4. Identifying an Underserved Market

The most successful companies of the last 25 years haven’t always been based on radically new products or technologies. Some have sprung from their leaders’ ability to identify and cater to markets that were emerging but whose needs had not yet been identified. Vanguard Group founder Jack Bogle sold index funds directly to shareholders who previously had been charged high sales commissions and management fees; Charles Schwab, through his San Francisco-based discount brokerage, gave “Main Street access to Wall Street;” and Muhammad Yunus, founder of Grameen Bank, set out to “break the cycle of poverty” in his native Bangladesh by making loans to very poor villagers, thereby enabling them to become self-supporting entrepreneurs.

These leaders succeeded because the new markets they identified sustained demand for their product or service. Customers whose needs had never been met began to thrive and prosper, as did the companies serving them. The lesson that aspiring leaders can learn from their example is not to focus just on the dominant or most profitable markets of the day; these are obvious to all and are likely to attract enormous competition. By identifying underserved markets (or niches) and customers (or segments) that no one else is targeting, companies can enter new areas and develop successful businesses long before their competitors.

John Bogle

The Challenge: Setting Up a New Kind of Mutual Fund Company

During the stock market’s go-go era in the 1960s, it seemed that investment managers could do no wrong. But the bubble popped in 1973 and stock prices fell by nearly 50%. Wellington Management Company, a mutual fund manager in Philadelphia, saw frightened investors withdraw $300 million as Wellington’s share price plummeted. Early in 1974, the firm’s board terminated its CEO, John Bogle.

“I think it’s pretty clear that the biggest business challenge you can face is what to do when you are fired,” Bogle says three decades later. His response: Use common sense and—as he puts it—a touch of “disingenuousness” to convince the board to form a new type of mutual fund company and to hand over control.

Bogle, who joined Wellington fresh out of Princeton in 1951, was named CEO in 1967. To broaden the company’s offerings, he had engineered a 1966 merger with Thorndike, Doran, Paine and Lewis Inc., a Boston equities management firm. Now these partners had pushed him out. But Bogle was not entirely unemployed. In addition to running the management company, he was chairman of the Wellington Funds, the family of mutual funds run by Wellington Management. This job he kept.

Since his college days, Bogle had been bothered by the conflict of interest inherent in many fund operations. Mutual funds are corporations owned by the ordinary people who buy fund shares to invest for retirement or college. But funds typically use outside money managers to select the stocks and bonds held by the fund. Those management companies also handle the administrative, marketing, and distribution functions for the funds they serve. Though the funds and their management companies are legally separate entities, in most cases, the fund company’s board is dominated by executives from the management company. Income for the management companies comes from fees charged as a percentage of each fund’s assets; the bigger the fee, the more it hurts investors’ returns.

Bogle had long argued that funds and their management companies should have ethical standards like those of the legal and medical professions, based on an obligation to put the investors’ interests first. Funds should constantly look for ways to reduce fees, not excuses to raise them. “All things considered, it is undesirable for professional enterprises to have public shareholders,” he told the board in the early 1970s.

The day after being fired, Bogle formally proposed a change to the fund board that he had first suggested several years earlier. The funds should “mutualize” by purchasing the management company from the group of investors that owned it, he says. Because the funds themselves are owned by the people who invest in them, the management company would be owned by the funds’ ordinary investors, eliminating the manager-investor conflict. Fund investors would be owners as well as customers.

The Wellington Funds board was less than enthusiastic about the proposal, but six months later, it gave Bogle part of what he wanted. A new company, The Vanguard Group, was formed as a wholly owned subsidiary of the Wellington Funds. Vanguard’s only role, however, was mundane administrative chores, such as keeping records of customers’ accounts. Asset management—the buying and selling of stocks and bonds for the funds—was forbidden. Vanguard was also barred from distribution—the selling of fund shares to investors. Those more essential duties remained with Wellington Management. “So I had lost,” Bogle says. “I called it a Pyrrhic victory.”

He didn’t give up. “It was clear to me that what you need to build a fund company is control over how the funds invest—what kinds of funds you have, how they invest, and how they are distributed.”

For more than two decades, Bogle had been intrigued by the idea of index funds. Instead of employing teams of expensive analysts and stock-pickers, an index fund would simply buy and hold the issues in a market gauge, such as the Standard & Poor’s 500. Over time, the law of averages meant that few actively managed funds could outperform the indexes. Indeed, the high fees and expenses incurred by managed funds typically caused them to trail the passively managed index by 2 to 3 percentage points a year. So a fund modeled on the index, and charging very low fees, could beat most managed competitors most of the time. It could offer investors far superior returns when that annual edge was compounded over many years.

Soon after Vanguard was formed, Bogle was back before the board asking it to create an S&P 500 index fund. “It seemed to me that would be a great entrée into investment management,” Bogle says. “When the directors said I wasn’t allowed to get into investment management, I argued the fund wouldn’t be ‘managed.’” Managed funds constantly seek new investments, and they typically change their entire portfolios every year. An index fund, he said, would just buy the stocks in the underlying index and hold them for the long term.

“This was a way to basically sneak into the field of investment management...They approved it. They didn’t really want to, but they did because I persuaded them that it was not ‘management,’” Bogle recalls.

Next, he went after the distribution operation. Ever since the Wellington Fund’s founding in 1928, the funds had been sold to investors through stock brokers, often with “loads,” or commissions, as high as 8%. After paying an upfront load, the investor started out in the red and had to earn that much just to break even. The alternative, still rare in the 1970s, was to bypass the brokers and sell directly to the public, charging no commission.

“I argued that we should go no-load, and Wellington Management didn’t want to go no-load,” Bogle says. Unfortunately, Wellington Management was still controlling distribution of the funds, and Vanguard was prohibited from that role. “I argued we weren’t going into distribution, we were eliminating distribution,” Bogle says. Again, the board acquiesced, and by the end of the summer in 1977, Vanguard had control of the fund management and the no-load distribution. “We were the full-fledged complex we are today,” he notes.

Vanguard’s S&P 500 index fund grew to become the largest fund in the world, with assets of about $96 billion early in 2004, and it inspired dozens of imitators. Vanguard and other companies also created a host of funds tracking other indexes. By 2004, Vanguard was the country’s second largest fund complex, with some $700 billion under management in 161 funds and about 10,000 employees.

After retiring in 1999, Bogle devoted himself full-time to writing and speaking about conflicts of interest and excessive fees in the fund industry. “There’s a tendency as we get older to lose our idealism,” he says, “Don’t do it. It’s the most valuable characteristic you have...I think mine gets stronger all the time.”

Leadership Lesson

An Index for Successful Investing

Ever since his undergraduate days at Princeton, Jack Bogle had been interested in research that showed the average money manager could not compile a portfolio that would consistently beat the overall market. If this were the case, the best mutual funds would be those that charged customers the lowest fees, because fees deducted from fund assets undermined performance. At the time Bogle formed the Vanguard Group in the mid-1970s, most funds were sold through stockbrokers who charged hefty upfront “loads” or sales commissions. In addition, the funds themselves charged substantial fees to pay their analysts and other employees, and to provide profit for the management company.

Bogle saw an underserved market: cost-conscious investors who might welcome the opportunity to buy index funds that would track the overall market and charge very low fees. To eliminate loads, Vanguard would sell funds directly to shareholders. Instead of outsourcing fund management to an expensive external management company, Vanguard would take over this role itself. Most fund companies are privately held or run as public companies beholden to shareholders. Vanguard would be owned by the people who invested in its funds, eliminating the conflict of interest between customers and owners. By making Vanguard a mutual company, owned by its investors, Bogle would be putting investors’ interests first. “You can say that was callow college idealism. Or you can say it was vision that created Vanguard,” says Bogle. “It’s probably more of the former—idealism that just stuck with me all those years. It’s also common sense.”

To cater to underserved markets, Bogle had to come up with an innovative pricing strategy. Long before the Internet changed the way people shop, Bogle was thinking about price, value, and customer service. In the 1950s, ‘60s, and early ‘70s, experience and a study of the academic research confirmed his view that very few money managers were good enough to pick stocks that could consistently outperform the broad market. This fact formed the cornerstone of Bogle’s low-price strategy at his mutual fund company, The Vanguard Group. “None of it required any particular brains,” Bogle says. His approach, he adds, “took a little common sense, knowing that in the financial markets gross return minus cost is net return. Therefore, the lower your cost, the higher your net return.”

In part, Bogle’s strategy depended on his educating investors about the poor performance of the average, actively managed fund—then selling to this more knowledgeable class of buyers. It is a never-ending process because traditional, high-expense funds are always tempting customers with ads based on high, short-term performance. “Investors seem largely unaware of the substantial gap by which stock, bond, and money market funds lag the returns of the markets in which they invest,” Bogle wrote in a July 8, 2003 op-ed piece for The Wall Street Journal. “While the Standard & Poor’s 500 stock index has risen at a 12.2% average annual rate since 1984, for example, the average equity fund has grown at a 9.3% rate, only three-quarters of the stock market’s return...What accounts for these shortfalls? They are largely created by the costs incurred by mutual funds.”

“In 2002, the average expense ratio for equity funds reached an all-time high of 1.6% of fund assets,” he wrote in the same article. Trading commissions and other costs related to the high level of buying and selling in actively managed funds increased expenses another 0.8 percentage points. With miscellaneous expenses included, total costs averaged nearly 3% of assets. However, at Vanguard’s flagship S&P 500 index fund, the expense ratio was 0.18%—just over one-tenth that of the average stock fund industry-wide. Because index funds operate, essentially, on autopilot, with very little change in holdings, commissions and other expenses are low as well. Such funds also enjoy a tax advantage because there is little of the turnover that triggers capital gains taxes. To further minimize costs, Bogle decided the funds would be sold directly to investors without the “loads” or sales commissions, often as high as 5% of an investment, charged by funds sold through stockbrokers.

For Bogle, credibility is a big reason for Vanguard’s success. “Create an identity, a company that stands for something...And when you make promises to the crew [Vanguard’s term for its employees], deliver. When you make promises to investors, deliver. If people can trust you...you’re never going to have trouble,” he says.

Speaking at Vanguard’s 25^th anniversary ceremony on September 24, 1999, Bogle summarized the company’s identity in a single word: “Stewardship: The one great idea that explains what Vanguard is, who it is, and what it does. Serving the shareholder first; acting as trustee, in a fiduciary capacity. Mutual funds of the investor, by the investor, for the investor.” The same themes characterize Bogle’s many public speeches, articles, and letters to newspaper editors—earning him the nickname “Saint Jack,” which is not always used admiringly by his competitors. In retirement, he has carved out a role as fund industry gadfly. Most of his criticisms of the industry—that fees are too high, for example—serve to enhance Vanguard’s brand as the low-cost leader.

“Bogle had this incredibly compelling vision that made such perfect sense in an industry that was so resistant to it,” says Wharton’s Peter Cappelli. What’s astonishing, he adds, is that “nobody had tried this index approach before.” Bogle pulled it off because he was “enough of an insider to be able to start an investment company and yet willing to be an outsider in his approach.” In addition, Bogle brought science to this industry, Cappelli says, referring to research studies that show managed funds rarely beat index funds over long periods, and also to analyses of the corrosive effect of high fees on returns.

All of these cost savings are possible, Bogle says, because Vanguard is a mutual company owned by the people who invest in the Vanguard funds. “I guess the lesson would be to capitalize on your innate advantage,” he suggests. “Make your product proprietary. Stake out some ground that other people can’t afford to deal with. That’s been a big part of Vanguard’s success—we don’t have low-cost competitors.”

Bogle’s strategy of long-term investing based on low costs helped the Vanguard Group build an image as the mutual fund industry’s good guy—an image that can be especially valuable in periods of turmoil and scandal in the financial services industry. He constantly reminded his employees of the Vanguard mission, pounded away at the basic message in every public forum he could find, and reaffirmed the company’s commitment to core principles in annual letters to investors. And when he felt that his peers had let him down, he didn’t hesitate to castigate the offenders. “By our failure to act as good corporate citizens, this industry shares much of the responsibility for the great stock market bubble,” Bogle wrote in a July 8, 2003 piece in The Wall Street Journal. “In the long run, this industry will grow only as fund shareholders are given a fair shake, not only in costs and disclosure, but also in having truly independent directors who place [investors’] interests first. Truth [be] told, this industry needs a change of heart.”

Charles Schwab

The Challenge: Getting Out from Under All the Paper

By the mid-1970s, Charles Schwab was best-known for chipping away at the dominance of button-down Wall Street investment houses with his discount brokerage firm. But it seemed that Charles Schwab & Co. would remain a small-time, regional broker, more of a nuisance than a challenge to the full-service brokerages. The problem? The company was getting buried—not by the competition—but by paper.

All brokerages faced a similar situation, although the established houses had legions of clerks sorting and managing transaction and order receipts. The highly regulated securities industry needed to fill out a form for every small or big trade order or transaction. The Securities and Exchange Commission (SEC) and the New York Stock Exchange (NYSE) mandated specific standards on how to record, manage, and archive the paper trail.

To keep up with trading volume, the Schwab offices were rigged with a three-track conveyor belt over which orders moved in one direction and confirmations moved in another. When trade orders poured in, the volume of paper sometimes clogged the belt and brought the office to a standstill. Schwab employees used something akin to a plunger to unplug the jam.

“We were just getting buried in paper,” says Schwab, who hired Bill Pearson, a technology whiz, in 1975 to help overhaul how the company conducted its paper-intense business. “I realized we could never progress beyond that limitation without adopting a technology solution.”

Against this backdrop, Schwab made a “bet-the-company” move to computerize the transaction order process—a step that helped grow the discount brokerage into a real threat to Wall Street and laid the foundation for the company’s repeated success in harnessing new forms of technology. The move, however, was fraught with growing pains as glitches and technical problems made the company even more vulnerable.

Pearson “scoured the earth,” says Schwab, to find a computer system that would allow a broker to make trades without generating the piles of paper needed to satisfy the SEC and the NYSE. Pearson found a software outfit in Milwaukee, Wisconsin, that had developed trading software that could be customized to fit Schwab’s needs. This early back-office software, however, ran on mainframe computers, the giant systems that took up an entire room and cost a small fortune to buy. Schwab purchased a used IBM 360 mainframe computer and software for $500,000—“my entire net worth” at the time, says Schwab. “It was a giant step and a huge risk.”

The new technology allowed Schwab’s brokers to take orders over the phone and enter them directly into the computer using desktop terminals. The order would go off electronically to the stock exchange where it would be executed, eventually returning a confirmation to the broker who then relayed it to the client. The technology was revolutionary, allowing Schwab to broker higher and higher transaction volumes at a fraction of the paper-based cost. “Most firms didn’t get there until 10 years later,” he says.

But the company didn’t immediately realize any benefits from the purchase. The used IBM mainframe, for example, did not integrate well with the brokerage back-office software. “It was a mistake,” says Schwab, who turned to IBM for assistance. The computing giant offered to lease Schwab a brand new IBM 370 mainframe computer and help integrate the software. The result was a more reliable system.

The company’s difficulties in shifting to technology, however, were far from resolved. “We had a lot of hiccups,” remembers Schwab. “It was a little like cell phones are today—the way they go down every few blocks.” Schwab says his initiative may have been just a little ahead of its time because the existing telecommunications network was not built for this particular use. The glitches and customer complaints kept mounting. Whatever savings were generated by reducing paperwork were lost in reimbursing delayed trades and transactions.

The technology initiative even doomed Charles Schwab’s chances of going public in the early ’80s. At the time, the company was the largest discount broker in the country, with 20 branches and nearly 100,000 customers. Schwab was hoping to raise about $4.8 million for capital expansion by floating 1.2 million shares. When the company registered with the SEC in 1980, Wall Street became privy to the extent of trouble the discount brokerage had to put up with during its technology upgrade. The prospectus showed that in the first six months of 1980, the company had to fork over nearly 11%, or $1.1 million, of its total commission income of $10.4 million to cover bad debt and execution errors at a time when the average error rate for New York Stock Exchange members was a low 1.4% in comparison.

Charles Schwab’s own books provided the full-service brokerages with the firepower to disparage discount services and warn clients to stick to Wall Street’s reliability. In its prospectus, the company blamed its woes on the new electronic order processing system, which was constantly breaking down during periods of heavy trading. The error rate was pegged at 3.4% in 1978, rising to 5.4% in 1979 and soaring to 10.5% in the first half of 1980.

“It was a pretty painful three or four months. We had some bad publicity at the time,” says Schwab, who traveled from office to office trying to instill a sense of confidence in his employees. “I became a cheerleader, assuring people that things would get better—and it did get better.”

Having grown up on the West Coast, Schwab—a graduate of Stanford University, located in the heart of Silicon Valley—had an affinity for technology and sensed its immense possibilities. As an early adopter of technology, he knew he would be required to surmount obstacles not faced by others. “You’re never going to introduce a perfect software solution. Any software or system you install will have setbacks and glitches,” says Schwab. “You just get in and fix them.”

Indeed the outlook began to improve as the company worked the kinks out of its Brokerage Execution and Transaction Analysis (BETA) system. Suddenly, each Schwab broker could handle a greater number of trade orders while the system did much of the background work, including checking open orders, calculating margin trades, and moving cash from trading accounts to money market funds. The company’s costs fell while its efficiency and accuracy in processing trades rose.

Wall Street nervously took notice and slapped the upstart with yet another major hurdle to its paper-less trade system. This time, the NYSE said BETA’s paperless order tickets violated the exchange’s rule requiring its member organizations to save paper tickets for seven years. Since there were no paper tickets generated by BETA, the NYSE refused to certify Schwab’s system.

Schwab fought back by exploiting the wording of the regulation. The company insisted that the rules required the member firms to only save paper tickets but did not require them to write paper tickets. The NYSE had taken it for granted that brokers would have to write paper tickets while Schwab leapfrogged over the entire process. The exchange acquiesced and the orders began to flow into Charles Schwab’s mainframe.

Sensing the inevitable—and watching as Schwab’s trading volume soared while costs plummeted—other brokerage houses in the early 1980s also began migrating from their paper-based procedure to computerized systems. But Schwab had taken an early gamble that positioned his discount brokerage years ahead of his discount brokerage competitors as well as Wall Street. The move also established a technology paradigm—a comfort level with technology—within the company as well as for its clients. Schwab continued to seek ways of using existing and emerging technologies to revolutionize the securities industry. In the years ahead, he was among the first to give his clients the ability to bypass a broker completely by connecting directly to Schwab’s systems to place trades—a precursor to Internet trading.

“This was the major stepping stone in the early days of the company,” says Schwab. “If I had not taken a chance on technology, we would never have been able to create all the other technology-driven opportunities for our clients.”

Leadership Lesson

The Best at Fair Value

Charles Schwab, like Jack Bogle, was also out to shake up the financial services sector. Until the mid-1970s, there was really just one way to invest in the stock market: a broker at a full-service brokerage firm would recommend a stock to buy and would charge about $225 for the transaction as a commission. “Fundamentally, at that time, most people thought that individual investors were sold stocks; they didn’t buy them,” recalls Schwab. Wall Street, he adds, was in the business of generating commissions by “creating stories” to convince people to make these purchases.

In 1975, the Securities and Exchange Commission changed a long-standing law that had required Wall Street to charge fixed brokerage fees. Yet, while the revised law now allowed firms to offer discount fees, the securities industry had no intention of reducing commissions just because the law permitted it. Schwab, however, saw an opportunity to revolutionize the system by allowing investors themselves to choose stocks and buy them at a fraction of the cost charged by traditional brokers. Although he was not certain how much demand there would be for such a service, he speculated that there would be a “small sliver” of independent investors who based their decision to buy a stock on their own research and analysis. “I thought probably 3–4% of investors were in this category,” including himself, he says. “I had deep empathy for what these people were looking for because I had grown up as a financial analyst and not as a stock salesman.”

What Schwab could see was the “need for a very pure transactional firm that [would operate at] a much lower price” without “any so-called help or intimidation from the sales guys.” So Charles Schwab & Co. charged $70 per trade. To his surprise, individual investors—about 10–15% of the individual investor population—took to the concept of discount investing immediately. Says Schwab: “I underestimated the size of the market.”

Like Bogle, Schwab made sure that the organization he built to cater to this underserved market bought into his values. “When I started the company all those years ago as a pure discount broker, I weighed what I wanted to eliminate,” says Schwab. He decided it was imperative to scrap the conflict of interest inherent in a broker receiving a commission for making a sale. “Imagine how you would feel if you knew your doctor was getting a commission for each drug he prescribed to you. You wouldn’t feel too comfortable with that.” Even as the company has added a multitude of financial products and services—like investment advisors, mutual funds, and instruments for high net worth individuals—Schwab says he has always “maintained its heart and soul.” His employees, he adds, many of whom have come from traditional brokerage firms, express a sense of relief that they are not under a mandate to sell “the stock of the month,” “make their commission quota,” or “call clients to build book.” “Yes, of course, we make money some place in the process from our clients, but our employees aren’t incentivized to convince clients to be active,” says Schwab. “It’s a different culture here.”

Price also plays an important part in the Schwab culture. The company never tried to position itself as the lowest priced service, he says. There were always discount brokers, and later, online trading firms that could undercut even his company. “That was not our mantra. I always tried to be what I considered the best at fair value. I wanted the best people working for me; I wanted the best computers, the best innovation. I didn’t want our service to be ‘cheapest’ in any way...It’s a ticklish balance and we certainly lead the conversation with price, but we finish it up with...superior service.”

“King of Online Brokers”

Part of Schwab’s vision hinged on discovering innovative uses of technology to introduce his clients to financial products. In 1979, he was among the first to harness the power of computers to scale his trading volume higher. Though the decision led to some early rough spots—trades that failed to be completed, a high error rate, and customer complaints—Schwab instilled in his company the importance of always being on the lookout for fresh opportunities.

In the 1980s, for example, new legislation had created a financial savings instrument called Individual Retirement Accounts (IRAs)—basically retirement mutual funds that grew on a tax-free basis. Schwab sensed that the demand for mutual funds was about to increase and quickly adapted his discount brokerage service to cater to the needs of individual investors hoping to take advantage of tax-free growth. “I decided that we needed to make it easier for people to buy a variety of no-load funds through a central account,” says Schwab. The company created a mutual fund marketplace that revolutionized the mutual fund industry and helped companies like Vanguard and Fidelity gain greater traction.

Meanwhile, a part of Charles Schwab & Co. had morphed into a distribution vehicle. “Smaller, very effective money managers knew how to manage money. They didn’t know much about distribution,” says Schwab. “We essentially became their distributors by giving them a marketplace.” By the mid-80s, this mutual fund marketplace allowed investors to buy and sell hundreds of different mutual funds in a single account. By 2000, Charles Schwab & Co. was pulling in about 10% of the net new money flowing into mutual funds.

During the 1990s, the company was again at the forefront by jumping onto the Internet before rivals even considered using the emerging networking technology. The company forged ahead despite the realization that online trading would cannibalize its broker-based transactions. David Pottruck, who later became co-CEO of Charles Schwab & Co., spearheaded the effort. While commissions on broker-assisted trades started at $39, Schwab charged $29.95. The company believed, correctly, that the growing number of online trades would make up for the revenue lost from its established business.

Again, Schwab had merged his readiness to innovate with his desire to offer more opportunities to average investors. The company’s online trading system was considered the paragon for the medium. Forbes magazine even named Schwab the “King of Online Brokers.” While the company’s online trading business has slowed since the Internet bubble burst in 2001, at the height of the online trading frenzy between 1997 and 2000, the firm’s profit rose 112%, driven by a 183% increase in daily trades.

Muhammad Yunus

My Greatest Challenge: Using Microcredit to Lead Beggars into Business

Muhammad Yunus, founder and managing director of Bangladesh’s Grameen Bank, has long focused on lending to the poor. As an innovator who recognized that lending need not be linked to collateral, he built Grameen by offering minuscule loans to very poor people, giving them the means to generate incomes and work their way out of poverty. Since its inception in 1976, Grameen has provided more than $4 billion in loans to some 3 million borrowers, the vast majority of whom are women.

Most observers have recognized Yunus’s achievement in finding an innovative solution to perennial poverty—one that relies on the enterprise of the poor rather than on government aid or other kinds of charitable handouts. Lately, however, Grameen—and microcredit in general—have faced criticism for helping just the top tier of the poor, those who are able to use credit. The poorest of the poor, the argument goes, have no need for credit—they need water and food, and that can only be provided by charity.

A case in point: A recent report in The New York Times cited the example of Firuza Akhter, a young woman in the village of Gorma in Bangladesh, who borrowed small sums to invest in everything from cows and land to tutors for her children. The report said that while borrowers like Akhter may come from “humble backgrounds,” they “hovered at the upper fringe of poverty.” Based in part on such arguments, the U.S. Congress has approved rules requiring that half of $2 billion in aid for such programs go to people earning less than $1 a day.

Yunus disagrees with this view, and he has often argued that microcredit benefits all layers of poor people, including those at the very bottom. Moreover, he is used to pushing forward in the face of opposition. He points out that skeptics abounded even when he was trying to get Grameen off the ground in the 1970s. “Things were always difficult for us, but I knew they would be because I was trying to do something that no one else believed in,” he said in an interview from his office in Dhaka. Yunus had to develop Grameen’s initial programs despite considerable opposition from bankers, who doubted that the initiative would work. In addition, he faced criticism from academic economists, who argued that microcredit could not foster true economic growth. Some religious leaders also opposed Grameen because its programs advocated giving loans to women. “There was opposition all around,” Yunus says. “And it continues. Even today, there are lots of naysayers. I treat it as part of life. You just have to move on.”

Moving on, for Yunus, means demonstrating what he believes is true, rather than just arguing his case. Faced with criticism that Grameen only reached the relatively better-off among the poor, Yunus was determined to show that microcredit could work for the poorest. To establish that, Yunus and Grameen launched a program in 2004 targeted at 10,000 beggars around Bangladesh. “We went to the beggars and told them, ‘Look, when you go from house to house for begging, would you consider carrying some merchandise with you? Take some bangles, candles, cookies, or other kinds of food. Now you have a choice; you can beg, or you can sell. Maybe at some houses you could sell and at others you could beg.”

Grameen Bank set up special rules to encourage beggars to join its program. For example, it clarified that the bank’s rules would not apply to beggar members; they could make up their own rules. In addition, all loans would be interest-free, long-term, and have low repayment installments. (For a loan to buy a blanket, for instance, the repayment rate would be 3.4 cents a week.) All beggars are also covered by life insurance and loan insurance programs without having to pay premiums. The bank’s website says, “The objective of the program is to provide financial services to the beggars to help them find a dignified livelihood, send their children to school, and graduate into becoming regular Grameen Bank members. We wish to make sure that no one in the Grameen Bank villages has to beg for survival.”

Attracted by these terms, thousands of beggars in Bangladesh responded to Grameen’s program. Following a modest beginning in January 2004, the program by April had signed on 8,000 beggars to sell simple products from house to house. Plans are afoot to increase the target to 25,000. Beggars who once sat under trees to beg could be seen selling Coke or Pepsi to thirsty customers. “As the beggars become successful, they remove their begging bowls and replace them with cash boxes,” says Yunus. “The beggars become businesspeople. The next step is to put roofs over their heads and make them shopkeepers. It is working very well. We hope that in a year or so, many of them will stop begging.”

As such transformations occur, Yunus hopes they will help prove that programs motivated by charity, however well-intentioned, are less effective in reducing poverty than those that unleash the creativity and energy of the poor. In this regard, he believes that knowledge can play a critical role in ending poverty. “Knowledge is at the core of everything,” he says. As a professor, he sometimes doubts whether traditional instruction helps students or merely molds them in their teachers’ image. “Education shouldn’t destroy the students’ creativity and freshness,” Yunus says. “Students are always imitating their professors, and imitation is dangerous.” Knowledge should help students while allowing them to remain themselves.

Yunus believes the same approach should apply to anti-poverty programs. “People believe that a poor person can be helped through aid,” he says. “He or she is not considered a creative person. This is wrong. A poor person is just as good a human being as anyone else in the world, but she is a victim of circumstances; the way in which she lives is only a reflection of the way in which society has rejected her. Instead of looking at her like a different kind of human being, we should be treating her as an equal, and extend to her the kinds of services that others enjoy. Once we do that, we will get out of the ‘charitable’ mode of thinking. We will get out of ‘welfare system’ mode.” That, according to Yunus, is what will stimulate the creation of institutions that allow the poor themselves to develop their capabilities.

His ultimate vision is to build a world free of poverty. “We have created a slavery-free world, a smallpox-free world, an apartheid-free world,” he wrote in Banker to the Poor. “Creating a poverty-free world would be greater than all these accomplishments while at the same time reinforcing them. This would be a world that we could all be proud to live in.”

Leadership Lesson

The Poorest of the Poor

“Poverty,” says Muhammad Yunus, “is...like a bonsai tree. You get only this little base to grow from. You are a stunted little thing. Maybe you could be a giant thing, but you never find out. That’s poverty.”

Thirty years ago, when Yunus was just beginning the journey that would lead to his founding of Grameen Bank, the rural poor in Bangladesh were a market that no one had clearly defined, let alone targeted as a constituency that could make a profit for a bank.

In 1974, a prolonged famine had devastated the residents of many of the country’s small villages. Yunus, at that time an economics professor at Bangladesh’s Chittagong University, first decided to enlist the media’s help in calling attention to the rising number of starvation deaths, and then determined that he would focus his own efforts on trying to increase food production in one small village called Jobra, close to his home. Over the course of a year, he succeeded in helping farmers improve an irrigation system that would allow rice production on previously unused land.

That experience taught Yunus something that would prove instrumental to the future of microlending. He recognized that not all poor people are alike, that there are different levels of poverty depending on a person’s individual circumstances. And yet, he said, government officials, economists, and social scientists failed to make these distinctions when they created programs to ease poverty. For these officials, the term “poor person” was a catch-all phrase that “could mean many things,” Yunus wrote. “For some, the term referred to a jobless person, an illiterate person, a landless person, or a homeless person. For others, a poor person was one who could not produce enough food to feed his family. Still others thought a poor person was one who owned a thatched house with a rotten roof, who suffered from malnutrition, or who did not send his or her children to school. Such conceptual vagueness greatly damaged our efforts to alleviate poverty.” Yunus noticed, also, that most definitions of poor people didn’t include women and children.

He set about to establish different classifications of the poor based on such factors as region, occupation, ethnic background, gender, and age. At the end of this process, he had a definition of “poor” that differentiated, for example, between “marginal farmers” who were often the focus of international development programs, and the “really poor” who “had absolutely no chance of improving their economic base. Each one was stuck in poverty.” This group of landless poor—who make up about 50 million of Bangladesh’s 120 million inhabitants—would become the market that Grameen Bank would serve.

Yunus has repeated many times the story of how he first recognized the potential for growth inherent in poverty. On a visit to the same village of Jobra in 1976, Yunus met a 21-year-old woman making a bamboo stool in front of a run-down house with crumbling mud walls. This woman’s daily profit, Yunus discovered after talking to her, was two cents, barely enough to feed one person, let alone feed, clothe, and shelter her three young children and send them to school. Consequently, these children, Yunus said, “were condemned to a life of penury, of hand-to-mouth survival, just as [their mother] had lived it before them, and as her parents did before her. I had never heard of anyone suffering” because she didn’t have 22 cents.

Over the course of a week, Yunus and a university student made a list of other people in Jobra who had to depend on middlemen and money lenders for their subsistence work. The list had 42 people, who among them borrowed 856 taka—less than $27. “All this misery [exists] in all these families, all for the lack of $27,” Yunus wrote in his book, Banker to the Poor.

With these insights, Yunus started up what eventually became the Grameen Bank—”an institution that would lend to those who had nothing,” including no collateral and no credit history. The goal was to turn these villagers into entrepreneurs by giving them money to start their own small businesses, such as furniture making, egg production, basket weaving, commercial gardening, fish ponds, livestock rearing, and paddy cultivation. Loans—ranging from $1 to $100—were typically for a year, first at 16% interest and later at 20% interest. Recipients were required to start making payments the second week of the loan. Grameen only lent money to individual borrowers who had formed into groups of five. The idea was that peer pressure as well as peer support would help ensure that the individual loans were repaid.

Grameen also lent mostly to women, reasoning that they are more reliable than men and more likely to spend profits on their families. And because Bangladesh is a country plagued by disasters—famines, floods, epidemics, tornadoes, and civil wars—the bank lent villagers new money to start up again if their means of production had been washed away, blown away, burned out, or destroyed. Old loans were not erased, but were converted into long-term loans that allowed individuals to pay them off more slowly.

When Yunus was asked why he charged these villagers any interest at all, his typical response was to challenge anyone to manage a bank for the poor that offers lower interest rates. Institutions such as his that are not self-sufficient, he added, will run into trouble because they will be dependent on politicians and government bureaucrats whose support is not always constant.

Indeed, from the beginning, Yunus was very clear what this market needed and didn’t need. One thing it didn’t need was government aid. “Our experience, in this region and everywhere else, has been that for the government to give credit—in rural areas, particularly, and credit as a whole—doesn’t work,” Yunus said in an interview in 1999. “Credit and government don’t have a good chemistry. Government should distance itself from microcredit or, for that matter, any credit because it very quickly gets politicized.”

Another approach that Yunus resisted was survival training. Yunus disagreed with those who claimed that before you loan poor people money, you should first teach them survival skills. For Yunus, the answer was “credit first.” Poor people “do not need us to teach them how to survive; they already know how to do this...The fact that the poor are alive is clear proof of their ability,” he said. By giving the poor access to credit, you “allow them to immediately put into practice the skills they already know....” Eventually, Grameen Bank made loans to villagers to help them build new houses or repair existing ones. The Bank also established Grameen Phone Ltd., a rural cellular phone company; Grameen Cybernet, a for-profit internet service provider; and Grameen Textile Mills, Ltd., among other ventures.

Yunus’ trust in the creditworthiness of the village people seems to have paid off. By 2004, the Bank had loaned $4.18 billion, out of which $3.78 billion has been repaid, with a recovery rate of 99%. The microlending business that he started has spread far beyond Bangladesh.

An article in US Banker, written in August 2003, pointed to what it called “the consistently high profits of microfinance.” Microloan borrowers, the article says, quoting Nancy Barry, president of Women’s World Banking, a New York City-based non-governmental organization (NGO) with a microcredit arm, “are excellent credit risks.” Barry pointed to the example of an Indonesian bank that had to “write off 100% of its corporate portfolio and 50% of its middle market loans during the 1988 financial crisis. But on-time repayment in its microfinance portfolio slid only 1%, to 97.5%. These borrowers are less risky than the Donald Trumps of the world,” Barry said. “These borrowers have financial discipline. They know that if they screw up, they won’t have access to lending.”

Among our Top 25 leaders, Yunus is probably the only one who sincerely hopes that the market which has made him successful eventually disappears. His stated goal, he has said, is to halve the number of poor people by 2015.