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What Ails Microfinance?

There is no proof that microcredit alleviates poverty; on the other hand, it can make the already risky lives of the poorest even riskier, says researcher David Roodman

Published: Feb 14, 2012 06:41:26 AM IST
Updated: Feb 8, 2012 04:45:12 PM IST
What Ails Microfinance?
RAISING A STORM Researcher David Roodman suggests reducing support for microcredit as too much credit comes with risks to both customers and the organisations

In the post-implosion analysis of the microfinance sector in Andhra Pradesh, one entity came out virtually unscathed—the idea that microfinance is basically a force for good. The argument was that microfinance has the potential to alleviate poverty and empower people, and the real problem is with a few unscrupulous or greedy microfinance organisations. The solution therefore was better regulations—such as capping the interest rates and increasing transparency.

Muhammad Yunus, founder of Grameen Bank and winner of the Nobel Prize, for instance, has put the blame squarely on the profit-seeking microfinance companies and their compulsions to grow fast at any cost. In an interview to Microfinance Focus recently, he argued that commercial firms should not use the term microfinance, so that customers know it’s different from the ones offered by social enterprises. A few days later, P.N. Vasudevan, MD of Equitas, a microfinance company, defended for-profit companies saying the problem had nothing to do with the constitution of a company, but with how they behave on ground. The underlying assumption is that microfinance per se is good, but there could be rogue or fair Microfinance Institutions (MFIs).

It’s easy to see why this assumption is prevalent. Literature on microfinance is full of anecdotal evidence of how customers started small businesses, earned more, sent children to school and so on. The view even had an academic backing. A study by Mark Pitt of Brown University and Shahidur Khandker of the World Bank, supported these conclusions. There were many stories that showed women—the predominant customers of MFIs—felt empowered by the access to credit.

Yunus captured both the mood and the argument in his Nobel Prize lecture. He first felt the power of microcredit when he helped about 40 women who were struggling to repay loans, by paying an amount of $27. “The excitement that was created among the people by this small action got me further involved in it. If I could make so many people so happy with such a tiny amount of money, why not do more of it?”

Over the last 10 years, a researcher, David Roodman, now a senior fellow at Washington D.C.-based Center for Global Development, has been looking at the phenomenon of microfinance across the world. What he brought to the table was a good amount of scepticism, and what he found might not go down well with many in the industry. He looked at microfinance using three frameworks: Development as escape from poverty, development as freedom and development as industry building. Roodman found that there was no evidence for the first, mixed results for the second, and a strong case for the third.

Roodman started his inquiry into microfinance by looking at the study by Pitt and Khandker. When he tried to replicate the study, along with New York University professor Jonathan Morduch, he found that the widely cited paper did not succeed in proving that microcredit alleviated poverty. Two further randomised evaluations made by others did not find any impact on poverty for 12 to 18 months. There was a lot of hype, but little evidence of microfinance raising people out of poverty. “India is improving economically, and that’s not because of tiny loans, but because of the broader changes in the economy. I don’t think we should believe that financial services to the poor is going to be economically transformative,” he told Forbes India.

But proponents of microfinance have argued that access to credit empowers women, and that’s a worthy goal too. Roodman found the evidence to be mixed. Some women found doing business in public liberating. But those who failed to repay loans, found the peer pressure too constraining. “It appears to me, the kind of microcredit model that has dominated in India, the group-based microcredit is the most problematic in development as freedom,” he said. Microcredit is like any other loan. If you take it in moderation, it helps, but when you take it in excess, it actually reduces your freedom.

Where microfinance works best is in industry building—not in turning clients into entrepreneurs, but in building microfinance institutions that compete, innovate, create jobs and cater to the poor. Roodman cites KGFS (Kshetriya Gramin Financial Services), a low-cost, branch-based model being piloted by Chennai-based IFMR (Institute for Financial Management and Research) Trust. KGFS doesn’t just give microcredit, but also a range of financial services including savings and insurance. It offers savings product in the form of money market mutual fund and by innovating on the process, bringing the transaction costs close to zero.

That is a key learning—to move beyond credit and offer other products. MFIs that offer both savings and loan products tend to behave more responsibly, and avoid excessive growth. Perhaps, the most important contribution made by Roodman to this field is the nuanced way he urges one to think about microfinance. The question to ask is where microfinance works best. Conventional wisdom says it is good at reducing poverty and empowering women. But, he argues with evidence, that it’s actually good at building dynamic industries that offer inherently useful financial services to the poor.

Roodman’s recommendations for aid agencies and policymakers flow from this conclusion. He discourages lending efforts to the poorest saying credit would make their already risky lives even riskier. Since access to finance is inherently useful, he urges supporting any move into taking deposits, insurance and money transfers. At the same time, since too much credit comes with risks both to customers and the organisations, he suggests reducing support for microcredit.

Given these views, one would have expected a staunch supporter of microcredit like Yunus to vehemently disagree. Yet, when Roodman published a book, Due Diligence: An Impertinent Inquiry into Microfinance, in January 2012, one of the most enthusiastic endorsements came from the Nobel laureate. In the world of ideas, there is always a demand for cool, evidence-based analysis.

(This story appears in the 17 February, 2012 issue of Forbes India. To visit our Archives, click here.)

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  • Ashten Regan-denham

    Micro-credit is certainly a seductive picture of sustainable development neo-liberal style. When I began looking into it I was convinced it was part of the neo-liberal conspiracy, a way to trap poor women into a life of triple shift work. I read every academic study I could find on the subject of micro-finance and female empowerment in Bangladesh (in English, I'€™ll admit) and I was a little surprised by what I discovered. (There is quite a public disagreement between Pitt Khandker and Morduch over methodological differences.) This way of looking at micro-finance as a purely economic tool for addressing poverty misses the mark. The micro-finance loans themselves act like honey drawing in the husbands, providing increased welfare, the meetings themselves, with all that they entail, provide gains in confidence, training, interaction with authority, mobility, gender awareness and ultimately change. It is not so much the micro-finance loans themselves that are empowering but this affront to purdah, these meetings of women, that give back a voice, as one women said; "€˜I have learned to talk"€™, (Kabeer 2001) which is so powerful in increasing agency. When these previously isolated women band together in groups, they are much more able to fight injustice together and become involved in public action. €˜At the same time, a growth in women'€™s self confidence, in their knowledge of their rights, their willingness to participate in public action and even a reduction of domestic violence may have occurred as a result of women'€™s participation in the new forms of social relationships embodied in credit organisations; they bore little relationship to the productivity of their loans.€™ (Hashemi 1996) It is the participatory way that good micro-finance programmes are delivered that holds the key to explaining the link between micro-finance participation and increased public action. Programmes work in this way if they are delivered by a development organisation and not a financial one. MFI'€™s should not emphasize minimal micro-finance programmes in order to increase profitability but to continue to maximize micro-finance programmes as an extremely important vehicle for social development, training and education. Micro-finance participation increases women'€™s agency, through increasing bargaining power and decision making. It improves welfare, reduces subordination, and leads to a strengthening of women'€™s €˜voice€™, breakdown position and challenges negative gender structures, primarily due to the suggested link between participation and the resulting increase in political empowerment and public action. Micro-finance (in Bangladesh at least) is empowering and a very useful tool as part of a mix of development strategies.

    on Jun 15, 2012
  • Natalia Harjono

    I agree with the opinion but I think the rating institution also contribute the problems. Many times we think of poverty alleviation with microcredit program, actually we also talking about poor microcredit institutions, with limited capital and no sufficient system. And this instititions need investors (mostly donor agencies and development banks) so they have to be rated by appointed rating institution. Here the mistake begin, repayment rate, prudent, etc...etc...have to be rated very good. So when we says we create progressive microcredit model to help more people, actually we squeeze poor people to help the poor, but the 'name' as the initiator or development agent goes to the microcredit institution. And the the investor also will recognize as intitution which is concern to the poor. I more pity to the credit officers they just job seeker and trap in between

    on Mar 1, 2012
  • Anil

    Microfinance needs a makeover urgently. With thinner margins, microcredit will not make the sailing easy let alone floating.The larger canvass for microfinance (FSPs) is to have basket of financial products, customised for the customers.

    on Feb 16, 2012
  • P N Vasudevan

    David Roodman joins the most debated topic: whether micro finance is good or bad. we all recognise that availing loans is essential for growth, be it for governments, organisations or individuals. however there is a saying in Tamil: "When taken in excess, even nector turns poison". Thus too, with loans - taken in excess, it not only does not lead to development (of the individual, company or governments) but leads one to the path of self-destruction (a la some European Governments!) So, what is the right quantum of loan one should take? and in the context of micro finance, what is the right quantum, a typical women who lives either in villages or low income colonies in cities and is dependent on daily business earnings, should take? The answer cannot be generic and must be custom fit based on that individual's earning capacity, other existing loans, other family pressures and needs and her ability to meaningfully use the extra loan amount to undertake enhanced business activity and improve their earnings. While this is a mother hood statement no one can disagree with, in reality, when you are dealing with thousands and hundreds of thousands of people and who have very little documented information either on earnings or expenses, one realises that an individual based assessment of the above variety is not possible. Hence one would be required to take a kind of middle path where a majority would be comfortable with the quantum of loan. This is exactly what the RBI has tried to do in its recent regulatory framework put in place for MFIs in India. The regulation lays down that only 2 MFIs can give loan to one borrower and both loans put together should not exceed Rs. 50000 at any point in time. This amount of Rs. 50000 can be debated endlessly and there would always be cases where it can be proved that the client can easily service higher loans and make better income for herself and cases where people cannot even absorb this level of amount in a useful manner. But a median line needed to be drawn and RBI has done just that. May be over time, based on experience this amount can be tweaked but atleast it is a good beginning. and within this ceiling on amount, MFIs would still be required to ensure that the client can usefully absorb and repay the loan and not blindly give loans even within this ceiling of Rs. 50000. In some situations, market forces cannot be relied upon to produce what is good for the client and RBI has done the right thing in introducing regulation to ensure clients are not put to too much of risk of being over indebted beyond their means. And if MFIs in India follow not just the letter but spirit of this regulation, surely the menace and resultant distress of over indebtedness by micro borrowers in India would not haunt the sector in future. The arguments on 'for profit' vs 'non-profit' MFIs is done to death! Instead of wasting time on such frivolous discussion, one should put down standards of ethical and fair behaviour by MFIs and then classify MFIs only as 'Fair' who comply with these standards and 'rogue' as those who violate these standards. and today, in India, for the 'for-profit' MFIs, the RBI has already laid down pretty stiff standards and so long as 'for-profit' MFIs follow these diligently the chances of them turning 'rogue' does not arise. Of course, there is no regulatory standards for 'non-profit' MFIs in India today but one hopes the draft Micro Finance Bill pending in Parliament would someday, turn into an Act which would regulate the non-profit MFIs also. For too long, everyone concerned has been too naive thinking that MFIs (both varieties) would follow individually set high ethical standards and rightly the RBI and Central Government have come out with steps to regulatorily define these standards, thus eliminating possibilities of 'rogue' MFIs (of either varieties). And finally if I have to give credit to anyone for the MFI sector in India transforming into a well regulated and sustainable sector offering sustainable services to the low income groups, the credit must go to the Andhra Pradesh Government! There would of course be endless discussion on whether what they did is right or excessive, reformative or damaging etc etc, but it definitely has galvanised the rest of the eco system to put in standards of ethical behaviour and in the long run, benefit the clients!

    on Feb 16, 2012
  • Muralita

    I am glad that the author has been able to provide some empirical observations on how micro finance works or actually doesn't work. The fact of the matter is, without repayment discipline no lending programme can work. To foster repayment discipline peer group or cohort pressure, implemented throu group or circular guarantees is the solution. In order for that to happen the borrowers should all come from the same small compact group - say a small village or a group within a village - and all should borrow and borrow about the same amount. Else the incentives to repay get skewed and repayments will not happen. Here is where the problem arises: is everyone in a village entrepreneurial enough to run some business? Can the immediate community support all the services they can produce? In one example an MFI financed women to buy and keep goats. How many goats can a village sustain? If everyone has a goat or everyone became a vegetable seller then how does the business work successfully? Clearly the answer is that everyone cannot become an entrepreneur and therefore, by winding the Rgument backward, MFI on a large scale cannot succeed except a a means of providing consumption finance. The problem with the latter is repayments. Consumption finance leaves the pore in deeper debt then they were in to begin with. Then there is the aspect of the cost f finance - the rates of interest charged are usurious and unaffordable while admittedly less than what a local loan shark charges. Charging lower interest is not feasible given the administrative costs, especially those of collection and we have seen that without the collection discipline the model cannot work. On top it given the profile of the target clients, this is asensitive segment of the society and politics is ever ready to barge int unannounced for the detriment of everyone concerned. Which is what happened in Andhra. Unfortunately private capital saw one more opportunity to make money out of a nascent idea without waiting to delve deeper and ask uncomfortable questions. They poured the money in, built up sme MFIs made IPOs and walked away with a lot of money. The entire MFI model stands discredited. The more sustainable model is one of saving. There have been some wrk done, at IFMR I believe that holds that micro savings is a better option than micro finance as we know it. One can even operate micro insurance programmes on a mutualised basis with actuarial support etc being provided gratis by an outside agency. It is time to critically re-examine the micro finance model and keep private capital out of it if it is to work for the poor.

    on Feb 15, 2012
  • Vinay Singh Jadon

    The analysis is good but it is the primary responsibility of the MFI and the member that they should not lend members more loans and members should not take more loans, rather MFI should also spread awareness that they should not take excess loans. The recent RBI guidelines, if implemented by all the NBFC-MFI or non NBFC-MFI and they should compulsorily consult Highmark report to check loans availed by the proposed members.

    on Feb 14, 2012