The wonders of Microfinance

During the past few days, I was reading existing economic literature on Microfinance. I think it may be the only credible way to uplift the poor through a market mechanism. Microfinance is especially popular in Bangladesh, Indonesia and Bolivia. The main point of a credit market catering to the poor is that it should not only have lower interest rates than those charged by the moneylenders, but it should also be self-sustainable without any significant subsidy from the government.

When Muhammed Younis had started Grameen Bank as a means of lending to the poor, it was highly successful in meeting both the objectives. What was different about Grameen Bank then was that it was targetted towards women who wanted to use the money to start a small venture like buying a cow or poultry farming or retailing. The money lent had to be payable within a year usually and involved weekly repayments. The most interesting feature that was present in the contract (though not unique to Grameen Bank) was that no collateral was needed and the money was only lent in a group of five. This meant that if one of the five team members fails to repay their loan, the other members either need to step in for her or forgo further loans from the bank. This social banking experiment revolutionalised Microfinance across the globe. Grameen Bank today has helped 2.5 million poor people get loans which would otherwise have been either exorbitant or simply not possible.

Where this banking experiment probably suffers now is in the repayment rates, which fell from a pristine 95% to below 90% in the past few years. This was partly due to the floods in Bangladesh, and partly due to insufficient interest charged on the loans when adjusted for risk. The challenge is to keep the experiment running without making it become a burden on the government.

There are many benefits to microfinance beyond providing for a stable employment. It has been shown to reduce income inequality, the gender gap, it provides for health education (excellent studies by Morduch and Khandker elaborate on this point).

There are other positive externalities as well, which are harder to measure. Women studied as part of researches have been shown to spend atleast some part of the loan on the education of their children. The extra cash may give them more confidence and make them more financially aware. As part of the group-contracting, they have an incentive to keep tabs on their group members and this may actually increase the social capital. The vulnerability of the poor to natural and unforeseen disasters is lowered if there are loans available without the need for a collateral.

The variables that may affect the success of a microfinance experiment are the interest and duration the loan, the number of people in a group contact, the frequency of the repayments, if collateral is required or not, the location of its branches, the attitudes of the people (for example risk averse or risk neutral), how prone the region is to unforeseen shocks, does the programme cater to women only, the punishment mechanisms, and if the loans are given incrementally or not.

Mechanisms need to be able to evolve if they start to become unsustainable. How realistic that is and if realistic, how successful it may be is still an open question.