First introduced in the 1970s, the concept of microfinance was created as a way of helping individuals to lift themselves out of poverty. For many living in poor communities in developing countries, access to capital can deliver a much-needed boost to their standard of living, an opportunity to provide an education for their children, or act as the impetus necessary to start a new business.
Microfinance Institutions (MFIs) lend money to those who are not able to take out loans from traditional banks. At the time when of its introduction, the concept was celebrated as the desperately needed key to solving poverty in countries around the world, and was quickly thrust into the international spotlight.
Microfinance all started with the Bangladeshi economist Dr Muhammad Yunus, who became the first and biggest name in the novel but rapidly growing industry. One day in 1976, during a visit to the village of Jobra, Yunus met a stool maker who needed just 22 cents to bypass her usurious lenders. Yunus took it upon himself to give her his first micro-loan for the amount of $27. He went back to Jobra the very next day to hand out more micro-loans, thus forming the roots of this alternative lending model.
For many living in poor communities in developing countries, access to capital can deliver a much-needed boost to their standard of living
Microfinance became an official concept in 1983 when Yunus founded Grameen Bank as a vehicle to provide micro-loans. The organisation’s expansion was rapid; by 2005 Grameen Bank had 2,422 branches with 7.06 million customers in over 78,000 villages, 97 percent of which were women. In 2006, both Yunus and Grameen Bank were awarded the Nobel Peace Prize for their work in developing microfinance as an innovative financial system.
In the years since, however, criticism from various outlets has built up. Indeed, many now doubt the effectiveness of microfinance in aiding poverty reduction, while some even go so far as to say the opposite is true for the very poorest members of a community.
Many people living in developing nations are trapped in an endless cycle of poverty; living on very little each day and deprived of regular work and access to vital services. In the absence of financial history, collateral, steady employment or indeed any form of repayment assurance, banks are generally unwilling to provide would-be customers with capital. Yet without access to financial services, there is little hope of escaping. Microfinance aims to bridge this gap.
“I’ve been at the coalface of microfinance for 45 years, my whole working life. I have seen the transformative impact it has on many people’s lives”, said Rupert Scofield, Founder and CEO of Finca, an MFI that was established in 1985.
Nowadays, MFIs operate across the globe, positively impacting the economies of dozens of countries (see Fig 1). “Some larger organisations work closely with the World Bank, while other smaller groups operate in different nations. Most were formed with the simple goal of improving lives with funding from donations, grants and other forms of generosity”, Scofield explained.
Aside from standard loans that usually start at $1,000 and can reach up to around $20,000, group loans are also available for those people at the very bottom of the pyramid. Known as ‘village banks’, each participant within a group acts as a guarantor for one another’s loans.
“A lot of people like the group guarantee model, as they don’t have to go through a big process of registering and collateral and so forth”, Scofield told World Finance. “And it’s particularly helpful for low income individuals – it’s a very popular vehicle for them to get credit.
“Many people use the money to start up their first businesses, often mentored by experienced entrepreneurs in their local communities. Or they use the money to expand their current businesses, adding new products, opening new stores, or launching new enterprises in other sectors. This grassroots economic development not only generates income for the business owners, it creates additional jobs for other members of the community as well.”
Getting a bad rap
Despite various aspects pointing towards the good that can be achieved from the product, the reality of microfinance is incredibly complex. In fact, many argue there is a distinct lack of evidence to show microfinance actually does help to reduce poverty. Over the years, a series of controversial events have given microfinance a reputation for unscrupulousness.
The backlash began in 2007 when Mexican microfinance bank Banco Compartamos transformed itself from being a non-profit organisation into a profit-making finance institution. After raising over $400,000 in its initial public offering (IPO), just like any other public company, Banco Compartamos became ultimately answerable to its shareholders and the bottom line.
Yunus was one of the first to speak out against Banco Compartamos’s IPO, arguing that turning the company into a for-profit organisation went against the core objective of microfinance – namely, to reduce poverty. Compartamos, on the other hand, contended that, by becoming profitable, it could further extend its reach to poor communities in Mexico.
The reputation of microfinance was further damaged by the exploits of SKS Microfinance (since renamed Bharat Financial Inclusion): India’s biggest MFI had expanded rapidly under the leadership of its founder and former McKinsey consultant, Vikram Akula, reaching some 5.8 million customers and taking in billions of dollars in revenue (see Fig 2). In 2010, it became the first institution in the country to offer its shares through an IPO. The fact it raised over $350m was praised by some as an indication of the system’s self-sufficiency – others, however, reacted with outrage, noting how millions had gone directly into Akula’s pocket. Incensed at the idea of taking from the poor to give to the rich, local entities and politicians began convincing SKS’ clients to stop paying back their loans.
A new trend thus emerged in the world of microfinance, which saw groups using the platform not just to help others, but to also turn a profit. The likes of Barclays, CitiGroup and General Electric initiated microfinance projects that gained from lending small amounts of capital to so-called ‘unbankables’.
“Back in 1985, when my partner and I started Finca, microfinance and loaning money to low-income people was a novelty. Now it seems like everyone is getting into microfinance”, said Scofield. “Not only commercial banks, but also large consumer lenders, retail stores, telecoms, utilities – anyone, in short, who has large numbers of low-income customers.”
Even Yunus himself, the father of microfinance, has not been shielded from criticism. At the tail end of 2010, the Bangladeshi Government launched a high-level investigation into Grameen Bank. In addition to accusing Yunus of evading taxes, Sheikh Hasina, the Bangladeshi prime minister at the time, condemned MFIs for “sucking blood from the poor in the name of poverty alleviation”.
Stories also began to proliferate about the aggressive techniques used to pressure borrowers into making repayments. The worst case reported at the time came from the Andhra Pradesh state of India: according to local media reports and the Associated Press, in late 2010 over 200 over-indebted residents had committed suicide. Also emerging was evidence of SKS verbally and physically harassing customers, which included various forms of public humiliation.
Blaming MFIs for the upsurge in suicide rates, the state implemented stringent new microfinance laws, which included compulsory lender registration, weekly repayments for borrowers and limiting the sum of interest payments so they could no longer exceed the loan itself.
Granting financial access
In the early days of microfinance, the industry’s focus rested primarily on micro lending – which was a large part of the problem. However, the system has since evolved.
“Microfinance is more than micro lending, and in fact other financial services are probably more important than the lending part. Asset building, micro insurance, savings – those are becoming more prominent now, and I think that’s a welcome change”, said Bhagwan Chowdhry, Professor of Finance at UCLA. “The whole cycle of borrowing comes much later. First you need to build financial history; you need to show continuity of spending patterns, earning patterns, and then the micro lending comes in.”
In terms of significantly reducing poverty, as its critics have long argued, microfinance is not actually the answer – or the sole answer, at least. “We tend to get carried away; we are always looking for silver bullets for the answer to poverty. There is no one answer to poverty, but I think these [microfinance products] are steps”, Chowdhry told World Finance. Without access to financial services, it is far more difficult to escape poverty – much more is required in terms of opportunities, jobs and skills. “So microfinance – or in general, I like to think about it as financial services – are steps to facilitate that”, he added.
In 2007, Kenya’s biggest mobile operator, Safaricom, introduced M-PESA, a new platform for making payments and transfers via mobile phones. At no extra cost or monthly fee, users could transfer balances and deposit money through their mobiles, marking a dramatic improvement to the access and delivery of microfinance services to customers, even in the country’s most remote areas. This was a significant departure from the work of telecoms firms that charged inordinate fees to customers who wished to move or deposit money via their mobile phone – a norm for many countries in the developing world. As testament to the impact M-PESA has had in Kenya, after just three years, the number of users rose to a whopping 10 million.
Technology now plays a pivotal role in developing microfinance as a tool for providing financial access to those living below the poverty line. Through the use of smartphones, MFIs can reach far more people, which is of particular importance when the potential clients are located in hard-to-reach areas.
Prior to recent technological developments, large sections of a population were grouped together in the over-simplified category of ‘unbankable’. Chowdhry said: “Now that we are able to collect data on people, because they are using mobile phones or other electronic technology, in some sense they become more visible to us – suddenly these people become ‘bankable’.” Technology has also reduced the cost of transactions, which in turn may allow more competition in the field, and so better offerings for customers. “I am very optimistic that those developments will actually make microfinance more of a success in the coming years than it has been in the past”, said Chowdhry.
Active investors in the microfinance sector in 2014
Growth of the Indian microfinance sector in Q1 2016
Fighting the naysayers
Another famous point of contention is the often-high interest rates MFIs charge. For example, shortly after its IPO, Banco Compartamos came under fire for its shocking APR of 75 to 100 percent. In a 2007 interview with Bloomberg, Yunus said of the company: “Microcredit was created to fight the money lender, not to become the money lender.”
To many, charging such a high rate of interest to those already contending with extreme poverty would seem nonsensical. Even borrowers with steady incomes would be hard pressed to make such repayments, let alone the type of clientele MFIs generally deal with. Naturally, lenders have fought back against this objection, arguing high administration costs – particularly as most customers are based in remote area – justify such high rates.
When asked about this point in particular, Scofield said: “The financial cost globally for us is about 10 percent of the cost of our money, and that’s a blended rate of savings and external debt. Our administrative costs could be as much as another 20 to 25 percent, because our loans are small and they are also dealing with remote groups, and it’s expensive to get out and service them.
“Interest rate caps always happen inevitably, then the MFIs can’t afford to make the small loans in the remote areas so they just withdraw from the markets where they are most needed.”
Chowdhry too sees a problem with interest caps, saying they “impede the development of the competitive market – it gets very messy once you reach that stage”.
The other frequent criticism facing microfinance refers to the severe improbability of there being a Bill Gates or Mark Zuckerberg in every village in which MFIs operate. Unsurprisingly, very few customers are able to take a small amount of capital and turn it into a thriving business, while even fewer can also create new jobs within a community in the process.
In truth, most people living in severe poverty rely on so-called entrepreneurship to earn a wage. Numerous people in low-income communities cannot hold regular jobs for various reasons – one obvious example being that of child rearing – and so, when only intermittent hours are available for working, flexibility is essential.
“I hesitate to use the word ‘entrepreneurship’, because it’s romanticised and we talk about it as if it’s also a silver bullet. At the very poor level, entrepreneurship is a necessity, rather than an answer”, said Chowdhry. “I think a very poor person would rather have the security of a job and security of income.”
For a large section of a population that works in the unorganised sector – meaning those who do not have consistent, long-term jobs – entrepreneurship is just one way to fill the gap. “If you can do something on the side – start a food stall, or make something and sell it – that’s where you need capital, and that’s where I think microfinance can help”, Chowdhry added.
Very few customers are able to take such a small amount of capital and turn it into a thriving business
As with so many ventures that started out with good intentions, over time the core objective of microfinance has been warped by the reality of life. The notion of microfinance is wonderful; it represents a tool that can enable economic empowerment. It represents the missing link that could help the millions of people around the world who are living in dire poverty.
Unfortunately, despite high hopes, the results of microfinance have been somewhat disappointing, particularly in light of organisations using it to extort money from the poor under a mask of philanthropy. There is also a note of corporate irresponsibility hovering over reports of over-indebted individuals who reached such desperation regarding their financial woes they felt they had no choice but to take their own lives.
But despite such a chequered history, there is still something to say for microfinance. Every person on this planet is entitled to basic goods and services, and as a prerequisite to those things, they are entitled to financial inclusion as well. That many banks will not and cannot help the poorest segments of society is no excuse to deny financial inclusion to millions. As Scofield said: “There are still many places around the world that are starved of capital.” MFIs can surely step in to fill this crucial role.
“It simply makes sense that once these communities are provided with the resources they need to expand their businesses at an affordable level, they will do so”, Scofield continued. And to some extent, he’s right. However, microfinance should not be considered an absolute solution to alleviating poverty – it is simply one integer in a highly complex equation.
Moreover, microfinance must not solely focus on micro lending. If it is to truly help improve living standards, it must offer other vital products, such as insurance and savings. Namely, it must provide vital financial access to those that cannot obtain it otherwise.
The international community and individual governments are unremittingly charged with the responsibility of reducing poverty, but such a feat can only be achieved through sound, sustainable polices. Job creation, education, healthcare form the thrust of this vital mission; microfinance is simply one stepping stone of many. But at least it exists, supporting communities until the rest of the path is formed.