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What’s Wrong With Microfinance

What’s Wrong With Microfinance. First Principles.

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What’s Wrong With Microfinance

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  1. What’s Wrong With Microfinance

  2. First Principles The informal sector—made up of informal institutions, including microfinance—is in most places a default mode, a function of failing economies. It is not the incubator of economic growth, but a holding action where everyone (including government employees) is force to go since little else is available to them. These markets are not the Way Out of Poverty. They are driven by it. (Thomas Dichter)

  3. Informal Institutions: the Second Best Market Failures • Inherent limitations: information, transaction costs • Underdeveloped institutions: property rights • Bad policy: interest rate caps, rules against lending Response: Informal Institutions • See a lot of “strange” practices in developing economies • Sharecropping, MicroFinance: seem really inefficient! • But solve fundamental problems and allow economy to work Important to understand • Tradeoffs • At what point do these institutions impede further growth?

  4. Microfinance as Second Best Market Failure: There is a weak formal credit market in developing countries almost completely missing for the poor. Historic 2nd Best Solutions: moneylenders, cooperatives, friend and family, ROSCAs, commercial credit, interlinked contracts. Like all good informal institutions, MicroFinance exploits local conditions • Tight social networks, low migration, joint liability, etc.

  5. MicroFinance is a Second-Best Institution, Giving Second-Rate Financial Services. There are Limitations.

  6. If it’s Second Best…Why the Hype? • Undeniable appeal: Giving tiny loans, to good but poor people, helping them earn a livelihood without making them –or their countries—dependent on handouts..and Getting Our Investment Back! • Promises more than poverty reduction: Loans are used to increase productivity, create jobs, stabilize and strengthen the rural sector Long-run economic growth. • Left-ies and Right-ies can get behind this.

  7. What’s the Problem? We’ve Started Treating MicroFinance Like the Long-Term Solution to the Problem of Broken Credit Markets. And the Poor Deserve Better.

  8. #1: Exaggerated Expectations and Outsized Claims • Most frequent criticism: MicroFinance can never deliver on the hype • We do NOT know the impact of microfinance • Anecdotal evidence that it helps with consumption smoothing, and some empowerment benefits We don’t know if it works, but it is claimed to solve poverty and develop economies. Some might say…so what? It brings money to poor people, and that can’t be a bad thing?

  9. #2: Where the Hype Hurts: Crowds Out Other Initiatives But with those big promises, MicroFinance is presented as substitute for other initiatives that would benefit the poor in the: • Financial Sector: • Commercially financed MFIs divert attention from cooperatives, credit unions: and actively discredit them • Crowds out high-impact microfinance programs: private money chases minimalist programs that scale quickly, instead of high-impact livelihood finance • Social Service Sector • Public funds directed out of proportion to proven impact • Diverted from less glamorous, but proven social services: nutrition, clean water • NGO Sector • Many NGOs pressured to take up microfinance as part of their work: health, environment education • They aren’t good at it • It takes human resources You may ask, what’s the problem, if it’s a great product?

  10. #3: Pushing a Bad Product • Same Old Model: (high-interest debt with fast repayment); to the same customers (poor, but not the poorest, women); in the same way (groups); for the same false story (loans are used for enterprise). • Cost of debt too expensive, and terms not right, for anything but refinancing moneylender loans, or petty trade • Most microfinance loans are used for enterprise, but for consumption: clients are forced to lie • When it is used to do more than marginal self-employment—to create a real enterprise—credit is not the only input required • Savings, Insurance, and Remittance Innovations are more useful, and in higher demand– for consumption smoothing, to manage emergencies, and save for dowry • MicroFinance Practitioners don’t recognize the need for • Credit Products that can finance employment-generating enterprises • Non-Credit products for Savings, Remittances, and Insurance

  11. #4: Group Membership Imposes Costs on Clients • Groups reduce the Transaction Costs for the lender • But: group members take on those costs • High Opportunity Cost to Meetings: Poor people do not have “leisure” • Group membership is invasive of privacy • “Social sanctions” can be humiliating, coercive, and in some cases, dangerous So far, we have a substandard product with a costly delivery channel…

  12. #5: And the Substandard Product Excludes Those Who Might Use It…Best? • It Targets Women, and Excludes Men • Good reasons for Targeting Women But Men’s enterprises are larger, and tend to actually generate employment. • It Targets the Poorest, and Excludes the Slightly Less-Poor • Good reasons for Targeting the Poorest • But the poorest are already vulnerable to high risk, tend to have the least skills and assets, and least likely to make productive use of the Credit. High-interest debt means more risk.  The slightly less-poor, who have a few assets and can manage risk, are excluded. • Irony: The poor with skills, a few assets, a little enterprise—who can leverage a high-interest loan for productive purposes—are excluded.

  13. Caveat: Let’s not abandon MF…yet • The credit market is still broken • All the efforts to bring tiny loans to good but poor people aren’t misplaced • MicroFinance is one more option for poor people to take advantage of choices to fix their roofs, to pay school fees, to buy 2-wheelers, to pay 1st month’s rent on a storefront, to repay their moneylender. • Not as glamorous as transforming the Indian economy, but we shouldn’t deny people that choice.

  14. What’s right: Recent Improvements Small number of institutions are innovating: • Support for the “Ultra-Poor”, including asset-building • Livelihood or Business Development Services along with Credit • Moving “up-market” to finance enterprises, and farm investments • Working within regulations to mobilize investment • Product innovations and experimentation: Micro insurance and remittances Let’s not forget, it will never be a First-Rate Financial Service

  15. Moving to a Better Solution • The best practitioners and operators should plan to become banks • Learn to deal with banking policy and market constraints • Risky innovation and product experimentation • Lending for Agricultural Investment • Lending to Men • Lending at Longer loan terms • Lending for Consumption: forget the liar’s loan • Taking impact evaluations seriously • Not just “does microfinance work” • “How does it work?” • “Who does it work for?”

  16. How to evaluate improvements? • Adjust institutions and products to address fundamental problems • Be aware of second-best implications • Follow up with evaluations • Be aware of self-interested behavior by stakeholders • Compare solutions to other finance available to the poor: cooperatives, commercial agents, ROSCAs, family and friends. Ask honestly, are we doing a better job?

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