmark suggests that every person with an income equivalent to USD 1.25 per day or less in 2005 prices should be considered poor. Since especially in developing countries many commodities are not traded, the approach is based on Purchasing Power Parity rates rather market exchange rates, on which the computation of earlier poverty line levels is based on. Therefore it avoids a deception of the benchmark. The study takes into account the national poverty benchmarks of the world’s 15 poorest countries (by consumption per capita) with USD 1.25 representing the sample mean, which shall be assumed in the following whenever reference is made to “poverty”.

[18] Cf. Yunus (2007), p. 45-47.

[19] Cf. Yunus (2007), p.119 ff..

[20] Cf. Felder-Kuzu (2004), p.19.

[21] Cf. La Torre (2006), p.2-5.

[22] Cf. Mann (2006), p.2.

[23] Cf. Cull et al. (2005), p.4-5.

[24] Cf. The MixMarket: http://www.mixmarket.org/ (as of May 23rd, 2009).

[25] Cf. Mann (2006), p.3.

[26] Cf. Byström (2008), p.2109.

[27] Cf. Sundaresan (2008), p.5.

[28] Cf. Meehan (2004), p.19.

[29] Cf. Latortue et al. (2006), p.15.

[30] Cf. Hulme (2007), p.20.

[31] Cf. Mann (2006), p.4.

[32] Cf. Latortue et al. (2006), p.16.

[33] Cf. Krauss (2008), p.184-185.


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Title: Microfinance investments in German retail banking