The problems (and promise) of microfinance

Just three decades ago, billions of people around the world were stuck in a trap. Faced with low incomes on the one hand and exploitative loan sharks the other, they could neither save for the future nor purchase the capital required to generate a living. This changed with the pioneering work of Mohammad Yunus in Bangladesh, and with the establishment of the Grameen Bank in 1983, microfinance was born.

The mechanics of microfinance are simple. People living in poverty often have few tangible assets to use as collateral against a loan. Instead, microfinance institutions (MFIs) rely on borrowers’ social capital to ensure loans are repaid. An example is group lending, in which borrowers are grouped together and given loans sequentially. If one member of the group defaults, the whole group suffers. This reduces borrower risk by creating an incentive for group members to monitor one another and to select other group members carefully.

Driven by the promise of sustainable poverty alleviation, early MFIs flourished; enjoying high repayment rates, expanding their lending to a growing pool of customers and delivering strong returns. However as they have gained market share, a darker side of microfinance has emerged, bringing three closely related problems into focus:

First, microfinance’s original focus on poverty reduction has given way to a market-oriented system based on microfinance as a viable business model.[1] This can lead to positive outcomes, ensuring more loans are provided to the world’s poorest and more efficiently. However it can also encourage exploitative practices. In some cases, MFIs have failed to adequately disclose interest rate fees, before using coercion to force borrowers to repay.[2] At their worst, MFIs have deliberately offered multiple loans to indebted borrowers and, in collusion with manufacturers, provided credit for unnecessary consumer goods.[3] This has led some to conclude that microfinance has become ‘a poster child of exploitation of the vulnerable.’[4]

Second, the number of MFIs, both for-profit and not-for-profit, has increased sharply, in some cases oversaturating the market. In an influential paper, Jayati Ghosh suggests that extreme competition in oversaturated markets forces MFIs to lend to riskier borrowers.[5] Similarly, a Deutsche Bank report suggests that it leads MFIs to “lower their standards to gain market share” and issue loans beyond the capacity of their clients.[6] Saturated markets also create an opportunity for clients to obtain multiple loans,[7] a pattern closely linked to over-borrowing.[8] These are big problems for the microfinance industry; if uncollateralised borrowers cannot repay their loans, it is the MFIs which suffer the losses. Unsurprisingly, many of the countries with the highest industry growth rates and most saturated microfinance markets have experienced the largest deterioration in portfolio quality.[9]

Third, regulation has mostly failed to keep up with growth in the microfinance sector. Growth and competition should be beneficial for borrowers and countries, as market pressures force MFIs to become more efficient, develop better control mechanisms and ultimately lower interest rates. Yet the weak regulation of MFIs in saturated markets severely limits their ability to manage client risk. The absence of a central credit bureau or regulator means that borrowers can obtain multiple loans simply by applying to different MFIs;[10] however well-meaning, the MFI has no way to assess the client’s level of indebtedness. Weak regulation also fails to protect consumers: it enables risky and exploitative lending practices and turns a blind eye to coercive repayment strategies. [11]

The case of the Indian state of Andhra Pradesh provides a drastic illustration of just how interrelated these problems are, and of the personal tragedy and broader economic problems that follow. At its height, Andhra Pradesh was home to one of the world’s fastest growing, most saturated and competitive microfinance sectors. Largely unconstrained by regulation and driven by their commercial focus,  MFIs increased their lending at an alarming rate. According to the Deutsche Bank “in [2009] alone, the ten largest MFIs doubled their client base.” Multiple borrowing was commonplace and household debt soared, climbing to eight times the national average.[12]

Under the nose of the local government, debt reached unsustainable levels. Dozens of debt-related suicides were reported, many attributed to the coercive repayment tactics used by MFIs. Only in 2010, facing widespread social unrest and growing criticism, did the state finally intervene, waiving loans for which over twice the principal had been repaid, limiting the ways in which MFIs could collect payments and implementing a strict registration system. As borrowers defaulted and investors fled, the microfinance sector collapsed.[13] By that stage, hundreds of thousands had been affected, and the industry’s clean image tarnished. This is not a unique case; MFIs and microfinance sectors in Pakistan, Mexico, Nicaragua, Bolivia, Morocco, India and Bosnia have also suffered collapses.[14]

To date, the largest criticisms of microfinance have been directed at for-profit MFIs. Mohamed Yunus, for instance, has claimed that they undermine the work of more socially-minded MFIs. However for-profit MFIs still generate opportunities for the poor that would not otherwise have been available. A group of researchers have even suggested that their interest rate fees are not significantly different from those of non-profits, nor are their loans any riskier.[15] For-profit microfinance lending is not the problem. The real issue is aligning the interests of MFIs and borrowers.

At the height of the Andhra Pradesh crisis, a prominent group of economists called for a range of immediate reforms.[16] Regulation favourable to MFIs lending at reasonable interest rates needed to be introduced, as did a code of conduct regulating MFIs’ dealings with borrowers. As an added safeguard, a consumer grievance process was required. Most importantly, the economists called for the establishment of a credit bureau “to which all MFIs are required to report their entire portfolio of lending.” This would help coordinate MFIs’ lending and control credit risk, preventing over-borrowing and subsequent portfolio deterioration.

These proposals are a good starting point. Over time, however, microfinance needs to be brought further into the financial and economic mainstream. Broader oversight of microfinance markets should be undertaken by central and development banks. Tighter prudential norms, including controls on portfolio quality, should be implemented, with a corresponding strengthening of auditing procedures. As far as possible, these rules should be harmonised between states and countries. And regulators should never be complacent; far too much is at stake.

Creating such a regulatory environment will not be easy. MFIs already face high transaction costs distributing small loans to a large group of clients. Poorly designed regulations risk greatly harming the poor by making lending prohibitively difficult. On the other hand, even the soundest rules need to be actively monitored and enforced. This is sure to put a strain on the weak legal infrastructure in many developing countries.

Yet for all its troubles, microfinance can be a potent weapon in the fight against poverty. By opening up new financial channels and bringing millions of people into the market, it is a tool for sustainable economic development. Above all, it offers the hope of escape to those living in poverty. It is worth fixing.

[1] Ghosh, J. 2013. ‘Microfinance and the Challenge of Financial Inclusion for Development’, Cambridge Journal of Economics.

[2] Ghosh, J. above n. 1.

[3] Priyadarshee, A., Ghalib, AK. 2011. ‘The Andhra Pradesh Microfinance Crisis in India: Manifestation, Causal Analysis and Regulatory Response,’ Brooks World Poverty Institute Working Paer No. 157.

[4] Priyadarshee, A., Ghalib, AK. above n. 3.

[5] Ghosh, J. above n. 1.

[6] Lützenkirchen, C., Weistroffer, C. 2012. ‘Microfinance in Evolution: An Industry Between Crisis and Advancement’, https://www.db.com/cr/en/docs/Microfinance-in-evolution.pdf (last accessed 8 April 2014).

[7] Ghosh, J. above n. 1.

[8] Schicks, J., Rosenberg, R. 2011. ‘Too much Microcredit? A Survey of the Evidence on Over-Indebtedness’, CGAP Occasional Paper No. 19.

[9] Lützenkirchen, C., Weistroffer, C. above n. 6.

[10] Ghosh, J. above n. 1.

[11] Priyadarshee, A., Ghalib AK. above n. 3.

[12] Lützenkirchen, C., Weistroffer, C. above n. 6.

[13] Mader, P. 2013. ‘Rise and Fall of Microfinance in India: The Andhra Pradesh Crisis in Perspective’, Strategic Change: Briefings in Entrepreneurial Finance.

[14] Ghosh, J. above n. 1.

[15] Downey, K., Conroy, S. 2010. ‘Microfinance: The Impact of Nonprofit and For-Profit Status on Financial Performance and Outreach’, Academy of Economics and Finance.

[16] Banerjee et al. 2010. ‘Help Microfinance, don’t kill it’, The Indian Express, http://economics.mit.edu/files/6614 (last accessed 8 April 2014).