Microfinance - a trifle hyped up?

The award of the Nobel peace prize for this year to Grameen Bank founder Mohammed Younus has evoked a barrage of peans in praise of microfinance. Here at last, it seems, there is a trusty cure for poverty. Don't give the poor handouts or jobs, let them help themselves by gaining access to credit. Give the poor a loan and you have the makings of an entrepreneur.

I have been rather sceptical of the claims made on behalf of microfinance and found my scepticism reinforced by a recent exchange between two redoubtable economist-bloggers, Richard Posner and Gary Becker, the latter a Nobel laureate himself.

Posner notes that microfinance fills a gap left unfilled by commercial banks who may be averse to taking the risks involved or may be constrained by interest rates they can charge. Microfinance takes over from informal loans made by relatives and clan members. It thus marks a transition from an economy based on trust to one to a normal commercial society.

Having placed microfinance in a conceptual framework, Posner goes to underline its shortcomings:


As a substitute for trust, microfinance has obvious drawbacks. Extremely high interest rates, though justified not only by the risk of default(and the opportunity cost of money, that is, the riskless interest rate) but also by the very high transaction costs of a tiny loan (since those costs are largely fixed,
rather than varying with the size of the loan), burdens the borrower with very heavy fixed costs, since he must repay the loan regardless of the success of his enterprise.....Borrowing at astronomical interest rates seems an unlikely formula for commercial success--and the more unlikely the poorer the borrower......

The evidence for the efficacy of microfinance in stimulating production and alleviating poverty is so far anecdotal rather than systematic. The idea of borrowing one's way out of poverty is passing strange. And I am unaware of any historical examples of nations that climbed out of poverty on the backs of small entrepreneurs financed by credit. Also, recall that Grameen Bank has lent almost $6 billion to some 6 million persons. This implies an average loan of almost $1,000, which in a country like Bangladesh is not chicken feed and makes one wonder how much of the Grameen Bank's loan portfolio is actually microfinance.....

I suggest, albeit tentatively, that there may be a good less to microfinance than its boosters claim.


In his response, Becker says that he does not believe that micro-finance loans are at market rates, that, is they price risk correctly. There is an element of subsidy in microfinance.It is the subsidy element in microfinance that explains why commercial banks have not ventured into micro-loans.

The Grameen Bank and other groups active in making micro loans have had some financing from NGO's that do not seek to make commercial returns on their spending. So my belief is that despite the seemingly "high" interest rates on these loans, they have earned returns, adjusted for servicing, risk, and other costs, that are below market interest rates in their respective countries

On the positive side, Becker notes that a big chunk of microfinance goes to women. To the extent that this enhances empowerment of women, it is welcome. So microfinance should be seen as a more effective way for private groups to make gifts to women that the customary handouts.

Microfinance will begin to make a big impact only when it becomes viable as a for-profit operation. That alone will make it a sustainable business model. It remains to be seen whether this challenge is addressed.

In India, microfinance is still very small in size with an estimated Rs 40 bn of total loans and mostly concentrated in four states in the south. The big impact on poverty will still come through job creation and through financial deepening, that is, commercial banks enlarging their reach and covering the under-served segments of society.

The danger with all the hype about microfinance is that it becomes an excuse for government and bankers to not do their bit- hey, we have microfinance, so why should the government or commercial banks bother about poverty alleviation?