There has been less attention paid to the concentration of these loans in neighborhoods that are largely black, Hispanic, or both. This pattern, documented in federal loan records, holds true even when comparing white middle-income or upper-income neighborhoods with similar minority ones.

Last year, about 70 percent of the loans made in the Detroit neighborhood (97% black) carried a high interest rate — defined as 3 percentage points more than the yield on a comparable Treasury note — while in Plymouth (97% white) just 17 percent did.

Last year, blacks were 2.3 times more likely, and Hispanics twice as likely, to get high-cost loans as whites after adjusting for loan amounts and the income of the borrowers, according to an analysis of loans reported under the federal Home Mortgage Disclosure Act. (Asians are somewhat less likely than whites to take out high-cost loans.)

One can draw several interesting inferences from this. First, it would appear that banks in America have been unable and unwilling to move down the “pyramid” to cater to people with bad or unknown credit histories. This stands in start contrast to the success microfinance in the developing world.

Second, credit is not a good thing by itself. In this case, it was overzealous and highly competitive lenders that “actively sold subprime loans” (see also). The corollary for microfinance is that if the aim is development (as opposed to building a new business model), one needs more than credit.

The problems Karnani cites are well known, and were pointed out years ago by Thomas Dichter, among others. People take microfinance’s poverty alleviating characteristics as fact - so much so that nobody has really studied the phenomenon. Those that have, says Karnani, find the impact on poverty is not as unambiguous - and he quotes several studies:

One of the most comprehensive studies reaches a surprising conclusion: Microloans are more beneficial to borrowers living above the poverty line than to borrowers living below the poverty line. This is because clients with more income are willing to take the risks, such as investing in new technologies, that will most likely increase income flows. Poor borrowers, on the other hand, tend to take out conservative loans that protect their subsistence, and rarely invest in new technology, fixed capital, or the hiring of labor.

Microloans sometimes even reduce cash flow to the poorest of the poor, observes Vijay Mahajan, the chief executive of Basix, an Indian rural finance institution. He concludes that microcredit “seems to do more harm than good to the poorest.”

The failure of microfinance to bring people out of poverty should not be surprising, except to those deafened by its hoopla. People below the poverty line simply “do not have the skills, vision, creativity, and persistence to be entrepreneurial. Even in developed countries with high levels of education and access to financial services, about 90 percent of the labor force is employees, not entrepreneurs.” Indeed, Thomas Dichter made a similar point, pointing out:

The microcredit paradox is that the poorest people can do little productive with the credit, and the ones who can do the most with it are those who don’t really need microcredit, but larger amounts with different (often longer) credit terms.

Karnani’s Solution: Jobs, not Microcredit

Karnani - as you may remember - previously challenged C.K.Prahalad and his “Bottom of the Pyramid” theory (see also NextBillion). He, of couse, has his own solution - creating jobs through encouraging labor intensive industrial production. The PDF of his article is worth reading, for it shows how poverty declined rapidly in China, but not India and Africa - largely due to such growth.

Yet my analysis of the macroeconomic data suggests that although microcredit yields some noneconomic benefits, it does not significantly alleviate poverty. Indeed, in some instances microcredit makes life at the bottom of the pyramid worse. Contrary to the hype about microcredit, the best way to eradicate poverty is to create jobs and to increase worker productivity.

To understand why creating jobs, not offering microcredit, is the better solution to alleviating poverty, consider these two alternative scenarios: (1) A microfinancier lends $200 to each of 500 women so that each can buy a sewing machine and set up her own sewing microenterprise, or (2) a traditional financier lends $100,000 to one savvy entrepreneur and helps her set up a garment manufacturing business that employs 500 people. In the first case, the women must make enough money to pay off their usually high-interest loans while competing with each other in exactly the same market niche. Meanwhile the garment manufacturing business can exploit economies of scale and use modern manufacturing processes and organizational techniques to enrich not only its owners, but also its workers.

A Good Idea Gone Worse: Markets Trump the State

Karnani makes a lot of sense. Microfinance may have some non-economic benefits but it has been hijacked by “development experts” and “grassroots NGOs” to expand their legitimacy, and become something it never was intended to be. He is equally critical of Prahalad, who in his opinion “glosses over the real issue” - the failure of government and public service - by urging companies to provide consumer goods when what they need are the fundamentals:

Why do poor people accept that they cannot expect running water? Even if they do accept this bleak view, why should we? Instead, we should emphasize the failure of government and attempt to correct it. Giving a voice to the poor is a central aspect of the development process.

That is the key here - the development process. In that sense, the hoopla around microfinance and markets is doubly egregious - for it encourages a blind belief that markets will solve the world’s poverty issues by themselves. They will not. Indeed, by promoting microfinance, and micro entrepreneurs, the hoopla might make things worse, by encouraging economic activity well below economies of scale.

For too long, the world has naively believed that microfinance alleviates poverty. A nobel peace prize and several hundres of millions in private capital have been dedicated to the cause. Yet, the cause is ephemereal. The reality of microcredit is less attractive than the promise, and “even The Economist is beginning to realize it”. Time the well informed development expert, philanthropist, and policy maker focused on something real.

There are two similarities between the poor in the US and the poor in the rest of the world. First, they don’t make much money. Second, everyone wants to lend to them. This article gives plenty of food for thought, for why that may not be such a good thing - not as a business, but as a way out of poverty.

A Question of Choice

Some support credit based on the faith that the market knows best. Credit - even expensive credit - allows the market to function, and is better than no credit at all simply because it increases choice. Much the same argument is made by C.K.Prahalad, in support of the Base of the Pyramid theory - which extols corporations to see the billions of poor as consumers:

Nobody, poor or rich, is compelled to pay a high price for a used car, a credit card, or anything else…”The only feasible way to run a capitalist society is to allow companies to maximize their profits,” says Tyler Cowen, an economist at George Mason University in Fairfax, Va. “That will sometimes include allowing them to sell things to people that will sometimes make them worse off.”

Even if one were to accept the superiority of free-markets (not a given), this argument has a flaw. The theory fails because low-income consumers - and the poor in developing countries - do not live in perfect markets. Rather, they live in markets that are imperfect and subject to asymmetric information. The result is exploitation, and a choice that can be often illusory, and sometimes dangerous:

A public housing administrator who reviews tenants’ tax returns pointed out to Thomas that Jackson Hewitt had pared $453, or 10.4%, in tax-prep fees and interest from Thomas’ anticipated refund. Only then did she discover that various services for low-income consumers prepare taxes for free and promise returns in as little as a week. “Why should I pay somebody else, some big company, when I could go to the free service?” she asks. The lack of sophistication of borrowers like Thomas helps ensure that the Money Now loan and similar offerings remain big sellers.

Cheap Credit
Another argument for microcredit is that it is cheaper than the alternative - a moneylender. In America, there is no equivalent, so low-income credit is indeed the only alternative. But is it really cheap?

Not quite. If anything, credit has become more expensive:

Federal Reserve data show that in relative terms, that debt is getting more expensive. In 1989 households earning $30,000 or less a year paid an average annual interest rate on auto loans that was 16.8% higher than what households earning more than $90,000 a year paid. By 2004 the discrepancy had soared to 56.1%. Roughly the same thing happened with mortgage loans: a leap from a 6.4% gap to one of 25.5%. “It’s not only that the poor are paying more; the poor are paying a lot more,” says Sheila C. Bair, chairman of the Federal Deposit Insurance Corp

The microcredit market is still new, but one sees a similar trend there. As access to credit has expanded, institutions have grown and tapped commercial capital. That capital seeks market and risk-adjusted returns. Those returns can only come at the cost of more expensive credit - and poorly informed consumers.

The Myth of Enterprise & the End of Poverty

Finally, the diehard also believe that microcredit helps start new sustainable businesses. By some miracle, the developing world’s poor are an army of entrepreneurs, seeking capital to start sustainable and profitable businesses, that will pull millions of microcredit customers out of poverty. Yet, evidence suggests microcredit does not go to start enteprises, but to smooth consumption. And that is a road that is just as likely to lead to indebtedness, as to riches:

She graduated in 1992, owing $45,000 on student loans. That debt became her main financial burden, she says. The 9.5% interest rate isn’t particularly steep, but she tended to view the payments as less pressing than putting food on the table or paying rent. Late fees piled up. Today she owes $159,991, up from $117,000 only 18 months ago. When dunning notices arrive, she tosses them in the stove.

There is no reason to believe that the poor in America are any less entrepreneurial than their developing world bretheren. So if credit - cheap or not - has not saved the former from poverty, is there reason to believe it will save the latter, who have substantially fewer skills and opportunities?

Calling a Spade a Spade: A Good Business

Low-income consumers in the U.S. are an interesting case study for microfinance proponents worldwide. Because credit by itself doesn’t seem to be helping them. “Instead of becoming an opportunity for upward social and economic mobility, it becomes a debt trap for many trying to move up,” according to Nouriel Roubini, an economics professor at New York University’s Stern School of Business.

There is a lot of money involved here. According to Stephens Inc, such “alternative financial services” totals more than $250 billion a year. Still, let stop pretending that credit will save the world and its poor. It hasn’t yet in a country where it has been plentiful for a long time. This is a business, and microcredit an industry. Like all businesses, it will help some and make others worse off. Let us figure out what to do with the latter.

Understanding how microfinance affects clients is not straightforward because there are several possible explanations for why, say, a borrower is doing well compared to her non-borrowing peers. The credit might be helping–or perhaps the borrower was already comparatively prosperous and would have fared as well even without the loan. These new papers elucidate cause and effect by performing controlled experiments, in which a few parameters are randomly varied and the effects measured.

Controlled Experiments?

The idea of ‘experiments’ sounds good. It gives scientific legitimacy to what are essentially social phenomena marked by multiple variables, complex correlations, and extraneous - often invisible - factors. I need to look at these reports to see just how ‘controlled’ they are.

Another organization that has been taking a similar approach to impact assessment is Innovations for Poverty Action (IPA). Genevieve has joined IPA and will lead a couple of evaluations in the Philippines, including one on group vs. individual lending that sounds awfully close to what the CGD has published.

I have two propositions for Genevieve that could lead to some interesting evaluation projects.

Experiment One: Social Impact - Profit vs. Development Benefits

First, there is an inherent tradeoff between microfinance as a business and as a development tool. Microfinance will largely benefit one of two stakeholders - commercial enterprises and their shareholders, or poor borrowers. As Muhammad Yunus recently made me realize the two are mutually exclusive.

So, how may one test this assertion? Evaluating the interest rates offered by MFI’s and asking the following questions may offer a few clues:

• How do MFI rates compare with what a money lender was offering?
• How do they compare to those of Grameen Bank - which says it can offer lower interest rates by being ‘non-loss, non-dividend’.
• Is there a trend towards higher interest rates, the higher the commercial pressure on an organization? Do banks offer higher rates than independent MFIs, than grassroots NGOs?
• Did an MFI’s interest rates go up after it partnered with a bank?
• Have aggregate interest rates gone up over time, as the need to prove development benefits has gone down?

This is an important test, because if true it allows us to categorize MFIs into two groups and then test for development impact across them. It may also show that most MFIs today embrace the rhetoric of a ‘market based development solution’, ignoring the fact that development benefits accrue only when the solution is priced somewhat below the market rate (set by the money lender). In other words, the major benefit of these providers is to expand the market by bringing in external funds, not any development impact, per se.

Experiment Two: Generating Enterprise - Equity vs. Debt

My second assertion is that microfinance is inherently flawed as a tool to create ’sustainable enterprise’. Studies show that microfinance ends up funding consumption of individuals. This may well be commendable in itself. However, if our goal is to create enterprise for long-term economic growth how can microfinance be more effective?

The problem is that the incentives of MFIs are not oriented towards generating sustainable enterprise. They are oriented simply towards repayment of loans. The latter is not an indication of success of the former. One way to generate private enterprise through ‘the market’ may then be to use equity, not debt, to fund micro and small entrepreneurs.

So, here’s another test. Do organizations which take equity stakes in micro and small enterprises (MSE) have a better incubation success rate than microfinance providers?

I am compelled to write this (long) post, because I must recommend to everyone that ever has a chance, to listen to him. Listen to him not because his work is en vogue, nor because of his Nobel Prize, nor because he is an excellent speaker mixing humor with the dirty reality of his work. Listen to him simply because he is a man whose idea – microfinance – has been completely misunderstood.

A Brief History of Microfinance

In telling the story of Grameen Bank, they say the first loan every given was $27. What they do not say is that that loan was given to a collective of 42 people. The tiny scale of that amount, and how its usefulness contradicts everything we believe to hold true, sets the stage for Yunus’s life. To hear the story from a man who cannot hide the excitement in the excitement of his clients, is to hear it come alive.

Prof. Yunus started with a simple proposition. In his words, he saw a terrible problem – the grip of moneylenders on a community – to which there was a very easy solution – to lend the money himself. The response he got from the poor – of being almost deified – “hooked him” to what he was doing.

Yet, because he did something nobody else did, or was prepared to do, his work was all about challenging the status quo. Even his insistence on lending to women, was a reaction to banks that did not. Surprisingly women, when initially offered a loan refused saying they did not know what to do with it. Yunus had a simple explanation for that, saying to his colleagues, “it is not her saying no. It is her history saying no.”

Microfinance and Grameen Bank’s Business Model

In 2006 there were about 100 million clients worldwide. Of these, 85% were in Asia with 50 million in India (34mn) and Bangladesh (16mn). 10% of the clients were in Africa with a further 5% in Latin America.

Yet, two thirds of the people in the world do not have access to the financial system, a state of affairs Prof. Yunus believes to be inherently unjust, suggesting that credit should be a human right. In Bangladesh, Grameen Bank (GB) covers 80% of poor households, and soon hopes to reach the rest. But to make financial services a ubiquity requires a policy framework that legalizes microbanking (a process underway in India). GB, I was surprised to learn for instance, has special legal status that allows it to operate as a bank.

There are, however, more fundamental differences between GB and other MFIs. In particular, when GB creates a new branch, its manager is set two targets:

1. That each branch raise its own money. No money is provided to a branch, which implies that branches must raise deposits from the community and use that to disburse loans.
2. That each branch must breakeven within 12 months. At present, GB has achieved that target in 80% of the cases.

The first point is worth repeating because it is very different from what happens in conventional banks. Microfinance today is really microcredit. Banks do not collect deposits from the very poor, and when they do that money is channeled to metropolitan areas. While both strategies may be good for the business they have a negative impact on the community.

The contrast with commercial banks became even more stark when Prof. Yunus was asked what he thought of farmers committing suicide in Vidharbha (a region of India) from chronic indebtedness. That, in his opinion, was a failure of the institution that lent the money – because by making money more important than the client’s life, the institution had failed in its orientation.

Grameen Bank takes a different approach to default. If one person in a group fails to make a payment, the Bank asks other members not to pressure the borrower but to help her repay. For instance, if the default happens because a woman’s husband ran away with money, other group members should bring pressure to bear on the husband, not the woman herself. If everything fails the loan is converted into a very long-term loan. Similarly, bank loans often have insurance built in, so that if a woman is unable to pay or she or her husband dies, the loan can be written off.

The Non-Quantifiable Impact of Microfinance

There were times when I thought Yunus sounded just like any other proponent of microfinance – and I have heard many. When he said, for instance, that he hoped to reach 100% of the people in Bangladesh, I could not help but ask – “then what?”

My problem is that nobody really asks anymore if microfinance actually helps people get out of poverty. It has become an end in itself rather than being a means to an end.

The roots of my skepticism lie in studies that show little income growth among microfinance borrowers. Yet, my insistence on numbers stems from my training in western thinking. To know what percentage of people microfinance helps is necessary, but not sufficient. Because if it helps even one person, that is one more than the alternative. Yunus describes a program that lends to women beggars, encouraging them to become roaming saleswomen. From its 85,000 clients, if even 5,000 were to give up begging that would in Yunus’s opinion be worthwhile (so far 8,000 have done so).

One cannot count the value of social impact simply with those that escape poverty. One must also remember the many who do not but feel otherwise empowered. To dismiss them as irrelevant to the ‘impact’ of microfinance, is to reduce them – and our measure of happiness – to an incomplete number.

And finally, there are knock on effects. Yunus was asked what he thought of the rise of Islamic fundamentalism in Bangladesh, which excludes women from the mainstream? In response, he saw microfinance as a tool against that rise. “The more women are empowered, the more fundamentalism is weakened,” he said.

Social Business, Incentives, and Competitive Advantage

Grameen Bank, by putting its clients before profits, is what Yunus calls a “Social Business”. This orientation challenges the very core of economics and what we are taught in business school of the profit-maximization theory. “Yet,” he says, “I find it humiliating that I have to fit into a theory, rather than the other way around.”

In Yunus’ words, classical economics and the theory of profit maximization have done lasting damage by focusing only on one part of human nature. Because while humans are excited by money and the ability to make it, that is not all they are. Doing otherwise, we reduce ourselves to less than what we really are (a point made very forcefully by Amartya Sen in critiquing the dismissal of ethics in economics).

The success of a “social business enterprise” is measured not by profits, but by the number of people served. For instance, a joint venture between GB and Danone that provides fortified milk products to poor children measures its success by the number of children it feeds. Similarly, GB itself can be distinguished from other MFIs that have climbed the bandwagon but offer higher interest rates to maximize profits, rather than cover costs.

The idea is not new. David Green had the same motive in creating Aurolab. But Prof. Yunus is clear that the two motives cannot co-exist in the same business. For if that happens eventually profit-maximization will win over other incentives. There is, as he says “only one bottom line.”

Interestingly, it struck me that among the poor being a social business can also be a competitive advantage. For instance, by being “non-loss, non-dividend”, GB can offer lower interest rates than its competitors. It is an interesting paradox – that by not being profit-maximizing, one has an evolutionary edge over companies that are.

Social Market Exchange

Taking the argument further, if social businesses can exist, they can also benefit from a stock exchange of their own. This would be an exchange on which companies are traded, but each listed company is a social business measured not on its profit but on how many people it helps.

It is an interesting idea. Because people are not only profit-oriented (as demonstrated by philanthropy), each of us exhibits a range of motives for what we do. Our relative share of ‘investment’ in profit-maximizing and social businesses may vary, but there will be many people that will put their money where their belief is.

Parting Impressions: An Ironic Achievement

That really is what Yunus is all about. He is about challenging the mainstream thought process and offering a more complete perspective to what is important, beyond profits.

Yet Yunus’s attempt to prove that social business is viable has been only selectively recognized, and the very businesses he set out to challenge have subsumed his message. Microfinance has gone mainstream, but lost its proposition of being focused on the poor.

It is sobering to ask if social businesses can indeed coexist in society obsessed with western economic theory. Would any social business face the same tradeoff? Would it have to compromise on its values in order to attract global attention?

I retain my criticisms of microfinance as a development tool. In particular the blind belief that it helps alleviate poverty – a belief that prevents objective analysis and the development of alternatives. I share Yunus’s belief that business need not only be profit-maximizing. Yet, the rise of microfinance shows that the gap between how things work today and how we would like to see them work is vast. Microfinance today is not what Yunus set out to do, and he is being applauded for the wrong things. That is the irony of his achievement.

To prepare, I did some background research, speaking to colleagues at ICICI, YES Bank, and ABN Amro. The most significant take-away for me was the extent to which ‘rural and micro-banking’ was now an industry in India – with each bank having a dedicated Rural, Agricultural, and Micro-banking (RMAG) division. This post shares my learnings on the financial services industry, how it is moving on from microfinance, and how this relates to development and economic growth. Given its length, I have made it available in PDF.

For those interested, this is based largely on the paper Economic Growth, Financial Deepening, and Financial Inclusion (PDF here), by Dr. Rakesh Mohan, Deputy Governor of the Reserve Bank of India, which I highly recommend.

Microlending: Current Industry Trends

In the Indian context, microfinance is no longer the purview of development institutions. While the rhetoric of development has been retained, banks have embraced it as an extremely profitable business, for two reasons.

First, Indian banks are required to lend a certain percentage (currently 40%) into priority areas – called priority sector lending – which includes agriculture, SMEs, and government securities. Compared to returns on government bonds of 6-7%, MFI lending provides returns of 10-14%. Banks, therefore, have expanded investments in these areas.

Second, microfinance lending - as it is currently practiced - is simply not very risky. In the absence of individual credit assessments, MFIs lend to groups or through referral, leading to repayment rates of 95% or more. Banks then get the best of both worlds - higher rates of return with very low risk.

The result is massive expansion in microlending. ICICI Bank, the largest private bank in India, had 1.2 million microfinance clients in 2005 and a portfolio of $227 million. A year later, ICICI has multiple partnerships and 3 million clients, targeting 25 million in 3 years. Other banks, such as ABN Amro, and YES Bank have smaller but still sizable operations that generate goodwill benefits for their entire operations (both featured on FT’s sustainable banking awards last year).

Public sector banks usually operate as integrated micro-lenders, creating self-help groups (SHG) to which they disburse loans directly rather than through an intermediary. Private sector banks, by contrast, operate through a partnership model, contracting with existing MFIs to function as the bank’s retail arm to acquire and manage micro-clients. In return, MFI’s retain a percentage of the interest earned on loans. Many MFIs are now financially independent of such funds, but high effective rates (of over 30%) have also led to a regulatory backlash.

Mismatch between Credit and Deposit Growth

This expansion of rural credit tracks a more general expansion of retail credit in India. In 2006, non-food credit expanded by over 30%, up from a growth rate of 28.8% in the 3 years prior. Simultaneously, the share of retail credit in overall credit stood at 46% in 2005-06, up from 6.4% in 1990-91.

Interestingly, this growth has not been accompanied by growth of deposits, particularly in rural areas. As a result:

Banks have been financing much of the incremental credit expansion by unwinding their surplus investments in government securities. What deposit growth that has been observed is, moreover, concentrated in the larger cities…[this] could also mean that financial inclusion may have suffered.

The implications of this mismatch are important to understand some of the constraints faced by an expanding microbanking industry. In the absence of deposit growth banks face a liquidity problem which limits further credit expansion. This problem is evident in recent policy changes to reduce the statutory liquidity ratio (SLR) of Indian banks.

In other words, the banking system will be expected to increasingly provide larger quantum of funds to existing and emerging enterprises. And without adequate deposit growth, however, credit expansion might not be sustainable over the medium-term, without putting immense pressure on real interest rates and impacting the overall stability of the financial system.

Financial Inclusion: Consequences and Benefits

The preceding discussion does not distinguish between rural and urban markets. However, the expansion of financial services to all sections of society (financial inclusion) is important, in order to leverage development and growth benefits. There are obvious reasons to encourage such financial inclusion and deepening:

Countries with low levels of income inequality tend to have lower levels of financial exclusion, while high levels of exclusion are associated with the least equal ones. In Sweden, lower than two per cent of adults did not have an account in 2000…[while] in Portugal, about 17 per cent of the adult population had no account of any kind in 2000.

The Gini index for Sweden was 24, and for Portugal 37 in 2001 (lower is better). Sweden ranked 119, and Portugal 59 in income inequality in 1996.

At the macro-level a well-developed and widespread financial system accelerates growth “through expansion of access to those who do not have adequate finance themselves.”

In its absence, the sources of finance available to individuals and enterprises are limited. The McKinsey Quarterly reports that companies in emerging markets demand further development of financial systems, and remain limited in their ability to access external finance. This results in fewer economic activities being financed, resulting in lower growth potential. Further, financial exclusion is self-propagating and limits growth prospects:

It is the incumbents who have better access to financial services through relationship banking. Moreover, incumbents also finance their growth through internal resource generation. Thus…growth is constrained to the expansion potential of incumbents.At the individual, micro-level, however, the consequences of financial exclusion are very different. Exclusion results in a susceptibility to cash flow disruptions, inability to benefit from interest rates, and lack of long-term financial security and planning through saving opportunities.

It is very important to note the distinction between the enterprise level macro benefits and the individual micro benefits, as the two are often confused in development literature. In the former, the benefits of inclusion are productivity and higher trend growth. These are benefits commonly ascribed to microfinance, yet microfinance as it is currently practiced is targeted not at enterprises but at individuals. The benefits that accrue therefore are smoothening consumption and safeguarding assets from major disruptions (e.g. disease, natural disaster). Recent studies seem to suggest as much.

Policy Responses to Financial Exclusion

Despite the massive growth in micro-credit mentioned previously, the author expresses serious concern over financial exclusion in India, backing those concerns with data. For instance, spatial distribution of banking services indicates that rural credit, deposits, and offices as a share of overall services decreased between 1996 and 2005, with most expansion restricted to metropolitan areas.

There are two obstacles to greater financial inclusion. The first is simply commercial. Transaction costs for both banks and clients remain high, particularly in disbursing credit, which is essentially a high cost, distributed business. Further, interest rates remain high in the absence of structured credit assessments. The second obstacle is policy requirements such as know your customer (KYC) procedures that limit the geographical reach of financial services beyond physical bank branches.

Yet, the importance of financial inclusion becomes important, particularly in the context of doubling agricultural productivity, targeted for India’s 11^th five year plan. Consequently, the RBI has moved to enforce multiple policy and industry changes:

1. Banks have been asked to voluntarily make available a ‘no-frills’ account, and all printed bank material has to be made available in regional languages.
2. KYC procedures have been simplified for low income groups.
3. Significantly, since January 2006 banks can provide a full range of banking services through ‘business facilitator and correspondent’ (i.e. MFI partnership) models. Previously, MFIs could only provide credit, but not open bank accounts.
4. The Credit Information Bureau Act, 2006, will eventually establish a credit bureau that makes available credit histories of individuals and small businesses. This should lower risk for banks, in extending credit further.

Conclusions

This has been an inordinately long post, but an eye-opening one. Most microfinance literature has seen credit expansion as an end in itself, with productivity benefits magically accruing from such expansion.

This discussion, however, debunks that belief without denying the importance of microcredit. However, microcredit must be part of micro-banking, which must be seen as a viable and important business within the financial sector.

Contrary to popular belief, the reach of microfinance in India remains limited. Both market and policy reforms are necessary in order to correct this, expand microcredit, and sustain it through deposit growth. The resulting industry and policy moves may prove important for other countries on a similar trajectory.

“We are selling between 50,000 and 60,000 policies a week. We have insured 9 million Mexicans since Seguros Azteca was born three years ago,” said Honsberg, who expects to underwrite over 1 billion pesos ($92 million) in premiums this year.

“To date we have found that credit is the most important vehicle (to sell microinsurance) because it is the principal need of the people in these segments,” Seguros Banamex Commercial Director Hugo Aguilera said in an interview last month.

Microinsurance & Microfinance

Offering microinsurance to the poor seems a no-brainer. However, I find an even more compelling case for putting microinsurance and microfinance together.

First, serving the poor is largely about cost. The costs of distributing and administering micro loans, with high volumes but low transaction values, is extremely high. This explains the high interest rates charged by MFIs (between 20-30%). Sharing the distribution network between multiple service providers, such as microfinance and insurance, reduces at least part of the cost.

Interestingly, I recently learned of an Indian startup - FINO - doing something similar. It is deploying smart card infrastructure for MFI clients. To make the system economical, cards support not just microfinance, but also microinsurance and other services.

Another challenge in selling to the poor is their extreme vulnerability to their environment. Farmers are always at risk of loosing their entire crop, from too much or too little rain. Similarly, medical services place too high a financial burden on families, which they must repay at high interest rates.

It is not certain that individuals borrow from MFIs to start potentially profitable enterprises. However, even where they do the chances of success must be miniscule, given the vagaries of the environment in which the poor operate.

Microfinance seems to be about smoothing consumption and expenditure patterns. By protecting the poor from catastrophic loss, however, microfinance by definition prevents customers from slipping into an abyss of poverty that they cannot hope to climb out of. At the very least, it maintains that consumption pattern. At best, it increases the chances of enterprises turning profitable.

Supporting Enterprise

Microfinance has not proven yet to be massively effective in eradicating poverty, as some proponents suggest. At best, it has established that the poor have the ability to pay small amounts over extended periods of time. In that sense, it is similar to Hindustan Lever selling shampoo in small packs. It is a highly profitable business, and should exist as such.

That is not to say that microfinance cannot have any poverty impact. One may argue that consumers are better off, as they now have an additional choice. However, if microfinance is to have a serious poverty impact, other things are needed, such as insuring loan investments. Even microinsurance can be strengthened by provision of weather and health services, as well as market information. It would reduce overall risk, while further helping the poor be more productive.

Could this be a classic case of symbiosis? The providers lower costs, and minimize their investments. The poor are better protected and in the best case, now have at least a fighting chance to look beyond the next monsoon cycle. Microfinance and microinsurance, together, can be important pieces of the ecosystem that benefit all players.

The True Scale and Efficacy of Microfinance

The first is a fact often overlooked in the hype over microfinance - that despite its immense growth, the actual scale at which MFIs operate is fairly small. The Grameen Bank, for instance, has 300,000 borrowers annually, in a nation of 150 million. Considering with the high interest rates charged by MFIs (anywhere between 20-35% annually), the target population that will approach MFIs is even more restricted:

The high interest rates that the microfinanciers charge induce self-selection by the borrowers: a borrower has to have confidence in the project for which he is seeking microcredit in order to be willing to assume the burden of servicing his debt. Of course such confidence is sometimes, and perhaps among the poor often, misplaced.

This point has been made before. The efficacy of borrowing as a way out of poverty, and the ability of microloans to generate profitable and sustainable enterprise is severely suspect. There is no reason to believe that the poor have the skills, knowledge, or opportunity to create such ventures with small loans, and several studies are proving as much.

Abraham George writes in an article at the Knowledge@Wharton website that only 5% of borrowers among 50 microcredit programs in India start their own ventures. A study by Basix, an Indian MFI, showed that only 52% of borrowers reported an increase in income. Most significantly, even for the 52% reporting increased income, only a correlation is established, not causation.

Microfinance vs. Trust-Based Financing

The most important new insight by Posner is to compare microfinance with trust-based financing often available to the poor through extended family channels. As Posner points out, however, microfinance has higher transaction costs and therefore higher interest rates. In this scenario:

As a substitute for trust, microfinance has obvious drawbacks. Extremely high interest rates, though justified not only by the risk of default (and the opportunity cost of money, that is, the riskless interest rate) but also by the very high transaction costs of a tiny loan (since those costs are largely fixed, rather than varying with the size of the loan), burdens the borrower with very heavy fixed costs, since he must repay the loan regardless of the success of his enterprise. The higher a producer’s fixed costs relative to his total costs, the riskier his enterprise, since if demand for his product falls or his marginal costs rise he will find it extremely difficult to adjust by cutting output; the cut will reduce the revenue out of which he has to pay principal and interest on the loan. Borrowing at astronomical interest rates seems an unlikely formula for commercial success–and the more unlikely the poorer the borrower.

Stated another way, microfinance as a source of seed capital is actually likely to reduce the chances of entrepreneurial success, rather than the other way round. This, by itself, is an important argument worth exploring futher.

In the family or clan alternative, trust may provide an extremely low-cost substitute for the transaction costs involved in microfinance. Perhaps then microfinance will occupy a narrow niche in capital markets between family and clan resource pooling at one end and commercial lending at the other. Indeed, the fact that the overwhelming majority of microfinance borrowers are women suggests that the particular market failure that microfinance corrects is discrimination against women in the family and clan capital markets.

When the Nobel Prize was announced, I had suggested that the true contribution of Yunus was to prove that social norms can replace commercial contracts, in order to reach the poor. This is still true, but that does not imply that microfinance is the only, or even the best way to organize social groups to address the lack of market rules.

Posner may overstate the availability of trust-based financing to the poor, as entire families may be too impoverished to make significant loans unavailable to individuals. However, he is correct in suggesting that microfinance, as a commercial alternative to social mechanisms, requires higher interest rates to substitute for trust and justify a market investment. By contrast, in any trust-based systems, a ‘commercial’ market rate of return may not be necessary. Therefore, other mechanisms such as rotating group pooling and lending can retain the low-cost benefits of trust financing.

Microfinance: A Subsidized Business

So if microfinance has so many problems as a development tool, why then has it been pushed, and pushed so well?

The answer may be, simply, that microfinance benefits not those that receive the loans, but those that give them. Abraham George makes a scathing criticism of these players:

Not surprisingly, it is the intermediaries — commercial banks and loan facilitators — that gain the most from the spread between the cost of funds for the intermediaries and the loan interest charged by them. Commercial banks in India, for example, receive funds for microcredit programs from the government-run NABARD bank at 5% to 6%. They then lend at 10% to12% to a microcredit intermediary which, in turn, lends at 24% to 36% to the final borrower.

Worse still, microfinance may simply be a way to give grants to the poor. In India, for instance:

If one borrows and repays twice (no need to start any business, but maintain good paperwork), then he/she becomes eligible for a grant for $100 or more from a separate government program (each state offers its own variation of this facility). The free money from the government can be used to repay the third micro-loan made to that beneficiary. The government is short the amount of the grant, but the borrower is debt free, and the microcredit middle man is assured of capital and high returns.

Conclusion: Microfinance’s Future Agenda

Even as experts have started to question the efficacy of microfinance, the mainstream has embraced it as a panacea. The result is an entirely new industry that hires and retains thousands of people to manage these funds, disburse and monitor loans. However, while microfinance as a business has been a resounding success, its benefits for development are anecdotal and largely overstated, thus far.

And therein lies the risk for microfinance and its recipients. As data starts to suggest that microfinance does not generate gains against poverty, funding for MFIs is likely to dry up given the short attention span of development funding. International aid agencies will direct funding elsewhere, rich social investors will find other ’social entrepreneurs’ to fund, and governments will create new, more ‘trendy’ initiatives.

None of this is to deny that microfinance is useful at least for some borrowers. And while micro-loans of amounts that are currently common may not help recipients develop sustainable enterprise, slightly larger loans that allow microentrepreneurs to grow may well be useful. As the industry grows, it is likely to experiment with such loans and develop credit rating and risk assessment mechanisms for microentrepreneurs.

That may well be the watershed for microfinance and should be its future agenda. Somewhere in selling microfinance to the people that fund it, the industry seems to have lost sight of what it was selling and needed to build. The industry should drop its sky high expectations, created by itself. It cannot help everyone, and as a business microfinance is not about ending poverty. The focus should not be on poverty, anyway, but on on the original idea of creating sustainable profitable enterprise. That is, indeed, the way out of poverty, if not for everyone then for some.

More Reading:

• Hype and Hope: The Worrisome State of the Microfinance Movement, by Thomas Dichter

Many studies show that the impact of microcredit is limited. Vijay Mahajan, founder of Basix, India’s best-known MFI, has the following to say:

“In an impact assessment study carried out at Basix six years after inception, we found that only 52% of our three-year plus microcredit customers reported an increase in income, 23% reported no change while another 25% actually reported a decline.

Hmm…So mainstream media seems to be getting the drift. Poverty, and solutions to it, aren’t as easy as some would have us believe. The article, particularly in its print version, is worth a read, with a nice summary of all the major theories for poverty alleviation out there. If nothing else, it is worthy for being a fresh perspective from a domestic media that seldom produces anything noteworthy.

It is not news that Microfinance doesn’t work the wonders we ascribed to it. But it is interesting to note that MFIs have, in the absence of objective studies, used their own internal data to conduct such assessments. Because this is tricky territory. After all, how many MFIs would want to conduct studies that undermine their biggest reason to exist - namely poverty alleviation?

The CGD points to coverage of the report in Salon. That piece and the author’s response (Rodham) are extremely insightful, and highly recommended (see also, Hype & Hope).

Conventional wisdom suggests that microfinance must help people because the creditors are successfully paying off their loans. Yet, that is a naive, if not dangerous assumption. Despite the haloed status of microfinance in development circles, no study has proven that it does in fact help socio-economic development.

The CGD report further undermines conventional wisdom, showing that the loan may create little of economic value, and its repayment may be completely unrelated to the loan itself. As Salon points out:

Roodman and Qureshi note that the recipients of most microfinance loans must begin repayment almost immediately. This raises a fundamental paradox about the provision of credit to the extremely poor. Where do they find the money to repay the loan if they use that loan to invest in some profit-making enterprise?

“Thus, microcredit restricts itself to those who already have enough income to repay the loan from other sources, regardless of the success of any new enterprise they pursue.”

Microfinance pundits presume, also, that lack of credit is the problem. Yet, the ones that most need credit are those already engaged in productive activities (micro and SMEs) - an audience MFIs typically ignore. The very poor, by contrast, may be using microcredit simply to ’smooth out consumption’.

The CGD report introduces a further, related problem. Credit can be good, but also bad. And business - which microfinance is - can exploit just as it can provide services:

What I worry about with microcredit is what I worry about with all credit when it is pushed hard by the supplier…For some, debt becomes a debt trap. That doesn’t mean we should ban credit cards or ARMs. Credit is extremely useful…But the dangers of credit should remind us of the need to deploy it with care when targeting poor people, with clear and watchful eyes. It is an empirical question whether, in any given place, it is helping people on average. The available evidence suggests that microfinance sometimes doesn’t help people and sometimes does. It does not appear, on average, to transform lives, to end poverty.

Yet, if the CGD report questions Microfinance’s efficacy as a development tool, Rodham himself provides a convincing argument to keeping it around, nonetheless. The report, tellingly, is titled “Microfinance as Business”.

The report is doubtful of microfinance’s success as a development tool. But it is not skeptical of its success as a business. Microfinance may have started as a development tool, but it now mainstream - it is a business. It is perhaps time to change our viewing lens accordingly. Viewed that way, and as a great believer in Friedman, maybe I’ve found a reason to support Microfinance. Perhaps the mere existence of a business that caters to the poor, even a potentially exploitative one, is better than no business at all?

ASIDE: See also a NYTimes article on remittances and how they could tie into microfinance and development.