Impact of Microfinance: A Critical Survey

Author(s): Niels Hermes and Robert Lensink

Source: Economic and Political Weekly, Vol. 42, No. 6 (Feb. 10-16, 2007), pp. 462-465
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 H T Pareh finance forum

microfinance can make in reducing

Impact of Microfinance: global poverty.

A Short Description
A Critical Survey Microfinanceinstitutionsaim to pro-
videcreditto thepoorwhohaveno access
It is unclear whethermicrofinancecontributesto a reductionin to commercialbanks. In general, these
institutionsreceivefinancialsupportfrom
poverty or is the most efficient methodto reducepoverty without western donors, NGOs or commercial
additionalmeasures in areas such as education,health and
banks,who lend to microfinanceinstitu-
infrastructure.The entry of commercialbanks into microfinance tions,oftenagainstbelow marketinterest
may increase the competitionfor traditionalmicrofinance rates.Themicrofinance inturn,
institutions
institutionsand reduce lending to the core poor, even if it improves lend this money to domesticsmall com-
financial sustainability. panies and poor agents. The size of the
loansvaries,butis oftensmall.According
to MixMarket (www.mixmarket.org),
NIELSHERMES,ROBERTLENSINK According to the Nobel Committee, the averageloan size in 2005 was only
microfinancecanhelppeopleto breakout about $ 470.
ccordingto the United Nations of poverty,which in turnis seen as an In additionto loans,microfinanceinsti-
(UN), in 2002 almostone-fifthof importantprerequisiteto establish long tutions also provide a wider range of
the worldpopulation(i e, 1.3 bil- lasting peace [Nobel Committee2006]. financialservices,such as savings funds
lion people) was living in extremepov- Thishasled to analmosteuphoricattitude and insuranceservices. Moreover,they
erty,earningless than one dollar a day. amongpolicy-makers andaidorganisations also play an importantrole in training
In recentpublicdebatesmicrofinancehas aboutpotentialpovertyreducingeffects potentialborrowershow to runa firm,and
been mentionedas an importantinstru- of microcredit. deal with health provision.These non-
ment to combat poverty. Therefore, The question, however, is whether creditserviceshavebecomemoreimpor-
microfinancehas receiveda lot of atten- microfinancereallywill be ableto signi- tant during recent years. This article,
tion, bothfrompolicy-makersas well as ficantly reduce worldwide poverty? In however,focusesprimarilyon the roleof
in academic circles. Especially during this article,we providea criticalevalu- microfinance institutions in providing
the past 10 years, microfinance pro- ation of the discussionon the potential credit to the poor.
grammeshave been introducedin many contributionof microfinancein reduc- A recentsurveyamong518microfinance
developingeconomies.Well known ex- ing poverty. We do not deny that institutions in Africa, Latin America,
amples are the Grameen Bank in microfinancemay potentially play an easternEuropeand Asia revealsthatthe
Bangladesh,Banco Sol in Bolivia and importantrole in improvingthe income majorityof the microfinanceborrowers
BankRakyatin Indonesia.The Grameen of the poor. At the same time, however, areservedby institutionsin southandeast
Banksystemof grouplending(established we feel that recent discussions on Asia. The largest microfinanceinstitu-
in 1976 by Muhammad Yunus, a microfinance have to be put into the tions are found in countries such as
Bangladeshbanker and economist), in right perspectivein order to preclude Bangladesh,India, Indonesiaand Thai-
particular,hasbeencopiedin otherdeve- overly optimistic expectations about land. Bank Rakyat in Indonesiaserves
lopingcountries.BetweenDecember1997 the impact microfinance may have on over 3.3 millionclients;GrameenBank,
andDecember2005 thenumberof micro- reducing poverty. ASAandBRAC,alllocatedinBangladesh,
finance institutionsincreasedfrom 618 Theremainder of thisarticleis organised have 4 to 5 million active borrowers.In
to 3,133. The number of people who as follows.In thenextsectionwe provide India, large microfinance institutions
receivedcreditfromtheseinstitutionsrose a short backgroundto the microfinance are SHARE(8,14,000 active borrowers)
from13.5millionto 113.3million(84 per concept. This is followed by a critical and Spandana (7,72,000 borrowers)
cent of them being women) during the reviewof the argumentsmadeby propo- (www.mixmarket.org). Surprisingly,the
same period [Daley-Harris2006]. nents of microfinanceas an important extension of services of microfinance
To supportthe view thatmicrofinance instrument to combat poverty. Next, institutionsto poor people (outreach)in
can be an importantinstrumentto fight we discuss measurement problems
poverty, the UN declared 2005 to be thatstudiesontheimpactof microfinance
the internationalYear of Microcredit. are confrontedwith, which is followed The H T Parekh Finance Forum
Recently,the attentionfor microfinance by a review of availableevidence from is coordinated by Errol D'Souza,
and its role in reducing.poverty was recent empirical impact studies. We ShubhashisGangopadhyay,Subir Gokarn,
further increased when Muhammad conclude this article by discussing our Ajay Shah and Praveen Mohanty.
Yunusreceived the Nobel Peace prize. view on the potential contribution

462 Economicand PoliticalWeekly February10, 2007

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the most populated countries in Asia, such
as IndiaandChina, is relatively low [Weiss
and Montgomery 2004].
Microfinance institutions use innova-
tive andunconventional methods to reduce
lending costs. The main problem with
lending to the poor is that information
costs are high as compared to the size of
the loan. It is generally known that infor-
mation costs of lending may be high since
lenders are not able to distinguish projects
with respect to their risk profiles when
allocating credit (adverse selection prob-
lem) and borrowers may be able to apply
the funds to different uses than those
agreed upon with the lender (moral hazard
problem). Commercial banks use several
methods to reduce these costs, such as
screening potential borrowers, and moni-
toring the progress of the project. These
methods, however, are too costly if a bank
would lend small amounts of money to
potential poor clients in remote areas.
Moreover, commercial banks often ask
borrowers to pledge collateral. However,
the latter solution assumes that collateral
is available, which is often not the case,
particularly not for the poor in many
developing countries.
Microfinance institutions also use
methods of screening and monitoring to
reduce the costs of lending. Yet, these
methods are adjusted to local circum-
stances, enabling them to offer small-sized
loans without incurringtoo high costs. The
most well known example is the use of
group lending with joint liability. With
joint liability lending, the group of bor-
rowers is made responsible for the repay-
ment of the loan of an individual group
member, i e, all group members arejointly
liable. The advocates of group lending
argue thatjoint liability lending provides
clear incentives to borrowers to monitor
and screen each other. Moreover, the
monitoring and screening of group mem-
bers is efficient and cheap, because mem-
bers usually live close to each other and/
or have social ties (also referredto as social
capital in the existing literature). When
social ties are present, group members are
supposed to be well-informed about each
others' projects and that this information
is almost freely available. Ideally, then,
the microfinance institution does not need
to take care of the monitoring and screen-
ing of group members.
Despite the focus on group lending in
the academic literature on microfinance,
microfinance institutions often provide
individual-based lending. In fact, at the
Economic and Political Weekly February 10, 2007
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momentthereis a strongmovementfrom investmentin the future.They will there-
group based lendingto individual-based fore benefitonly to a very limitedextent
lending systems. Even well known frommicrofinanceschemes.Second,the
microfinanceinstitutions,whichtradition- core poorareoften not acceptedin group
ally werefocusingon grouplending,such lending programmes by other group
as theGrameenBankof Bangladesh,have membersbecausethey are seen as a bad
startedto use individual-basedlending. credit risk [Hulme and Mosley 1996;
Withindividual-based lending,the infor-Marr 2004]. Third, staff members of
mation costs are reduced by means of microfinanceinstitutionsmay prefer to
regularcontactsbetweentheborrowerand exclude the core poor since lending to
the microfinanceinstitution(relationship them is seen as extremelyrisky [Hulme
lending), and by making future loans and Mosley 1996]. Finally, the way
dependent onregularrepayments microfinanceprogrammesare organised
(so-called
dynamic incentives). Nevertheless,group and set up may lead to the exclusion of
loansarestill the mostimportantin terms thecorepoor.Examplesfor thisexclusion
of the amountof borrowersthat receive are the requirementto save beforea loan
a loan. Accordingto a study by Lapenu can be granted,the minimumamountof
andZeller(2001),basedona surveyamong the loanthatneedsto be acceptedandthe
1,500institutionsaroundtheworldcarried requirement thata firmis registeredbefore
out in 1999, 68 per cent of borrowersof the loan can be granted[Kirkpatrick and
microfinanceinstitutionsreceive a loan Maimbo2002; Mosley 2001].
throughgrouplendingprogrammes. There- Severalcriticsalsoarguethatgrouploans
fore,theremainder lead to high transactioncosts. The main
of thisarticlewillmainly
focus on grouploans. advantageof group loans according to
the advocates of microfinance is that
Contribution and Critique grouploansdrasticallyreducemonitoring
costs, since group memberslive in the
The advocatesof microcreditarguethat same village and know each other well.
microcreditcan help to substantiallyre- Therefore,theyareableto assesstheriski-
duce poverty [Littlefield et al 2003; ness of a projectagainstlow costs (some
Dunford2006]. Access to creditcan con- even believe that in group lending
tributeto a long-lastingincreasein income programmes monitoring is almostcostless).
by meansof a risein investmentsinincome Additionally,groupmemberscanprevent
generating activities and to a possible any moralhazardbehaviourwithoutcosts
diversificationof sourcesof income;it can by using social sanctions.This, however,
contributeto an accumulationof assets;it ignores the fact that group members
canreducethevulnerabilitydueto illness, sometimeslive farawayfromeachother,
droughtandcropfailures,andit can con- and need to spend time and energy to
tributeto a bettereducation,health and assess each other'sprojects[Marr2004].
housing of the borrower.In addition, Moreover, most microfinanceschemes
microcreditcan contributeto an improve- haveregulargroupmeetings.Duringthese
mentof the social andeconomicsituation meetings,informationaboutthe projects
of women.Finally,microfinancemayhave is exchangedandrepaymentproblemsare
positivespillovereffectssuchthatitsimpact discussed. These group meetings often
surpassestheeconomicandsocialimprove- implyhigh transactioncosts [Armendariz
ment of the borrower. De Aghion and Morduch2000; Murray
Notwithstanding the predominantly and Lynch2003]. Obviously,then, these
positive view on microcredit, several costs may reduce the positive income
authorsdoubtthatmicrocreditcan contri- generatingeffects from access to credit.
buteto a substantialreductionin poverty. In addition, it has been argued that
Manycriticsshowthatmicrofinancedoes sometimes the size of the needed loan
not reachthe poorestof the poor [Scully exceeds the maximumamountthat can
2004], or thatthe poorestaredeliberately be borrowed in terms of a group loan.
excludedfrommicrofinanceprogrammes This especiallyhampersthefuturegrowth
[Simanowitz2002].First,theextremepoor of those agents who have invested in
often decide not to participatein micro- successfulandgrowingprojects[Khawari
finance programmes since they lack 2004; Madajewitcz2003]. Group loans
confidenceor they value the loans to be are rigid, and often it is very difficult
too risky [Ciravegna2005]. The poorest to adapt the loan to the desired credit
of the poor, the so-called core poor, are needs of individual borrowers within
generally too risk averse to borrowfor the group.
463
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 Finally,some authorscriticise the im- thisbiasesanycomparisonbetweenrecipi- must be that it is still unclear whether
pact of microcrediton women. Many ents of microcreditandthe controlgroup microfinancesubstantiallycontributesto
microfinanceschemeshave a clearfocus [Karlan2001;Armendariz De Aghionand a reductionof worldpoverty.Noris it clear
on women.Researchshows that women Morduch2005]. whethermicrofinanceis themostefficient
aremorereliableandhavehigherpayback method to reduce poverty. Much more
ratios.Moreover,womenuse a moresub- Results solid empiricalresearchis needed.
stantialpartof theirincomefor healthand In addition,it shouldbe notedthatthe
education of their children [Pitt and The empiricalliteratureon the outreach outreachof microcreditis still small.De-
Khadker1998].Thus,womenplay a very of microfinance,in termsof the number spitetheenormousincreasein microcredit
importantrole in reducingpovertywithin (breadth)andsocio-economiclevel(depth) to poorborrowers,in 2004 only 6 percent
households.However, the critics argue of clientswho areservedby microfinance of borrowerswithan incomebelow $ 365
thatoftenwomenareforcedto handover institutionsis vast.However,mostof these were able to borrowfrom microfinance
theloanto men,who subsequentlyuse the studiessufferfrombeinganecdotalandcase institutions[Daley-Harris2006]. It is not
loanfortheirownpurposes.Thismaylead studydriven.Moreover,only some of the to be expectedthatmicrofinance,without
to an additionalburdenfor womenif they outreachstudies are publishedin estab- additionalmeasuresin the areaof educa-
are held responsiblefor the repayment lished refereed internationalscientific tion, health,and infrastructure,is able to
[Goetz and Gupta 1996]. journals,so thatit is difficultto valuetheir substantiallyreducepoverty.
quality.Nevertheless, someconclusionscan Moreover,recentlywe observea trend
Microcredit and Poverty be drawnbasedon the existingliterature. towardsa furthercommercialisation of the
Most studiesconcludethatmicrocredit microfinancesector.Amongotherthings,
The theoreticaldiscussion about the positively contributesto poverty reduc- this has led microfinanceorganisations
impactof microfinanceon povertyreduc- tion. Microcredit,therefore,may help to to decide on providinga widerrangeof
tioncalls forthoroughempiricalresearch. solve the povertyproblem.This seems to financialservices.We alsosee a movefrom
Therefore,it is surprisingthat there are be good news. However,there is much traditionalgrouplendingtoindividual loans.
onlyafew solidempiricalstudiesavailable discussionaboutthequestionof theextent This move seems to be bad news for the
on the possible povertyreducingeffects to which microfinancereaches the core poor,since the fractionof poorborrowers
of microcredit.A majorproblemis how poor. Here,a new measurementproblem andfemaleborrowersin theloanportfolio
tomeasurethecontribution arises, i e, how to identifythe core poor
of microcredit. of individual-basedinstitutionsis lower
Threeissuesareof importance: first,which [Dunford2006]. Nevertheless,Khandker than for group-basedinstitutions.At the
contribution is seen as the mostimportant (2005) andEdaRuralSystems(2004)find sametime,individual-based microfinance
(improvement of income,accumulationof thattheextremelypoorbenefitmorefrom institutionsseemto performbetterin terms
assets, empowermentof women, etc); microfinancethan the moderatelypoor. of profitability,ashasrecentlybeenshown
second,does microcreditreachthecoreof On the otherhand, severalother studies in a studyby Cull et al (2007). Due to the
thepoorordoes it predominantly improve indicate that it is the "betteroff" poor trendof commercialisationof the sector,
incomeof the better-offpoor; and third, ratherthan the core poor who stand to financial sustainabilityof microfinance
do the benefits outweigh the costs of benefitmost.Evidenceforthisis givenin, institutionsis becoming more and more
microfinanceschemes [Dunford2006]? for e g, Hulme and Mosley (1996) and importantat the expense of using credit
Thelatterissue dealswith the questionof Copestakeet al (2005). to help overcomepoverty.
the extent to which subsidies to It is also importantto know whatcosts To someextent,thetrendtowardsfinan-
microfinanceorganisationsare justified. are involved in making microfinancea cial sustainability is counteracted by
Most studies measure the impact of successfulinstrumentto combatpoverty. establishingspecial programmesfor the
microcreditby comparingrecipients of Evenif microcreditpositivelycontributes core poor. Especially in Bangladesh,
microfinance witha controlgroupthathas to a reduction in poverty, it is unclear programmes have been initiatedto speci-
no access to microcredit.This approach to what extent these results cannot be fically supportthecorepoor,for instance,
may be problematic, however. First, reached by other more cost-efficient by the well knowninstitutionsof BRAC
changes of the social and/or economic instruments.Providingmicrofinanceis and ASA. These programmesnot only
situationof the recipientsof microcredit a costly businessdue to high transaction focus on credit,but also aim to providea
maynotbe theresultof microfinance.For and informationcosts. Recent research broadrangeof servicesfor the poor,such
instance,it is well known that relatively showsthatmostmicrofinance programmes as training,healthprovisionand more in
rich agentsareless risk aversethanrela- are still depending on donor subsidies termsof the generalsocialdevelopmentof
tively pooragents.This may inducerich to meet the high costs, i e, they are not this categoryof poor. Yet, the impactof
agents to applyfor microcreditwhereas financiallysustainable[Cull et al 2007]. theseprogrammesis still unclear,andthe
pooragentsdo notapply.In this situation, A controversial question is whether outreachis small,at leastfor the moment.
an ex post comparisonof income of the thesesubsidiesarejustified. Unfortunately, Fortunately,thereis another,potentially
two groupsmayleadto the incorrectcon- this questioncannotas yet be answered hopeful, development.The involvement
clusion that microfinancehas stimulated due to a lack of solid empiricalresearch. of traditional commercial banks in
income.Second,in orderto improvethe microfinanceis growing rapidlyaround
probabilityof microfinancebeing suc- A Panacea? theworld.In severaldevelopingcountries
cessful, microfinanceorganisationsmay large state banksand privatebankshave
decideto develop theiractivitiesin rela- After having reviewed the debate on startedto providemicrofinanceservices.
tively more wealthyregions. Obviously, microfinanceandpoverty,the conclusion In Pakistan,for instance, a numberof

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privatecommercialbankshavemovedinto
microfinance.In Malaysia, Nepal and
Thailandthereare programmesstimulat-
ing commercialbanksto becomeinvolved
inmicrofinance. InIndiatheNationalBank
for Agricultureand Rural Development
(NABARD)recentlyinitiatedaprogramme
to involveprivatebanksin microfinance.
Accordingto recentstudiesthe growthof
microfinancein Indiais led by a number
of commercialbankssuchas ICICI,HSBC
and ABN AMRO,togetherwith private
venturecapitalfunds and social venture
capitalists[Lakshman2006; Iyer 2006].
A possible advantageof the move of
commercialbanksintomicrofinancemay
be thatthese bankscan providecreditto
thepoor,withoutbeingdependentondonor
subsidies.Commercialbankshave diver-
sifiedportfolios,andareableto use profits
fromlendingto wealthyclientsto finance
(subsidised)loans to the poor, i e, cross-
subsidisation wouldtakeplace.Atthesame
time, however, one may question why
commercialbankswoulddo this.To some
extent,thistrendcanperhapsbe explained
by the increased attention to socially
responsible entrepreneurship,at least
amongthelargewesterncommercialbanks.
Probablymoreimportantly, however,will
be thefactthatthesecommercialbankswill
try to use subsidisedloans to the poor as
aninstrument to enlargetheirfutureprofit-
makingportfolio,basedon theassumption
thatlendingto themwill makethemmore
wealthyclientsinthefuture,whocanafford
to pay market-basedinterestrates.
A potentialdisadvantage of theincreased
involvementof commercialbanksis that
traditionalmicrofinanceinstitutionsare
confrontedwith increasedcompetitionin
themarketformicroloans.Whileincreased
competition mayleadtoincreased efficiency
and stimulatefinancial sustainability,it
may also reducethe scope for lendingto
the core poor, an argumentwe already
highlightedabove. Moreover,increased
competitionandincreasedsupplyof loans
mayresultinhigherlevels of indebtedness
of theclientsas theymaytakeup multiple
loans from differentsourcesat the same
time [Ciravegna2005]. This may lead to
lower repaymentrates, endangeringthe
long-termsustainability of theprogramme
[Vogelgesang2003]. Lower repayment
rates,in turn,may lead to less favourable
creditcontractsforthepoorestborrowers,
forinstancebecauseinterestratesareraised,
whichmayleadthemto dropoutfromthe
loanportfolioof microfinanceinstitutions.
Researchshows that whereas wealthier
Economicand PoliticalWeekly February10, 2007
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borrowersare likely to benefit from in-
creasingcompetitionamongmicrofinance
institutions,it also leads to lower levels
of welfare for the poorer borrowers
[McIntoshet al 2005].
Thetrendof commercialbanksentering
the marketfor microfinanceappearsto be
one of the most importantchallengesfor
themicrofinance businessinthenearfuture.
The potentialof this trend in terms of
reducingpovertyis stillunclear,however.
Furtherresearchinto this importantissue
is thereforehighly desirable.lli
Email:b.w.lensink@rug.nl
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