Policy Briefs

Financial ladders out of social exclusion

EQUAL supports micro-finance

Supporting small business

There is a recognised shortage in the supply of finance from banks to support small-scale income generating activities by under-represented groups^[1] [2]. The most important reasons are:

• The relatively high transaction costs of managing loans of under €25,000 which lowers the returns to conventional financial institutions.
• The fact that disadvantaged people often lack both collateral and experience (or a business track record). According to traditional methods of assessment this increases their risk to financial institutions.

Studies also show that ethnic minorities refer to difficulties in accessing finance as the most important barrier to setting up a business, women as the second and young people as the third^[3]. Regulatory reform^[4] and the gradual withdrawal of traditional banks from the local and mutual economy, partially due to the pressure from the banking regulations (including Basel II), are predicted to make things worse^[5].

However, there is also evidence^[6] that there are problems related to the demand for micro-credit. Not all business proposals and people are "investment ready". The take-up of micro-credit is heavily affected by the competing availability of grants and the tax and social security implications of setting up a business.

In this highly complex scenario, it has become clear that it is not enough simply to increase investment in funds, which offer smaller loans. On the one hand, the take-up of such funds has been slower and less than expected in some countries and regions. On the other, some people warn that an indiscriminate increase in small loans could simply increase problems of over- indebtedness (resulting from credit card and consumer loan abuse) among certain sections of the population. The key problem, therefore, appears to be not just how much finance is offered to disadvantaged people but what kind.

The promotion of entrepreneurship high on EU agenda

At its meeting of 20 and 21 March 2003, the European Council highlighted the importance of promoting entrepreneurship through an action plan and measures to increase access to finance, and for the first time, stressed the importance of micro-credit.

In this context, the European Commission relies on two main instruments for promoting micro-credit. Firstly, there is the micro-credit guarantee window managed by the European Investment Fund (€250 million). The Commission's DG Enterprise recommends expanding this and other micro-credit instruments in its Action Plan on Entrepreneurship^[7] and its recent consultation document for a new Community Support Programme for Entrepreneurship^[8].

Secondly, there are the various "risk capital" schemes, including micro-credit, financed through the Structural Funds in a decentralised way in the various Member States and regions of the EU. Total spending on these schemes now stands at around €1 billion between 2000-6 or approximately 15% of grant aid to SMEs.

DG Regional Policy provides three reasons for expanding these schemes^[9]. Firstly, that "despite many years of providing grant aid from the Structural Funds on a massive scale, regional disparities have not diminished significantly and alternatives therefore have to be considered". Secondly, risk capital financing methods are better suited to the knowledge economy. Finally, "with increasing demands on EU resources arising from the accession of Central and Eastern European countries there is a need to make funds work harder".

Tailoring microcredits to real needs

Although it cannot be said that the individual solutions being tested by EQUAL constitute global innovations to micro-finance methodology, they do provide a series of lessons on how to integrate different aspects of micro-finance and to adapt them to the real needs of specific target groups in quite different national and regional contexts.

Research into needs and effective outreach for specific target groups
EQUAL demonstrates how important it is to find out about the real (rather than assumed) financial and business needs of disadvantaged groups. Given the degree of financial and social insecurity some disadvantaged groups face, one needs to guard against taking steps which do not take into account that one or more sources of income (paid work, social security, informal work) could be jeopardised. A shift is required from simply selling a specific financial product to adjusting both products and services (based on solid experience of or research into the target groups) so that they genuinely help to increase income flows and the ability to repay the loan. EQUAL has carried out more formal types of research as well as supported efforts by seasoned micro-credit players that branch out and "feel" their way into providing finance for new groups such as ethnic minorities who rely wholly or partly on the informal economy. This demonstrates how effective marketing and outreach is essential to deliver finance to these groups.

Creating a sensitively designed package of mentoring and business support
EQUAL shows the need within strong welfare states to complement financial products with a sensitively designed package of mentoring and business support to increase investment readiness. One can discern at least two models. Firstly, there are schemes which focus on social support. In some cases, the financial support is totally dwarfed by the "soft" services and is just a small tool of the latter (eg loans of under €500). Secondly, there are approaches which focus more on innovation within the financial circuit. However, both types agree that the services should never be used to mask poorly designed financial products.

The content of the business support provided has to be designed to meet the needs of the specific target public and context. This often involves what has been called "financial capacity building" (teaching people how to manage diverse income flows in a way that they can gradually capitalise their activities). However, the initial process of screening and the knowledge that is built up about both the characteristics of the people and the strength of their business plan is also seen as a guarantee against excessive risk.

Mentoring of all kinds is probably the most extensively used form of support. Given the vagueness surrounding this term, EQUAL has worked towards common standards, benchmarks and systems of quality control for mentors.

Another associated support service is the provision of incubators (real or virtual) in order to tackle the absence of consistent support after the business creation and loan provision.

Adapting financial products and methods to the specific needs of clients
At present, the main focus within EQUAL has been on smaller sized loans and exploring the use of the various techniques for controlling risk (substitutes for collateral). Many loans have been much below the €25,000 official definition of a micro-credit. Most are around €5,000 with relatively few schemes with loans of over €15,000.

The need for collateral is seen as a major obstacle to credit. In addition to using guarantee schemes such as those of the EIF, EQUAL has demonstrated two ways to deal with this risk. As mentioned above, the first is to substitute a detailed knowledge of the person and the viability of the project with regard to material guarantees, with support services using various methods for simplifying and unifying the documents required for business plans and applications.

The second method is to substitute individual guarantees with group or peer pressure. Many of the same schemes also favour "Step lending" - starting with relatively small loans, which are renewed progressively after short periods.

There is a growing consensus that interest rates are not the most important factor and should be set close to market rates (and frequently higher) in order to increase the sustainability of the funds. Some funds make a fixed service charge in order to avoid religious objections to the payment of interest.

Partnerships to bring in organisations with financial, business and social expertise
EQUAL has been successful in bringing together the public sector, banks, specialist microcredit intermediaries (providing for example a credit board for approval of loans, collateral, supervision of repayments and debt collection) and organisations dedicated to providing the patient business support (in terms of training, coaching, mentoring, monitoring and control) required by hard to reach groups. The non-financial organisations[1] [2] often work as the port of entry to the financial organisation.

Engineering both organisations and funding sources to maximise sustainability
Although there are exceptions, most of the funds connected with EQUAL aim for operational sustainability. The first strategy is to increase the scope of operations by bringing fragmented microlending initiatives together. For example, in Germany EQUAL has brought together 22 microlending initiatives to form the Deutsches Mikrofinanz Institut and to create a single Federal Fund for Microlending Initiatives backed by EIF guarantees. Local initiatives will tap into this fund by adopting a tripartite common local funding model, thereby, increasing their economies of scale.

A second strategy, followed by many European organisations, is to shift many of the additional costs of dealing with disadvantaged groups onto the support side of the operation. After an initial start-up grant the financial activities themselves are expected to be self-sustaining whereas the necessary business support requires 70-100% public grants.

Several of the longer standing financial operators within EQUAL are able to provide excellent evidence of the cost-effectiveness of their support (for example one tenth of the annual cost of unemployment in France). Indeed, the average cost of support for microcredit schemes in Europe is reported to be under €5,000 per job created^[10]. In purely economic terms this makes intervention worthwhile even if the job created only lasts a year. However, EQUAL support has led to business survival rates of well over 60% after 2 years. In addition, there is the change of mentality, confidence and capacity in people who start to feel that they are serious "clients" of a financial institution rather than the beneficiaries of social support.

Finally, the importance of networking, training and financial capacity building (especially in the use of structural funds and other funding sources) is to be noted. Benchmarking and accreditation services have been developed in order to provide a means to track and guide progress.

Policy recommendations

The experience of EQUAL can offer the following recommendations that are relevant to the European policy framework.

Financial initiatives to disadvantaged groups would benefit from:

• solid previous experience of the target group and/or sound research into financial needs
• an integrated package of mentoring and advice in order to build the financial capacities of the disadvantaged and reduce risk for the initiative (not necessarily provided by the same organisation)
• products and methods that are adapted to the target public, taking account of different methods of guaranteeing/covering risk. Far more experimentation is required particularly in the transition from welfare to entrepreneurship. Possibilities include mutual guarantees, micro guarantees, mezzanine products and insurance products to manage insolvency risk
• reinforcing sector specific national and European networks to increase sustainability and improve both hard and soft skills
• using partnerships with social services and other frontline support workers for bringing financial institutions closer to disadvantaged clients

Finally, there is a need to document and highlight the changes required in national framework conditions. For this, relevant public sector actors must be involved in the partnerships. These conditions include: progressive tax regimes which facilitate the transition from the informal to the formal economy, the legal situation of migrant workers, the extension of unemployment benefits during the early stages of starting a business and interpretations of the banking regulations.

Endnotes

 Top