In Housing Microfinance is More Than Microfinance, I inferred that housing microfinance without a housing outcome is not housing microfinance at all. How do you ensure that housing microfinance results in a tangible improvement to housing? This is a practical question that is at the core of housing microfinance product design and implementation.
The means by which a financial service provider approaches the conversion of housing microfinance into housing purposes is often reflective of its overall housing paradigm and the extent to which it feels comfortable controlling the customer’s housing process. There are a wide variety of methods to mitigate the risk of a housing microfinance product being diverted to non-housing purposes. Each method has its own pros, cons, risks and implications for reaching scale when the product is implemented. I will briefly look at seven methods of mitigating diversion and promoting a successful conversion of housing microfinance into home improvement. There are certainly more possibilities, and often combinations of methodologies are used, but the following are a few common examples. I will generally refer to housing microfinance loans, but savings products could also be included.
The means by which a financial service provider approaches the conversion of housing microfinance into housing purposes is often reflective of its overall housing paradigm and the extent to which it feels comfortable controlling the customer’s housing process. There are a wide variety of methods to mitigate the risk of a housing microfinance product being diverted to non-housing purposes. Each method has its own pros, cons, risks and implications for reaching scale when the product is implemented. I will briefly look at seven methods of mitigating diversion and promoting a successful conversion of housing microfinance into home improvement. There are certainly more possibilities, and often combinations of methodologies are used, but the following are a few common examples. I will generally refer to housing microfinance loans, but savings products could also be included.
1. Honour System: Some products are designed without any tangible method for encouraging the finance to housing conversion. A customer presents an application for housing finance, perhaps with a budget or other requirements, and states that the loan will be used for housing. After disbursement, it is simply assumed that the loan was used for its intended purpose. The advantage of this is that it is extremely cost effective and has a low level of management complexity beyond the institution's normal business. Naturally, it can be assumed that some of the "housing" loans are not actually being used for housing. A counter argument is that given the high rate of diversion of business loans into housing activities, it could also be assumed that a large number of loans are being used for housing. If the product can achieve high volume, it might actually serve more customers with their housing needs than a product designed to better ensure the housing finance to housing conversion which has challenges scaling up.
2. Verification of Loan Use: In order to move away from assumptions about how a housing microfinance product is being used, an institution can verify the loan use. This would usually require at least a post-disbursement site visit to see that the proposed loan use activity was carried out. A pre-disbursement visit would improve reliability of the findings, to ensure that the customer does not show work that was completed long before the loan was even disbursed. Loan use verification simply puts a number to the finance to housing conversion. How many loans or what percentage of loans actually resulted in home improvements? Because there is no penalty or incentive for loan use built in, there is relatively low risk. The cost would be the cost of the verification visit, and the time taken to do it and report.
3. Cost Structure: Verification of loan use can be taken a step further by building in incentives or disincentives into the product’s cost structure based on loan use. The proposed housing project is inspected before the loan is disbursed and then again after disbursement. An incentive or penalty is then applied based on loan use. In my work in Uganda and Tanzania, we have disbursed loans at higher than market rate interest. If the loan is verified as having been used for housing purposes, it is then discounted to market rate or slightly below market rate. This seems to have a positive effect in curbing diversion. There are some risks and costs associated with this method. There is a possibility of collusion between the customer and staff to declare a loan verified as having been used for its intended purpose (when it was actually diverted) in order to receive a lower interest rate. Related costs include the cost of the visits as well as the administrative costs of changing repayment schedules, reporting and internal controls.
4. Multiple Disbursements: Multiple disbursements are another popular means of promoting the finance to housing conversion. This might also be thought of as “loan use verification in stages.” Rather than disbursing the entire loan at once, customers are given the loan in tranches and work is verified as a pre-requisite for the next disbursement. This limits the risk of diversion to the first disbursement only, rather than the entire loan amount. There is still a risk of collusion between customer and staff as with the cost structure methodology. The cost of verification is higher that the verification of cost structure methods, because of multiple visits to the site. There are more administrative tasks and financial transactions involved with the multiple disbursements
5. Site Supervision: Site supervision as a means of mitigating loan use diversion assumes that a key problem is poor use of materials, rather than mal-intent. It is sometimes thought of as a means of ensuring that housing finance results in a house, but it tends to be more of a quality control response than mitigation of outright diversion. On its own, there is little risk if it is not associated with a penalty or incentive for loan use. The only risk may be that of Turner's Third Law of Housing, should the customer be unhappy with the supervision and result. Associated costs include multiple visits and technical staff sufficient to support the product at scale. Site supervision can easily be linked to other methodologies that are more effective at mitigating actual diversion of funds, such as multiple disbursements or in-kind service.
6. Materials / Services In-Kind: The challenge of the finance-housing conversion is that cash is fungible and a loan designated for housing can just as easily be applied to something else. By providing materials or building services in-kind, it greatly decreases the likelihood that the loan will be diverted to non-housing purposes. This method could be an arrangement with a supplier through which the customer collects the materials needed, or it could be procurement by the lender. Procurement adds numerous risks of fraud. Kickbacks from suppliers are common and prices can be manipulated. This method has increased management complexity, especially when the requisite internal controls needs are taken into consideration. Turner’s Third Law may also be experienced if customers perceive that they have been provided with materials that are either more expensive or of a quality different than what they would have chosen on their own.
7. Full Service Delivery: One of the most certain ways to ensure a finance-housing conversion in housing microfinance is to control the housing process and deliver the service in full. The financial service provider essentially becomes a general contractor or linked to an outsourced general contractor-type service. This an effective but expensive and management intensive method of preventing loan diversion and ensuring the housing outcome. It has multiple risks throughout the process that must be mitigated with internal controls. Due to the intensive nature of the services provided, this methodology is the most challenging to operate at scale.
Each method has its pros and cons. Some appear to mitigate diversion better, but with added risks, costs and management complexity. As cost, risk and complexity increase, the product will be more difficult to deliver at scale, especially for financial providers without construction experience. Choices are made along the way of developing a product. Is it better to offer services at high volume and acknowledge that some housing loans are diverted to non-housing purposes, or to tightly control the process and significantly decrease diversion even if it is at the cost of volume and the number of customers served?
No method completely eliminates diversion if the product is delivered at scale. I have personally experienced cases of “ghost houses” even where materials were provided in-kind in a full service delivery package. How the finance to housing conversion is approached, however, continues to be perhaps the critical consideration in housing microfinance design. Which trade-offs will be made and why? The institution's approach microfinance linked with its housing paradigm are likely to be the guiding factors in making the decision.
2. Verification of Loan Use: In order to move away from assumptions about how a housing microfinance product is being used, an institution can verify the loan use. This would usually require at least a post-disbursement site visit to see that the proposed loan use activity was carried out. A pre-disbursement visit would improve reliability of the findings, to ensure that the customer does not show work that was completed long before the loan was even disbursed. Loan use verification simply puts a number to the finance to housing conversion. How many loans or what percentage of loans actually resulted in home improvements? Because there is no penalty or incentive for loan use built in, there is relatively low risk. The cost would be the cost of the verification visit, and the time taken to do it and report.
3. Cost Structure: Verification of loan use can be taken a step further by building in incentives or disincentives into the product’s cost structure based on loan use. The proposed housing project is inspected before the loan is disbursed and then again after disbursement. An incentive or penalty is then applied based on loan use. In my work in Uganda and Tanzania, we have disbursed loans at higher than market rate interest. If the loan is verified as having been used for housing purposes, it is then discounted to market rate or slightly below market rate. This seems to have a positive effect in curbing diversion. There are some risks and costs associated with this method. There is a possibility of collusion between the customer and staff to declare a loan verified as having been used for its intended purpose (when it was actually diverted) in order to receive a lower interest rate. Related costs include the cost of the visits as well as the administrative costs of changing repayment schedules, reporting and internal controls.
4. Multiple Disbursements: Multiple disbursements are another popular means of promoting the finance to housing conversion. This might also be thought of as “loan use verification in stages.” Rather than disbursing the entire loan at once, customers are given the loan in tranches and work is verified as a pre-requisite for the next disbursement. This limits the risk of diversion to the first disbursement only, rather than the entire loan amount. There is still a risk of collusion between customer and staff as with the cost structure methodology. The cost of verification is higher that the verification of cost structure methods, because of multiple visits to the site. There are more administrative tasks and financial transactions involved with the multiple disbursements
5. Site Supervision: Site supervision as a means of mitigating loan use diversion assumes that a key problem is poor use of materials, rather than mal-intent. It is sometimes thought of as a means of ensuring that housing finance results in a house, but it tends to be more of a quality control response than mitigation of outright diversion. On its own, there is little risk if it is not associated with a penalty or incentive for loan use. The only risk may be that of Turner's Third Law of Housing, should the customer be unhappy with the supervision and result. Associated costs include multiple visits and technical staff sufficient to support the product at scale. Site supervision can easily be linked to other methodologies that are more effective at mitigating actual diversion of funds, such as multiple disbursements or in-kind service.
6. Materials / Services In-Kind: The challenge of the finance-housing conversion is that cash is fungible and a loan designated for housing can just as easily be applied to something else. By providing materials or building services in-kind, it greatly decreases the likelihood that the loan will be diverted to non-housing purposes. This method could be an arrangement with a supplier through which the customer collects the materials needed, or it could be procurement by the lender. Procurement adds numerous risks of fraud. Kickbacks from suppliers are common and prices can be manipulated. This method has increased management complexity, especially when the requisite internal controls needs are taken into consideration. Turner’s Third Law may also be experienced if customers perceive that they have been provided with materials that are either more expensive or of a quality different than what they would have chosen on their own.
7. Full Service Delivery: One of the most certain ways to ensure a finance-housing conversion in housing microfinance is to control the housing process and deliver the service in full. The financial service provider essentially becomes a general contractor or linked to an outsourced general contractor-type service. This an effective but expensive and management intensive method of preventing loan diversion and ensuring the housing outcome. It has multiple risks throughout the process that must be mitigated with internal controls. Due to the intensive nature of the services provided, this methodology is the most challenging to operate at scale.
Each method has its pros and cons. Some appear to mitigate diversion better, but with added risks, costs and management complexity. As cost, risk and complexity increase, the product will be more difficult to deliver at scale, especially for financial providers without construction experience. Choices are made along the way of developing a product. Is it better to offer services at high volume and acknowledge that some housing loans are diverted to non-housing purposes, or to tightly control the process and significantly decrease diversion even if it is at the cost of volume and the number of customers served?
No method completely eliminates diversion if the product is delivered at scale. I have personally experienced cases of “ghost houses” even where materials were provided in-kind in a full service delivery package. How the finance to housing conversion is approached, however, continues to be perhaps the critical consideration in housing microfinance design. Which trade-offs will be made and why? The institution's approach microfinance linked with its housing paradigm are likely to be the guiding factors in making the decision.
