The Challenges of Microfinance
Since its inception in the 1970s, microfinance has become the darling of development organisations the world over - the idea with the potential to save the planet’s poor. Pioneered by Bangladeshi social entrepreneur and Nobel Peace Prize Winner Muhammad Yunus, it provides the financially marginalized with banking services that, given their impoverishment, would otherwise be out of reach. Such provision, its proponents claim, empowers the poor to take control of their own lives and plot their own path out of poverty - an antidote that is humane, retains the dignity of it recipients, and is lucrative. Aside from bank accounts and insurance, it is mostly implemented in the form of microloans.
Rebranded as microcredit and more recently, financial inclusion, it has come to dominate the social investment sector, acquiring something of a cult following in the process. Described as transformative, and touted a panacea by its loyalists, the craze has persisted despite growing academic evidence questioning its efficacy.
In some ways, such loyalty is unsurprising. There is little shortage of inspiring anecdotes of hardworking individuals pulling themselves up by their bootstraps having put their meagre micro-loan to exceptionally good use. These stories are uplifting and it’s tempting - and all too easy - to conclude that they’re typical of recipients of microfinance. And yet, when the data has been assessed - of which, it should also be said, there is not a huge amount - the results have been inconclusive, at best. Empirically speaking, a resounding endorsement of microfinance is impossible; the research simply isn’t there. ‘On current evidence, the best estimate of the average impact of microcredit on the poverty of clients is zero’ declared development economist David Roodman. The UK’s Department for International Development (DFID) has expressed similar reservations. Commenting on a systemic literature review into microfinance it concluded that ‘no clear evidence yet exists that microfinance programmes have positive impacts’, also stating that the zealous support it receives is based on ‘foundations of sand’.
It’s certainly curious that although formal, government-backed microfinance initiatives are now widely available across much of the developing world, a huge number of loan sharks and predatory lenders still operate in parallel. Surely if microfinance is failing to compete with informal lenders, it’s not functioning as intended? Here the problems it's encountered are explored in an attempt to better grasp why a seemingly so-well-intentioned endeavour has reportedly been so badly misfiring.
There are a number of problems that microfinance has run into, problems which Roodman’s sobering book, Due Diligence, has taken great pains to uncover. Some are the result of good intentions gone awry, others the result of mismanagement; most, though, are underpinned by the commercialisation of the industry that took place in the 2000s, when many non-profits involved in microfinance became commercial enterprises. The unleashing of the profit motive saw interest rates rise as boards caved to money-hungry shareholders, while an increase in aggressive marketing and loan collection simultaneously occurred. During the 2000s, in both Zambia and Mexico, interest rates for some microloans were hiked to over 200%. Rather than relieving, they actually exacerbated poverty in the areas where they were taken out.
Similar problems were also uncovered in Bangladesh, one of the biggest recipients of microfinance, where women were found borrowing money from relatives, and at times, even forgoing basic necessities in order to repay their loans. Often, this was for fear of the consequences of defaulting. The majority had been lent money through borrowing groups - a means of credit where groups are jointly responsible for one another’s loans - and research revealed that this had created intense peer pressure with regard to repayment, the ‘group’ sometimes taking the law into its own hands when payments went unpaid.
The industry has also become a victim of its own monetary success. Massive proliferation of profit-seeking microfinance programs has led to fierce competition in the sector, with some institutions surrendering to a ‘race for clients’ in order to increase their profitability and to attract lenders. As a corollary, background checks made on prospective borrowers’ ability to pay back their loans became less and less stringent. In many cases, this caused spiralling over-indebtedness - microfinance’s long-term foe - as people were unable to pay back the money they’d been lent.
Use of the loan
This lack of prudential oversight has contributed to another big issue facing microfinance: that many loans are used to fund consumption rather than income-generating initiatives. A study from 2015 showed that in South Africa 94% of microloans were being used simply to fund subsistence. In these instances, those borrowing do not generate any new income, making the repayment of the initial loan difficult, if not impossible, which prompts them to take out further loans, thus accruing further debt. On the occasion that loans are used to bankroll new businesses, the pervasive poverty that often surrounds them can mean a lack of consumer demand, leading to the eventual failure of the venture.
A potential solution to this would be to place greater restrictions of those eligible to take out loans. Applicants, for instance, could be obliged to fulfil some kind of financial criteria like providing a credible business plan. This, however, introduces a host of ethical problems, the most prominent being to what degree should rich people be able to determine how poor people spend their money? And relying on the behavioural standards of the rich, as history has repeatedly shown, is rarely a good idea.
The ill-judged allocation of credit, as is commonplace across microfinance schemes, also provides entrepreneurship opportunities for ‘middle men’. Borrowers who have greater access to microfinance initiatives have been known to then lend to poorer borrowers at higher interest rates than they themselves received. Consequently, the poorest micro-entrepreneurs benefit less than the comparatively less poor, in a dynamic that reinforces existing socio-economic hierarchies and creates greater room for exploitation.
What can be done?
Many of these problems arise from a lack of sufficient regulation. Until now the sector has regulated itself, with undue faith placed in the free market’s ‘natural’ efficiency. The main effort to protect clients thus far has come in the form of a global regulatory initiative called The Smart Campaign, described by chief operational officer of Alliance Microfinance, Hugh Sinclair, as offering a ‘watered-down, ineffective set of voluntary principles’. In 2014, it was widely panned when it certified the infamous Banco Compartomas, Latin America’s largest microfinance bank, which had previously made headlines for charging poor Mexicans triple-digit interest rates. This led even Yunus to concede that ‘self-regulation doesn’t really work’, and that many practices really should not continue as they were.
Perhaps part of its appeal is based on the fact that microfinance does not threaten existing political or economic structures. It is simple and highly seductive: the poor can be saved by the rich, who, by doing so, become richer. What’s not to like? It’s the neoliberal’s dream. Clearly, though, things are not that simple. When the profit motive is involved, exploitation is rarely far behind. Whether it’s extortionate interest rates or general misallocation of funds, the transgressions of this project have been many. For this reason, regulation, currently all too lacklustre, must be rigorously enforced so that the benefits of microfinance are not entirely lost.
Countries like Ecuador have recognised the need for a national regulatory framework and offer the beginnings of a roadmap that could be emulated elsewhere. Reasonable interest rate caps, client protection, beefed-up risk management, flexible repayment periods; all must be considered if the true potential of microfinance is ever to be realised. Quite how far that may stretch remains to be seen.