The myth of microfinance

It is ironic that microcredit – originally designed for poor, ‘unbankable’ people – has become a focus of major banks such as Deutsche Bank, Citi, Barclays and others. They say they are in it to make a profit, but this is hard to believe. Of the thousands of microfinance institutions established since the market began more than 30 years ago, only a handful have come close to being self-sustainable. Most would not exist without subsidies. Do big banks know something that experienced microcredit providers do not?

In the poorest countries, the microcredit business proposition often suffers from generic barriers: most borrowers’ weak collateral position; their lack of credit history; the no-growth nature of their income-generating activities (which tend to be low-barriers-to-entry buy and sell transactions in the informal economy); high administrative costs and high risk over the long term for lenders; the need for high interest rates to cover costs; and often an institutional environment that is unfavourable to development. Does this sound like an exciting new line of business?

Doubly deluded?

Banks are fooling themselves on two fronts: the ‘socially responsible’ and the business fronts. And they are unlikely to make money unless they redefine what they do as ‘microcredit’ (when it is not).

It is both politically correct and good for one’s image to be seen to offer microcredit, especially after Mohamed Yunus and Grameen Bank won the Nobel Peace Prize in 2006. So many players are labelling what they already do as ‘microfinance’. EU development banks, for example, who say they are offering microfinance are, in fact, referring to European small and medium-sized enterprises, more than 90% of which have up to 10 employees. Such enterprises would not considered by microcredit lenders in the developing world.

So if commercial banks follow this model in developing nations, with poor people as target clients, and with loans for start-up businesses or for working capital, they are unlikely to manage it profitably. Perhaps the fact that the two earliest commercial banks in the sector, Citi and Deutsche Bank, have been doing microcredit through their non-profit foundations, suggests they already know this.

On the social front, banks assume, (as does the microcredit sector as a whole) that microcredit is a real path to poverty reduction, for which, read development. It is not.

Palliative only

In the poorest countries, where corruption, underdeveloped institutions, poor infrastructure and immature markets are the norm, microcredit is, at best, a palliative. People flood the informal marketplace not because they dream of being the next Richard Branson or Bill Gates, but because they have no other choice. Most are not entrepreneurs and cannot make developmental use of microcredit: they remain poor, with or without it. After 30 years of microcredit, there are no rigorously controlled data to suggest it has resulted in a serious reduction in poverty.

Further, the idea that the number of the world’s ‘unbanked’ poor is equal to the ‘unmet demand’ for access to banking services does not hold up. Debt capacity is what should determine demand, not simply having no access to credit. Looked at that way, the ‘unmet demand’ for credit that the banks may be counting on is dramatically less.

Finally, history offers adequate proof that economic development has always preceded mass access to banking services – and when such services arose they were savings-based. As University of Chicago economic historian Richard Posner has put it: “The idea of borrowing one’s way out of poverty is passing strange.” Yet, so frustrated are most of us by world poverty that our hope for a magical solution clouds our thinking. Microcredit has that appeal. Banks may be as soft-hearted as the rest of us, but one would hope that in the end they are not as soft-headed.

Thomas Dichter has worked in development aid since 1964 and is co-editor, with Malcolm Harper, of What’s Wrong with Microfinance? (2007).