The challenge of transaction costs

Microfinance institutions learnt that they needed to reduce transaction costs to serve the poor - traditional banking models are too expensive to handle small transactions in remote areas. Microfinance lowered costs by designing a new delivery mechanism.

Investing in SMSEs faces the same problems. Enterprises are too small for traditional analysis or oversight. Additionally, agencies located far from the SMSEs will not understand local market realities. New delivery mechanisms are needed. Some models already exist, more experimentation is needed.

SANASA Development Bank specialises in lending to smaller social enterprises. This specialisation has allowed it to create 'rules of thumb' that allow initial rapid evaluation in each sector to determine which loans are most likely to be a success . Additionally, since it is well known for focusing on social sectors, it is able to channel funds from the government and international agencies that contribute to its costs. Finally, it works hard to minimize its costs, using low-cost systems and small branches. As a result, its cost income ratio is 57%.

Equity investment carries additional costs as more analysis is needed. Aavishkaar, an innovative supplier of private equity to SMSEs in India has tried to reduce its costs by only using local staff and locating its offices in low cost areas.

Creating networks of SMSEs can allow increased scale and support channelled through the network will reach a large number of SMSEs. SANASA societies have created a network which owns companies that support the SMSE microfinance organizations. An investor could create similar networks in other sectors, for example pharmacies or schools.

Given the positive social impacts of social investments, a jointly funded model may be possible, whereby some of an investor's costs are covered by a funding agency. Some social investors, including Aavishkaar, have resisted any external support believing it breeds lax practices and undermines long-term financial sustainability, but others find external funding helps so long when it is used to develop organisation capabilities or fund expansion.

Partnerships, using local staff and increasing scale will all reduce transaction costs of supporting SMSEs, but more experimentation is needed to find a business model with acceptable transaction costs.