Is Microfinance Dead?
I was shocked at a recent meeting with the Programs Director of a Canadian development agency to hear him say that they no longer support microfinance as it does not contribute to development. This was in reaction to my client’s proposal to provide micro-loans to farmers in India. Many farmers there are indebted to land-owners for the costs of farm inputs (seeds, fertilizers etc) and are obliged to sell their crops to the land-owners. It seemed obvious to me that providing the loans would allow the farmers to break out of this servitude to the land owners and regain the ability to sell their crops when and to whom they wished.
I decided not to take issue with him then and there, as I am not the most objective person when it comes to microfinance. I worked with Opportunity International (OI) in Canada, Russia and Ghana for several years during the period when the OI Network’s CEO, Larry Reed, introduced his “Change or Die” directive, a wake-up call for OI’s microfinance institutions to convert to formal financial institutions or risk failure, as grants from international agencies dried up. Then I consulted to the World Bank, working on the strengthening of MFIs, and the evaluation of banks and MFIs for their eligibility for lines of credit. I chaired a micro-credit organization in Toronto, making loans for first-time entrepreneurs. So dispassionate I am not. But in the face of such a gloomy pronouncement I decided to make sure that the facts supported my conviction before I commented.
The Problems with Microfinance
The problems afflicting microfinance are well known, and indeed I have seen many of them first hand. The worst abuses have occurred in India where over-indebted customers of MFIs, many of them farmers, have committed suicide to escape the pressures and the shame of not being able to repay their loans.
How did this happen? How could an activity designed to provide access to credit for marginalized people now be destroying them? The main reasons are:
- Using loans for non-productive purposes– a conventional micro-credit is advanced to help finance a small business and it requires monthly payments of interest and principal which are paid out of the business’ cash flow. But some lenders have promoted the same type of loan for consumption (eg for buying a fridge or a TV) which of course doesn’t generate any cash. Sometimes the same type of loan is made to a farmer, but the farmer has no cash flow until the crops are sold – in the interim the farmer becomes delinquent in his payments;
- Lack of credit checks – a bank checks your credit rating before lending to you, but an MFI often has no ability to evaluate a potential borrower’s credit worthiness. It is difficult – and often not cost effective – for a Credit Reference Bureau to capture loan information from MFIs and even where credit checks can be made, an MFI has to pay a fee for a credit report. The fee for a credit report can be as much as the profit on a $50 loan. As a result, borrowers can borrow from several lenders, sometimes using the loan from one lender to repay the loan from another lender, and quickly becoming over-indebted;
- Loan officers’ incentive schemes promote volume over quality – Most MFIs pay their loan officers a combination of salary and incentive, with the incentive component often exceeding the salary component. Unless the schemes provide incentives for the quality of loans, loan officers will concentrate on making a high volume of loans, regardless of the borrowers’ ability to repay;
- Aggressive collection practices – Borrowers in some countries feel considerable shame at not being able to repay their loans and this shame can become overwhelming when collection agents confront borrowers where they live.
Because of these practices, farmers in the state of Andhra Pradesh, India will no longer consider borrowing from MFIs and in particular farmers want nothing to do with Spandana, SKS or Share, all large and profitable lenders in the state.
Clearly microcredit has to be profitable if MFIs are to attract the capital they need. But the single-minded drive for profitability of some MFIs is another problem. Mohammed Yunus, the originator of microcredit and founder of the Grameen Bank, was quoted recently[1] as saying that “once we became respected, some people started using the same methodology to make money for themselves – departing from a social business to a profit-making business, and that’s where all the problems were created. That’s not microcredit, that’s an aberration of microcredit. If you accept that as microcredit , you have to accept all the loan sharks calling themselves microcredit as well”.
The Benefits of Microfinance
The microfinance industry has not done a good job of evaluating the outcomes and impacts of their lending, relying instead on anecdotal evidence. All practitioners have their anecdotes, and mine include:
- The mother in Honduras who started a small grocery shop with her first loan and was soon able to pay her daughter`s school fees and put a concrete floor in her hut;
- The mother in Nicaragua who started a dress shop with her loan, then helped her son start a taxi business with their next loan;
- The unemployed in Russia who would much prefer to work as employees but who, with no jobs on offer and no social assistance, start and grow their businesses with their loans; and
- The start-up flower shop in Toronto unable to get a loan from a bank but which flourished after getting a $5,000 loan from a microcredit lender.
And surely 200 million people would not have borrowed from MFIs if they saw no benefit in doing so.
But the skeptics are right – there ought to be a systematic evaluation of the outcomes that goes beyond the anecdotal. And indeed there are some.
In 2003 The Consultative Group to Assist the Poor (CGAP – a multi-donor microfinance program at the World Bank) published a review of a number of case studies in an article entitled Is “Microfinance an Effective Strategy to Reach the Millennium Development Goals?” These studies examined the characteristics of groups of microfinance clients compared to control groups of non-clients. While the authors did not claim that the case studies proved causality, they did claim that the studies demonstrated the benefits of microfinance in helping clients improve the quality of their lives. For example:
- In Bolivia, two-thirds of the clients of CRECER, an MFI, had seen their incomes increase after taking loans. 86% of clients said their savings had increased; 78% had no savings prior to participating in the program;
- In India, 75% of clients of SHARE saw significant improvements in their economic well-being, and half the clients graduated out of poverty;
- In Ghana, a study of Freedom from Hunger loan clients founds that they had increased their incomes twice as much as non-clients; 80% of clients had secondary sources of income versus 50% of non-clients;
- In Indonesia, borrowers increased their incomes by 12.9% compared to increases of 3% in control-group incomes. Another study of borrowers on the island of Lombok found that the average incomes of clients had increased by 112% and that 90% of households had moved out of poverty.
Economists Abhijit Banerjee and Esther Duflo[2], take issue with the above reports, dismissing them as “case studies”. I’m not sure if this is a valid criticism, or simply academic snobbery. But they went on to conduct their own evaluation of a new lending program by Spandana, a leading MFI, in Hyderabad’s neighbourhoods. They chose 52 neighbourhoods at random out of 104, used the remaining 52 as a comparison group, and tracked them over fifteen to eighteen months. They found that people in the Spandana neighbourhoods were more likely to have started a business. And those who had started a new business were actually consuming less, tightening their belts to make the most of the new opportunity. Households started spending less money on what they themselves saw as small “wasteful” expenditures such as tea and snacks, perhaps a sign that they now had a better sense of where they were heading.
Banerjee and Duflo write that “As economists, we were quite pleased with the results: The main objective of microfinance seemed to have been achieved. It was not miraculous, but it was working …. In our minds, microcredit has earned its rightful place as one of the key instruments in the fight against poverty”.
Where to Next for Microfinance?
The microfinance industry is going through tough times. The recent financial crisis has made institutional lenders more conscious of risks, both country risks and institutional risks and many have curtailed their lending to MFIs. The securitization of microcredits has led MFIs to adopt practices of the formal financial sector, which as Doug Saunders points out, is ironic since the formal sector might have done better to have adopted the practices of the microfinance sector. Pressures on profits have made it difficult for many MFIs to grow, and closer regulation and supervision of the sector is inevitable.
However MFIs are innovating. Mobile phone money transfer services such as M-Pesa in Kenya are allowing MFIs’ customers to make their loan payments by their cell phone. Hooked up to a bar code scanner, cell phones are even being used to disburse loans. Quite apart from their convenience, these systems allow MFIs to reduce their transaction costs and increase their outreach to remote areas.
Nonoy Tan, a microfinance specialist, writes [3]that “Some MFIs, especially socially-motivated ones have been able to invest surpluses into non-microfinance ventures that would have otherwise been impossible. These MFIs understand that microfinance is not a panacea and have thus decided to address non-microfinance issues. Thus, microfinance can be a “stepping-stone” to other endeavors. These practitioners look at microfinance as a component of something larger and not a stand-alone activity”.
The entry of major financial institutions like ICICI Bank and Citibank, the advent of micro-insurance and the application of new technologies have led to innovations both in products and in processes that promise to expand the use of microfinance and drive down costs. We even have Muhammad Yunus expanding to set up Grameen lending institutions for poor people in Glasgow and New York! Clearly microfinance is an important tool in the drive to alleviate poverty and is here to stay.