Investors should let microfinance institutions get creative
Improving loan contracts and expanding financial access for farmers means getting comfortable with uncertainty…
Since 2005, Kiva.org has worked to support financial services for low-income entrepreneurs and finance inclusive economic growth. From the start, a key element of that mission has been financing rural and agricultural growth in East Africa, and there’s broad evidence that economic growth is especially inclusive in rural agricultural economies.
In the past, Kiva’s main strategy has been to work with microfinance institutions and agricultural social enterprises, which are often the most accessible credit providers in rural areas. But finding viable ways to invest in small-holder farmers is challenging, and FSP’s will need to innovate and develop on their traditional models if they want to drive change in the sector.
Much of the challenge for rural and agricultural finance is that microloans tend to be expensive and inflexible, relying on quick repayment and strict risk-management strategies, while agriculture is fundamentally unpredictable, risky, and intermittent. When serving crop farmers, “innovation” has meant finding ways to provide patient, low-cost loans to adjust for the long delay between investment (planting) and payoff (harvest). But as Kenya’s economy grows, farmers have increasingly found an opportunity to invest in a much more consistent cash flow: Dairy farming.
Instead of pulling in revenue once or twice a year, dairy farmers sell to a local dairy every day, and get paid on a predictable weekly or monthly schedule. That makes loan repayment much easier and more reliable, but the consistency doesn’t come for free. Dairy farming is expensive and complicated, so “innovation” in dairy financing means controlling risk and finding skilled, reliable farmers who can make the big upfront investments like highly productive breeds, veterinary services, and water storage tanks.
Thanks to a collaboration with the Mastercard Foundation, Kiva Labs has been able to document a promising example of innovation in dairy financing, and are in the process of assessing its impact on farmers’ incomes. Thanks to the Kiva Labs partnership and a year of hard work and careful financial management, our outstanding MFI partner ECLOF Kenya now offers individual-liability loans and technical assistance for dairy farmers to invest in large, profitable assets.
Kenyan dairy farmers are under-financed
We believe Kenya’s dairy sector is underfinanced, with widespread opportunities for inclusive growth. But the sector faces a number of constraints, with broad assumptions about how risky investment is and underdeveloped supply chain linkages creating bottlenecks and excluding farmers who could otherwise increase their scale and profitability. Kiva Labs sees this as the sort of environment where risk-tolerant finance and the donor community can add real value, helping to connect partners across the value chain and make the business case for risk-averse investors wary of early entry into agricultural markets. In this context, the work of ECLOF Kenya stood out to Kiva’s R&D team.
In 2015, ECLOF started forming partnerships with regional dairies and milk aggregators to provide credit to small dairy farms around central Kenya. Milk production is a unique part of the agricultural sector in these areas since dairy farmers are heavily reliant on an industrialized supply chain for storage and processing. This can make dairy farmers vulnerable to bottlenecks in the supply chain and reduce their profit margins when dealing with a small number of large local buyers, but the consistent output of dairy cows means that these farmers have a much more consistent and reliable cash flow compared to those raising maize or other common crops. This all means that under-financed dairy markets can present an excellent opportunity for MFIs. Clients need to make big, expensive up-front investments in both physical capital (cows, sheds, vaccines, etc.) and human capital (training, connections, etc.), and have reliable, carefully recorded, and consistent revenue. ECLOF, with help from Kiva and the UK’s Department For International Development (DFID), have taken on the challenge of providing both the training and capital required to invest in Kenya’s smallholder dairy industry.
Pros and cons of group lending
As ECLOF’s dairy portfolio grows, the question has become how it can scale to serve more clients sustainably. Based on valuable research from researchers at the Poverty Action Lab, we asked ourselves how financing for small dairy farming could be structured to ensure it was valuable to as many farmers as possible. With MFI’s leading the way on dairy supply-chain financing, we’ve seen loans structured in much the same way as those sold to crop farmers and small enterprises with weekly payments made during group meetings. However, as ECLOF worked to expand in 2016, they saw the need to make this portfolio more flexible and client-centric. In collaboration with the Kiva Labs research team, we’ve revisited one of the core parts of their microfinance model: the group lending methodology.
Group lending allows reputation and social capital to stand in for physical or financial collateral, letting people put their good standing with the group on the line instead of some big asset. This unlocks community knowledge to identify risks among borrowers without well-documented financial histories. So despite being decades old, this sort of contract is still essential for many microloans. Still, some evidence has suggested this kind of social capital may actually be too valuable an asset for entrepreneurs to risk putting up as collateral. That means that group lending over-collateralizes credit to financially excluded borrowers and prevents them from making profitable investments. For example, a study from IPA with Rift Valley dairy farmers found that farmers were several times more likely to buy a water tank on credit when they didn’t have to get someone to guarantee the loan. Farmers were happy to put up some cash as collateral, but were reluctant to ask someone in their community to be on the hook for the loan if they defaulted.
Once farmers were taking out loans to buy water tanks, what was the impact? On one hand, farmers who had someone guaranteeing their loans were much less likely to be late in repaying, telling us that increased demand for financing would likely come with increased risk and cost for the lender. On the other hand, having a large water storage tank is really useful for a dairy farmer, and lifting the need for group liability lead to as much as 10 times as many farmers getting one. Being able to store rainwater freed up time spent carrying water and increasing girls’ school enrollment. So while there were potential risks, ECLOF and Kiva understood the importance of asset financing for improving farmer welfare and productivity.
So would a collateralized, individual loan increase demand for ECLOF’s dairy financing like it did for IPA? Loan officers, agribusiness managers at the local dairy, dairy farmers in the area all agreed that the chance to borrow money as individuals would be a valuable opportunity. With this research in hand and looking for ways to scale the CSA project, Kiva and ECLOF agreed to pilot a contract that would allow some farmers to finance investments in their businesses outside of groups, using Kiva’s risk-tolerant funding to support the process.
Initial input from borrowers and stakeholders
While ECLOF worked to design this product and work out the details, Kiva Labs conducted a baseline survey. Over three weeks, Kiva worked with independent researchers to survey 650 dairy farmers in Embu county, asking them about their businesses, investments, incomes, and experiences with ECLOF and other financial service providers. While most had just one or two cows, and had started or expanded their dairy farming using ECLOF funding, each group had a few members with five or more cows. Interviews about the amount of milk they were producing validated the general assumptions of the CSA model that their hybrid breeds are more productive and efficient. That said, we found that the value of those high-productivity cow breeds depends heavily on how much one invests in them (feed, water, shelter, etc.), emphasizing the importance of financial access. We found that 80% of borrowers say they’re happy with their loans and 87% were happy with their quality of service, though 75% also said they’d prefer individual loans if they had the chance.
Introducing individual liability loans
In late 2017, loan officers approached borrowers in pilot groups and let them know that they had the opportunity to borrow as individuals if they chose. With loan officers, dairy managers, and the farmers themselves all saying that farmers wanted individual loans, we began the pilot optimistic about take-up. But to our surprise, only a couple of borrowers said they wanted individual loans. Why?
After a little more discussion with farmers, we realized that, to adjust for the perceived increase in risk, individual-liability loans weren’t being approved at the same size as the standard group-liability ones. Despite the relative consensus around individual loans as a path to higher take-up and more investment, no one inside the organization has an incentive to take on a new product with an uncertain future. This turned out to be the first and most basic lesson of the pilot: Developing new client-centric financial services means taking financial risks, which means empowering staff to make more risky decisions in the face of uncertainty.
Adapting to the challenge
The team at ECLOF Kenya could have taken the low demand for individual loans as a sign that the pilot project had failed, and that their existing model was fine the way it was. Instead, they decided that with Kiva’s support for promising but unproven investments, they could afford to assess risk for individual and group loans in the same way, and went back to make sure farmers really understood the loans being offered. And as more farmers have begun to take advantage of the pilot, preliminary reports suggest they’re relatively safe, opening the door to a more ambitious roll-out of this new product to more farmers in more regions.
What’s next for ECLOF Kenya?
Will this greater flexibility result in higher incomes or more financial access? It’s still probably too soon to say. But in this early stage, loan officers have found that individual loans are seen as more useful than group loans for some of the large, long-term investments needed to require the big production gains that ECLOF promises (cattle sheds, water tanks, etc.). As we wrap up the next wave of Kiva Labs surveys, we’ll get a much clearer understanding of whether and how ECLOF’s services increase incomes overall, and whether the more flexible lending model changes the way farmers use credit. In particular, we’ll be able to compare growth in assets, investments, and incomes among farmers with access to individual liability loans, those with access only through the groups, and those who haven’t engaged with ECLOF at all. We’ll also be able to integrate this with administrative data from the dairy to see if farmers see the jump in their milk production that ECLOF expects when they join the program.
Either way, the past 18 months have shown us how Kiva’s work funding financial innovation, both through subsidized capital and technical assistance, can help MFIs establish a sustainable business case for improvements in their services. Indeed, now that there appears to be a viable business case for offering group and individual loans alongside each other, ECLOF has started to offer them in new markets, and will also include a new set of farmers in Nakuru, where the pilot product is being rolled out as part of ECLOF’s standard services.
What’s next for investors and donors?
This kind of collaborative research and product development can multiply the impact of donor funding and investment, leading not just to greater scale at the margin, but to improvements in the structure of financial contracts that allow for more investment and deeper impact. We see this as a powerful model for both impact investors and donors going forward. Rather than focusing strictly on deal flow and finding high-impact companies in which to invest, socially minded investors and donors can take on the uncertainty that acts as a bottleneck for private capital, investing in promising new models for inclusive growth and making the case for private investment as the model scales up. By encouraging iteration and experimentation, we can create an innovative business environment where investors can identify and finance successful models for rural and agricultural development.
Learn more about Kiva Labs.
