Challenges of Microfinance

Nearly two decades ago, when the concept of microfinance as a poverty reduction tool was in its infancy, there was hope that microcredit would transform economic and social structures. With its focus on reaching the previously unbanked, microcredit was expected to bring about change at the household level, a market in developing countries that traditional financial institutions had failed to reach.

Twenty years later, the microfinance industry around the world is estimated at $60 to 100 billion, with 200 million clients. Yet, results of microfinance appear to be mixed. Critics cite modest benefits associated with microcredit, over-indebtedness, and a trend toward commercialization that is less focused on serving the poor.

The microfinance sector has grown rapidly since the 1990s, paving the way for other forms of social enterprise and social investment. But recent evidence shows only modest average impacts on customers, generating criticism of microfinance.

The impact of microcredit has become a subject of much controversy. Supporters of microfinance argue that it reduces poverty by providing access to financial services which eventually help borrowers earn higher incomes. This in turn is expected to lead to improved nutrition and improved education in the borrowers' households. In the US and Canada, it is argued that microcredit helps recipients to graduate from welfare programs.

However, critics argue that microcredit has not increased incomes, but has driven poor households into a debt trap. They add that the money from loans is often used for durable consumer goods or consumption instead of being used for productive investments, that it fails to empower women, and that it has not improved health or education. Moreover, as the access to micro-loans has become increasingly widespread, borrowers often acquire several loans from different lenders, making it nearly impossible to pay the debt back.

In a paper titled: “Analysis of the Effects of Microfinance on Poverty Reduction”, Jonathan Morduch explains that empirical indications are that the poorest can benefit from microfinance from both an economic and social well-being point-of-view, and that this can be done without jeopardizing the financial sustainability of the MFI. While there are many biases presented in the literature against extending microfinance to the poorest, there is little empirical evidence to support this position. However, if microfinance is to be used, specific targeting of the poorest will be necessary. Without this, MFIs are unlikely to create programs suitable for and focused on that group.

Shahidur Khandker in his “Microfinance and Poverty: Evidence Using Panel Data from Bangladesh” explains that microfinance supports mainly informal activities that often have a low return and low market demand. He states that it may therefore be hypothesized that the aggregate poverty impact of microfinance is modest or even nonexistent. If true, the poverty impact of microfinance observed at the participant level represents either income redistribution or short-run income generation from the microfinance intervention. Khandker examined the effects of microfinance on poverty reduction at both the participant and the aggregate levels using panel data from Bangladesh. His analysis found that access to microfinance contributes to poverty reduction, especially for female participants, and to overall poverty reduction at the village level. Microfinance thus helps not only poor participants, but also the local economy.

A 2017 paper by the World Bank examined the claims about microfinance, highlighting the diversity in evidence on impacts and the important (but limited) role of subsidies. The paper concludes by describing an evolution of thinking: from microfinance as narrowly construed entrepreneurial finance toward microfinance as broadly construed household finance. In this regard, microfinance yields benefits by providing liquidity for a wide range of needs rather than solely by boosting business income.

In their paper titled: “The Miracle of Microfinance? Evidence from A Randomized Evaluation”, Duflo, Banerjee, et al explain how they conducted the first randomized evaluation of the impact of introducing standard microcredit group-based lending products in a new market (Hyderabad, India). Their research results show that 15 to 18 months after the MFI Spandana began lending in treated areas, households were 8.8 percentage points more likely to have a microcredit loan. After gaining access, households were no more likely to be entrepreneurs (that is, have at least one business), but they were more likely to start more than one business (due to higher access to multiple financing sources), and they invested more in the businesses they did have (or the ones they started). The authors also found that there was no effect on average monthly expenditure per capita.  Expenditure on durable goods increased in treated areas, while expenditures on ‘temptation goods’ declined. Three to four years after the initial expansion (after many of the control slums had started getting credit from Spandana and other MFIs), the probability of borrowing from an MFI in treatment and comparison slums was the same, but on average households in treatment slums had been borrowing for longer and in larger amounts. Consumption was still no different in treatment areas, and the average business was still no more profitable, although we find an increase in profits at the top end. Duflo, Banerjee, et al found no changes in any of the development outcomes that are often believed to be affected by microfinance, including health, education, and women’s empowerment.

Duflo, Banerjee, et al add that microcredit therefore may not be the ‘miracle’ that it is sometimes claimed to be, although it does allow some households to invest in their small businesses. One reason may be that the average business run by the target group is very small (almost none of them have an employee), not particularly profitable, and difficult to expand, even in a high-growth context, given the skillsets of the entrepreneurs and their life situations. And, consistent with theory, the marginal businesses that get created thanks to microcredit are probably even less profitable and dynamic. The authors found that the average new business in a microcredit treatment area is less likely to have an employee than the new business in the control areas, and the median new business is even less profitable in treatment versus control areas.

Jessica Schicks in her paper: “Microfinance Over-Indebtedness: Understanding Its Drivers and Challenging The Common Myths” explains that with over-indebtedness emerging among microfinance customers, the industry’s sustainability  and  social  impact  are  at  risk.  Schicks provides a framework of over-indebtedness causes, highlighting the role of external influences and the responsibility of lenders (lender behavior). She discusses the role that borrowers play in over-indebting themselves.  The paper reveals why the five myths of microfinance over-indebtedness erroneously oversimplify the reality of micro-borrowers.