Although the spotlight might be uncomfortable, microfinance institutions (MFIs) should welcome some soul searching, the author agues. Has microcredit been oversold as a poverty eradication tool? Should access to credit be considered a fundamental right, and if so, what does that imply? What’s wrong with for-profit lending if its aim is good?
A growing unrest is stirring the global microcredit market. Not too long ago the world feted microcredit pioneer Muhammad Yunus and the Grameen Bank with the Nobel Peace Prize. Now some are asking whether microcredit has really benefited the poor. Concerns about interest rates, lack of transparency and loan recovery methods provide an opportunity to ask whether microcredit has lost its way. Development practitioners, government regulators and all who care about poverty have a stake in the answer.
Although the spotlight might be uncomfortable, microfinance institutions (MFIs) should welcome this soul searching. Has microcredit been oversold as a poverty eradication tool? Should access to credit be considered a fundamental right, and if so, what does that imply? What’s wrong with for-profit lending if its aim is good? Like the recent U.S. subprime scenario, there are echoes of overzealous lenders and overextended borrowers, but the situation is markedly different. Unlike subprime borrowers, MFIs are the only source of affordable financial services for most microcredit clients. It is also an entry point for other development assistance. Despite microfinance’s evolution, it is estimated that there are still three billion people globally without access to formal financial services.
Microfinance leverages financial access to give the poor one of many tools needed to take control over their own lives and navigate the myriad routes out of entrenched poverty. Microcredit started out as the provision of small loans, usually without collateral, to individuals with limited access to other sources of capital. In a world where the poor, especially women, were deemed un-creditworthy, this in itself was a significant innovation. Microfinance became larger, however, with the provision of additional financial services such as savings, remittance transfer, and specialized loans. While many started out simply as lending and deposit-taking institutions, some microcredit lenders have now expanded their services to insurance provision and other services, leading regulators to get more involved in their activities.
An open secret of microcredit is that not all loans are used for improving livelihoods. Some are taken merely to smooth consumption needs. Whether used to marry off a daughter, buy a computer, as a fixed deposit earning interest, or even to support a husband’s enterprise, these loans can operate the same way credit cards do for some. The oft-touted image of women taking microloans to ply their trades or launch micro-businesses is not always reality. To critics, this is evidence that microcredit doesn’t work or really alleviate poverty.
But that is a misunderstanding of microfinance’s true potential. Financial inclusion remains a valid and essential form of economic support for the poor. Occasionally, microcredit is the only way to pay for healthcare, for instance. Natural disasters, poor harvests and or even a single bad day at the market can wreak havoc on livelihoods without a reliable credit support mechanism.
Meanwhile, borrowers who were already entrepreneurs now have less costly sources of credit. It is indisputable that for many borrowers these loans are the cheapest and most readily available financing. What is more debatable is whether they should have the same ability to make bad financial choices or whether they deserve a bailout any more than others.
Microfinance regulation might have murky motivations and unintended consequences. Was it a spate of borrower suicides that led to a government crackdown in Andra Pradesh, India, bringing micro-lending to a halt in 2010? Or was it competition with state-run savings programs? The answer is not entirely clear.
In July 2011, caps on microcredit interest rates in Bangladesh were meant to protect poor borrowers but may have had the opposite effect. As interest rates are lowered, the supply of lending capital tightens, which forces lenders to cut costs. The danger is that this will mean fewer loans to the poorest. Some may stop lending the smaller sized loans usually made to those with the least access to capital. Others may stop lending in disadvantaged, hard-to-reach areas that are more costly to serve. It can also drive out lenders lacking the cushion to absorb the costs of servicing smaller loans, leaving only the largest MFIs in place facing less competition.
One criticism of microfinance is relatively high interest rates. But the costs for servicing a microcredit loan can be quite high. Many non-profit providers maintain loans in under-or-unserved areas which have no other options. Loan officers travel to their clients and can be expected to work at all hours providing the hand-holding their clients need. Let’s be clear: microcredit must at least meet its costs in order to be sustainable. And it must be sustainable to have a long-lasting, positive effect. Despite higher interest rates, demand for microfinance services remains strong at the base of the economic pyramid.
That said, microfinance needs to retain its human face and its focus on serving the needs of the poor. For that, transparency in the lending process is critical. Borrowers, especially those unfamiliar with banking, must know — and MFIs should help ensure that they understand — their loan terms and budget management. MFIs can aid this process — an effort to provide clients with access to information as well as credit — by investing in financial literacy training.
Another criticism is of abusive loan recovery practices. Inaction against defaulters jeopardizes everyone’s ability to borrow in the case of non-collateralized loans. Certainly loan officers are under tremendous pressure to both service their clients and collect their repayments. An additional pressure on loan officers is their PAR rates (‘portfolio at risk’ or loans whose installments have not been repaid within 30 days). They will do all they can to lower these rates, since investors and funders judge them accordingly. MFIs can help balance these concerns, but over-reaction by regulators in the face of real problems might not be the best way to reform the microfinance industry.
In the early days, many MFIs included a development component, especially in Bangladesh, considered the birthplace of microcredit. Bangladesh has a track record of over 30 years where other countries have a far more limited experience with microfinance. Different markets have different orientations with their own issues. The trailblazers of microcredit, BRAC and Grameen, both saw microcredit as a social development scheme. Development MFIs are able to use their reach and targeting of women to distribute other non-financial resources. BRAC, one of the world’s earliest and largest providers of microcredit, used its microcredit platform to deliver health, education, legal and other services to the poor, as a ‘credit plus’ program. BRAC’s lending experience continues to allow it to come up with new solutions to borrower’s needs such as migration loans or health insurance.
Whether it was BRAC’s Eighteen Points or Grameen’s Sixteen Decisions seeking to encourage positive behaviors, lenders demonstrated a direct link between loan utilization and social development. They also found, not surprisingly, that they got the best return on their investment when their borrower’s basic needs were met. Since both BRAC’s Points and Grameen’s Decisions reinforced social values like refusing dowry or educating girls and boys equally, to other requirements such as savings or using clean latrines, these helped build group solidarity and social norms, whether or not they were practiced in reality.
Numerous debt crises around the world, including the one in the West sparking the most recent global downturn, have shown that bad debt and bad policy make exceptionally bad bedfellows. MFIs should have the ability to provide capital as well as social support to prevent over-indebtedness. The experience of BRAC, Grameen and other MFIs show that their members are better able to cope with financial setbacks resulting from natural disaster or health problems as they can avail their savings to tide things over.
Microcredit should neither be credited with ending poverty on its own nor held responsible for promising more than it can deliver. It is simply one way to enable more people to participate in the capitalist system, not the magic bullet guaranteeing prosperity. In this regard, information is as essential as capital in ensuring that all parties understand and share expectations related to microcredit.
At the core of microfinance’s promise is a borrower who deserves better than what prevailing economic systems have given her. It is time for microfinance to return to its innovative roots and scale up its ancillary benefits. It should be properly regulated — both to protect the poor against profiteers and to shield providers from political attacks. Research and experience alike have shown microcredit is making a profound difference in borrower’s lives, even in cases where it does not raise income levels, as even skeptics such as David Roodman have shown. It has strengthened entrepreneurs. It has created new consumers. It has raised wages by tightening the labor market. It has helped protect against the loss of assets or livelihoods. It has even helped improve social conditions.
Lenders, borrowers and regulators must work together to ensure that microcredit is principled, remains sustainable, and continues to act as an essential tool to fight poverty and provide greater freedom and opportunity to the poor.
* Moushumi Khan is the Director of Legal and Compliance at BRAC, a global development organization founded in Bangladesh in 1972. BRAC is known as the world’s largest nongovernmental organization, with over 100,000 employees reaching an estimated 126 million people in 10 countries. Ms. Khan has also extensively worked with the Grameen Bank. The opinions expressed are hers and do not necessarily represent the views of BRAC or Grameen.