Foundations of Microfinance and the Economic Development of the Poor

Nandan Raghavan

In recent years, access to efficient financial services has been shown to have an

impact on the long-term economic growth of a nation, due to a variety of reasons. Financial

systems allow for funds to flow freely within the economy. This is particularly helpful for

individuals with a shortage of funds, as they can receive them directly or indirectly from

those with a surplus. Reliable and efficient finance increases the individual incentive to place

funds in a bank. These funds are in turn lent by the bank and used to jumpstart

entrepreneurial activity. This also generates opportunities for investment by the bank and

allows for funds to be reallocated to those who can extract the most productivity from it. The

level of development in Britain’s financial systems played a central role in identifying

profitable investment avenues and allowing funds and capital to flow “like water” from areas

of high concentration to areas of low concentration during the Industrial Revolution. The

development of these financial systems is often unheralded as a factor for the Industrial

Revolution’s success.

Reallocation of funds and capital is just one example of how financial systems are beneficial

to economic growth. Efficient financial systems allow cash to be deposited into a bank and

saved for a later date, smoothing out the rate of consumption. Smoothed consumption ensures

that individuals can optimize their standard of living over the course of their life. Financial

systems also make credit available at a reasonable rate, which negates the need for usurious

moneylenders, and allows borrowers to invest. They also provide a form of insurance, which

can be especially important to those in agriculture. When external shocks settle in, those with

crop insurance are not as impacted by the financial impacts of these external shocks. The

ability of efficient financial systems to extend credit, reallocate funds, and generate

investment funds are all examples of how financial systems contribute to economic growth.

While financial systems exist in almost every country, the quality of these systems greatly

varies. In countries with subpar financial systems (generally low income countries), many

individuals and firms do not have access to these services. Even in low income where

individuals may have access to financial systems, usage of these systems comes with high

transaction and opportunity costs. These high transaction and opportunity costs may be due to

factors such as corruption or poor infrastructure.

A common usage of financial systems is to obtain credit, something that is often very difficult

for those in poverty. When a bank extends credit, they conduct a series of checks on the

individual or group whom they will be lending to. These checks are used to determine how

risky the borrower is, and what likelihood the bank will have of repayment. The bank also

requires that the borrowing party places collateral against their loan, to be taken in the event

of default. For many poor people, their collateral is not deemed as acceptable by the bank.

Many banks believe that poor individuals lack the knowledge of how to best put borrowed

funds into use. These two factors combined with low repayment rates among the poor has

caused a major disconnect between financial institutions and the poor. Other factors such as

corruption and poor infrastructure generate high opportunity and transaction costs, causing

those in poverty to be excluded from using financial services. Financial inclusion provides

services to these individuals that allows them to compete with other individuals and firms in

the market. Financial innovations in the past 35 years have allowed groups of people in

developing countries to receive the benefits of efficient financial services.

Microfinance is an encompassing term that provides financial services to those without

access to traditional banking avenues. While initially only focused on credit, in recent years,

microfinance has coupled savings and insurance policies with traditional lending, known as

microcredit. Microcredit typically refers to the lending of relatively small volumes of funds to

those who would otherwise be financially excluded. This has allowed individuals around the

world to escape extreme poverty, as microfinance endeavors have enabled several of them to

engage in entrepreneurial activities. While successful microfinance institutions have sprung

up in countries such as Bolivia and Indonesia, the most touted microfinance institution has to

be Muhammad Yunus’ Grameen Bank in Bangladesh.

In 1974, Muhammad Yunus was a professor of economics at Chittagong University in

southeast Bangladesh. After becoming disillusioned, he decided to go into nearby villages,

and find out from the poor what was causing their poverty. Yunus eventually concluded that

it was a lack of access to credit, not work ethic or skills, that entrenched these people in

poverty. In the specific case of women who sold woven bamboo baskets, since the women

had no access to credit, they had to take out loans from the same middleman who sold their

baskets. With high transaction costs in place, these women only realized a profit of two cents

per day. Yunus lent $27 of his own money to these women, and began working on a model to

extend credit services to the poor. By 1983, in collaboration with the Bangladeshi

government, he had developed an independent financial institution with the aim of lending to

the poor, called Grameen Bank.

As a predominantly Muslim nation, there are several channels of the economy from which

women have not received the same level of inclusion as men. Equal levels of financial

inclusion between men and women was a goal of the Grameen Bank, and as a result, 95% of

the Grameen Bank’s clients are women. In 25 years, the Grameen Bank has grown to offer

financial services to over five million people in poverty. The success that the Grameen Bank

has enjoyed over the years has shown that traditional perceptions on lending may be

somewhat outdated.

While the story of the Grameen Bank is one of success, there have been a number of

microfinance ventures that have failed. Why is it that the Grameen Bank has succeeded while

these other ventures fail? To properly understand this, it is important to look at the details of

the Grameen Bank, and the way in which they operate. One of the most innovative changes

that the Grameen Bank made to their lending model, was that of joint lending. Instead of a

loan being disbursed exclusively to one person, the Grameen Bank lends only to borrowers

who have organized themselves into groups of five. While individual lending efforts have

shown better returns, this is largely due to the more involved screening processes, which

eliminate large numbers of potential borrowers. Microfinance institutions, or MFIs, that offer

individual lending tend to be closer to regular banks, and treat poverty alleviation as a

secondary goal.

Joint lending initiatives have become popular with other microfinance institutions, but the

way that the Grameen Bank implements joint lending is particularly interesting. Out of a

group of five, only two members will initially receive funds. The availability of funds to the

remaining three members hinges on the repayment by the first two people. If any member

defaults, then all remaining people within the group are denied future credit. After the first

two people make repayment, then the second two receive funds. After another set of

repayment, finally the last person receives their funds. While members receive funds at

different times, they all must agree to the conditions at the same time.

As loans for others in the group are dependent on group repayment efforts, an incentive is

created for the group to ensure that repayment efforts are made, and it significantly reduces

screening and enforcement costs for the lender. Since borrowers choose their own groups and

have more information about the others in the group as compared to the bank, they are

unlikely to choose other individuals who are potentially high risks for repayment. Screening

and monitoring processes that would normally be undertaken by a bank, are passed onto the

borrowers. The Grameen Bank mandates that repayment is made on a weekly basis, which

essentially requires borrowers to have an existing source of income as well as f highly risky

investment with the funds.

Since the inception and success of the Grame en Bank, microfinance has spread to the rest of

the world, although not all ventures have been as successful. Lending to the poor remains

even to this day, a complicated matter. For this reason, many financial institutions simply

avoid the subject altogether. Existing literature has shown that the poor tend to borrow for

consumption purposes. Even if there was some way to enforce proper investment of funds,

lending to the poor still poses an immense risk. With nothing or little to show for on their

credit history, the bank has a considerable lack of information on the borrower. There is little

evidence to show that microfinance does anything to reduce the amount of information

available to the bank on their borrowers. Some argue that due to their location, local

moneylenders are more informed than banks on their borrowers. However, it is far too easy

for moneylenders to take advantage of the fact that they are the only source of credit for

several people. Many of them sadly do, resulting in high borrowing rates.

The purpose of a bank is to remain financially viable and sustainable. In the event of credit

default, banks are able to seize the collateral posted by the borrowing party. For most of these

cases, the value of the collateral is sufficiently high. Most individuals in higher income

countries will pledge an asset such as a house, or another asset of high value. In low income

countries, the value of assets that are pledged typically tends to be lower. This is especially

highlighted for those living in poverty, as many of these individuals are unable to even pledge

collateral.

How is a financial institution supposed to sustain itself when: there is a severe lack of

information on the borrowers, many borrowers are unable to pledge collateral of reasonable

value, and there is no way to enforce proper use of funds? While MFIs are sustainable to

some degree, most of the funds used in microfinance come from charitable donations. Even

the Grameen Bank, whose extensive rules allow it to be one of the most successful MFIs in

history, derives the majority of its funding from a steady stream of donations. The continued

success of the bank only generates more publicity for itself, which in turn increases the

volume of donations. This has allowed the Grameen Bank to implement changes to their

program over the years, without fear of going bankrupt. Key changes include: acceptance of

non-traditional collateral, delayed repayment programs, as well as dynamic and progressive

loans. Dynamic and progressive loans essentially refer to the concept that timely repayment

of current loans qualifies borrowers for future loans, as well as loans of greater size. This idea

in particular is replicated by other MFIs, while acceptance of non-traditional collateral and

delayed repayment programs often are not. Acceptance of non-traditional collateral and

delayed repayment programs carry greater risk, and therefore cannot be employed by MFIs

that do not have as steady a source of financing. Steady financing is also one of the reasons

why the Grameen Bank has been unwavering in their prioritization of poverty alleviation

over financial sustainability.

In addition to steady financing, Grameen Bank’s continual success is due to a combination of

the contractual obligations of borrowers and luck. The Good Faith Fund is an example of a

MFI that aimed to replicate the success of the Grameen Bank, but was unable to do so. In

1986, governor Bill Clinton invited Muhammad Yusuf to the state of Arkansas in order to

discuss how microfinance could be implemented in one of the poorest states in the United

States. One major difference was that unlike the Grameen Bank, which requires some form of

collateral, loans from the Good Faith Fund didn’t require any form of pledged collateral. The

average loan value in this case was around $100,000, orders of magnitude higher than the

Grameen Bank. While the Good Faith Fund was subsidized by the state government, the

number of subsidies required to maintain sustainability was simply too high. Additionally,

while Bangladesh and rural Arkansas both contain groups of people in poverty, these groups

are very different. As expected, rural Arkansas is very different from Bangladesh.

Bangladesh is a country with a very high population density, and an even higher density of

individuals in poverty. While there are several problems that arise from this concentration of

poverty, it does allow borrowers in Bangladesh to match themselves to entrepreneurs with

significantly greater ease. This population density allows networking to occur at a much

higher rate in Bangladesh as opposed to rural Arkansas. Eventually, the Good Faith Fund

gave up on trying to implement a microfinance model and shifted their focus to job training.

Other MFIs such as Bolivia’s Banco Solidario and Mexico’s Compartamos are examples

where microfinance ventures have worked. In both of these countries, financial inclusion of

women is lacking compared to men, and the poor do tend to live in areas of relatively high

concentration. However, there are some key distinctions between the Grameen Bank model,

and the ways in which these other MFIs are modeled. Under Bolivian law, there are certain

restrictions placed on non-governmental organizations, which is what many MFIs would be

classified as. To circumvent this, Banco Solidario has transitioned to a full-fledged

commercial banking institution. As of 2008, their total loan portfolio was in excess of $172

million, with only 1.78% of these loans being reported past-due. However, much of this is

due to the fact that Banco Solidario made the transition away from an NGO whose goal was

poverty alleviation, and to a commercial bank. Despite their status as a commercial bank,

Banco Solidario still does receive government subsidies to ensure their continued existence.

Compartamos on the other hand has retained a mission that stays closer to the idea of poverty

alleviation. Since their inception in 1990, Compartamos has offered loans to women through

joint lending. Only in the past five years has Compartamos made their services available to

men. While the Grameen Bank has relied heavily on donor funding, Compartamos has been

able to raise the majority of their funds on their own through debt financing. In 2002,

Compartamos listed themselves on the Mexican stock exchange and began to finance

themselves through the sale of bonds. The successful sale of these bonds has transformed

Compartamos into a highly sustainable MFI that has been able to operate for over a decade

without any subsidies.

In late 2004, the United Nations named 2005 as the “International Year of Microcredit”, and

highlighted the role of microfinance as a tool for economic development. In 2006, the Nobel

Committee awarded Muhammad Yunus and the Grameen Bank the Nobel Peace Prize, for

their efforts in alleviating poverty, and spurring economic development among those in

poverty. In recent years, there have been a number of technological innovations that have

allowed individuals to reduce transaction costs, and do things such as make payments on

time. The proliferation of mobile phones has greatly aided in this, with services such as

Safaricom’s M-Pesa allowing for monetary transfers to take place through mobile phone

networks. Online technologies have also begun to allow borrowers and lenders to manage

their finances from remote destinations, eliminating the need to physically travel to a

destination. This has proven to be especially helpful for the borrowers, as reduced

opportunity costs means that they can spend more time with their businesses.

While the stories of the Grameen Bank, Banco Solidario, Compartamos, and all other MFIs

are all heartwarming, the truth of the matter is that many of these institutions are simply

unsustainable. High operation costs combined with relatively low returns has generated a

number of criticisms for this model. While economic development and poverty alleviation is

universally agreed to be beneficial, critics argue that there are other, less costly ways to

encourage economic development from the bottom. Many of these critics maintain that a lack

of access to finance is not the only thing that keeps people in poverty, and points to the lack

of evidence of major economic growth stemming from increasing financial inclusion among

the poor. They also cite the fact that economic development and financial sustainability are

unable to coexist under the current model.

Despite these claims, microfinance should be welcomed as an effective and adaptable method

by which poverty can be alleviated. While there are a number of flaws in the system that can

be exploited, no system capable of tackling this problem will be free of flaws. With careful

oversight and dedicated experts, existing microfinance systems can be successfully utilized

and retooled to alleviate poverty throughout the world.