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A Crossroads for Microfinance

Author: Lee Hudson Teslik
June 10, 2008

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The practice of tailoring financial services to the world's poor isn't new, but technological advances and media attention have brought a microfinance vogue that is hard to ignore. On an individual level, microloans have enabled countless success stories, helping entrepreneurs invest in their own communities. Experts estimate that over 60 million individuals have received small-scale loans, generally less than $100 each and targeting specific projects—anything from opening a shop to buying fertilizer for a farm. Yet microfinance has had its "growing pains," says Matt Flannery, the cofounder of a popular website that connects donors with local lending institutions worldwide. Some local institutions find themselves flooded with more cash than they can responsibly disperse. Others draw flack for making profits off loans to the poor—one Mexican firm, Compartamos, drew criticism when its initial stock offering netted a windfall (NYT). At the heart of the debate over microfinance is the question of whether it should be considered a business or a charity.

While the goal of many of the sector's practitioners is financial sustainability, CFR Senior Fellow Isobel Coleman noted at a recent meeting that the overwhelming majority of microfinance institutions, or MFIs, don't make money. Even those that do gain financial traction often require support (NuWire Investor) from nonprofits to get off the ground. Still, the sector has expanded well beyond lending to include insurance, savings, and other financial products, and its business success stories have inspired interest from major global financial players. The investment bank JPMorgan recently opened a unit seeking the "double bottom line of social benefit and financial returns." A handful of other banks have made similar investments, though, like JPMorgan's, they often come couched as part of quasi-charitable "social responsibility" programs.

The business-charity distinction isn't wholly semantic. If a microlending outfit is run purely as a business, lenders ought to charge very high interest rates, given the high amount of risk they assume to give small loans to people with no credit history. (The recent subprime lending fiasco in the United States puts these risks in stark relief.) Some analysts decry such practices, saying it is downright usurious (BusinessWeek) to charge poor people annual interest rates that typically range between 50 percent and 120 percent, and sometimes much higher.

Others respond that this criticism flies in the face of economic theory. The Economist notes that microloan repayment rates are in fact very high, partly because recipients are much more carefully vetted than loan recipients in the developed world. It notes a recent case study (PDF) from South Africa. A lending institution charged 200 percent interest annually and made a profit, overall, even accounting for defaults. The borrowers also seemed to come out favorably. Their poverty rates dropped, and while they displayed somewhat increased stress levels, they also reported a more optimistic outlook and greater control of their lives.

Regardless of whether one treats microfinance as a business or charity, the model has its complications. For instance, experts say a fully saturated market would be roughly eight times the size of the current one, but the careful vetting that has traditionally led to high repayment rates won't be easy—or cheap—on a broader level. Similarly, as for-profit ventures move into microfinance, it raises new risks. Flannery notes that somebody making a $25 loan assumes a different set of risks from somebody "putting their retirement account into microfinance" through a hedge fund or other institutional investor. Cross-border factors like currency risk also increase as the sector grows, notes a recent paper (PDF) by MicroCapital, a research group focused on microfinance. In some respects, however, the sector's new visibility has played a positive role. A 2006 World Bank paper notes recent gains in the transparency of MFIs, particularly as competition drives these institutions toward a higher standard of accounting rigor.

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