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Making Microfinance Work

Tuesday, September 16, 2008

Microfinance institutions do not offer a panacea for poverty, but they can play a significant role in development.

Over the past two decades, “microfinance”—the extension of small loans and other financial services to individuals in poor countries—has become a darling of the international development community. The movement’s founding father, Muhammad Yunus, was awarded the Nobel Peace Prize in 2006; the United Nations says that microfinance can help countries achieve the Millennium Development Goals.

Given the newness of the industry and the informal nature of many microfinance institutions (MFIs), relatively little is known about the size and quantity of the lenders, the kinds of loans that are disbursed, or the conditions under which clients are served—but the available data tell an impressive story. According to the most recent figures from the nonprofit Microfinance Information Exchange, more than 2,200 MFIs are currently lending to around 77 million borrowers worldwide. The Microcredit Summit Campaign reckons that the numbers are even higher: it counts more than 3,300 MFIs serving 133 million clients, including 92.9 million of the world’s poorest people (representing an increase of over 700 percent from 1992). In 2006, capital investment in MFIs eclipsed $4 billion, more than triple the level in 2004. The global MFI industry has also attracted hefty amounts of U.S. aid, including $245 million in 2008.

In 2006, capital investment in MFIs eclipsed $4 billion, more than triple the level in 2004.

Still, the rapid proliferation of MFIs has drawn criticism. Some observers fear that it has outpaced the capacity of developing-world governments to implement sensible regulatory measures. Because they are not considered “banks,” many MFIs fall outside the regulatory purview of government agencies. While this has contributed to the industry’s flexibility and dynamism (and propelled its fast growth), it has also created a “Wild West” environment in which borrowers with limited financial experience may be exploited by incompetent or unscrupulous lenders. In 2005, for example, government regulators in Kenya closed Akiba Micro Finance on the grounds that it had unlawfully taken customers’ deposits and reneged on the repayments. In 2006, the Indian government cracked down on two large MFIs following the suicides of at least 60 of their customers (who were under pressure to repay loans at prohibitively high interest rates).

Lenders often screen borrowers without the benefit of a credit bureau or another convenient credit-scoring system. Inexperienced borrowers can take out several loans from multiple sources and thereby undermine the entire system, which normally makes the extension of a second loan contingent on repayment of the first.

The microfinance movement’s trend toward greater commercialization has also raised some concerns. Supporters of the for-profit model insist that it promotes greater accountability and efficiency, and that it is likely to be more sustainable than the donor-driven model. But skeptics fear that increased sensitivity to a bottom line may lead MFIs to ignore the poorest (and most unprofitable) regions of the world. The CEO of Mongolia’s XacBank, a self-described “community development bank,” has said that competitive pressures are “pushing MFIs out of their traditional market [with] abandonment of the poor as a result.” The least developed parts of Africa and India have very little microfinance capital primarily because for-profit lending in those regions is not yet considered viable.

But others believe that commercialization, and the stiffer competition that comes with it, may actually improve loan access for the poorest people. Elisabeth Rhyne and Maria Otero of ACCION International argue that MFIs will “turn to the lowest income borrowers as one way of capturing and retaining clients,” even if this initially means lending at a loss. But this has yet to happen, at least on a large scale.

Perhaps the most pressing question is whether MFIs can drive long-term development. The evidence suggests that MFIs may disproportionately benefit those countries that have already reached what Columbia University economist Jeffrey Sachs calls a “tipping point” of development. As longtime global development consultant Thomas Dichter explains, “In the history of today’s rich countries…economic growth occurred first, then came credit for the masses.” Citing the example of Bangladesh, American Enterprise Institute scholar Jon Entine makes a similar point, showing that economic growth is driven by job creation and a country’s integration into global markets, not merely by the presence of self-contained, limited-scale enterprises like MFIs.

The evidence suggests that MFIs may disproportionately benefit those countries that have already reached what Columbia University economist Jeffrey Sachs calls a ‘tipping point’ of development.

On the other hand, MFIs can generate significant opportunities for countries that make them part of a broader development portfolio. Take Rwanda. By 2006, there were hundreds of MFIs operating in the central African country. But with poor capitalization and a record of bad lending policies, many were jeopardizing the savings of poor borrowers and undermining confidence in reputable lending institutions. To reassure local investors, the National Bank of Rwanda (BNR) shuttered eight MFIs and introduced a tiered regulatory scheme in which the largest, most “systemically important” MFIs were subject to the most stringent requirements, while the smallest ones only had to register with local authorities. “In order to give credibility to the sector we needed to weed out non-performing [MFIs],” says Consolate Rusagara, the former BNR vice governor. The BNR also launched an education campaign to increase the financial literacy of both lenders and borrowers.

Kenya, too, has taken steps to encourage greater transparency in its MFI industry. In 2007, Kenyan legislators passed a bill subjecting all MFIs to mandatory government audits. At a stakeholders forum in early 2008, Jacinta Mwatela, deputy governor of the Central Bank of Kenya, urged MFIs to “develop a self-regulatory mechanism” that would include a “code of conduct” as well as “minimum reporting and performance standards.”

The Ugandan government, meanwhile, is currently experimentingwith a “Credit Reference Bureau,” which issues financial identification cards to borrowers and then creates debt profiles and tracks loan repayment rates. According to Agnes Kamya Kijjambu, Uganda’s acting director for non-bank financial institutions, the bureau is expected to accelerate approval times for loans and also ensure lower interest rates for borrowers with strong credit records.

Striking the right regulatory balance will be tricky. In South Africa, critics of a 2005 consumer credit bill charged that its onerous disclosure requirements might “overburden established microfinance institutions, pushing their operating expenses to unsustainable levels,” as a report by the Consultative Group to Assist the Poor noted. “You don’t want to start setting the cost structure [and] capping the interest rate,” says Rusagara, now director of the World Bank’s Financial Systems Department. “It’s more about teaching [borrowers and lenders]…rather than deciding what they should do.”

In a world where more than one billion people live on less than $1 per day, MFIs are hardly a panacea for poverty: poor countries also need better infrastructure, more secure property rights, and freer trade. But when borrowers and lenders are properly informed, microfinance can play a significant role in boosting access to capital and spurring economic development.

Karen Porter is a research assistant at the American Enterprise Institute and an editorial assistant at THE AMERICAN. Fauzia Jamal, a senior at the University of Pennsylvania and a former intern at the American Enterprise Institute, contributed to this article.

Image by The Bergman Group/Darren Wamboldt.

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