Juan lives in Orosi, surrounded by mountains where you can hear the murmur of the river winding through the valley. His days are spent tending to a few small plots of land and dreaming of expanding his property to produce more coffee. A neighbor wanted to sell him a piece of adjacent land, but Juan knows that if he goes to a bank, the answer will be “no” because his ability to pay is very limited.
Elsewhere in the country, Marta, who works for a microfinance institution (MFI), reviews files. She knows that among her clients are entrepreneurs with ideas but without access to formal credit, like Juan. Marta had worked at a commercial bank where she learned that millions of people in Latin America were left out of the financial system.
At the microfinance institution, Marta not only approves loans, but also ensures that she is very clear with her clients about the rates applied to the credit and informs them about proper payment practices, even providing recommendations to help them avoid the risk of over-indebtedness. She doesn’t just evaluate the numbers; she has also begun to ask herself how she can help her clients deal with environmental and social risks.
Marta’s question and Juan’s story are reminiscent of the cases that economist Muhammad Yunus observed and analyzed in Bangladesh decades ago. Yunus discovered that, with a little financial help, low-income people could start or strengthen their businesses and thus, little by little, escape poverty.
Muhammad Yunus began by lending small amounts of money to low-income women. In 2006, he received the Nobel Peace Prize, along with the bank he founded in 1983 to provide microcredit: Grameen Bank. One of the key principles of microcredit, according to Yunus, is that it must be accompanied by financial education and social empowerment.
Environmental and social risk assessment in lending
Marta knows that her clients often lack procedures for assessing and managing environmental and social risks, as well as for understanding the legislation that applies to them. Therefore, when an accident occurs, they have no controls in place to mitigate the impact on their operations and creditors. For example, if a fire breaks out in a motorcycle repair shop, it is unlikely that her client will be able to continue operating, which would prevent them from repaying the loan.
Marta’s concern has been present in the financial sector. Some countries, but especially funders, have requested that financial institutions, including MFIs, have an environmental and social risk management system (ESMS) in place. ESMS can be defined as the set of actions that allows a financial institution to identify, mitigate, and monitor portfolio risk. This process is successful when clients perceive that the financial institution wants to help them improve their performance.
Therefore, before approving the loan, Marta organized an environmental and social assessment. She checked that Juan complied with environmental and social legislation, that he took care of his workers, that his farm used resources efficiently, and that biodiversity conservation was guaranteed.
Marta identified areas for improvement and, together with Juan, designed an action plan: safer pesticide management and a review of the working conditions of some of the workers Juan hires on a temporary basis for the coffee harvest. This action plan included tasks for Marta to carry out, such as training on good environmental and social practices.
This process has enabled Marta to identify other financing opportunities, since by better understanding her clients’ operations, she better understands their needs. For example, financing gas biodigesters to process the waste generated by animals in a livestock operation, or the opportunity to open a line of credit to finance solar panels for electricity production, aimed at clients located in remote areas.
ESMS in microfinance
Maintaining an ESMS in place at MFIs is challenging. As indicated in the European Microfinance Platform’s Assessment of the Sustainable Performance of Financial Service Providers for SMEs, environmental and social risks are often undermanaged because MFIs rarely have a ESMS in place. When they do have one, they tend to classify SMEs and low-value transactions as low risk without conducting an assessment.
However, this situation is changing in Latin America. In 2022, Ecuador’s Superintendency of Popular and Solidarity Economy issued Resolution No. 003, which refers to the Control Standard for Environmental and Social Risk Management in Savings and Credit Cooperatives and Mutual Savings and Credit Associations for Housing. This regulation states that entities whose share of the microcredit segment in terms of number of transactions and/or volume exceeds 20% must have an ESMS in place by 2024.
Likewise, in 2020, the Colombian Banking and Financial Institutions Association (ASOBANCARIA) presented the ESMS Microfinance General Guide, with the aim of providing guidelines for MFIs to incorporate good environmental and social practices into their credit processes.
These advances in regulation, together with increasingly stringent requirements from funders, have enabled MFIs to incorporate environmental and social risk assessment into their loan portfolios. Thus, in a corner of Costa Rica, Muhammad Yunus’ vision of economic and social development from the bottom up continues to take shape. And Juan, with his new plot of land and a more sustainable plan, demonstrates that microcredit, when properly supported, is a true win-win for the entrepreneur, the community, and the environment.