By Erin Nealer

Microfinance was the trendiest new player in economic development for the first decade of the 2000s. In 2004 Vinod Khosla, founder and CEO of Sun Microsystems, called microfinance “one of the most important economic phenomena since the advent of capitalism.” In 2006 Muhammad Yunus, founder of the Bangladesh-based Grameen Bank, was awarded the Nobel Peace Prize for his work in establishing micro-loans for entrepreneurs struggling to rise out of poverty. Microlending programs such as  Kiva, World Vision Micro, and Zidisha have sprung up to take advantage of the internet, creating peer-to-peer lending programs where individuals can supply small loans or pool funds for larger loans for entrepreneurs all over the world. The ability of microfinance institutions (MFIs) to reach those experiencing the greatest need and to provide long-term solutions for extreme poverty, however, remains uncertain.

The term “microfinance” refers to a broad umbrella of economic opportunities with one common objective: increasing access to financial services for those who are unable to access traditional banks. The theory is that small loans, savings accounts, insurance programs, and other basic financial services will provide the structure necessary for low-income individuals to lift themselves out of poverty, begin businesses, and provide for their families. MFIs that focus on underserved populations – particularly women, those living with HIV/AIDS, and populations in inaccessible rural areas – have the potential to enact great change in the lives of individuals, enabling them to participate in the local and global economy.

Women submit applications for microloans in Ghana. While microfinance is a popular and relatively new vehicle for increasing access to financial services, the lasting impact of microloans on business profits and overall income is negligible. Photo by Rachel Strohm via Flickr.

While MFIs can enable otherwise isolated persons to engage with the global economy, economists regularly question MFIs’ ability to help people out of poverty in the long term, citing three primary concerns. First, there is the question of financial literacy: if recipients of these low-interest, long-term loans do not understand the mechanics of interest rates, saving their income, and making smart investments, an otherwise successful entrepreneur will struggle to pay back the original loan. MFIs are not always purely philanthropic nonprofits – many are for-profit institutions tied to larger banks or insurance programs – and the complexities of local loan markets can obfuscate the true cost of a loan to a financially illiterate recipient. A 2013 Harvard Kennedy School article includes stories of MFI loan recipients taking out additional loans in order to pay off the original, which undermines the purpose of MFIs and demonstrates the hopelessness that accompanies large debts of any kind, no matter how altruistic the original intention.

Second, women disproportionately feel the effects of poverty – accounting for over 70 percent of those living under $2 per day – and are participants in microfinance. They are also less likely than men to be financially literate, which makes them particularly vulnerable to scams, identity theft, and other pitfalls of taking out loans. MFIs such as the Women’s Microfinance Initiative work with women who have been excluded from traditional financial transactions because of illiteracy, lack of collateral, male-centered ownership laws, lack of identification, and geographic isolation. However, this model is not the norm.

The most prominent debate around microlending programs is the long-term impact of the loans. MFI loans are inherently short-term, and their success as stop-gap measures of poverty reduction are measurable. However, MFIs have no incentive to track their loan recipients months or years after they finish paying back their loan, which makes the longer-term benefits difficult to measure. Studies published by the American Economic Journal, J-PAL, and the Centre for Economic Policy Research that track loans from MFIs all determined that these loans do not correlate with increased short- or long-term business profits or income. The long-term impact of MFIs on women’s income in particular appears to be negligible.

This is not to say there are not important benefits to microfinance: MFIs that target disenfranchised women operate under the principle that women act as agents of change within their families and communities, with a larger percentage of their income funneled toward nutrition, education, and healthcare than men in similar communities. Domestic violence and substance abuse rates also decline as women become more integral to the local economy.  However, if the goal of MFIs is to boost profits and incomes in the long-term, this primary objective is not typically met.

Finally, since MFIs are not governed by the same regulations that bank loans face, they lack accountability, and for-profit MFIs tend to act as loan sharks with steep interest rates and high default rates. Independence from bank regulations is part of what makes good MFIs successful, but it allows poorly managed MFIs to continue bad business practices and causes more harm than good. While credit rating agencies for MFIs do exist, they advertise themselves as optional services for institutions to prove their credit worthiness. Without mandatory, rigorous monitoring and evaluation programs, and participation in ratings agencies or governing bodies, MFIs have the flexibility to reach out to the underserved populations that traditional banks cannot, but they can also take advantage of financially illiterate and geographically or culturally isolated loan applicants.

To ensure that the philanthropic spirit of MFIs is not overshadowed by inconsistent results, predatory lending, and other bad business practices, MFIs should:

• Require and provide basic financial literacy classes for all potential loan recipients – with a special focus on teaching women – in order to protect both the investment of the lenders as well as the financial future of the recipients;
• Focus on long-term monitoring and evaluation, and transparently publish these results so potential borrowers can make smart choices about which MFIs best suit their needs and goals; and
• Hold fellow MFIs accountable through ubiquitous enrollment in credit rating systems, competitive interest rates, and other good business practices that encourage competition among MFIs to provide the most honest, transparent, and effective services to individuals and communities in need. Reputable and robust international watchdog organizations may be necessary to ensure accountability among MFIs.