How to Boost Microfinance in the United States
Since it first emerged in its modern form in Bangladesh in the 1970s, microfinance—the practice of providing financial services like loans, insurance, and savings accounts to low-income individuals or groups who are traditionally excluded from the banking system—has become a multibillion-dollar global industry. In 2018, there were around 140 million microfinance borrowers worldwide (80 percent of whom were women) accounting for a total of $124 billion in loans. In many ways, this is unsurprising. After all, even today, there are over 1.7 billion adults worldwide who are financially excluded. These people have credit needs just like everyone else and often end up depending on their family and friends (whom they can only turn to a limited number of times) or moneylenders (who charge exorbitant interest rates). Microfinance allows people to take on reasonable small loans consistent with ethical business practices. The goal is to give the individuals an opportunity to become self-sufficient. In accordance with the “Grameen model” that originated in Bangladesh, many Microfinance Institutions (MFIs) do group lending. Research on microfinance has found that uptake of microfinance is linked to not just increased access to credit but also increased investment and profit in small businesses, increased household expenditure, and even enrollment of children in schools. Microfinance has not been the panacea to global poverty its most optimistic proponents had once hoped, and it has risks like increasing indebtedness in already vulnerable communities, but it has materially improved the lives of many low-income people around the world.
Is there a market for it in the United States?
Even as microfinance has grown from its humble beginnings to over 140 million borrowers worldwide, it has not seen the same explosive growth in the United States. Is this because there is not much of a market for microcredit in the country? The proportion of financially excluded individuals in the United States is certainly much lower than in developing countries like Bangladesh or Peru, where microfinance has thrived. But there still is a sizeable population of financially excluded Americans. According to a Federal Reserve survey in 2020, 5.4 percent of U.S. households (7.1 million people) were “unbanked,” meaning no one in the household had a checking or savings account with a bank or a credit union. Another 13 percent were “underbanked,” meaning they had bank accounts but insufficient access to banking services, requiring them to make use of alternative sources like payday loans to meet their financial needs. Taken together, nearly a fifth of U.S. households are either unbanked or underbanked. Unsurprisingly, these rates are even higher among communities of color and immigrant groups. Over 40 percent of African-American and 30 percent of Latino households were either unbanked or underbanked. These groups form the bulk of the customer base of microfinance in the country. In addition, 92 percent of U.S. businesses are microenterprises employing fewer than five workers. These companies are responsible for more than 41 million U.S. jobs, and millions of them report insufficient access to credit.
Is it suited to the U.S. market?
Even when there is a potential market for microfinance, the question is whether it is suited to developed countries like the United States. Many argue that practices like group lending require a level of social solidarity that is a better fit for developing countries. To study this, the MDRC, a social policy research organization, conducted an in-depth study of those who borrowed from the pioneering microfinance institution Grameen Bank in Union City, New Jersey—primarily low-income Latina women immigrants. The study found that recipients were more likely to operate their own business, see a modest increase in income, experience fewer material hardships such as running out of money in the preceding three months, and afford basic necessities. They were also more likely to have established a credit record, a “prime” Vantage score (an alternative to the FICO credit score) that allowed them to access mainstream financial markets and lower interest rates, deeper relationships with members of their loan groups, and broadened social support systems. The study results demonstrated that microfinance can work to improve the lives of low-income individuals, even in developed countries like the United States.
The way forward—reforming regulatory frameworks
So, if it can work here and there is a market for it, why has microfinance lagged in the United States? The biggest obstacle is the regulatory framework that MFIs are forced to operate under. They are subject to the same regulations—including usury laws and capital requirements—as traditional commercial banks that exclude the communities that MFIs serve. MFIs are serving a different customer base than traditional commercial banks, one often without credit histories or collateral, which is why they are not served by commercial banks in the first place. As a result of catering to a higher-risk clientele, MFIs may not be financially sustainable charging interest rates that usury laws currently permit.
The solution, then, is not to loosen usury requirements broadly but to pay special attention to the nature of the microfinance industry’s risk, recognize MFIs as a separate category of financial institutions, and provide separate rules. Some developing countries with thriving microfinance sectors have recognized this and established regulatory frameworks for MFIs separate from traditional banks. The United States should follow suit. While at first this may seem like permitting higher interest rates to be charged for lower-income people, the nature of risks that MFIs take mean that they cannot survive charging the same rates that traditional banks do. While MFIs may need to charge somewhat higher interest rates than traditional banks (around 15 percent), in their absence—with the latter refusing to serve them— unbanked people may be forced to turn to payday lenders who charge far more exorbitant rates (400 percent or more). MFIs should also be subject to separate capital requirements than commercial banks.
To be clear, while regulations on MFIs should be separate from those on commercial banks, regulations must exist and be rigorously enforced. The Federal Trade Commission Act and Consumer Credit Protection Act should have provisions recognizing MFIs as a special category of financial institution that, in the end, helps protect borrowers from abusive collection practices. There should also be an entity that serves as a supervisory and regulatory body to ensure stability and solvency of MFIs in the country, conducting inspections of them. MFIs should be required to submit internal audit reports on their interest rates and loan portfolios to this body. This oversight would provide the transparency critical to the MFI sector’s success. The regulatory body could be at the federal level or it could be left to states, at least initially. States could be allowed to figure out what type of regulatory body works best for their residents. There is some precedent for this. Industrial banks or industrial loan companies (ILC), for instance, are exempt from the Bank Holding Company Act of 1956. In Utah, industrial banks are regulated by the Utah Department of Financial Institutions and the state has emerged as a hub for these entities. Industrial banks have their share of critics, who argue that the ILC exemption is a loophole for commercial firms to own insured banks without being subject to federal regulations. But the principle of allowing states to establish their own regulatory bodies for MFIs could still prove to be a prudent one, and eventually the best practices of some of them could be adopted for a nationwide regulatory body.
In short, while microfinance has grown exponentially worldwide, its slower progress in the United States is due the ill-fitting rules that MFIs are forced to operate under. Providing separate, but still responsible, regulatory frameworks would help the sector expand, ultimately increasing access for America’s underserved and providing them with better tools to improve their financial futures.