Draft 3.

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The Subprime Crisis and its Implications for the Microcredit Market 
 
Sahba Sobhani, Programme Manager, and Suba Sivakumaran, Research Associate, 
Growing Inclusive Markets Initiative, UNDP* 

MICROCREDIT OVERVIEW 
The microcredit market today has advanced by leaps and
bounds from its early conception, from the evolution of its
Box 1: Definition and Concepts 
funding profile (i.e. from being funded by just deposits to now
Microcredit: The lending of small 
capital amounts, usually unsecured, to  being additionally funded through cross-border securitization),
individual borrowers for the short to  to the expansion of its outreach to those previously excluded,
medium term. Borrowers are  to its product innovations that enable clients to mitigate
sometimes organized into joint‐ shocks and smooth consumption and income in more and
lending groups with social cooperation  more sophisticated ways, and lastly, to its regulation both
and trust mechanisms underpinning  domestically and internationally. Today, the exponential
borrowing and repayment.  increase in lending to low-income clients, coupled with the
explosion of the subprime bubble, warrants an investigation
into whether relevant lessons can be learnt from the latter.

Figure 4 shows the most recent data on evolving MFI Figure 1: Evolving MFI Capital Structures by Region

capital structures by region. The expansion of
commercial borrowings (including securitized portfolios
as well as plain-vanilla loans), while representing
significant opportunities for increased reach to the
financially excluded, also represents increased leverage
in the system. While these systems remain under
regulated, this remains a source for concern due to its
potential for inadequate consumer protection.

RELEVANT CAUSES OF THE SUBPRIME CRISIS TO THE 
MICROFINANCE MARKET 
 
The subprime crisis in the United States mortgage
lending sector lends itself to a comparison analysis with
the current microcredit sector in the developing world. Research1 from the World Bank on this
comparison, as well as other sources indicate the following pressing concerns. While this analysis is
focused purely on the negative implications of subprime lending and microcredit lending, it is important
to remember that both practices extend financial access to the financially excluded, and when executed
properly, can improve welfare.
                                                            
* The views expressed in this paper are the authors’ and do not represent those of the United Nations 
Development Programme. 
1
 Gwinner, William B. and Saunders, Anthony, “The Sub Prime Crisis: Implications for Emerging Markets”, 
September 2008, The World Bank, Policy Research Working Paper 4726 
1
 
 
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Microfinance Institutions (MFIs): Fall into five categories, traditional banks, credit unions, non‐bank financial institutions (NBFIs), non‐
governmental organizations (NGOs), and rural banks. Of these, some are allowed to take in savings deposit whilst others 
are mandated only to provide credit and credit‐related products. 

The use of credit scores

Lending in both the subprime market as well as many microcredit markets is predicated on credit scores
and default models that are frequently outdated, or inappropriate2 to the particular market.
a) In the case of subprime lending, default models have not kept up with the evolving market, and so
subprime default rates have surprised investors and lenders3.
b) In the case of microfinance, as Kate McKee from the Consultative Group to Assist the Poor (CGAP)
at the World Bank points out: in microfinance there tends to be an over reliance on cheap-to-obtain
credit scores, vs. better analyses that incorporate extended affordability analysis, income verification
and savings profiles4.

Claims that lending has provided access to those previously excluded need to be examined carefully.
a) Subprime lending has provided only limited access to finance5.More than half of subprime loans in
the United States have been for refinancing existing mortgages rather than purchasing a house6.
b) In microcredit markets, the claims that microcredit has increased access to finance by the poor are
also in doubt. Jonathan Murdoch cites studies completed as part of legislation mandated by the US
Congress that show that in Peru, Kazakhstan and Uganda, roughly, only 15% of microfinance
customers were among the ‘poorest half’ of the poor, as defined by the official poverty line in their
countries7. In addition, borrowers are also susceptible to debt traps (for example using one source of
micro loans to pay off another source), that may mask the true reach of microcredit.

Moral hazards involved in the “originate and distribute” model of securitization8.

a) The traditional bank model (one followed by most banks in emerging markets) is one where
banks originate and hold the loans in their portfolios, fund them with deposits and retain the
default risk9. Between 2001 and 2006, between 60 and 80% of subprime loans were bundled into
mortgage backed securities and sold to investors in capital markets10. This led to a moral hazard
in that those ‘originating’ the loans did not have to hold them on their balance sheet, and could
originate riskier loans.

                                                            
2
 Ibid.  
3
 Ibid. 
4
 McKee, Kate, “Meditations on the US Sub‐prime crisis: Implications for International Microfinance”, May 19, 
2008, Consultative Group to Assist the Poor, World Bank. Presentation for the Silicon Valley Microfinance Network 
5
 Gwinner, William B. and Saunders, Anthony, “The Sub Prime Crisis: Implications for Emerging Markets”, 
September 2008, The World Bank, Policy Research Working Paper 4726 
6
 Ibid. 
7
 Morduch, Jonathan, “Smart Subsidy for SUSTAINABLE MICROFINANCE”, Finance for the Poor, December 2005, 
Volume 6 Number 4, Asian Development Bank.  
8
 Gwinner, William B. and Saunders, Anthony, “The Sub Prime Crisis: Implications for Emerging Markets”, 
September 2008, The World Bank, Policy Research Working Paper 4726 
9
 Ibid. 
10
 Ibid. 
2
 
 
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b) The comparison in the microfinance sector is the increasing use of securitization of microcredit
loan portfolios. This suggests a potential misalignment in incentives for those who originate the
loan to ensure creditworthiness. While there are mechanisms to mitigate these (ICICI Bank for
example, ensured that originators of securitized microfinance loans were also subject to a first
loss default guarantee (FLDG)), they are limited in scope.
c) Besides securitization, there also exist potential incentive misalignments in loan origination that
utilizes a principal-agent method on the ground, when brokers originate loans which are kept on
another institution’s balance sheet.

Lending has increased indebtedness and leverage for consumption purposes instead of investment
purposes.
a) The availability of cheap credit for subprime clients led to reckless refinancing as house prices
rose, for the purposes of consumption rather than investment.
b) In microfinance, the claims that loans are fed to enterprises or income-generating activities rather
than consumption-smoothing or income-smoothing activities may be overstated. The
susceptibility of such clients towards debt traps needs to be carefully examined.

Disparate regulation for banks, non-bank financial institutions, mortgage-agents etc11 leads to lack
of appropriate oversight.
a) For example, the US financial regulatory system permits mortgage lenders to move risk to where
capital charges are lowest and regulatory scrutiny is lightest12.
b) The opacity and disparity of regulation also exist in microcredit markets where banks, and non-
bank financial lenders that originate similar loans are regulated differently in domestic markets.
The global market for investors that invest in microfinance institutions are largely self-regulated
at the moment, though there is movement towards adopting a common set of principles (see
Pocantico Declaration.)

Consumer protection is limited

a) Predatory subprime lenders in the US have misled borrowers and convinced them to take out
loans that they did not understand or that carried inappropriate risks. Subprime borrowers are
predominantly minority, lower income, less well financially educated and less likely to search for
the best interest rates and terms for their mortgage loans13.
b) These characteristics, particularly regarding financial literacy is true in microcredit markets. In
addition a commonly cited practice has been fee packing, where excessive processing fees are
included in the balance of the new loan. In microcredit, while many countries have pushed to
have transparency regarding effective interest rates (i.e. including fees etc.), more can be done to
ensure that the consumer is fully informed about loans.
 
 
RECOMMENDATIONS FOR MICROCREDIT MARKETS 

                                                            
11
 Ibid. 
12
 Ibid.  
13
 Ibid. 
3
 
 
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The lessons learnt from the subprime crisis, especially in response to the above causes, can be useful to
think about similar implications in microfinance markets.

Financial Innovation: Taming the Tiger

Microcredit has seen significant innovation in terms of the products now available to low-income clients.
These products range from event-related deposit products (such as maternal health savings accounts) to
loan products with flexible repayment options, innovative collateral options and third party guarantees, to
complex insurance products like weather insurance products and emergency health insurance products.

In addition, there has been process innovation in microfinance delivery (for example, using retail agents
to deliver services in rural areas), as well as technological innovations (e.g. use of biometric identification
processes; the use of mobile telephony) that have mitigated risk and increased institutions’ ability to
differentiate their products. In total, such innovations have reduced transaction costs, increased efficiency
and have attracted increased capital to the arena. For the poor, benefits have arisen from having increased
flexibility in dealing with investment and consumption-smoothing needs and reducing vulnerability to
shocks14.

Within the global capital markets, the increased profile of microfinance internationally, as well as
consistently low default rates and high commercial rates of return, has attracted a large amount of capital.
Between 2004 and 2006, the stock of foreign capital investment – covering both debt and equity, more
than tripled to US$ 4 billion15, and over forty specialized microfinance investment funds have been
established in the past three years alone16. While this capital may also be motivated by social returns, its
raison d’être remains financial return, and there is concern that aggressive practices by certain investors
could hamper the social objectives of microfinance institutions.

Figure 2: Foreign Capital Investment in Microfinance, CGAP, Focus Note 44

                                                            
14
 Ibid. 
15
 Xavier Reille and Sarah Forster, Foreign Capital Investment in Microfinance, Balancing Social and Financial 
Returns, CGAP Focus Note, No. 44, February 2008, page 1 
16
 Ibid. 
4
 
 
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In addition, as the table above shows, the increase in structured investment vehicles (particularly
collateralized debt obligations (CDOs)) which securitize microfinance loan portfolios is a concern as it
mirrors the same principal-agent problem that fuelled the subprime crisis (see the “originate-distribute”
model above)17. The other concern is that most of the capital seeking microfinance institutions to invest
in, is mainly in the form of debt and not equity. Prudently managing leverage, liquidity and currency risk
remains the responsibility of MFI managers (especially those in countries that have yet to develop
adequate national microfinance regulation), especially when faced with such a wealth of funding
opportunities, where debt markets may be “overheated” and “pricing does not reflect credit and country
risks”18.

The roles and responsibilities of credit rating institutions

In the subprime crisis, the ratings on securitized portfolios of subprime loans were given by agencies that
faced an inherent conflict of interest (i.e. issuers paid agencies for ratings). While the agencies have
undertaken their own internal review to improve such practices and mitigate such conflicts, alternative
funding sources for developing country rating agencies may be critical in establishing independence
particularly in an agency’s early stages. Another issue is that the historical risk models that the agencies
used in the subprime crisis were not wholly relevant or accurate to these instruments; a risk that is also
true for microfinance loans. While new data from microfinance borrowers has been collected and fed into
many microfinance institution models and credit rating agency models, all must remain vigilant in order
to maintain lending prudence.

The characteristics of good national regulation in microfinance, finance and social policy.
As in all good regulation, microfinance regulation should be targeted (with side effects minimized),
transparent, accountable and proportionate. In particular, where applicable, the objectives of microfinance
regulation should also be reflected consistently in financial institution regulation and social policy. This is
not always the case (anomalies abound of how banks and non-bank financial institutions that dispense the
same microloans, are regulated differently in the areas that matter). Furthermore, the creation of a
conducive policy environment that encourages innovation in this still-experimental sector, and promotes
sustainability is key. Policy distortions like capping/fixing interest rates may reduce efficiency, as well as
the supply of capital. It has been argued that instead, “smart subsidies” may be the way to go in
supporting the growth of the sector19. Besides interest-rate regulation, policies that promote development

                                                            
17
 “The first formal CDO,12 BlueOrchard Microfinance Securities I (BOMS), was structured in 2004–2005 by 
BlueOrchard in partnership with OPIC and Developing World Markets (a private U.S. company set up by 
emerging market banking professionals). Fourteen MFIs received loans with a seven‐year maturity, and 
investors were offered five risk classes of the same maturity.13 Since then, seven CDOs have been structured, 
and over US$525 million in microfinance securities have been issued”‐ Xavier Reille and Sarah Forster, Foreign 
Capital Investment in Microfinance, Balancing Social and Financial Returns, CGAP Focus Note, No. 44, February 
2008, page 1 
18
 Xavier Reille and Sarah Forster, Foreign Capital Investment in Microfinance, Balancing Social and Financial 
Returns, CGAP Focus Note, No. 44, February 2008, page 1 
19
 Morduch, Jonathan, “Smart Subsidy for SUSTAINABLE MICROFINANCE”, Finance for the Poor, December 2005, 
Volume 6 Number 4, Asian Development Bank. 
5
 
 
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outcomes should also be in place for this sector (as differentiated from consumer lending policies for
example.)

In terms of consumer protection, while the Pocantico Declaration has gone some way towards codifying
an industry-wide set of self-regulating principles based on consumer protection for microfinance lending
institutions, enforcement mechanisms have yet to be laid down. National governments can and should
look at the following elements of microfinance practice to ensure consumer protection. These include ; a)
quality of service, b) transparent and fair pricing, c) avoiding over-indebtedness by aggressive,
inappropriate lending, d) appropriate debt collection practices, e) the privacy of customer information, f)
the ethical behavior of staff20.

The importance of high quality credit information

Credit information systems in competitive microcredit markets reduce information asymmetries between
borrowers and lenders and lead to improved default rates and repayment rates. However in many
competitive microcredit markets, the absence of independent credit information bureaux has conversely
led to over-indebtedness and the threat of non-repayment, particularly as clients can borrow from multiple
institutions who do not share their credit data. While building up and sharing good client credit histories
are critical, it is not enough, especially for new clients who face only a very basic credit score test before
being approved for borrowing. CGAP argues that behavioural information should be incorporated into
loan origination, saying that “consumer psychologists and behavioural economists have just started to
explore decision making and cognitive biases of typical microfinance clients. Our market research,
product design, delivery techniques, and client interface should use these insights to make credit work for
the borrower and lender alike21.”

Conclusion: Prudence, transparency and accountability

The subprime crisis and the situation in microfinance today have raised concerns with many practitioners.
For example, one practitioner states: “The MFI market in Nicaragua is one of the most competitive ones
in Latin America, with over 300 MFI’s. The presence of just about every donor, a large influx of
international funding, and banks downscaling has created an environment of market saturation and over-
indebtness of clients. MFIs have begun to see a significant increase in arrears and a decrease in margins.
Some MFIs have toughened their collection methods, creating friction among clients. This, compounded
with a more populist regime, interest-rate caps, and a very weak legal system, has resulted in a number of
customer complaints being printed in the press. A group of people with criminal backgrounds and the
backing of the political party have begun striking against MFIs and threatening employees, even setting
one branch on fire.22”

As CGAP says, careful underwriting, risk management techniques, and a strong focus on portfolio quality
are critical to the impressive repayment performance of microfinance internationally. The subprime
                                                            
20
  “Microfinance Pro‐Consumer Pledge”, The Center for Financial Inclusion 
21
 McKee, Kate, “Meditations on the US Sub‐prime crisis: Implications for International Microfinance”, May 19, 
2008, Consultative Group to Assist the Poor, World Bank. Presentation for the Silicon Valley Microfinance Network 
22
 Gabriel Solarzano, Banex, “ comment in “Consumer Protection‐ Is there a Business Case”, Center for Financial 
Inclusion at Accion International Blog (http://www.accion.org/Page.aspx?pid=1295) accessed November 2008 
6
 
 
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experience reminds us that innovations like credit scoring, outsourcing and partnership models require
care in their implementation. Creating the right incentives for staff, managers and partners- to balance
volume with quality- is essential and especially challenging when providers are facing increased costs of
capital, and stepped up competition23.

POSSIBLE ROLE OF MULTILATERAL ORGANIZATIONS IN MICROCREDIT MARKETS 

Development institutions and multilateral organizations can have a strong positive impact on the
development of microfinance markets due to their ability to influence policy, their understanding of on-
the-ground through their field operations, their conveying power through their strong networks with
corporations, nonprofits and the public sector and their social missions. The following, though not
exhaustive, are some suggestions for their role.

I. Support the development of appropriate local and national regulation

These institutions have the technical and advisory capacity to support the drafting of appropriate
legislation for microfinance in countries that are struggling to keep pace with the exponential growth of
this sector. Training regulatory staff in enforcement, monitoring and ongoing policy drafting that keeps
pace with the changing realities of this dynamic market is also critical. Furthermore, these institutions can
also bring together best practices from other countries to influence national regulation. Such practices can
also standardize regulation globally; which is critical given how mobile capital currently is.

II. Investigate the formation of an international task force

Following the above, such a task force will seek to define public policies at the national level that are
consistent with financial inclusion while also addressing the potential to reshape the international
financial architecture (such as examining international standards in areas like capital requirements,
payment systems)24

III. Contribute research and thinking regarding credit analysis

Microfinance, while having moved beyond a wholly start-up phase, is still in an experimental phase.
Much more research into behavioural techniques, contextual realities, product innovation and
technological innovation needs to be completed in order to refine the model in each particular context that
it operates in. Such research is currently being carried out by think tanks and academics and need to be
supported with resources in order to find conclusive evidence of what works in microfinance.
Development institutions are best placed to both support and disseminate this research.

IV. Field support: Acting as a coordinator for credit information collection

With extensive field operations, and a long history of working in-country, development institutions are
uniquely placed to effect change at the local levels. This could happen in a variety of ways for
microfinance; for example, country field offices can collect and provide village level credit data to MFIs
operating in that area in order to prevent duplication of loans from multiple village MFIs to the same
client (creating over-indebtedness). Field offices can also twin programs; i.e. institute development
                                                            
23
 Consultative Group to Assist the Poor, “The U.S. Subprime Crisis: Five Lessons for Microfinance”, 2008, 
http://www.cgap.org/p/site/c/template.rc/1.26.2705 
24
 The Pocantico Declaration, Microfinance Leaders Retreat, April 23, 2008 
7
 
 
 Draft 3.0 concept note 

programs in livelihood generation, enterprise development, and education to name a few, with the lending
programs that microfinance institutions themselves run. This has the potential to generate income,
increase financial literacy, increase repayment rates and lower default rates, and contribute to positive
development outcomes.

8