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Has Microfinance Failed? Evaluating the current state of microfinance

This post was written by Aaron Morris, PDT’s Summer Fellow. Today is Aaron’s last day of work. We’ve loved having you, Aaron! Aaron blogs at Verbal Vanguard.

 

The rise & fall

Once viewed as a ‘silver bullet’ for combatting poverty, microfinance burst into the consciousness of development practitioners in the 1970s and 1980s as early pioneers like recently-ousted Grameen Bank founder Muhammad Yunus and FINCA’s John Hatch demonstrated the social and financial value of providing financial services to the poor.  In the years that followed, microfinance took hold as aid agencies, NGOs, and even for-profit microfinance institutions (MFIs) began to establish operations in all corners of the developing world.  By the mid-2000s, the euphoria surrounding microfinance had reached its apex.  The UN declared 2005 the “year of microfinance,” Muhammad Yunus won the Nobel Peace Prize in 2006, and Kiva’s peer-to-peer lending platform connected North to South and East to West as never before.

Kiva provides a platform for people to provide microloans to entrepreneurs like Alexandra Castro of Guayaquil, Ecuador

This period of infallibility was not to last, and in recent years the microfinance industry has experienced significant backlash. In 2007 Banco Compartamos, which transitioned from a publically funded non-profit to a lucrative for-profit business, garnered the ire of observers including microfinance “father” Muhammad Yunas. According to critics, its excessive interest rates and profiteering allowed its charismatic founders to get rich on the backs of its poor clients. More recently, the suicide “epidemic” and regulatory changes in India have ignited a media maelstrom as allegations of irresponsibility, stifling over-indebtedness, and questionable social impact have led to a global microfinance meltdown.  What began as a ‘silver bullet’ has quickly transformed in the public eye into something no less nefarious than payday loan usury.

 

The baby vs. the bath water

Given the lofty and unreasonable expectations placed on microfinance, it was bound to ‘fail’.  Microfinance is not a silver bullet: it is but one weapon in a larger arsenal of poverty reduction tools that must be wielded strategically and selectively. The current tide of discontent surrounding the microfinance industry is not wholly unwarranted, but the underlying problem is not microfinance itself. Rather, its gross mismanagement, over-proliferation, and the outsized emphasis that it has received from aid agencies, development practitioners, and policymakers have rendered it less effective and on occasion, harmful. Microfinance has not failed, but the microfinance industry, in large part, has.

A rose by any other name

Microfinance is a form of finance, and at the heart of finance lies risk management.  To mitigate risk, MFIs must understand the markets in which they operate and make decisions based on sound analysis.  The fact that terms like ‘due diligence’ and ‘reporting’ are only now beginning to make their way into the microfinance parlance suggests that the thousands of MFIs created during the heyday of microfinance were not well attuned to this reality. Like everyone, the poor benefit from access to financial services, including loans, but this does not give MFIs or policymakers free license to distribute such services without careful consideration of underlying market and borrower risk. As is the case in the developed world, financial services can just as easily function as a catalyst for economic expansion or serve as a harbinger of greed and destruction if managed irresponsibly. (Just ask Lehman Brothers.)  Microfinance is neither inherently good nor bad.  It is simply a tool.

 

The ever-elusive dual bottom line

The original allure of microfinance was not simply that it alleviated poverty, but that it did so using an efficient and sustainable market-based approach. Microfinance was said to deliver a ‘dual bottom line’: social return (help the world) and financial return (profit). In recent years, this social component has been the source of considerable debate.

Over-indebtedness is quickly becoming a large problem in the developing world. Not only do many MFIs charge irresponsibly high interest rates, but the widespread proliferation of MFIs in recent years has provided the poor with the ability to overextend themselves by borrowing from multiple MFIs at the same time. Additionally, not all poor people are entrepreneurs, and failed or failing business ventures generate significant additional financial burden as borrowers attempt to pay off unproductive loans. The promise of microfinance is financial independence and improved livelihoods, yet too often microloans lead to deepening financial dependencies and decreased income. Moreover, because these loans are targeted so low on the economic pyramid, there is little opportunity for microfinance to efficiently generate macro-level economic growth. Even in the most successful of scenarios, microfinance creates income opportunities one person at a time, having little impact on infrastructure, institutions, or the capacity of the private sector as a whole.

 

What is it good for?  Envisioning a new era for development finance

“Microfinance! What is it good for?” asks Edwin Starr, development commentator

Fortunately, there are ways to avoid these pitfalls and maximize the effectiveness of microfinance initiatives. First, while everyone may not be inclined or able to start their own businesses, certain subsets of the population – like rural farmers – are well attuned to the requirements of self-employment.  Microfinance and microsavings can provide stability to farmers’ uneven yearly revenue flows, allowing them to invest more in inputs and capital, move from subsistence to surplus, and increase the productive capacity of local economies. Once we learn to view microfinance as a tool rather than a standalone strategy, it can play a key role in larger development programs. For example, rather than providing only microloans to the rural poor of Bangladesh, BRAC engages in large-scale value chain interventions, which provide borrowers with access to capital, training, specialized inputs, and linkages to regional and international supply chains. For those who may not have the tools or desire to run their own micro-ventures, a modified version of the microfinance concept may hold great potential.

SME (small and medium enterprise) financing has been shown to be more effective than microfinance at impelling job creation and generating economic growth. SMEs are nimble enough to take advantage of emerging market opportunities, yet large enough to generate significant employment in the formal economy and stimulate infrastructure and institutional growth. As a result, SME financing represents a better overall value proposition for NGOs, aid agencies, and policy makers.

Here at PDT, microfinance and SME financing are intimately tied to our aim of supporting local entrepreneurs and enterprises, which often require outside funding to complete large contracts from national and international buyers. Greater access to financial services in the developing world is key to building markets and generating economic growth.

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