An estimated 400–500 million people worldwide do not have access to financial services other than informal moneylenders. This lack of access constrains private sector development and economic growth, and has distributional consequences, since the poor and those living in rural areas are disproportionately affected. Microfinance has been touted as a promising means to reach the financially underserved. Is it? A recent IMF study examined the pros and the cons.
The concept of microfinance is now several decades old. Its institutions provide small credits and other financial services to low-income households and very small informal businesses. With constant innovation to meet the specific needs of the people they serve, microfinance institutions offer a menu of options. Through group lending, for example, they are able to provide credit, with minimal reliance on collateral, to group members who take turns borrowing and are jointly responsible for loan repayment.
Many microfinance institutions are owned and operated by nongovernmental organizations that receive grants, and sometimes loans, from multilateral development agencies, private charities, governments, and similar institutions. In parts of the world, they follow the model of financial cooperatives, funding their lending from members’ deposits and capital contributions. While some have grown into formal, self-sustaining financial institutions, most remain informal and dependent upon donor funds.
But after years of experience with microfinance, surprisingly little is known about it. There are no comprehensive and authoritative data, for example, on the size of the industry or the populations served. Stylized facts, however, can be drawn from studies at the country and regional levels. These suggest that while the industry comprises a very large number of institutions—in the tens of thousands by some esti-mates—the number of people served and the amounts of money involved are small. The studies also indicate that most microfinance activity is concentrated in a handful of countries and that only a few large institutions carry out a significant portion of the transactions.
The pros and the cons
Proponents advance many arguments in favor of micro-finance. Although these loans carry a higher risk and therefore have a higher cost than traditional loans, industry supporters and practitioners see benefits for poor families. There are numerous success stories to support their claims, and beyond the anecdotal evidence, there are public policy arguments in favor of microfinance. Economists have long recognized the existence of informational failures in financial markets that could prevent the realization of otherwise efficient transactions. Besides, access to financial services may help improve the living conditions of the poor and empower them, ameliorating the “aid-dependence syndrome” associated with other redistributive mechanisms.
But others point to counterarguments and note a number of caveats and risks. To them, it is not entirely clear whether microfinance techniques are effective in circumventing imperfections in financial markets or whether microfinance institutions have an intrinsic advantage over traditional financial institutions. If they have an intrinsic advantage, it should perhaps materialize in better access to private funding, possibly various forms of cooperation and vertical integration within the financial industry. But to date, most external funding for the microfinance industry continues to come from donor sources, with very limited integration with traditional private financial institutions.
The excessive reliance of the microfinance industry on donor funding prompts a second concern. Such subsidization comes at the risk of relaxing budgetary discipline in the microfinance industry and creating unfair competition with traditional financial institutions, preventing them from expanding their outreach. Should microfinance institutions aim to be profitable and financially self-sufficient, perhaps after an initial phase of subsidization to help cover start-up costs? Proponents of commercialization consider profitability as proof that microfinance is fulfilling its goals and see self-sufficiency as essential if the industry is to grow in the future.
They also voice concern that, as nonprofit organizations, microfinance institutions may lack the appropriate ownership structure, staff, operational systems, and incentives to improve operating efficiency. On the other hand, those who see microfinance chiefly as a poverty alleviation tool stress the importance of keeping the costs of financial services as low as possible while reaching the most destitute. In their view, the merits of subsidization should be decided on the basis of a cost-benefit analysis with other anti-poverty programs.
A related open question is whether microfinance institutions are a cost-effective tool for redistributing scarce resources. How do they compare with the alternatives? While these institutions are presumed to have some advantages over more traditional redistributive mechanisms (notably through empowerment of the poor and recycling of funds through loan repayments), there is, in reality, too little data to compare their relative costs and benefits. Since providing financial services to the very poor is costly relative to the volume of resources channeled, it risks dissipating a disproportionate part of the resources in administrative and operational expenses. Besides, the increasing popularity of microfinance among donors, combined with the lack of hard evidence on its cost-effectiveness, also risks diverting scarce resources from other basic redistributive mechanisms, such as health care and education.
If it is to realize its potential, the microfinance industry will need to tackle a number of important challenges that lie ahead. One of the most important of these is achieving financial sustainability and integrating the microfinance industry into the formal financial sector. Studies indicate that only 1 percent of existing microfinance institutions worldwide are financially stable. Despite apparently high loan recovery rates, the small scale of microfinance operations, combined with the costs of reaching out to clients, pushes up operating costs and absorbs most of the interest margins. The few financially self-sustainable microfinance institutions tend to be larger, spreading fixed costs and achieving greater efficiency. But those striving to become commercially viable do not tend to target the very poor.
A related challenge entails the interaction of microfinance and traditional financial institutions. While there are success stories of microfinance institutions growing into formal financial institutions, as well as banks entering the microfinance niche and business relationships developing between banks and microfinance institutions, no clear trends have yet emerged.
There is also the matter of whether and how the micro-finance industry should be regulated. So far, the industry has evolved largely outside the regulatory framework that applies to formal financial institutions. Prudential regulation of microfinance institutions would typically be predicated on whether they pose a threat to financial stability or engage in deposit intermediation. The weak approach applied to date in most countries thus seems justified, considering the small size of the industry and its infrequent reliance on deposit funding.
As microfinance institutions become larger and eventually move into traditional financial intermediation, however, regulatory and supervisory approaches would need to be considered. The optimal approach would have to weigh the specific circumstances of individual countries and avoid diverting scarce supervisory resources from more systemically important financial institutions or overburdening microfinance institutions with information and compliance requirements. In some cases, a lighter regulatory approach may be warranted, but it would have to minimize discrimination against traditional financial institutions and guard against establishing legal loopholes and opportunities for regulatory arbitrage.
Having the necessary information at hand is critical to addressing these challenges. While the information gap has been increasingly filled by independent data sets of varying quality and coverage, the task of generating more systematic information is complicated by a lack of consensus on the data needed, and the absence of clear-cut definitions of the products and services that qualify as microfinance. An ongoing World Bank initiative is seeking to assess existing data sets, determine current and anticipated data needs, and formulate the best strategy for closing these gaps. But information gathering is further complicated by the informality and dispersion of the industry, while the costs of data collection may prove excessively burdensome for microfinance institutions.
Ultimately, the path to developing a sound and sustainable microfinance industry, and deepening financial services, will provide the answers to these challenges.