Some thoughts on microfinance

MICROFINANCE IS the umbrella term encompassing microcredit, microinsurance, microsavings, remittances and other financial services for the poor in primarily developing regions of  South Asia, Latin America, South East Asia and Africa. 

Microfinance is different from conventional consumer banking products as the underlying aim is one of financial inclusion, targeting the financially undeserved.  Microfinance is provided by ‘microfinance insitituions’ (MFIs), credit unions and through rural/village banks.

Take microcredit (often used interchangeably with 'microfinance' and confused together). Microcredit is different from plain money-lending as it targets the poor (who are traditionally excluded from formal financial markets due to high transaction costs from banks’ perspective) and female clients (who have difficulties accessing loans in often patriarchal societies). Many MFIs require no collateral, lends in small doses -between $100-$1000  - and often has a social function; there is the aim of lending to micro-entrepreneurs, promoting literacy, children’s health and education it’s among clients.

Microcredit, pioneered in 1978 by Muhammad Yunnus (founder of the Grameen Bank) in Bangladesh, typically lends using a group lending mechanism so that social assets and local knowledge improves screening, enforcement and monitoring. In reality, loan default still occurs under group lending and some empirical studies have proved default under group lending to be just as common as individual lending. Some MFIs such as Bank Raykat Indonesia, who serve the ‘richer of the poor’ have reverted to using an individual based lending serves as a testament that group lending is not all designed to minimise what it is supposed to minimise. Individual lending is also less cumbersome and can allow wealthier (but still poor) clients to access more credit without the burden of their poorer counterparts who are more likely to default.

As microcredit targets entreprenuers, microcredit at face value clearly encourages self-initiative and self-sufficiency, potentially and hopefully for the long term.  It is no surprise that for some, microcredit is the savior of all the developing world’s problems and poverty eradicator.

For me, the impact of microcredit and also microfinance is more arguable. Like everything in this world, there is no such thing as ‘perfect’ and microcredit is not without it’s problems, some more serious and others. Just off hand, I can think of several: 

• Microcredit is focussed on lending to entrepreneurs but often, there is no strict enforcement by loan officers to spend loans for the purpose of building up their business. Effectively, this reduces the impact of promoting long term self-initiative.
  
  
• The vast majority of smaller MFIs are not financially sustainable – they rely on donors, government grants and ‘soft loans’ rather than securer customer deposits.
  
  
• No doubt have MFIs been affected by global macroeconomic difficulties. The financial crisis of 2008 reduced lending to MFIs from western commercial and investment banks. For such banks, regulatory changes such as Basel III and its national equivalents can also increase the cost of  holding some loan portfolios (such as in terms of regulatory capital) as lending to an emerging market is more risky. This effectively endangers the funding of MFIs.
  
  
• Over- indebtness: A lack of stringent regulation on MFIs has caused a MFI explosion in many developing countries. Individuals therefore have the chance to take on several loans by several MFIs resulting in own over-indebtness. The direct result is default and the tragic human cost can be exemplified by the Andhra Pradesh crisis.
  
  
• Last but not least, microcredit to some has been crowned as the solver of world poverty. The logic behind this is understandable; giving the poorest access to credit for starting a micro-business provides them with the initial capital.  Earnings from their micro-business provides income that can be used initially for basic everyday essentials. Further lending gives the client the scope to expand on the size of business and grow self-initiative/dependency and so on. Development economists through randomised control trials have proved microcredit to reduce poverty in a household and also have shown that there are positive spillover villiage effects compared to households/villages not in receipt of microloans.
  
  
  The big question is that, if microcredit can make households wealthier, why is aggregate is the take up so small at only ~5% of the world’s poor?  The main answer to this question lies in the fact that what is desired by the poor is an actually more stable and long term borrowing instrument(s) as well as opportunities to save, transfer remittance funds  and also to insure against the inherently risky nature of developing nations.
  
  
  It is important to remember that microcredit is NOT the sole champion in eradicating poverty. It is one tool, but other we need to mobilise microsavings and microinsurance and remittance services to help the ‘microfinance movement’ go down in history as something that helped to fight one of the world’s most prolific humanitarian problems – poverty.

Microcredit is not the golden bullet, but I wonder still, without it, wouldn’t the lives of poor households in developing countries be even more bleak?

JH