Thirty-eight years ago, Muhammad Yunus, after completing his doctorate in economics, decided to investigate poverty in Bangladesh. He found that the theoretical well-functioning markets did not exist, especially for the rural poor in developing nations. Their lack of collateral caused banks to refuse credit to them, leaving many simple, profitable business
ideas unfunded.
Yunus decided to lend small amounts to the poor, and thus started the field of microfinance by founding the Grameen Bank in 1983. Since then it has grown, funding 5 million borrowers, and many microfinance institutions (MFIs) have entered the field. Currently, MFIs are flourishing and have caused a stir in the development community. There are several pressing issues within the field; this article will discuss how MFIs operate, the controversy of profit, female empowerment resulting from microloans, and finally the extent to which microfinance helps eliminate poverty.
MFIs use “social collateral” as incentive for loan repayment, as opposed to traditional asset collateral (e.g., a house). Creating bonds strong enough to influence behavior requires using local communities: for example, providing additional loans to community members contingent on repayment of an initial loan. Oftentimes MFIs will restructure a loan instead of allowing a default, continuing the flow of credit into a community and preventing “debtor runs.” This system of social pressures is not perfect; it can disrupt community relationships or lead to bribes, but in general it provides strong incentive for repayment.
Microfinance is unique in its potential to both promote development and produce profit: many banks and non-profits (e.g., Citibank, Banco Compartamos of Mexico) have recently entered the field of for-profit microfinance. These MFIs can raise capital and expand into underdeveloped microfinance markets; one estimate claims that demand for microcredit is at $250 billion, 10 times the amount lent out. However, for-profit institutions are accountable to investors, obscuring the goal of development as peripheral. For-profit microfinance institutions often raise interest rates (as high as 100 percent with Banco Compartamos), cost-cut by removing social services, and encourage existing borrowers to take out larger loans rather than seek new borrowers.
Microfinance can be an effective weapon against poverty. It empowers the poor in developing countries by providing a means to break the cycle of poverty — a task at which most traditional forms of aid fail. A World Bank study demonstrated that participation in microfinance programs correlated with financial improvements, such as more consistent consumption, along with non-financial benefits, such as increased access to education and improved nutrition.
The participation of women in microfinance (they are the vast majority of loan recipients) facilitates a shift in values and expands their role in society. These women use the initial capital from microloans to start their own businesses and develop a steady income. The Grameen Bank’s early research in developing countries found that women had the best repayment rates for microloans.
Oxford researchers in Ghana also found spillover effects (benefits realized by non-participants) when analyzing microfinance’s impact on cocoa farming in small communities. Several farmers took out microloans to pay for fertilizers and pesticides for their crops. The MFI instructed the farmers on more efficient application methods, resulting in more fruitful harvests and increased local employment. Interestingly, non-participant farmers also increased their productivity, suggesting the diffusion of informal knowledge within the communities.
Microfinance is a new and interesting form of development that has the potential to be both more effective (through empowerment) and efficient (through use of incentives) than traditional aid. It raises some significant concerns (e.g., exploiting the poor, disrupting communities) but warrants continued attention and investment from those interested in ending poverty.
Elizabeth Aldrich, Bradley Egbert, Mary Heberling, Chad Mullen, Michael Pierce, Jessica Rostad, Amanda Ryan & Tim Stanton
University of Oregon Microfinance Initiative, International Business & Economics Club
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