Microfinance institutions such as Grameen Bank have been tremendously successful in granting impoverished entrepreneurs access to small amounts of capital. The ability of these loans to improve the lives of their recipients made them a humanitarian success, while the incredible payback rates have made them a financial success.
Yet despite an incredibly low probability of default, these loans often carry sky-high interest rates. Banks say this has been necessary to cover their cost of capital as well as the transaction costs of locating and training borrowers. But what if there was a way of completely eliminating the banks’ cost of capital?
Behold the power of the internet! Websites such as kiva.org connect users with microfinance institutions around the world. A person like you or me can sort through a list of borrowers and select a person or business they wish to finance. The capital is then transferred through one of the sites’ partners to the borrower. The financer bears the default risk and does not receive any interest. When the loan is repaid, the financer can choose to withdraw their funds, or to finance another business.
This system effectively eliminates the cost of capital for banks, meaning that interest charges only need to cover operating and transaction costs. This should result in lower interest rates charged to the micro-entrepreneurs.
I decided to give the system a try, and loaned a small amount of money to a grocer in Peru. According to the borrower’s profile, the loan would allow her to buy flour and sugar needed for her small store. The borrower received the money about three hours after my credit card was charged, and if all goes according to plan, I will be repaid in July.
At a time when financial instruments have become increasingly complex (and often dangerous), this system is simple, transparent, and innovative. I just hope the microfinance industry doesn’t get as innovative as their macro counterparts - I’d hate to see the effects of microcredit-default-swaps.