Microfinance in the form of microcredits was born in the 1970s. The original idea of its founder and Nobel prize winner Muhammad Yunus was to provide the poor in less developed countries with an opportunity to take small loans of, for instance, $20. This money is given to people who lack access to conventional banks but need such capital in order to invest in a business, build up assets, raise income and protect themselves from external shocks. In order to achieve all of this, the range of financial services microfinance institutions (MFIs) introduced widened through years. Many of them now include insurance, savings, money transfer services, pensions, and consumer credits.
While all of these financial services are taken for granted in the West, it is approximated that more than 1.5 billion people still lack access to them. Banks are unwilling to accept clients with a high risk of not being able to repay a loan, and making risk assessments is generally harder in less developed countries due to a lack of data, proper models taking cultural context into account and technology. MFIs’ role thus seems of immense importance. According to Holland Fintech, MFIs reached 132 million clients worldwide with a loan portfolio of USD 102 billion in 2016. However, the impact of microfinance is widely discussed, with proponents arguing it offers an immediate help instead of just waiting for structural solutions, and others saying its net impact is zero. The rest of the article presents an overview of both sides of the story, with a focus on microloans.
EMPOWERING THOSE ON THE MARGIN
Let’s start with the benefits. Obviously, microfinance helps those on the margin of society neglected by standard banks. Not only does the introduction of financial services bring a sense of security into clients’ lives, but small loans can also give people confidence to become more active and innovative. Since two thirds of microfinance clients are female, financial services help women become economically empowered and more equal to men. It has been shown that, as more women gain access to financial accounts, spending on nutrition, education and healthcare rises. Moreover, some studies show that microloans lead to an increase in labour productivity in less developed countries. As people get access to money, they become able to invest in assets necessary to start a business or to improve the production process of an existing one. From an economic perspective, an increase in productivity leads to an increase in GDP, making microfinance’s potential wider than just providing people with cash.
Microfinance also has a positive social impact that is harder to measure. For example, it has been argued that groups become stronger when their members take microloans. This is because such loans are often given to people living in smaller rural communities, where it is in everyone’s interest that their neighbours are able to repay their loans. If one’s neighbour defaults on their loan, it means that their business has been suffering and very likely will continue to, forcing them to lay off of some workers living in the same community. Another positive social impact that has been pushed forward by microfinance supporters is that it prevents people from going to loan sharks and entering spirals of debt: taking one debt to repay another. However, this benefit is widely discussed and some argue that microloans put borrowers into exactly those debt traps that microlenders seek to prevent.
Water Taxi in Kibuye, Rwanda. Picture by Raisa Mirza.
WHERE DOES THE MONEY GO?
This leads us to the challenges microfinance faces. Its critics claim that microloans too often bring people into a cycle of debt. Providing a community with cash is not sufficient for businesses in that area to succeed; providing borrowers with trainings on how to manage money and/or run an enterprise may be necessary sometimes. If a person is struggling to satisfy their basic needs, they may spend the cash they receive on necessities such as food instead of investing in their career and producing additional economic value. In some cases, over indebtedness even leads to horror scenarios: in 2010, media reported that more than 200 poor indebted Indian citizens killed themselves after being pressured to repay their microloans. These scenarios lead critics to argue that microfinance is a naive and improper remedy to poverty and that deeper structural solutions are needed that will tackle root causes of socio-economic imbalances of power in the global economy. They deem that poverty cannot be solved with economic solutions only but that political ones are needed, as well as sacrifices of privileged classes worldwide, such as banks.
Another controversy around microloans is their high interest rates. One reason why rates are higher than in the West is considerable costs of microfinance institutions. As these institutions operate in less developed countries, they need to build at least basic infrastructure, but they also spend a lot on reaching residents of isolated rural communities and on providing them with trainings. Existing MFIs face a challenge here: whether to scale and thereby increase impact by reaching new communities at a considerable cost or to focus on the current communities and work on success and efficiency of the already existing institutions. Scaling is not only challenging because of costs but also because it results with an MFIs’ lower focus on the environment and the context of operating, understanding of which is crucial for MFIs to succeed. However, some also argue that high interest rates are not only a consequence of high costs but also of MFIs’ inefficiency.
Certain critics of microfinance generally argue that its overall impact is zero. They claim that positive stories do exist, but that many negative ones annul the positive ones. This argument is hard to either prove or disprove due to a lack of consensual metrics and regular reports in the field. Although measurements and data such as Global Financial Inclusion Database (Findex) do exist, they are mostly focused on the market perspective of financial inclusion or a social impact perspective, none being a sufficient overall indicator of financial inclusion according to Daniel Rozas, a microfinance expert. There are many measurements trying to measure similar things, but none of them is the one that would enable interested to make a proper evaluation.
TECHNOLOGY AS A HOPE
Therefore, the future of microfinance is unclear. More efficient microfinancial solutions may come with improvements in financial services technology and its accessibility in less developed countries. Access to these services through devices such as mobile phones will clearly benefit both the lenders and the borrowers, but having a smartphone is of course an important prerequisite for that. Technological innovation would enable institutions to collect data more easily, make more accurate models and risk assessments, leading to higher profitability. Having a digital overview of financial accounts could make financial services more accessible, financial planning more convenient and would leave clients with more time to spend on activities other than visiting a services provider.
Digitalizing financial services in less developed countries will, however, require huge upfront investments. Since around 1.5 billion people still lack access to any kind of financial services, redirecting investments into digitalization is controversial. Still, it may be the most efficient solution for challenges microfinance faces, but a solution that will require a lot of patience. Unfortunately, the poor are the ones who will have to suffer in the meantime.