Microfinance
Updated: April 14, 2010
Microfinance, or the practice of extending small loans to individual borrowers who have traditionally lacked access to credit, has become one of the most popular antipoverty strategies in the world. Microlenders help the poor start or expand businesses in places most banks shun, like the slums of Calcutta or the impoverished hills in Mexico's sugar cane country.
The practice has sparked a fierce debate over whether microloans actually lift people out of poverty, as their promoters so often claim. The conclusion of some researchers is that not every poor person is an entrepreneur waiting to be discovered, but that the loans do help cushion some of the worst blows of poverty.
Modern microfinance took root during the 1980s, although experiments in Bangladesh—with Muhammad Yunus and Grameen—and in other countries occurred earlier. It differed from traditional aid by insisting that loans be repaid, charging interest and seeking poverty reduction via enterprise-building. Mr. Yunus won the Nobel Peace Prize in 2006 for his work with microfinance.
The loans are made without collateral. Borrowers, often women, are organized in groups, which guarantee the loans. Stop paying and your friends must pay for you: the system keeps default rates down. Historically, microlenders point out, such borrowers are excellent risks.
In three decades microfinance has evolved—from small nongovernmental organizations lending $50 to women to buy sewing machines or fruit to sell at market to, in some cases, formal banks that cover costs and grow through profits, like any business.
Drawn by the prospect of hefty profits from even the smallest of loans, a raft of banks and financial institutions now dominate the field, with some charging interest rates of 100 percent or more.
The fight over preserving the field's saintly aura centers on the question of how much interest and profit is acceptable, and what constitutes exploitation. The noisy interest rate debate has even attracted Congressional scrutiny, with the House Financial Services Committee holding hearings in 2010 focused in part on whether some microcredit institutions are scamming the poor.
Rates vary widely across the globe, but the ones that draw the most concern tend to occur in countries like Nigeria and Mexico, where the demand for small loans from a large population cannot be met by existing lenders.
Unwitting individuals, who can make loans of $20 or more through Web sites like Kiva or Microplace, may also end up participating in practices some consider exploitative. These Web sites admit that they cannot guarantee every interest rate they quote. Indeed, the real rate can prove to be markedly higher.
The microfinance industry is pushing for greater transparency among its members, but says that most microlenders are honest, with experts putting the number of dubious institutions anywhere from less than 1 percent to more than 10 percent. Given that competition has a pattern of lowering interest rates worldwide, the industry prefers that approach to government intervention. Part of the problem, however, is that all kinds of institutions making loans plaster them with the "microfinance" label because of its do-good reputation.
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In response to a query about this article Kiva claims that it's field partners average about 36% interest and fees and that it's transaction and labor costs that are responsible (small loans in rural areas imply high cost per loan).
But this brings up several questions: With Kiva, if the borrower doesn't pay back then the "donor" is out the principal and the lending institution is out the interest. So that would seem to imply that loans could be cheaper compared to if the lending institution has to absorb losses of principal and interest. It's not clear that is happening (at least it's not clear to me!)
The other important question is if the only capital available is at 35 to 45 percent interest, what kinds of ideas are going to get funded, versus if capital is available at 5 or 10 percent? It seems like expensive microfinance capital is going to have a selection bias, and that could be studied if anyone cared to look. My suspicion would be that the selection bias is for projects with high potential short term return to the borrower over projects with long term sustainable contributions to a community; for example importing some fancy stuff that people don't normally have as much access to and selling it to the few people with any cash. Has anyone studied this question and if so where might one find those types of studies?