How microfinance can work

By Felix Salmon
February 17, 2011
David Roodman has some great comments on the video debate between me and Matthew Bishop.

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David Roodman has some great comments on the video debate between me and Matthew Bishop.

He asks whether I’m “completely against the idea of pocketing a profit from serving the poor” — of course not. In principle, I’m all in favor of it. Matthew’s point at the end of the video is a very good one — if we want to get education or water or healthcare to the world’s poor, we’re going to have much more luck if we do so with a profit motive than if we rely on overstretched and underfunded governments to do it.

But as Roodman goes on to say later in his post, credit is special. Loans come with onerous future obligations in the way that water and education and healthcare do not. All borrowers have to pay back more money than they borrowed, which means that they come out behind on the deal — unless they can put the money to good productive use. Sometimes they can; a lot of the time they can’t.

I’m not saying that bankers shouldn’t profit from serving the poor; I’m just saying that the banks should be local institutions which reinvest their profits in the community. If a microfinance institution is set up so that a substantial flow of money is going out of poor neighborhoods and into the pockets of millionaires, there’s something wrong, and I’m going to be very skeptical that the poor are actually being helped at all. As Roodman says, giving poor people capital and asking them to pay it back with interest does not, in and of itself, help reduce poverty. Loans can help at the margin, especially when they’re used to fund small businesses, rather than their more common use of consumption smoothing. But the cheaper the loans are, the more effective they are — and microfinance loans are generally very expensive. Credit did help to build a lot of western democracies, but it was never remotely as expensive as the loans we’re seeing in places like Mexico.

Matthew has an almost religious faith in the power of microfinance to help poor communities; when I asked him what evidence he’d need to see before changing in mind, he said that he’d want to see lenders with so much capital they’d run out of people to lend to. My feeling, by contrast, is that if you give most people the chance to get over their heads in overpriced debt, a huge proportion of them will take it. And doing so can easily do them more harm than good.

Roodman goes on to tell me that it’s possible to make a profit even when you’re paying 45% interest. He uses the only example he can use: a woman using the loan to enter the labor force. In that specific case, interest rates can be very high indeed — a point I made back in 2006 after reading a great paper by Shahe Emran, Mahbub Morshed and Joseph Stiglitz. What we see in a lot of these loans is a little bit of credit acting as a catalyst for women outside the labor market, turning them into economically productive individuals. Once they become economically productive, they can pay back their small loans. But they’re not productive enough to pay back medium-sized loans.

When big for-profit microfinance institutions start expanding aggressively in urban areas, however, the dynamic of getting women into the labor force for the first time falls rapidly by the wayside. And without that, it’s very hard to see how these loans can really be economically productive for the borrowers.

Finally, Roodman wonders whether it would help to turn microlenders into deposit-taking banks. Yes! It would! But of course that business doesn’t scale nearly as aggressively, nor is it as profitable, because once you start taking deposits you have to submit to all manner of government regulation which slows everything down massively.

My core argument is and has been that for-profit microlenders who don’t take deposits can be bad for the borrowers and also pose a significant systemic risk. Which I think is the main point that Muhammad Yunus is making these days too. Matthew Bishop is much more bullish on such institutions. But to date, they’ve hardly covered themselves in glory.

5 comments

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“My core argument is and has been that for-profit microlenders who don’t take deposits can be bad for the borrowers and also pose a significant systemic risk.”

Amen!

And, I should add, it’s much easier in blogging than in debating on video to work in all the nuances, so we should all put more weight on what you write than what you say. Heaven help me if someone starts doing close analysis of my video utterances. At least you speak in complete sentences!

Posted by DavidRoodman | Report as abusive

> catalyst for women outside the labor market, turning them into economically productive individuals.

Can you explain? I know what a productive individual is, but to be moreover economically so – WTF? Or is there a missing hyphen – do you mean “economically-productive individual”? I hope not since this would be insidious, near evil, to suggest that if there isn’t a cash wage attached then valuable work isn’t “economically productive”. Or on the third hand, maybe you are using one of those two words in a non-standard sense -?

Posted by bxg12 | Report as abusive

why not go the route of savings (demand side) instead of credit. that’s what Gates is doing. there are successful models, such as Kenya’s Mpesa. tech rails just need to be in place.

Posted by philanthropoid | Report as abusive

The case for a social business approach from a practitioner

“Limiting the financial return of a social business to return on investment (ROI) can help balance the company’s blended focus on profit and mission, says Terry Hallman, CEO of a U.K.-based social business addressing poverty relief and reformed childcare in the former Soviet Union.”

http://www.axiomnews.ca/gennews/966

In an earlier interview he describes a success in Siberia

http://www.iccrimea.org/scholarly/econom icdev.html

Posted by peoplecentred | Report as abusive

This is an interesting post but it leaves out one crucial element. It is stated “All borrowers have to pay back more money than they borrowed, which means that they come out behind on the deal — unless they can put the money to good productive use.”

The key aspect most people (and funds) miss, is that microfinance is woefully under-represented in the area of avoided costs, mainly energy. When microfinance is used in a pointed manner to attack potentially avoided costs (firewood use, time to gather wood or water when appropriate), the interest expense and transaction costs are not as comparatively heavy and in most cases, both the borrower and mother nature benefits. That is especially true if the avoided cost can be permanently eliminated.

Funds, online lenders like Kiva, generally miss this point as they assume all microloans go to entrepreneurs. Not true. Infrastructure finance that eliminates avoided costs and matches the payments with the avoided costs is the holy grail of microfinance. People are slowly getting it.

Posted by bobdillman | Report as abusive