Challenges with Government Microfinance

Misalignment of incentives can create structural problems

Originally published on May 31, 2010

One of the reasons a lot of people find microfinance attractive is that it is a fundamentally capitalist approach to economic development. Done right, it can be sustainable and even profitable. By focusing on a social mission, successful microfinance institutions (MFIs) can reach more clients by leveraging capital, similar to commercial bank. And just like the Ice Queen warns in Atlas Shrugged, government intervention in capitalist programs spells disaster. Whether or not this is true for other industries (it’s not), it is most definitely the case in microfinance. Successful government-run microfinance institutions are the exception, not the rule. And not only are governments generally bad at administering loans, they can be destructive to the market as a whole. On the CGAP website question 13 of the FAQ is “Do governments do a good job of delivering microfinance?” The answer is thorough:

There are several highly successful government MFIs, such as Bank Rakyat Indonesia’s microfinance department. However, the vast majority government microfinance programs do a poor job of delivering retail credit. Such programs are usually subject to political influence, high default, continuing drain on national treasuries, and sometimes lending based more on the borrowers’ influence than their actual qualifications. Among government programs reporting to international databases, only 1/8 of clients are being served sustainably.

To begin thinking about why government microfinance doesn’t work, it is important to think about the types of governments serving microfinance communities and the nature of government in general. On average, the governments of developing countries tend to be more corrupt and have less accountability than those of the first world. This is particularly true at the lower levels, where politicians can usually buy the votes of entire communities with cash handouts. In the same CGAP article, the political nature of government microfinance in discussed:

There are structural dynamics that make it hard for governments to deliver good retail credit. Sound credit administration requires screening out borrowers who are not likely to repay, charging interest rates high enough to cover costs, and responding vigorously to late payments. These requirements usually run counter to the practical incentives and imperatives of even the sincerest working politician. The government-run MFIs that deliver good microcredit tend to be insulated from politics, managed by technocrats, and strongly and explicitly focus on sustainability.

Aggressively pursuing microfinance loan defaulters isn’t going to win a politician any friends in a community, and funding for a government microfinance program is basically found money anyways. Using a microfinance program – already a means of distributing money to voters – as a way to win the favour of poor communities is an appealing proposition for an incumbent politician, particularly if he is not responsible for the program going belly-up. In other words, politicians can use a microfinance program as a voter outreach tool without dipping into campaign funds. Also, government programs will be less likely to use the group lending methodology since sustainability is not a priority (the federal funding spigot only turns off when there is a new team at the controls). Instead, many of these programs favour individual lending without the same protections afforded by the social collateral of the group lending model.

These dynamics cause repayment problems among the first troublesome clients, ultimately leading to epidemic of default. This is because ensuring repayment is as much about maintaining an appearance of solvency as it is “responding vigorously to late payments.” Perception is important, and if clients think you might not be around tomorrow to give them another loan, most will avoid going down with the ship and just stop paying altogether. For a NGO (non-government) MFI, this is a death blow. Once the number of clients in arrears reaches what Malcolm Gladwell calls the tipping point, the whole fragile institution can unravel. But at least successful NGOs with strong repayment records have leverage over their clients in the sense that defaulters will be sacrificing the ability to take out another loan if they choose not to pay. With government microfinance, the perception is that the money tree (the program) will continue to grow leaves (money) whether you pay or not, so not paying is less of an issue. No one feels individually responsible for contributing to the program’s demise, since it will also be buoyed by federal largesse.

A lot of government microfinance programs subsidize interest rates, which undermine the sustainability of the program and make it reliant on federal funding. This has a two-fold effect. The first issue the program will lose money and never reach sustainability, the goal of every microfinance institution. The second and more problematic issue is that subsidized interest rates undermine the market by creating artificially low conditions for competition. How can NGOs compete with a program that isn’t even charging enough to break even? In theory, the NGOs would not be able to compete with a robust government program, driving them out of business as they fail to attract enough clients to turn a profit.

Government-run microfinance institutions tend to be bloated, inefficient sinkholes that can be used as the tool of politicians. By undermining a market-based, competitive microfinance industry, government programs can be detrimental to the same communities they serve. In question 14 of the same FAQ, CGAP asks: What is the government’s role in supporting microfinance? The answer that government should perform its stated function, which is to craft sound macroeconomic policy, avoid trying to over-regulate the microfinance sector, and support non-government microfinance institution with funding. What they shouldn’t do is get involved in microfinance operations.