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Microcredit Deserves Support, Not Suppression

Published on March 21, 2011

Owing to its innovative program design and practices, microcredit reaches many poor people who lack access to formal finance. This is clearly a major gain that protects the poor and other disadvantaged groups from resorting to informal loans at extortionate rates.
Click here to read the CGAP Microfinance Blog article

Microcredit Deserves Support, Not Suppression
bangladeshSince 2006, when Muhammad Yunus, along with the Grameen Bank, was awarded the Nobel Peace Prize, worldwide support for expanding microcredit grew based on its potential to alleviate poverty and lead to economic justice. Over the past 30 years, this innovative banking program, pioneered in Bangladesh, has helped millions of poor people, especially women, to improve their lives with small loans used to start businesses. My colleague Hassan Zaman and I recently published an op-ed on the impact of microfinance in Bangladesh which can be found here.Owing to its innovative program design and practices, microcredit reaches many poor people who lack access to formal finance.  This is clearly a major gain that protects the poor and other disadvantaged groups from resorting to informal loans at extortionate rates.  Development literature abounds with examples of the many ways in which microcredit has benefited the poor. Microcredit’s empowerment of women in particular can play a pivotal role for poor families.Both flexible institutions and committed, socially-oriented leadership are required for microcredit to succeed.  For example, with government support, it has been possible to create the Grameen Bank in Bangladesh.  Under able leadership, Grameen has been transformed into a premier microcredit institution that now leads the world in understanding the concept and potential of microcredit.  The government of Bangladesh has also been instrumental in establishing PKSF, with World Bank support, in 1996.  By making on-lending funds available at concessionary rates, PKSF has ushered in the growth of nongovernmental microfinance organizations in Bangladesh.

These and many other examples worldwide have shown that it is possible to bank people who live in rural areas with high covariate risk, asymmetric information and who possess no physical collateral. Bangladesh has led the global microfinance revolution and the tireless efforts of microcredit leaders have shaped microcredit programs worldwide.  And yet today in Bangladesh, a standoff between the government and Yunus over the leadership of Grameen Bank has led borrowers to withdraw savings, causing alarm and uncertainty among MFIs in the country.

Microcredit in crisis
Besides reports of high interest rates, high indebtedness of borrowers, and coercive loan-collection tactics by microfinance institutions, microcredit has also been accused by the media of an apparent failure to significantly alleviate poverty.

The question of impact
Unfortunately, the rigorous research required to validate whether microcredit matters remains elusive.  One body of research asserts that microcredit offers no substantial benefits and thus is not the poverty-eradication miracle it is purported to be.  The other body argues that microcredit helps the poor by raising income and consumption, empowering women, improving reproductive outcomes, smoothing income and consumption, and managing shocks that otherwise would have imperiled livelihoods in a high-risk environment.

Irrespective of the methods used to assess microcredit’s benefits, the findings of impact evaluation studies may not reflect the relevance of microcredit services.  Even using an evaluation method with randomized trials, a researcher may not fully appreciate the benefits a borrower draws from an innovative credit system over time that supports his or her innate entrepreneurial ability, which a formal system would neglect.  Similarly, an evaluator may not fully comprehend the benefits that the poor draw from microcredit when they cannot cope with income shortfalls due to economic and environmental risks, much less situations in which individuals are willing to bid every possession just to safeguard their economic security, which the existing system overlooks entirely.  In short, microcredit creates the conditions for empowering the poor.

Evidence indeed confirms that microcredit can protect households from shocks, contribute to changing societal norms about the role of women in society and lead to some households moving out of poverty. For sure, not everyone uses loans productively and there is a risk of falling into over-indebtedness. The role of microcredit should be strengthened through innovations which take into account its pitfalls observed through careful research and development. Microcredit is not a panacea and will clearly not eliminate all poverty in any country. Providing microcredit to the poor is a means to an end and (if no such services are provided via other means) must be implemented as part of an overall poverty-reduction strategy.

Avoiding over-indebtedness
Does indebtedness imply microcredit’s failure to substantially impact welfare in a positive way?  Or is indebtedness due to economic, political, or environmental factors producing low returns to micro-investment?  Are the terms and conditions of microloans stringent enough?  Even if microfinance generates benefits over a short period of time, are the accrued benefits unsustainable in the long run for other reasons?  For example, a lack of entrepreneurial skill, combined with insufficient product demand, may lead to diminishing returns on micro-investment creating a potentially vicious cycle of micro-debt dependency.

Ensuring higher returns to micro-investment requires favorable conditions of economic growth and public infrastructure investment, including marketing facilities.  Without such enabling conditions, microcredit may create the conditions for market saturation, and thus negative or zero returns with a high incidence of indebtedness.

Growing indebtedness may not be alarming if a household’s net worth (the value of assets net of liability from all sources including microfinance) is growing along with rising loan portfolios, even with membership from multiple programs.  The research suggests that households who accumulate borrowing either from a single source or multiple sources are not necessarily over-indebted because the rising net worth of their portfolio is keeping pace with rising indebtedness; however, this is not the case for all borrowers.  Widespread indebtedness should be a major concern for microcredit borrowers and their lenders.  A prudent approach is to identify borrowers who are over-indebted, understand the reasons why, and then determine corrective measures to safeguard them from future over-indebtedness.

Lack of adequate insurance to protect the poor against natural calamities and other misfortunes is a major source of growing indebtedness.  For example, if a borrower loses a cow purchased using a microcredit loan, the program would rescue him or her by providing a fresh loan with which to help purchase another cow, possibly doubling the loan unless the first one can be repaid.  Under the current system, lenders are protected via fees charged against such losses, while borrowers lack any protection.  A full protection policy should be in force to protect both borrowers and lenders.  But this means innovation, experimentation, and appropriate product development.  Once in place, such a system may help to check over-indebtedness and thus ensure the sustainability of microcredit’s benefits.

High interest rates
The high interest rates reported by microfinance institutions, for example, up to 40% in Bangladesh, are a major concern for borrowers and policymakers alike; yet interest rates reflect various factors that cannot be arbitrarily fixed.  A borrower’s willingness to accept an interest rate depends on the purpose of the loan.  If the goal is to smooth consumption or absorb certain types of shocks, the borrower might be willing to take on a higher interest rate in order to survive.  But if the purpose is to support an income-earning activity, the rate of return would determine how much he or she is willing to pay.  Unfortunately, interest rates are set without distinguishing the loan purpose.  Lenders view interest rates as returns to capital and a screening device for identifying creditable borrowers who will not default.  The cost of an on-lending fund and administering small loans also matters.  The transaction costs for microloans (about 70% of the cost) are much higher than for those administered by formal institutions.

Capping lending rates is one way that some governments have chosen to regulate exorbitant interest rates, but it should not stifle incentives to lend. Capping must reflect product variety and the reasons for varying prices of credit; that is, no single rate can fit all purposes of borrowing.

The need for soft funds and institutional flexibility for ongoing product innovation and development must also be factored into setting interest rates.  When public institutions have hindered innovation, some leading quasi-formal institutions around the world have offered a flexible environment in which microcredit innovation and experimentation have occurred.

The way forward
Microcredit is at a crossroads.  What is practiced today was innovated yesterday, and some earlier practices may no longer be relevant. Committed and dynamic leadership is vital to ushering in the future of microcredit worldwide. Governments have a key role to play in supporting microcredit transition and transformation.  Public concerns about low impact on poverty, high interest rates and over-indebtedness must be carefully examined and open to scrutiny.  Similarly, public concerns over funds transferred to the MFIs to support the poor must also be examined.  If funds are diverted to diversify portfolios, the poor must be owners of the ventures or at least accrue their shares of dividends.

Evidence suggests that this is doable with partnership of government and NGOs.  Governments can help facilitate MFI growth, ensuring improved access to funds to support microcredit growth and innovation.  Government can help to protect the savings of the poor with microcredit institutions.  It can also protect the poor from the alleged coercive actions of debt-collection policies.  Indeed, government supervision and regulation through a regulatory body could provide long-term safety and sustainability for both microcredit borrowers and lenders.  The regulator’s role is to provide an environment that helps develop an institution that can deliver credit and other financial services to the poor in general and to a certain group of potential entrepreneurs in particular.  This would facilitate in turn the social transformation needed to lift people out of poverty and further social and economic prosperity.

But institutional trust and sustainability cannot be guarded by a forceful takeover or banning, which would lead away from the goal of poverty alleviation.  The microcredit movement, which took several decades to build, deserves support and better regulation, not suppression.

— Shahid Khandker is a lead economist in the World Bank’s Development Research Group.  The views expressed herein are those of the author and do not necessarily reflect those of the World Bank.

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