What Do I Think of Microfinance?
Reflections after three years as a practitioner and writer
Originally posted on May 27, 2012
Through Kiva and Negros Women for Tomorrow Foundation, microfinance became my entrée into this world. I knew very little about microfinance prior to finding Kiva, other than what I had seen on an episode of Frontline highlighting the company’s early days. Over the subsequent nine months on the ground in the Philippines, I learned as much as I could, and became a bit of a microfinance apologist, believing it could do no wrong. I will do my best to step back with the benefit of hindsight and look at it objectively.
Microfinance is an umbrella term describing the provision of financial services to the unbanked. That includes, but is not limited to, credit, insurance, and savings products. The first one – micro-credit – is the most widely known, popularized by Muhammad Yunus and his Grameen Bank, founded in Bangladesh. According to the apocryphal tale, Yunus lent money to a group of furniture makers whose margins were tiny due to high upfront cost of buying materials. With a loan of only $40, Yunus was able to increase their profits by orders of magnitude and still get a return on his investment. The poor, it seemed, could be worth of credit after all.
Yunus formed the Grameen Bank, which, while not the first, became one of the largest microfinance institutions (herein referred to as MFIs). The group-lending methodology utilized by Grameen and other large microfinance organizations, like Accion and FINCA, came to be replicated by other MFIs around the world. A while back, I wrote about the replication of the Grameen model, specifically.
The group-lending model was created to guarantee payment in lieu of collateral. Typically, women self-organize into groups of four or five, and, in the case of the MFI I worked with, Negros Women for Tomorrow Foundation (NWTF) in the Philippines, up to eight of these groups come together and work with a single loan officer. The money is distributed to each woman at the same time and none can receive another loan until each has paid back their own. The threat of hurting the entire group, which implicitly agrees to guarantee the loans of each member, creates pressure on individuals to pay back. Clients are predominantly women, since women are more likely to invest the money into the business or, at the very least, spend the money on the family rather than leisure activities. As keepers of the house, women are also less mobile and, therefore, less likely to run off with the money. Using this system, Grameen Bank and others consistently have repayment rates of 95-98% .
The wealth management Hawley Advisors says that because of the small loan sizes (generally less than $500 per loan), the cost of servicing the loan is high, necessitating what some might consider exorbitant rates. NWTF, for example, charges ~30% interest on a 6-month loan based on a non-declining balance, which adds up to more than70% annually. This seems high, except when compared with the alternative, which is commonly referred to as a “6-5” – receive $5 in the morning and pay $6 in the evening. This equates to a 20% daily interest rate. Annualized, it is several hundred percent.
This is just the cost of doing business in microfinance. Back in 2008 and 2009, a schism developed between two camps in microfinance. Some, led by Muhammad Yunus, saw microfinance as a mechanism for bringing financial services to the poorest members of society, and felt that making significant profit ran counter to the underlying philosophy. Others, led by Compartamos, a publicly-traded MFI in Mexico, and SKS, the largest MFI in India which also IPOed, saw a huge untapped market that could only be served if MFIs had the capital to invest in expansion. These MFIs charged even higher interest rates and expanded rapidly to reach the 90% of the poor that still lacked access to finance.
This schism reached a breaking point last year, when the Indian government placed new regulations on MFIs in response to a spate of suicides among microfinance clients who had become over-indebted to multiple MFIs. Aggressive tactics on the part of loan officers was blamed, and the entire microfinance industry in Andra Pradesh – a state in India – and the rest of country suffered significantly. Muhammad Yunus was then forced out as the head of Grameen Bank in what some people saw as punishment for his starting a political party in Bangladesh. All in all, 2011 was not a good year for microfinance in South Asia.
In the last post, I gave a rundown of the mechanics of microfinance and explained the criticism of high interest rates. Another criticism came from development economists like Dean Karlan, founder of Innovations for Poverty Action and pioneer in the utilization of randomized controlled trials for determining the efficacy of development interventions, and Jonathan Morduch, who, in his seminal book, Portfolios of the Poor, found that microfinance had limited impact in increasing incomes for clients. They found that, contrary to conventional wisdom, microfinance was actually most beneficial in “smoothing consumption.” Most people living $2 a day do not actually earn $2 every day. Instead, they might earn $10 one day and nothing for the rest of the week. So the consistent capital offered by a microfinance loan actually allowed them to feed their families and pay school fees when no money was coming in.
My opinion on the effect of microfinance has largely remained unchanged. First, I understand and recognize the necessity of charging high interest rates. In order to maximize their impact, MFIs must be profitable to some degree and operated largely unsubsidized if they are to be sustainable. If this means charging higher interest rates, so be it.
Regarding the criticisms from the development economists, a randomized controlled trial conducted over a two-year time frame is hardly a sufficient time frame to determine whether microfinance is an effective tool of poverty alleviation. The effects are generational. If a microfinance loan allows someone to keep their child in school consistently and maybe even graduate high school when they otherwise would have pulled them out to work on the family business, the impact on the community will not be felt until that child is grown and is sending money back from his or her well-paying job in the city in the form of domestic remittances. This is a 20-year time frame, at the minimum. To my knowledge, no longitudinal study comparing communities served by microfinance with those that are not has yet to been done.
Secondly, there are some incredible success stories of clients bringing themselves out of poverty as a direct result of microfinance loans. I know because I met some of them – the ones who started with a loan to build a small stall to sell vegetables, and expanded to purchase a small restaurant, a piggery, and a motorcycle repair shop. These stories cannot be discounted and, even if they were all that microfinance had to show for its efforts, that to me is enough.
Thirdly, microfinance institutions offer benefits beyond simply credit. I have documented on this blog many times the different products offered by NWTF and other institutions. Mass weddings for those who could never afford it, life and health insurance for families who are constantly in danger of falling deeper into poverty with a single illness, and financial literacy trainings to help them better run their businesses. MFIs also act as a distribution channel for products that might never reach the base of the pyramid market. Clean cookstoves, solar products, and other products can be sold to the hundreds of thousands of microfinance clients who, at least once a week, convene with a potential salesperson.
Lastly, and most importantly, I believe in the free market and the right for people to choose what they think is best for them. Most recently, I worked for a company whose mission – to provide an affordable, low-cost alternative to public education – is fundamentally libertarian (namely, school choice is a good thing). Criticizing microfinance institutions for misleading clients and offering a service that is flawed is, to my mind, patronizing to the clients who subscribe to the model. If the women taking loans from microfinance institutions felt they were being exploited, they would cease to take them, just as parents would pull their kids from Bridge schools if they felt their child was not being educated.
People in the development world too often underestimate the ability of the people they purport to serve to make rational decisions. I don’t, and, if I did, I might have the same criticisms. But I do, and have stated my reasons for doing so many times on this blog.
To try to document all of the benefits I see to microfinance would take far more time than I would like to allot in this segment of my re-cap of the last three years. In future posts, I will elaborate on other issues in microfinance. But I am comfortable saying that, to this day, I feel the same way about microfinance as I did two years ago, when I extolled its praises all over this blog.