Microfinance, Muhammad Yunus, and Global Poverty

The Basics

The concept of microfinance is fairly simple. Provide financial services to impoverished people that typically don’t have access to them, only smaller in size. Such services would include savings accounts, insurance, and most commonly, loans. Microloans also have the added advantage of having no collateral, which is something that the borrower pledges to give up if they can’t pay back the loan. An example of microfinance would be a $20 loan with higher-than-average interest rates, rather than a larger $1000 loan with collateral. This kind of small scale financial system doesn’t seem that innovative and has existed far before the 80s. But, Bangladeshi economist and 2006 Nobel Peace Prize winner Muhammad Yunus reframed the issue. He argued that giving credit to impoverished people wasn’t simply to give them relief, it was to give them an opportunity to create small businesses that would propel them out of poverty.

Up to that point, the common belief was that loaning to individuals living on meager wages would create a debt trap that would hurt them. Sticking to his convictions, Yunus created the Grameen Bank in 1983, aiming to offer microloans to poor people in Bangladesh. It’s success caused the idea to gain steam. More than 3,000 organizations began to enter microcredit, to general success. The microcredit borrowers tended to pay back their loans frequently, at 96 percent of the time.

Economist Muhummad Yunus, who is credited with the rise of microfinance

Peer Pressure

A couple of structural innovations set apart Yunus’ microloan model from his predecessors. First, repayment starts immediately and is frequent in small intervals over a year. This forces consistency and discourages rash spending. Second and more importantly, loans are given in groups. Potential borrowers must first group up with other borrowers from other households. Only a few of them receive the loan at first and following their successful weekly repayment, others will begin to receive the loan as well, continuing in a chain. Typically, collateral is used to incentivize borrowers to repay their loans, since if they don’t whatever they pledged would be seized. However, because those in poverty don’t have much to wager as collateral, loaners need to find a different way of incentivizing repayment.

So instead, by making the loans of others contingent on one person’s loan, they levy peer pressure against borrowers. By loaning in groups, banks can create group liability, where everyone has an interest in the repayment of everyone else’s loans. This increases transparency and pressure to meet payments.

Preliminary Filtering

In addition, because of the difficulty for a bank to determine whether the borrower is trustworthy, they instead substitute the borrower’s peers into the selection process. Often when too many risky borrowers are in a population, the interest rates grow to compensate. Banks are looking to turn a profit, and if a smaller proportion of borrowers repay them, they need to make more from each successful borrower, thus raising interest. However, overly high interests could drive potential safe borrowers away.

Because in Yunus’ model, the groups are formed by individuals, safe borrowers will tend to group with one another or report unsafe borrowers, in order to preserve their ability to get a loan. Thus, group liability counters adverse selection, which is when buyers and sellers have different amounts of information. Though banks don’t have information about who is trustworthy and who is not, the borrowers do. By putting it on borrowers to self regulate each other, microfinance companies can bridge that information gap to make a profit.

Impact on Women

Yunus’ microfinance structure tended to target women in developing countries since they often were relegated to working in the home, rather than outside. Even now, 80 percent of microfinance loans go to women. By giving women who are often relegated to home roles the capital needed to start a small business, microfinance offered the opportunity for impoverished women to fund their education and take control of their own finances. For all of his efforts, Yunus was awarded the Nobel Peace Prize in 2006.

So did microfinance live up to the hype? It’s a mixed bag.

Public Backlash

It started with excessively high interest rates. Microfinance institutions generally offer interest rates at 20-30 percent annually as opposed to the typical 10 percent mark. Some microfinance rates are even higher. Banco Compartimentos, a Mexican microfinance bank, is alleged to have charged up to nearly 200 percent interest on loans. In 2007, they changed from a non-profit to a for-profit institution, drawing the ire of the public. Even Yunus has argued against these excessively high-interest rates, pointing out that microcredit firms have replaced the problem instead of solving them. Many have been criticized for turning into predatory loan sharks, aiming at profits rather than aiding the needy. In Andhra Pradesh, a state in southeastern India, the government shut down microcredit institutions, accusing them of encouraging indebtedness and increasing suicides.

Questions on Efficacy

While these controversies shook microcredit, it also didn’t kill it, especially since they were usually issues with execution rather than conception. However, over time, more and more research came out and called into question the efficacy of microcredit. Six studies in 2015 found no evidence that microfinance helped lift people out of poverty. In fact, there was only a small effect found on the number of small businesses. Microfinance neglects to address structural causes of poverty, such as labor rights, trade agreements, and the global market. The popularity was unwarranted. Jason Hickel of the Guardian notes the privileged delusion that microfinance promotes, writing:

“The failure of microfinance is recognized at even the highest levels, and yet for some reason, it retains its staying power, like a zombie that refuses to die. Why is microfinance such a resilient idea? Because it promises an elegant, win-win solution to the problem of poverty. It assures us that we – the rich world – can eradicate poverty in the global South without any cost to us, and without any threat to existing arrangements of political and economic power. In other words, it promises revolution without the messiness of class struggle. And, what is more, it promises that we can help save the poor while making money from it.”
Jason Hickel, “The Guardian”

A Reason For Hope

Despite the flaws, microcredit does offer a lot of potential. For starters, the six studies also found that, at the very least, that microcredit didn’t have negative effects. The most vehement critics of microfinance had argued that it was a debt trap that harmed the poor rather than helped them. However, the studies found moderate positive effects: not as transformative as advertised, but nevertheless beneficial.

So if microfinance doesn’t actually impact small businesses, how does it actually help people in poverty? By providing a reliable credit line for those who might need it for emergencies. Microcredit is used more often for general consumption needs, rather than business loans. This could mean a health emergency, a large purchase, or just getting enough money when there is a lull in income. Microfinance gives those in poverty a certain degree of freedom in spending that they would not have without it, akin to the benefits that traditional credit cards give financially stable people. Researchers have found that these benefits still have been prominent and important, even if they aren’t as exciting as ending world poverty.

In addition, several reforms have been proposed in order to bolster the effects that microfinance has on poverty. Naturally, decreasing interest rates would help aid by focusing on those in need, rather than wealthy investors. Many have also suggested further expanding the variety of services offered, expanding beyond microloans. Insurance and savings are also important financial services that would help aid impoverished. Offering financial literacy classes prior to loans could also potentially serve to enhance the effect microloans have on small businesses.

Conclusion

However, no matter the reforms, what should have been obvious from the beginning is now glaringly clear. Microfinance isn’t a catch-all solution to global poverty. It fails to address fundamental systematic issues that cause those in poverty to stay stuck. Still, it’s an important resource for those in need and can alleviate some of their struggles. In short, microfinance doesn’t end poverty, but it does make it more bearable. In the long term, microfinance still has the potential to be a contributing factor to ending world poverty.