The Microfinance Revolution: An Overview

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The Microfinance Revolution: An Overview

Rajdeep Sengupta and Craig P. Aubuchon

The Nobel Prize committee awarded the 2006 Nobel Peace Prize to Muhammad Yunus and the

Grameen Bank “for their efforts to create economic and social development from below.” The

microfinance revolution has come a long way since Yunus first provided financing to the poor in

Bangladesh. The committee has recognized microfinance as “an important liberating force” and

an “ever more important instrument in the struggle against poverty.” Although several authors

have provided comprehensive surveys of microfinance, our aim is somewhat more modest: This

article is intended as a non-technical overview on the growth and development of microcredit

and microfinance. (JEL I3, J41, N80)

Federal Reserve Bank of St. Louis Review, January/February 2008, 90(1), pp. 9-30.

In its broadest sense, microcredit includes

the act of providing loans of small amounts, often

$100 or less, to the poor and other borrowers that

have been ignored by commercial banks; under

this definition, microcredit encompasses all

lenders, including the formal participants (such

as specialized credit cooperatives set up by the

government for the provision of rural credit)

and those of a more informal variety (such as the

village moneylender or even loan sharks). Yunus

(2007) argues that it is important to distinguish

microcredit in all its previous forms from the

specific form of credit adopted at the Grameen

Bank, which he calls “Grameencredit.” Yunus

argues that the “most distinctive feature of

Grameencredit is that it is not based on any col-

lateral, or legally enforceable contracts. It is based

on ‘trust,’ not on legal procedures and system.”

For the purposes of this article and unless men-

tioned otherwise, our use of the term microcredit

n 2006, the Grameen Bank and its founder

Muhammad Yunus were awarded the

Nobel Peace Prize for their efforts to reduce

poverty in Bangladesh. By providing small

loans to the extremely poor, the Grameen Bank

offers these recipients the chance to become

entrepreneurs and earn sufficiently high income

to break themselves free from the cycle of poverty.

Yunus’s pioneering efforts have brought renewed

attention to the field of microfinance as a tool to

eliminate poverty; and, since 1976 when he first

lent $27 to 42 stool makers, the Grameen Bank

has grown to include more than 5.5 million mem-

bers with greater than $5.2 billion in dispersed

loans. As microfinance institutions continue to

grow and expand, in both the developing and

developed world, social activists and financial

investors alike have begun to take notice. In this

article we seek to explain the rise in microfinance

since its inception in the early 1980s and the

various mechanisms that make microfinance

an effective tool in reducing poverty.

We also

address the current problems facing microfinance

and areas for future growth.

Other, more technical surveys of microfinance include Ghatak and

Guinnane (1999), Morduch (1999), and Armendáriz de Aghion

and Morduch (2005).

Rajdeep Sengupta is an economist and Craig P. Aubuchon is a research associate at the Federal Reserve Bank of St. Louis. The authors thank

Subhayu Bandyopadhyay, Patrick Pintus, and George Fortier for helpful comments and suggestions.

2008, The Federal Reserve Bank of St. Louis. Articles may be reprinted, reproduced, published, distributed, displayed, and transmitted in

their entirety if copyright notice, author name(s), and full citation are included. Abstracts, synopses, and other derivative works may be made

only with prior written permission of the Federal Reserve Bank of St. Louis.

will, for the most part, follow Yunus’s character-

ization of Grameencredit.

Although the terms microcredit and micro-

finance are often used interchangeably, it is

important to recognize the distinction between

the two. As mentioned before, microcredit refers

to the act of providing the loan. Microfinance,

on the other hand, is the act of providing these

same borrowers with financial services, such as

savings institutions and insurance policies. In

short, microfinance encompasses the field of

microcredit. Currently, it is estimated that any-

where from 1,000 to 2,500 microfinance institu-

tions (MFIs) serve some 67.6 million clients in

over 100 different countries.

Many MFIs have a dual mandate to provide

financial as well as social services, such as health

care and educational services for the underprivi-

leged. In this sense, they are not always perceived

as profit-maximizing financial institutions. At

the same time, the remarkable accomplishment

of microfinance lies in the fact that some of the

successful MFIs report high rates of repayment,

sometimes above 95 percent. This rate demon-

strates that lending to underprivileged borrow-

ers—those without credit histories or the assets

to post collateral—can be a financially sustainable

venture.

Not surprisingly, philanthropy is not a

requirement of microfinance—not all MFIs are

non-profit organizations. While MFIs such as

Banco Sol of Bolivia operate with the intent to

return a profit, other MFIs like the Grameen Bank

charge below-market rates to promote social

equity.

As will be discussed below, this distinc-

tion is important: As the microfinance industry

continues to grow and MFIs serve a wider client

base, the commercial viability of an MFI is often

viewed as crucial for its access to more main-

stream sources of finance. (We will return to this

and related queries in the “The Evidence of

Microfinance” section of this paper.) The next

section offers a brief history of the Grameen Bank

and a discussion of its premier innovation of

group lending contracts; the following sections

describe the current state of microfinance and

provide a review of some of the common percep-

tions on microfinance. The final section outlines

the future of microfinance, particularly in the

context of global capital markets.

A BRIEF HISTORY OF THE

GRAMEEN BANK

The story of the Grameen Bank is a suitable

point to begin a discussion of microcredit and

microfinance. After obtaining a PhD in economics

in 1969 and then teaching in the United States

for a few years, Muhammad Yunus returned to

Bangladesh in 1972. Following its independence

from Pakistan in 1971 and two years of flooding,

Bangladesh found itself in the grips of a terrible

famine. By 1974, over 80 percent of the popula-

tion was living in abject poverty (Yunus, 2003).

Yunus, then a professor of economics at

Chittagong University in southeast Bangladesh,

became disillusioned with economics: “Nothing

in the economic theories I taught reflected the life

around me. How could I go on telling my students

make believe stories in the name of economics?”

(See Yunus, 2003, p. viii.) He ventured into the

nearby village of Jobra to learn from the poor what

causes their poverty. Yunus soon realized that it

was their lack of access to credit that held them

in poverty. Hence, the origins of “microfinance”

emerged from this experience when Yunus lent

$27 of his own money to 42 women involved in

the manufacturing of bamboo stools.

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Microfinance Information Exchange (MIX) lists financial profiles

and data for 973 MFIs. The high estimate of 2,500 comes from a

survey conducted by the Microcredit Summit Campaign in 2002.

The social objectives of the Grameen Bank are summarized by the

16 decisions in their mission statement. The statement is available

at http://grameen-info.org/bank/the16.html.

Yunus (2003) describes his conversation with Sufiya, a stool maker.

She had no money to buy the bamboo for her stools. Instead, she

was forced to buy the raw materials and sell her stools through the

same middleman. After extracting interest on the loan that Sufiya

used to buy the bamboo that morning, the moneylender left her

with a profit of only 2 cents for the day. Sufiya was poor not for

lack of work or skills, but because she lacked the necessary credit

to break free from a moneylender. With the help of a graduate stu-

dent, Yunus surveyed Jobra and found 41 other women just like

Sufiya. Disillusioned by the poverty around him and questioning

what could be done, Yunus lent $27 dollars to these 42 women

and asked that he be repaid whenever they could afford it.

Through a series of trials and errors, Yunus

settled on a working model and by 1983, under a

special charter from the Bangladesh government,

founded the Grameen Bank as a formal and inde-

pendent financial institution. Grameen is derived

from the Bengali word gram, which means village;

grameen literally means “of the village,” an appro-

priate name for a lending institution that requires

the cooperation of the villagers. The Grameen

Bank targets the poor, with the goal of lending

primarily to women. Since its inception, the

Grameen Bank has experienced high growth rates

and now has more than 5.5 million members

(see Figure 1), more than 95 percent of whom are

women.

Lending to poor villagers involves a signifi-

cant credit risk because the poor are believed to

be uncreditworthy: That is, they lack the skills

or the expertise needed to put the borrowed

funds to their best possible use. Consequently,

mainstream banks have for the most part denied

the poor access to credit. The Grameen Bank has

challenged decades of thinking and received

wisdom on lending to the poor. It has success-

fully demonstrated this in two ways: First, it has

shown that poor households can benefit from

greater access to credit and that the provision of

credit can be an effective tool for poverty allevia-

tion. Second, it has proven that institutions do

not necessarily suffer heavy losses from lending

to the poor. An obvious question, though, is how

the Grameen Bank succeeded where so many oth-

ers have failed. The answer, according to most

economists, lies in its unique group lending

contracts, which enabled the Grameen Bank to

ensure repayment without requiring collateral

from the poor.

The Group Lending Innovation

This Grameen Bank lending model can be

described as follows: Borrowers organize them-

selves into a group of five and present themselves

to the Bank. After agreeing to the Bank rules, the

first two members of the group receive a loan. If

the first two successfully repay their loans, then

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Grameen Bank, annual reports (various years). Data can be viewed

at www.grameen-info.org/annualreport/commonElements/htmls/

index.html.

1976 1981 1986 1991 1996 2001

illions of Persons

Figure 1

Grameen Bank Membership

four to six weeks later the next two are offered

loans; after another four to six weeks, the last per-

son is finally offered a loan. As long as all mem-

bers in the group repay their loans, the promise

of future credit is extended. If any member of the

group defaults on a loan, then all members are

denied access to future credit. Furthermore, eight

groups of Grameen borrowers are organized into

centers and repayment is collected during public

meetings. While this ensures transparency, any

borrower who defaults is visible to the entire

village, which imposes a sense of shame. In rural

Bangladesh, this societal pressure is a strong dis-

incentive to default on the loan. Initial loans are

small, generally less than $100, and require weekly

repayments that amount to a rate of 10 percent

per annum.

Weekly repayments give the borrow-

ers and lenders the added benefit of discovering

problems early.

Group lending—or the joint liability con-

tract—is the most celebrated lending innovation

by the Grameen Bank. Economies of scale moti-

vated its first use, and Yunus later found that the

benefits of group lending were manifold. Under

a joint liability contract, the members within the

group (who are typically neighbors in the village)

can help mitigate the problems that an outside

lender would face. Outside lenders such as banks

and government-sponsored agencies face what

economists call agency costs. For example, they

cannot ensure that the borrowed money be put to

its most productive use (moral hazard), cannot

verify success or failure of the proposed business

(costly state verification/auditing), and cannot

enforce repayment. It is not difficult to see how

peers within the group can help reduce these

costs, particularly in a situation where the prom-

ise of future credit depends on the timely repay-

ment of all members in the group. Joint liability

lending thus transfers these agency costs from

the bank onto the community of borrowers, who

can provide the same services more efficiently.

But perhaps the more difficult agency prob-

lem faced by lenders is that of adverse selection—

ascertaining the potential credit risk of the

borrower. Market failure occurs because safe

borrowers (who are more likely to repay) have to

subsidize risky borrowers (who are more likely

to default). Because the bank cannot tell a safe

borrower from a risky one, it has to charge the

same rate to all borrowers. The rate depends on

the mix of safe and risky borrowers in the popu-

lation. When the proportion of risky borrowers

is sufficiently large, the subsidy required (for the

lender to break even on all borrowers) is so high

that the lender has to charge all borrowers a sig-

nificantly high rate. If the rates are sufficiently

high, safe borrowers are unlikely to apply for a

loan, thereby adversely affecting the composition

of the borrower pool. In extreme cases, this could

lead to market failure—a situation in which

lenders do not offer loans because only the risky

types remain in the market!

Economic theory helps show how joint liabil-

ity contracts mitigate adverse selection (Ghatak

and Guinnane, 1999). Under group lending, bor-

rowers choose their own groups. A direct way in

which this might help is when a prospective

customer directly informs the bank about the

reliability of potential joiners. Perhaps a more

surprising result is that the lender can mitigate

the adverse selection problem even when cus-

tomers do not directly inform the bank but form

themselves into like groups (peer selection). That

is, given a joint liability clause, safe customers

will more likely group together with other safe

customers, leaving the risky types to form groups

by themselves. This “assortative matching” miti-

gates the adverse selection problem because now

the risky borrowers are the ones who must bail out

other risky borrowers, while the safe borrowers

have to shoulder a lesser subsidy. Consequently,

all borrowers can be charged a lower rate, reduc-

ing the likelihood of a market failure.

CURRENT STATE OF

MICROFINANCE

Since the inception of the Grameen Bank,

microfinance has spread to cover five continents

and numerous countries. The Grameen Bank has

See www.grameen-info.org/bank/GBGlance.htm. Other sources

put the annual rates charged by MFIs at around 30 to 60 percent.

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been duplicated in Bolivia, Chile, China, Ethiopia,

Honduras, India, Malaysia, Mali, the Philippines,

Sri Lanka, Tanzania, Thailand, the United States,

and Vietnam; the microfinance information

exchange market (MIX) lists financial information

for 973 MFIs in 105 different countries. Some

MFIs have also begun to seek out public and

international financing, further increasing their

amount of working capital and expanding the

scope of their operations. As MFIs have become

more efficient and increased their client base, they

have begun to expand their services through differ-

ent product offerings such as micro-savings, flexi-

ble loan repayment, and insurance. We discuss

these three different product offerings below.

At the time of their inception, many MFIs

included a compulsory savings component that

limited a borrower’s access to deposited funds.

This promoted long-term savings, but ignored

the fact that many poor save for the short term to

smooth consumption during seasonal lows of pro-

duction. Figure 2 provides a look at the distribu-

tion of voluntary MFI savings by region. As MFIs

have become better versed in the microfinance

market, they have applied their innovations in

lending to the collection of deposits. One of the

leading examples is SafeSave, located in Dhaka,

Bangladesh, which uses the idea that frequent

small deposits will guard against the temptation

of spending excess income. To keep the transac-

tion costs of daily deposits low, SafeSave hires

poor workers from within the collection areas

(typically urban slums) to meet with clients on

a daily basis. By coming to the client, SafeSave

makes it convenient for households to save; by

hiring individuals from the given area, training

costs and wages are also kept low. With this effi-

cient model for both the bank and individuals,

SafeSave has accumulated over 7,000 clients in

six years.

Not surprisingly, microfinance deposits

(like microfinance loans) break from traditional

commercial banking experiences. The example

of Bank Rakyat Indonesia (BRI) suggests that the

poor often value higher liquidity over higher inter-

est rates on deposit products. In 1986, after a year

of field experiments, they offered two deposit

products: The TABANAS product offered a 12

percent interest rate but restricted withdrawals

to twice monthly, whereas the SIMPEDES prod-

uct offered an interest rate of zero but allowed

unlimited withdrawals. The SIMPEDES program

saw the largest gain in popularity and to this day

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See www.savesafe.org.

Africa, 8.4

. Asia, 10.6

atin America, 6.8

Eastern Europe/C. Asia, 2.7

E. Asia Pacific, 32.6

953 MFIs Reporting, July 2007

61 Million Savers

Figure 2

Savings by Region

SOURCE: Microfinance Information Exchange Network; www.mixmarket.org.

still offers a lower interest rate but maintains more

accounts than the TABANAS program.

The original Grameen Bank was one of the

first MFIs that incorporated a compulsory savings

requirement into their lending structure. Every

client was required to make a deposit worth 5

percent of their given loan, which was placed

into a group fund with strict withdrawal rules

(generally no withdrawals before three years). In

2001, the Grameen Bank reviewed both its lend-

ing and savings policy and reinvented itself as

Grameen II. At the heart of this change were more

savings options and more flexible loans, which

act as a form of insurance. New to Grameen II is

a pension fund, which allows clients with loans

greater than 8,000 taka ($138) to contribute at least

50 taka ($0.86) per month. The client receives 12

percent per year in compound interest, earning a

187 percent return after the mandatory 10-year

wait. This scheme allows Grameen II to earn more

money in the present and expand services, while

delaying payment in the near future.

Grameen II serves as a good example of a sec-

ond innovation in microfinance: flexible loan

repayment. Group lending still exists and is an

integral part of the process, but Grameen II intro-

duced a flexi-loan that allows borrowers multi-

ple options to repay their loan on an individual

basis. Yunus (2002) stated that “group solidarity

is used for forward-looking joint actions for

building things for the future, rather than for the

unpleasant task of putting unfriendly pressure on

a friend.” The flexi-loan is based on the assump-

tion that the poor will always pay back a loan and

thus allows the poor to reschedule their loan

during difficult periods without defaulting. If

the borrower repays as promised, then the flexi-

loan operates exactly like the basic loan, using

dynamic incentives

to increase the size of the

loan after each period. If the borrower cannot

make her payments, she is allowed to renegotiate

her loan contract rather than default. She can

either extend the life of the loan or pay only the

principle for an extended period of time. As a

penalty, the dynamic incentives of her loan are

reset; she cannot access larger (additional)

amounts of credit until the original loan is repaid.

Because her default now poses no threat to the

group promise of future credit, each member is

accountable only up to their individual liabilities.

The third offering is the addition of insurance

to microfinance loans. The most basic insurance

is debt relief for the death of a borrower, offered

by many MFIs, including Grameen. Other MFIs

have begun experimenting with health insurance

and natural disaster insurance. As with lending,

agency problems present a dilemma for micro-

insurance. To this end, some groups such as

FINCA Uganda require life insurance of all bor-

rowers, including “risky” and “healthy” alike and

thus avoid the adverse selection problem. Other

ideas include providing rain insurance to guard

against catastrophes. This relies on the assumption

that crop yields (and much of the developing

economy) are tied to seasonal rain cycles. This

innovation eliminates the problem of moral hazard

associated with a crop loan. By tying performance

to rain cycles, a farmer has no incentive to take

crop insurance and then fail to adequately pro-

duce a crop during a season of adequate rainfall.

A more recent phenomenon in microfinance

is the emergence of foreign investment in MFIs.

As more and more MFIs establish positive returns,

microfinance is being seen by many professional

investors as a profitable investment opportunity.

One of the most important developments for the

MFIs was the June 2007 release of Standard &

Poor’s (S&P) report on the rating methodology

for MFIs. By applying a common methodology,

S&P will be able to send a stronger signal to poten-

tial investors about the quality of MFI investments.

The process of debt offerings and securitization

in the microfinance sector will be covered in

greater detail below.

MICROFINANCE AROUND THE

WORLD

As Yunus and the Grameen Bank began to

prove that microfinance is a viable method to

The SIMPEDES program does also use a lottery system to give

rewards, often worth 0.7 percent of deposits. More details are

available at the BRI web page: www.bri.co.id/english/mikrobank-

ing/aboutmikrobanking.aspx.

Dynamic incentives threaten to exclude defaulted borrowers from

future loans.

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alleviate poverty, their methodology and program

began to spread around the world. It is difficult

to know exactly how many MFIs there currently

are, but Microfinance Information Exchange (MIX)

estimates range from 1,000 to 2,500 serving some

67.6 million clients. Of these 67 million, more

than half of them come from the bottom 50 per-

cent of people living below the poverty line.

That is, some 41.6 million of the poorest people

in the world have been reached by MFIs. MFIs

have expanded their operations into five differ-

ent continents and penetrated both rural and

urban markets. They have achieved success with

a variety of credit products and collection mech-

anisms. Table 1 provides a comparison of several

groups from around the world.

Banco Solidario (Bolivia)

Banco Solidario originally existed as the

Fundacion para Promocion y el Desarrollo de la

Microempresa (PRODEM), a non-governmental

organization (NGO) in the mid-to-late 1980s and

provided small capital loans to groups of three

or more people dedicated to entrepreneurial

activities. By 1992, PRODEM serviced 17,000

clients and disbursed funds totaling $4 million

dollars. Constrained by the legal and financial

regulations governing an NGO, the board of

directors decided to expand their services and

PRODEM became the commercial bank, Banco

Solidario, later that year. Currently, Banco Sol

has 48 branches in seven cities with over 110,000

clients and a loan portfolio of more than $172

million. As of March 31, 2007, Banco Sol reported

a past-due loans level of only 1.78 percent. An

important distinction between Grameen and

Banco Sol is the latter’s emphasis on returning a

profit with poverty alleviation stated only as a

secondary goal.

Banco Sol offers credit, savings, and a variety

of insurance products. Their initial loan offering

was based on Grameen-style joint-liability lend-

ing, offering a maximum of $3,000 per client to

groups of three or four individuals with at least

one year of experience in their proposed occupa-

tion. Using dynamic incentives, the size of the

loan is gradually increased based on good repay-

ment history. Annual interest rates average

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Table 1

Characteristics of Select Microfinance Institutions

nterprise

Grameen Bank, Banco Sol, Compartamos, Development Group,

Bangladesh Bolivia Mexico Washington, D.C.

Established 1983 1992 1990 1993

Membership 6,948,685 103,786 616,528 250

Average loan balance (US$) $69 $1,571 $440 $22,285**

Percent female 96.70% 46.40% 98.40% 30.00%

Group lending contracts? Yes Yes Yes No

Collateral required? No No No No

Portfolio at risk >30 days ratio 1.92% 2.91% 1.13% N/A

Return on equity 1.95%* 22.81% 57.35% N/A

Operational self-sufficiency 102.24%* 120.09% 181.22% 53%**

NOTE: *12/31/2005; **2004.

SOURCE: Data for this table come from the Microfinance Information Exchange (MIX) Network, which is a web-based platform:

www.mixmarket.org. Information was provided for the Enterprise Development Group because it is the only U.S.-based MFI that

reports data on the MIX network. Some of the information for EDG was taken from their 2003/2004 annual report, available at

www.entdevgroup.org. Comparable information is not available for the Southern Good Faith Fund, as the scope of their mission has

changed and expanded to more training-based programs. A more comprehensive summary chart exists in Morduch (1999).

between 12 and 24 percent and can be anywhere

from 1 to 60 months in length (120 months for a

housing loan).

With these higher interest rates,

Banco Sol does not rely on subsidies and, at the

end of 2006, posted returns on equity of 22.8

percent.

Compartamos (Mexico)

Compartamos is the largest MFI in Mexico,

servicing some 630,000 clients with an active

loan portfolio of $285 million. Located in Mexico

City, Compartamos is active in 26 Mexican states

throughout the country and services primarily

rural borrowers. Compartamos was founded in

1990 and began by offering joint-liability loans

to female borrowers for income-generating activ-

ities. Compartamos has only recently expanded

their services to allow men to borrow through

their solidarity group and their individual credit

program; still, around 98 percent of their borrow-

ers are female. In 1998, Compartamos formed a

strategic alliance with Accion International and

transformed into a regulated financial institution,

called a Sociedad Financiera de Objeto Limitado

(SFOL). In 2002, Compartamos took a unique step

for a MFI and became one of the first MFIs to issue

public debt, listing themselves on the Mexican

Stock Exchange. As an SFOL, Compartamos was

limited to only offering credit for working capital.

In order to offer more services, such as savings

and insurance programs, Compartamos became a

commercial bank in 2006.

Compartamos was one of the first MFIs to

raise additional capital funds through the sale of

domestic bond issuances. In 2002, Compartamos

was the first MFI in Mexico and one of the first

in Latin America to offer a bond sale. Because

this was Standard and Poor’s first attempt at rat-

ing a microfinance bond, they adapted their cur-

rent methodology and rated the bond using their

Mexican scale and assumed local buyers. S&P was

impressed with the diversified portfolio of debt

and offered Compartamos an MXA+ (Mexican

AA) rating. Reddy and Rhyne (2006) report that

their most recent bond was rated an MXAA

through the use of credit enhancements, allow-

ing them to place the bond with institutional

investors. Their fifth issue to date was three times

oversubscribed with 70 percent of the bond pur-

chased by institutional investors. By accessing

the commercial market, Compartamos has been

able to lower the cost of obtaining funds and, in

turn, offer better services to their borrowers, such

as absorbing the costs of providing life insurance

for all clients. Their efforts to improve operational

efficiency have also created a self-sufficient MFI

that has existed without subsidies for over a

decade.

Good Faith Fund (United States)

The Good Faith Fund was modeled after the

Grameen Bank and was one of the first MFIs to

be established in America. In 1986, while gover-

nor of Arkansas, Bill Clinton invited Muhammad

Yunus to visit and discuss microfinance. The

initial program was started as the Grameen Fund,

but the name was later changed to better reflect

the fund’s commitment to providing loans to

micro-entrepreneurs. Loans weren’t securitized

with collateral; rather, they were guaranteed on

“good faith” (Yunus, 2003, p.180).

As the Good Faith Fund grew, practitioners

and academics alike began to question the effec-

tiveness of a pure Grameen-style program in the

United States. Much like the original Grameen

Bank, the Good Faith Fund has relied on innova-

tion and change to apply microlending to the

rural economy of Arkansas. Taub (1998) argues

that the Good Faith Fund is a successful poverty

alleviation program, but that it is a poor eco-

nomic development program. In Taub’s words,

“the Good Faith Fund has never been able to

deliver a meaningful volume of customers, pro-

vide substantial loan services to the really poor,

or achieve anything close to institutional self-

sufficiency.” He argues that important social dif-

ferences arise because rural Arkansas is

inherently different from rural Bangladesh and

that these social differences cause the group

lending model to fail.

Group lending failed for several reasons, but

foremost was the inability of potential borrowers

to form a group. In Bangladesh, where poverty

Banco Sol, accessed July 27, 2007; www.bancosol.com.bo/en/

intro.html.

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rates and population density are much higher

than the those in the United States, potential

borrowers can more readily find other entrepre-

neurs. However, a close network of social ties

among the poor does not exist in rural Arkansas.

In response to this problem, Good Faith Fund

personnel established a mandatory six-week

training program for individual new members

and then created groups from the training pro-

grams. These newly formed groups of relative

strangers lacked the social cohesion to enforce

contract payments, unlike group members in rural

Bangladesh, who often live in the same village

and have family/community histories together.

Consequently, group lending was slowly phased

out of the Good Faith Fund. Today, the Good Faith

Fund focuses mainly on career training through

their Business Development Center and Asset

Builders program. They have also found a niche

in loaning larger amounts of money to small- and

medium-sized enterprises that are underserved

by the commercial banking center. These loans

provide the same service, but at $100,000 or more,

they can hardly be considered “micro” credit.

THE EVIDENCE ON

MICROFINANCE

In this section, we review some of the impor-

tant questions on microfinance. Our assessment

is based on numerous studies, technical surveys,

and newspaper reports on microfinance. The

attempt here is to be illustrative rather than pro-

vide a comprehensive review of microfinance.

Is Microfinance a Desirable Alternative

to Informal, Exploitative Sources of

Finance?

The spread of microfinance and the success

of MFIs in various countries around the world

prompts a question: Who served the poor before

the microcredit revolution? It is well known that

conventional banks, which act as creditors to most

entrepreneurial activity in the modern world, have

largely avoided lending to the poor. Instead, credit

to the poor has been provided mostly by local

moneylenders, often at usurious rates. Conse-

quently, moneylenders are typically perceived

as being exploitative, taking advantage of poor

villagers who have no other recourse to loans.

Therefore, it is not surprising that microfinance

has been welcomed by most as an alternative to

the abusive practices of village moneylenders.

However, this common perception requires a

more careful study: Why don’t mainstream banks

lend to the poor? In the banks’ absence, do local

moneylenders have monopoly power? More

importantly, are these high interest rates charged

by moneylenders welfare reducing?

We begin by listing the difficulties that arise

in lending to the poor. First, early studies believed

that poor people often lack the resources needed

to invest their borrowings to the most productive

use. In short, the poor borrow mostly to finance

consumption needs (Bhaduri, 1977; Aleem, 1990).

Second, even if loans could be earmarked for

investment purposes, commercial banks would

find it difficult to lend: Lack of credit histories

and documented records on small entrepreneurs

or farmers make it difficult for the bank to assess

the creditworthiness of the borrower. Finally, there

is the inability of the poor to post collateral on

the loans. This reduces the bank’s recourse to a

saleable asset once the borrower defaults on the

loan. Therefore, it is not difficult to see why com-

mercial banks have avoided lending to the poor.

On the other hand, it is believed that local

moneylenders could mitigate the problems faced

by outside banks in lending to the poor. Local

moneylenders are arguably better informed of

borrower quality and have more effective means

of monitoring and enforcing contracts than out-

side banks. In short, because of their social ties,

information, and location advantage, these mon-

eylenders are in a unique position to lend to the

poor. Some observers argue that usurious interest

rates in these markets can be explained by this

“monopoly” that the local moneylenders enjoy.

Several researchers have studied the market

structure of rural credit markets in developing

countries. Some argue that rural credit markets

are more competitive than previously imagined

because there is free entry for local moneylend-

ers if not outside banks. While there is no broad

consensus yet, most observers believe that despite

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free entry in these markets, moneylenders often

enjoy some form of local monopoly power (in the

manner of monopolistic competition), at least in

the short run.

However, there are other reasons why money-

lenders charge high interest rates. First, money-

lenders have to compensate for the high

transaction costs of issuing and servicing a small

loan. Second, some observers believe that these

funds have high “opportunity costs”—that is,

moneylenders can earn high returns by investing

in their own farms. Finally, and this is despite

their local informational advantage, moneylenders

face some of the same problems as commercial

banks in identifying risky borrowers and securing

collateral, particularly in poor rural areas. A

simple numerical example helps illustrate this

result

: Consider two lenders with the same cost

of funds. Suppose now that the first lender oper-

ates in a prime market where borrowers faithfully

repay all of their loans at 10 percent, giving him

an expected 10 percent return. However, the sec-

ond lender operates in a poor rural market where

borrowers arguably have a higher rate of default,

say 50 percent.

Consequently, her expected net

return is thus [共1 + interest rate兲

共1 – probability

of default兲 – 1]. Therefore, for the second money-

lender to earn the same 10 percent return, she

must charge an interest rate equal to 120 percent:

共1 + 120%兲

共1 – 50%兲 – 1 = 10%. This is not to

say that some moneylenders don’t engage in

price setting, but it does give a simple example

in which a moneylender can be competitive but

still charge extremely high interest rates.

Do moneylenders reduce welfare because

they charge high interest rates? To the extent that

borrowers willingly accept these loan contracts,

the answer is no.

These loan contracts do gen-

erate a positive surplus ex ante. That is, only those

borrowers who expect to generate a rate of return

from their investment that is higher than that

charged by the moneylender will enter into these

contracts. Clearly, this situation can be improved

upon by offering lower rates: This would allow

more borrowers—i.e., those who expect to gener-

ate a lower rate of return on their investment—to

enter into loan contracts. However, this does not

mean that a high interest rate per se reduces wel-

fare. On the contrary, getting rid of moneylenders

or preventing them from offering loans at these

high rates can be welfare reducing; in their

absence, entrepreneurs with the highest returns

on their projects have no recourse to loans.

In contrast, MFIs can often offer lower interest

rates than local moneylenders because of their

higher efficiency in screening and monitoring

borrowers, which results from both their economy

of scale (serving more borrowers) and their use of

joint liability lending mechanisms. This lowers

the MFI’s cost of lending relative to that of the

local moneylender. To the extent that MFIs can

provide loans at a lower rate than moneylenders,

enabling more and more borrowers to enter the

credit market, is an argument for both the effi-

ciency (because of the reduced cost of funds) and

welfare enhancement (because of an increase in

the borrower pool) of microfinance.

How High are the Repayment Rates

for MFIs?

This is widely regarded as the greatest achieve-

ment of microfinance. Many MFIs report high

rates of repayment, often greater than 90 percent.

These claims have driven considerable academic

interest in why and how microfinance works.

Furthermore, these repayment rates are widely

cited in popular media (Business Week, July 9

and 16, 2007; Wall Street Journal, September 23,

2007) and have been one of the reasons for the

recent interest generated by microfinance in finan-

cial markets worldwide. Although the theories of

joint liability contracts, progressive lending,

frequent repayments, and flexible collateral ade-

quately explain these high rates of repayment,

Morduch (1999) raises the important issue of

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Progressive lending is a type of dynamic incentive in which

access to larger amounts of credit becomes available after each

successfully repaid loan.

This example in Armendáriz de Aghion and Morduch (2005) is

drawn from the early work of Bottomley (1975).

Of course, Yunus believes that this wrong assumption is the root

of all the problems that the poor have in obtaining credit.

Bhaduri (1973) points to some degree of coercion in rural credit

markets, particularly in situations where landlords double as

moneylenders.

validation. Because many of these repayment

rates are self reported, it is important to under-

stand the methodology used to calculate these

repayment rates.

Morduch studies the repayment rates for the

Grameen Bank for the 10-year period of 1985 to

1996. During this period, Grameen’s average loan

portfolio grew from $10 million to $271 million

and membership expanded more than 12-fold to

include 2.06 million members in 1996. For this

decade, Grameen reports an average overdue rate

of only 1.6 percent.

Morduch’s contention is

that the Grameen Bank does not follow conven-

tional accounting practices and calculates the

overdue rates as the value of loans overdue (for

more than one year) divided by the current port-

folio, instead of dividing by the size of the port-

folio when the overdue loans were issued. Because

the size of the loan portfolio expanded 27-fold

during this 10-year period, the loan portfolio is

significantly larger at the end of any one year than

at the beginning. Morduch finds the adjusted

average default rate to be 7.8 percent for the same

10-year period. He makes the point that “the rate

is still impressive relative to the performance of

government development banks, but it is high

enough to start creating financial difficulties”

(Morduch, 1999, p. 1590).

As for these financial difficulties, Morduch

then focuses on reported profits, taking special

care to examine the provision of loan losses. He

finds that the bank is slow to write off bad loans,

dropping only a modest 3.5 percent of its portfolio

every year, again overstating the amount of profit.

He calculates that instead of posting a total of

$1.5 million in profits, the bank would have

instead lost a total of $18 million. The implica-

tions to Morduch’s findings are as follows: In the

early 1990s, to operate without subsidies, the

Grameen Bank would have had to raise interest

rates on its general product from 20 percent to

50 percent, and this would have raised the aver-

age interest rate on all products to 32 percent.

Morduch is careful to point out that it is unknown

whether or not borrowers would defect, because

for most borrowers the alternative is either no

loan or an even higher interest rate on loans from

a moneylender.

Although there is an apparent disagreement

between Morduch’s adjusted rates of repayment

and the Grameen Bank’s self reported rates, this

alone does not mean that Grameen is a financial

failure. In one case, the modest write-offs of bad

loans offer proof of Yunus’s organizational com-

mitment to the poor and the belief that, given time,

they will repay a loan. The since-implemented

Grameen II Bank builds on this concept and

allows borrowers to restructure a loan into smaller

payments or to take a scheduled amount of time

off, rather than default. Yunus describes the dif-

ference: “[The] overarching objective of the con-

ventional banks is to maximize profit. The

Grameen Bank’s objective is to bring financial

services to the poor, particularly women and the

poorest and to help them fight poverty, stay prof-

itable and financially sound. It is a composite

objective, coming out of social and economic

visions.” Given that the Grameen Bank’s focus is

largely on social objectives and not profit maxi-

mization, some have argued that it is not obligated

to adopt standard accounting procedures. What

is important is that Grameen is among the few

transparent microfinance organizations and

researchers have been able to review and evaluate

their financial statements.

An important consideration here is that MFIs

are known to charge considerably higher rates

compared with similar loans from conventional

banks. In their celebrated work, Stiglitz and Weiss

(1981) showed that the high interest rate that a

lender charges may itself adversely affect repay-

ment rates by either discouraging creditworthy

borrowers (adverse selection) or tempting the

borrowers to opt for riskier projects (moral hazard).

Consequently, the coexistence of high repayment

rates (around 95 percent) and higher interest rates

(a 30 to 60 percent interest rate is common) in

microfinance has “puzzled” economists.

One explanation offered by some economists

is that MFIs face an inelastic demand for loans.

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In comparison, nonperforming loans averaged between 1 and 1.5

percent for all U.S. commercial banks for the decade of 1995 to

2005. (Source: Federal Financial Institutions Examination Council.)

Braverman and Gausch (1986) found that government credit pro-

grams in Africa, the Middle East, Latin America, South Asia, and

Southeast Asia all had default rates between 40 and 95 percent.

However, in a recent empirical study on the

SafeSave program in Dhaka slums, Dehejia,

Montgomery, and Morduch (2005) show that the

elasticity of demand for microcredit may be sig-

nificantly negative even though certain groups

of borrowers (particularly the wealthier ones) do

not reduce their demand when faced with higher

interest rates. However, Emran, Morshed, and

Stiglitz (2006) offer a more promising explanation

for this puzzle. Departing from the traditional

focus on credit markets in studies of microfinance,

the authors examine the implications of missing

or imperfect labor markets for poor women in

developing countries (the typical customers of

MFIs in Bangladesh). Emran, Morshed, and

Stiglitz (2006, p. 4) demonstrate “the critical role

played by the structure of the labor market in

making the small-scale household-based invest-

ment projects ‘credit worthy’ in the face of very

high interest rates, especially for the poor house-

holds with little or no collaterizable assets.”

Is There More to Microfinance than

Group Lending or Joint Liability

Contracts?

The success of microfinance in generating

high repayment rates led many economists to

investigate the reasons behind this success. The

mid-to-late 1990s witnessed a large increase in

the number of journal articles on group lending

contracts, as economists sought to explain how

microfinance “succeeded” where traditional

forms of lending had failed. Joint liability con-

tracts were seen as the break from traditional

lending mechanisms and economic theory was

used to readily explain how these contracts

helped to improve repayment rates. The growth

of the literature on group lending contracts in the

mid-1990s offers the impression that all MFIs

operate as such, but the reality is that MFIs use a

variety of lending techniques, such as dynamic

and progressive loans, frequent repayment sched-

ules, and nontraditional collateral to ensure high

repayment rates among poor, underserved borrow-

ers. These mechanisms were either introduced

independently or in conjunction with joint liabil-

ity programs such as Grameen’s and in many cases

operate alongside group contracts. Practitioners

and theorists alike have now realized that these

mechanisms can operate with individual contracts

and in certain cases (e.g., in areas of low popula-

tion density) offer better repayment results than

group lending schemes.

The mechanism of progressive lending guards

against the borrower’s strategic default at the end

of a loan cycle, because by definition she has little

or no collateral to be seized in the event of default.

Instead, MFIs have offered small initial loans,

with the promise of future credit for timely repay-

ment. The offer of future credit serves as a power-

ful incentive for a micro-entrepreneur trying to

grow her business. In this scenario, a borrower

will default only if her current income is greater

than her future expected profits. With a small ini-

tial loan for a beginning entrepreneurial venture,

this is unlikely. To further increase the likelihood

of repayment, MFIs use dynamic lending, in

which the size of the loan is gradually increased

with each successive loan repayment. Now, the

expected future profits are almost certainly

greater than current earned income because the

size of the loan continues to grow.

Another mechanism used by MFIs is that of

frequent repayments, which often begin even the

week after the loan is disbursed. By requiring

small repayments before the business venture

has reach maturity, MFIs are essentially requiring

that borrowers have a second source of income

and, hence, borrow against their current consump-

tion. This allows MFIs to screen against high-risk

borrowers from the beginning because borrowers

will be able to repay the loan even if their venture

fails. Indeed, weekly repayments give the borrow-

ers and lenders the added benefit of discovering

problems early. Armendáriz de Aghion and

Morduch (2005) also suggest that frequent repay-

ments provide better customer service, contrary

to the belief that more repayments raise the trans-

action costs for the borrower by requiring more

travel to and from payment centers. Instead, fre-

quent repayments help borrowers with savings

constraints such as seasonality of income, family

members dropping by to borrow funds, or discre-

tionary spending by one or more of the family

members. When coupled with dynamic incen-

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tives, frequent loan repayments begin to resemble

savings deposits that will be paid with interest

(the graduated size of the next loan). This allows

families to break free of certain savings constraints

(such as those noted above) because the loan is

paid each week, before the money can be spent

on anything else.

The final mechanism is the requirement of

nontraditional collateral, which was introduced

by banks such as Bank Rakyat Indonesia (BRI).

This feature breaks from the commercial practice

that collateral submitted must have a resale value

equal to the loan. In a group lending contract,

joint liability often serves as collateral, but BRI

operates on the “notional value” of an item and

allows collateral to be any item that is important

to the household, regardless of market value. This

may include the family’s sole domestic animal,

such as a cow, or it may be land that is not secured

by title. Neither item could be sold for much of a

profit without significant transaction costs to the

bank, but both items would be even more difficult

and costly for the family to do without.

Armendáriz de Aghion and Morduch (2000)

offer evidence of the success of individual loans

that use progressive/dynamic incentives, frequent

repayments, and nontraditional collateral to

guarantee a loan. Using data from Eastern Europe

and Russia, they demonstrate that individual

loans can generate repayment rates greater than

90 percent (and above 95 percent in Russia). In

industrialized settings, borrowers are more likely

to face more competition, making it more costly

to form a borrowing group. In this scenario, loan

products will go to different entrepreneurs, with

different expected payoffs—hence, necessitating

different loan amounts. A group contract can be

inefficient because it imposes a ceiling on the

loan size equal to that given to the smallest mem-

ber of any potential group. They conclude by

suggesting that in areas that are relatively indus-

trialized, individual loan models may perform

better than traditional group lending models.

Is Microfinance an Important Tool for

Poverty Alleviation?

Microfinance started as a method to fight

poverty, and although microfinance still fulfills

this goal, several institutions have sought to make

a distinction between the “marginally poor” and

the “very poor.” The broadest definition distin-

guishing these two groups comes from the

Consultative Group to Assist the Poorest (CGAP),

which defines the poor as individuals living

below the poverty line and the poorest as the

bottom half of the poor. The World Bank estimates

that in 2001, some 1.1 billion people had con-

sumption levels below $1 and another 2.7 billion

lived on less than $2 per day.

As microfinance

continues to grow, questions have started to focus

on who is the optimal client. Should microfinance

target the marginally poor or the extremely poor?

Morduch (1999) tries to answer this question

by considering two representative microfinance

clients, one from each poverty group described

above. The first client belongs to a subsidized

microfinance program and her income is only 50

percent of the poverty line. The second client

belongs to a financially sustainable program that

accordingly charges higher interest rates. To

ensure repayment of the loan at the higher rate,

the second borrower is chosen to be marginally

poor, that is, with an income of 90 percent of the

poverty line. Using the widely used “squared

poverty gap” (Foster, Greer, and Thorbecke, 1984)

measure of poverty, Morduch suggests that a

dollar increase in income for the very poor bor-

rower has a five times greater impact than the

same dollar for the marginally poor borrower.

This simple example would suggest that, in

terms of poverty alleviation, MFIs should focus

on the poorest borrowers first, but this is not

always the case. As MFIs seek to become finan-

cially independent, they find themselves serving

only the marginally poor. This is an important

distinction between Grameen and Banco Sol of

Bolivia: The latter’s emphasis is on returning a

profit, and alleviating poverty is seen only as a

secondary goal. Not surprisingly, Banco Sol

charges higher interest rates,

does not rely on

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World Bank, “Poverty Analysis”; data can be viewed at

http://web.worldbank.org.

Annual interest rates average between 12 and 24 percent and can

be anywhere from 1 to 60 months in length (120 months for a

housing loan). The data are from Banco Sol, accessed 7/27/07;

www.bancosol.com.bo/en/intro.html.

subsidies, and at the end of 2006 posted returns

on equity of 22.8 percent.

This apparent dichotomy between financial

independence and poverty alleviation also gets

to the heart of a different problem. At what point

does a successful MFI begin to look like a regular

bank? If the MFI successfully serves poor clients,

then those clients should be able to use their loans

to lift themselves out of poverty. Because of the

nature of progressive and dynamic loans, success-

ful borrowers earn access to larger loans, helping

them break free of poverty even faster.

The Grameen Bank has found a way to make

this dichotomy work for them and now uses their

economy of scale to create a financially independ-

ent bank without raising interest rates. In 1995,

the Grameen Bank decided not to request any

more funds from donors and instead began to

fund the bank from collected deposits. With more

than two decades of successful borrowers behind

them, Grameen has had a chance to build up sav-

ings deposits slowly, to the point that it is now

self-sustainable, based on the amount of funds

provided by members. In a rough sense, it is now

the more-successful poor that are subsidizing

new clients. This is a significant step, especially

considering that, from the decade of 1985 to 1996,

Armendáriz de Aghion and Morduch (2005) cal-

culate that Grameen accepted $175 million in

subsidies, including both direct donations and

“soft” donations such as soft loans, implicit sub-

sidies through equity holdings, and delayed loan

loss provision.

Is Microfinance Sustainable or Even

Profitable?

With all of the positive publicity surrounding

microfinance, it may be surprising to learn that

not all MFIs are sustainable or able to return a

profit. Despite their rapid growth and sound

operations based on strong theoretical platforms

(such as using group loans, dynamic incentives,

and frequent repayments), less than half of all

MFIs return a profit and most still require the

help of donors and subsidies. A lack of financial

sustainability doesn’t necessarily indicate a failing

MFI, but rather raises questions about the mission

and direction of that particular MFI. Even with

subsidies, many MFIs remain the most cost-

effective method to alleviate poverty; and, as we

argued previously, subsidies can help change the

profile of the targeted client from the poor to the

extremely poor.

For an MFI to be sustainable can mean one of

two things: The organization can be operationally

sustainable or it can be financially sustainable.

An MFI that is operationally sustainable raises

enough revenue to cover the cost of operating

the business—paying loan supervisors, opening

branch offices, etc. Subsidies might still be used

to issue loans or cover defaulted loans. An insti-

tution that is financially sustainable does not

require any subsidized inputs or outside funds

to operate. Instead, it raises money through its

lending operations. The MicroBanking Bulletin

(2003) surveyed 124 MFIs with a stated commit-

ment to becoming financially sustainable. In their

survey, the Bulletin found that only 66 operations

were sustainable, a rate just slightly above 50

percent. As Armendáriz de Aghion and Morduch

(2005, p. 232) note, all 124 programs asked for

help in managing their accounting standards and,

hence, “in terms of financial management, [these

124 programs] are thus skimmed from the cream

of the crop.” Similar sustainability data do not

exist for the other 2,000+ MFIs; but, without simi-

larly strong commitments to financial sustain-

ability, the percentage of sustainable operations

is likely to be much lower than 50 percent.

Subsidized credit is financed in a variety of

forms, some of which have been discussed briefly

with the Grameen Bank example. MFIs also secure

funds from donors, many of whom want to alle-

viate poverty but have not seen strong returns in

the nongovernmental organization (NGO) or gov-

ernment sector. For many, donations and subsidies

are intended as a method to get MFIs started. But

without any accountability or empirical research,

it is difficult for donors to decide at what point

an MFI should forgo its dependence on outside

funds. Lacking in this debate is a clear under-

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MIX Market financial data are from BancoSol, accessed 8/2/07;

www.mixmarket.org/en/demand/demand.show.profile.asp?

token=&ett=280.

standing of how subsidies affect the supply and

demand of loans. Without subsidies, interest rates

may rise; and, as standard demand theory sug-

gests, fewer loans will be requested. Moreover,

rising interest rates without subsidies may exclude

poorer projects, thus raising average returns. But,

they may also increase the moral hazard problem;

at higher interest rates, only risky borrowers

apply for a loan, thus increasing the default rate

and lowering returns. Finally, it is unclear what

affect subsidized lenders have on the overall

credit supply. Do they segment the credit market

while serving the very poor or do they squeeze

out other lenders, reducing overall efficiency for

the market?

In some instances, government institutions

collaborate with local MFIs; but, more often than

not, government organizations and MFIs are at

odds with one another, despite the fact that both

share the stated goal of reducing poverty. A prime

example of the failure of government subsidized

initiatives in the market for microcredit is the

Integrated Rural Development Program (IRDP),

which allocated credit based on social targets in

rural India, giving 30 percent of credit to socially

excluded groups and 30 percent to women.

Armendáriz de Aghion and Morduch (2005)

report that between 1979 and 1989 IRDP offered

over $6 billion in subsidized credit but generated

loan repayment rates below 60 percent, with only

11 percent of borrowers taking out a second loan.

During the same decade, the Grameen Bank also

accepted subsidies in a variety of forms, but did

not change their lending model to include social

targets. During this time, the Grameen Bank saw

its membership grow to half a million members,

with repayment rates above 90 percent. The expe-

rience of the Grameen Bank and IRDP during the

late 1970s and early 1980s is important because

of the similarities between regions. Both

Bangladesh and India are densely populated,

rural, agrarian economies with high rates of

poverty. Therefore, it is likely that the Grameen

Bank's comparative success during this period is

indicative of a more efficient lending model rather

than variances in their lending environment.

In sum, even if many MFIs are not financially

sustainable, the microfinance movement may

still be the best per-dollar investment for alleviat-

ing poverty. Further research is needed to show

whether financial sustainability is even a desired

objective, and future work could help understand

how different subsidy mechanisms can best bal-

ance financial sustainability with the desired

social objectives.

Could Competition Among MFIs Lead

to Better Results?

At first glance, standard economic theory

suggests that competition should improve the

performance of MFIs and lead to better service

and lower interest rates. With such a large poor

population and high rates of growth, there is also

a large market to support more MFIs. Historically,

though, competition has failed to increase services

and often decreases the rate of repayment. When

clients have access to alternative sources of credit,

MFIs lose the leverage they gain from dynamic

incentives and progressive loans (i.e., future loans

are contingent on repayment).

During the late 1990s, Bolivia and Banco Sol

experienced a microfinance crisis. As the success

of Banco Sol increased and commercial banks

began to see the profitability in an MFI model,

competition increased. General economic theory

suggests that competition is inherently good, but

for the early MFIs, competition reduced efficiency

by weakening the incentives: As credit options

increased for borrowers, the incentives inherent

in a dynamic or progressive loan became weaker.

This proved difficult for Banco Sol, whose model

relies on group lending and dynamic incentives.

The competition mainly came from Acceso FFP,

a Chilean finance company that paid its employ-

ees on an incentive system. Within three years,

Acceso had 90,000 loans, and Banco Sol lost 11

percent of its clients. Regulated MFIs in Bolivia

saw their loan overdue rates increase from 2.4

percent to 8.4 percent in just over two years.

Because of the increased competition, Banco Sol

saw its return on equity fall by 20 percentage

points to only 9 percent in 1999 (Armendáriz de

Aghion and Morduch, 2005, p. 127).

In their study of 2,875 households from 192

villages in Thailand, Ahlin and Townsend (2007,

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p. F43) reach a similar conclusion. They note that,

with increased access to credit, borrowers do not

respond to dynamic incentives. Moreover, strong

social ties, such as the clustering of relatives in a

village, can also lower repayment rates in the same

manner of competition. In their words, “this

result has not been seen in the previous empirical

research, nor focused on in the theoretical models.”

In the early years of competition in the micro-

finance sector, MFIs struggled to maintain a credi-

ble threat of denying future credit on default. In

recent times, however, new regulation has helped

to promote competition in Bolivia as lenders

started to share more information on borrowers.

By law, Banco Sol and other regulated financial

intermediaries are now required to report the

name and national identification number of

delinquent borrowers to the Superintendent of

Banks and Financial Institutions. This informa-

tion is available to all financial intermediaries

through both formal and informal agreements.

This agreement helped to strengthen the threat

of dynamic incentives, and, as a result, competi-

tion among lenders has led to an increase in their

client base.

Does Microfinance Have Any Social

Impact in Terms of Female

Empowerment and Education?

Any review of microfinance is incomplete

without a discussion of its impact on women.

The Microcredit Summit Campaign Report (2000)

lists over a thousand programs in which 75 per-

cent of the clients were women. Yunus (2003)

recounts the initial difficulties overcoming the

social mores in rural Bangladesh and lending to

women in this predominantly Islamic nation.

However, his efforts were rewarded and 95 per-

cent of the Grameen Bank’s current clients are

women.

This focus on women follows largely from

Yunus’s conviction that lending to women has a

stronger impact on the welfare of the household

than lending to men. This has been confirmed

by a large volume of research on microfinance.

In countries where microfinance is predominant,

country-level data reveal signs of a social trans-

formation in terms of lower fertility rates and

higher literacy rates for women. Pitt and

Khandker (1998) show that loans to women have

a positive impact on outcomes such as children's

education, contraceptive use, and the value of

women's non-land assets. Khandker (2005) finds

that borrowing by a woman has a greater impact

on per capita household expenditure on both

food and non-food items than borrowing by a

man. Among other things, this also improves

nutrition, health care, and educational opportu-

nities for children in these households. Smith

(2002) validates this assertion using empirical

data from Ecuador and Honduras to compare

microfinance institutions that also offer health

services with institutions that offer only credit.

He notes that, “in both countries, health bank

participation significantly raises subsequent

health care over credit-only participation.” In

particular, he found that participation in MFIs

that offer health services reduces the tendency to

switch to bottle feeding as incomes rise. He notes

that breast-feeding children under age two is a

key health-enhancing behavior.

A pro-female bias in lending works well for

the MFIs. Practitioners believe that women tend

to be more risk averse in their choice of invest-

ment projects, more fearful of social sanctions,

and less mobile (and therefore easier to monitor)

than men—making it easier for MFIs to ensure a

higher rate of repayment. Various studies from

both Asia and Latin America have shown that

the repayment rates are significantly higher for

female borrowers compared with their male

counterparts.

However, critics have argued that microfi-

nance has done little to change the status of

women within the household. A much-cited

paper by Goetz and Gupta (1996) points to evi-

dence that it is mostly the men of the household

and not the women borrowers who actually exer-

cise control over the borrowings. Moreover, micro-

finance does little to transform the status of

women in terms of occupational choice, mobility,

and social status within the family. Therefore,

microfinance hardly “empowers” women in any

meaningful sense. Although this may truly be

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the case, there is no denying the fact that micro-

finance has provided heretofore unrealized work-

ing opportunities for women with limited skills

in traditional activities.

Can the Microfinance Experiment Be

Successfully Replicated Anywhere in

the World?

Although the microfinance revolution has

recorded success in most developing countries

of the world, it has achieved little success in

some of the more developed nations. The most

notable example here is the Good Faith Fund in

Arkansas, where microfinance has failed to deliver

the same rapid growth and poverty alleviation as

it has in the developing world. This seems reason-

able given the relatively smaller percentage of

those living in poverty and the much larger safety

net afforded the poor through welfare and unem-

ployment programs. As Yunus (2003, p. 189)

states, “In the developed world, my greatest

nemesis is the tenacity of the social welfare sys-

tem…[M]any calculate the amount of welfare

money and insurance coverage they would lose

by becoming self-employed and conclude the

risk is not worth the effort.” Yunus correctly

addresses a motivating factor for the relatively

weak success of microfinance in the United

States, but studies have found other reasons why

microfinance has failed to deliver: e.g., a lack of

entrepreneur opportunities for the poor, lack of

group structure, and the multitude of options

facing the U.S. poor.

Why Did Microfinance Initiatives Fail in

the United States? In their study of U.S. micro-

finance, Edgcomb, Klein, and Clark (1996) find

that micro-enterprise accounts for only 8 to 20

percent of all jobs—because of the availability

of wage jobs and public assistance. When com-

pared with the 60 to 80 percent of jobs supplied

by micro-enterprise in the developing world,

the pool of potential microfinance beneficiaries

in the United States is substantially smaller.

Schreiner and Woller (2003) make the point that

the characteristics of the poor are different in

the two regions. In the developing world, jobs

are relatively scarce and hence the unemployed

are more likely on average to include individuals

that are highly skilled or better motivated to

become entrepreneurs. In contrast, in the United

States, where poverty is much less prevalent,

most individuals with the aforementioned char-

acteristics can find jobs. Furthermore, the amount

of small business regulation in the United States

poses problems; a micro-entrepreneur must know

their proposed business but must also under-

stand local and federal tax laws and regulations.

To compete with much larger national markets,

small business owners must further understand

and excel at marketing their products in both

local and larger markets. The lack of highly

skilled or better-motivated workers among the

poor in the United States, combined with the

higher entry costs for successful micro-enterprise,

makes successful microfinance initiatives more

difficult. Schreiner (1999) finds that, in absolute

terms, only one person in a hundred was able to

move from unemployment to self-employment

through micro-enterprise.

Taub (1998) offers a slightly different expla-

nation: He found that the markets for the borrow-

ers differed between regions. In Bangladesh, most

small entrepreneurs engage in goods-producing

activities that, when combined with their small

local markets, offers an almost immediate stream

of revenue. This feature allows the Grameen Bank

and others to require weekly repayments, which

is often cited as a primary reason for their high

repayment rates. In the United States, most entre-

preneurs engage in service-producing activities

because it is difficult to compete against the

economies of scale in goods production and dis-

tribution within the U.S. market. These service

businesses provide a relatively unreliable source

of income, particularly in the early stages. This

risk, combined with the safety net afforded to the

poor through welfare, discourages many potential

entrepreneurs from starting a new venture. In

support of this point, Taub found that the likely

borrower comes from a family with at least one

source of steady income, so that their new ven-

ture is unlikely to substantially hurt their family

resources.

In the late 1980s, the Good Faith Fund demon-

strated the difficulty of forming a cohesive group

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structure to enforce joint liability loans. Schreiner

and Woller (2003) offer four basic failures of group

formation in the United States. First, they suggest

that the impersonal nature of U.S. market inter-

actions reduces the need for social reputations

and hence the group loses the ability to punish

delinquent borrowers. Second, the U.S. poor are

diverse and hence it is difficult to find other poor

potential entrepreneurs to guarantee a group loan.

In U.S. markets, there is also a limit to the poten-

tial number of small-business ideas. In developing

countries, a group of borrowers may all enter the

basket-making market with success because of the

much larger local economy. The group guarantees

the loan but also offers advice to help succeed in

the market. In the United States, the demand for

micro-businesses is much smaller and diverse

groups of people must start diverse business ven-

tures. There is little value to the group outside of

a loan guarantee because group members don’t

share the same risk to their businesses. Third,

defaults are often not enforced in group settings,

as found by Hung (2003). Finally, groups often

break down in the United States because the poor

have access to other forms of credit. This credit

may be more attractive because it doesn’t require

the transaction costs of dealing with a group.

For the United States, pure Grameen-style

group lending schemes have failed to deliver sub-

stantial results, but that is not to say they have

not benefited the poor. Rather, microfinance oper-

ations in the United States have often switched

to individual lending operations that require

borrowers to attend mandatory small business

training programs or offer loans to attend spe-

cialized schooling for particular professions. A

fundamental difference is that microfinance in

the United States helps place the poor into exist-

ing wage-earning jobs rather than create new jobs.

The additional training substantially raises costs

to the point that many U.S. MFIs are not self-

sustaining, instead relying on grants and subsi-

dies. Edgcomb, Klein, and Clark (1996) found

that the average cost to make and service a loan

was $1.47 per dollar lent, with a range of costs

from $0.67 to $2.95. Without charging usurious

interest rates, it can be difficult to earn such a

similarly high return, particularly with the smaller

microfinance market. Taub (1998) reports that

from 1989 to 1992, the Good Faith Fund averaged

only 18 new loan customers per year.

In the

following years, the average number of new loan

customers rose into the mid 20s, before a change

in management and change in focus substantially

reduced those numbers. With small loans, aver-

aging just $1,600 per year for the first four years,

it became impossible for the Good Faith Fund to

even come close to matching the combined staff

salaries of $450,000.

Due in part to these high-cost structures,

Bhatt, Tang, and Painter (2002) found direct evi-

dence that nearly a third of MFIs started in

California in 1996 had ceased to exist by 1998.

Instead of focusing on becoming self-sufficient,

Schreiner (2002, p. 82) argues for more quantita-

tive evaluation of MFIs. He claims that “the dirty

secret in micro-enterprise is that few evaluations

are really tests…[E]valuations were funded and

conducted by people who already believed that

micro-enterprise was worthwhile.” Schreiner

thus concludes that a main goal in helping alle-

viate poverty should be to evaluate the efficiency

of MFIs and, if need be, reallocate resources to

other training programs that specialize in poverty

alleviation, not economic development.

THE FUTURE OF MICROFINANCE

The number of MFIs has been growing

steadily, and the top 100 MFIs are increasing

their client base at a rate of 26 percent per year.

To fund this spectacular growth, MFIs have turned

to a variety of sources, many of which rely on

funding from local sources to guard against for-

eign currency risk. MFIs are currently moving

into the international market and confronting

challenges such as developing standard rating

methods; guarding against foreign currency risk

and country risk; and meeting the large volume

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At the time of Taub’s study, population density in Bangladesh

was 814 per square kilometer, while the population densities of

Arkansas counties served by the Good Faith Fund were only 36,

9, 8, 9.1, and 10.33 per square kilometer (Jefferson, Lincoln,

Desha, Chicot, and Ashley counties, respectively).

MIX Market analysis of top 100 MFIs; www.mixmarket.org.

requirements for an international offering. But,

according to Reddy (2007) of Accion International,

“Many believe that savings mobilized from local

depositors will ultimately be the largest source

of capital for microfinance. Foreign capital pro-

vides 22 percent of funding for the ‘Top 100’ MFIs,

but savings is the first source of capital, represent-

ing 41 percent of all assets in 2005.”

Many MFIs

have a mandatory or suggested savings rate; and,

for larger loans, MFIs will often require borrowers

to deposit 5 percent of the loan back into a savings

account. Some, but not all, have restrictions on

when and how that money can be accessed.

Although not the main source of funding,

foreign capital still represents a significant por-

tion of current funding for the top 100 MFIs. As

Elizabeth Littlefield of CGAP found, U.S. invest-

ment in foreign microfinance in 2006 was $4 bil-

lion, which is more than double the 2004 total of

$1.6 billion. This funding comes from two main

sources: international financial institutions and

microfinance investment vehicles. To access this

foreign investment, MFIs are beginning to use new

vehicles of debt-structured finance, including

collateralized debt obligations (CDOs) and

securitization.

To date, one of the most well-known interna-

tional debt issues was structured by Blue Orchard

Finance in 2004. This deal, worth $40 million,

linked 90 investors with nine MFIs in Latin

America, Eastern Europe, and Southeast Asia.

The main innovation of the Blue Orchard deal

was the introduction of a tiering system (of five

tranches) that allowed for different risk appetites

among investors. Microfinance is also beginning

to raise money in the equity market, through

organizations such as Accion Investments, which

has invested $12.4 million in five institutions

(Reddy and Rhyne, 2006).

In 2006, the first securitized microfinance

receivables went on the market from the

Bangladesh Rural Advancement Committee

(BRAC). BRAC is an NGO that lends money to

the extremely poor, focusing mainly on offering

women credit to develop their own income-

generating activities. The transaction was struc-

tured by RSA Capital, CitiGroup, the Netherlands

Financing Company, and KfW Bank of Germany

and has securitized $180 million in receivables

over a period of six years.

According to CitiGroup, 65 percent of the

loans are to the extremely poor, who borrow from

$50 to $100. BRAC offers three loans, based pri-

marily on the land holdings of the borrower. For

those with less than one acre of land, borrowers

can obtain from $50 to $500 at a flat 15 percent

rate, payable over one year through 46 weekly

installments. The marginally poor, those who

own more than one acre of land and are involved

in agricultural enterprise, can qualify for loans

between $166 and $833 with a flat 15 percent

interest rate. This product must be repaid in equal

monthly installments, with a 12- or 18-month

horizon. Finally, BRAC offers larger loans to entre-

preneurs to start their own business. These loans

are monthly products (12, 18, or 24 months) with

a 15 percent interest rate.

BRAC employs a

dynamic lending scheme, wherein timely repay-

ments guarantee future access to credit. This

mechanism is similar to a joint lending liability,

except in this case borrowers are liable to their

future selves.

International Financing Review Asia honored

the BRAC deal with the title of best securitiza-

tion in Asia Pacific for 2006 because “one of the

most impressive aspects of the transaction is the

way that it deals with the sheer complexity of a

dynamic pool that will contain about 3.3 million

short tenor loans for which the average outstand-

ing principal is around US$95.”

The security

was given an AAA rating from the local

Bangladesh markets, with CitiGroup and

Netherlands Financing Company each purchasing

one-third of the certificates. The remaining one-

third was split among CitiGroup Bangladesh and

two local Bangladeshi banks.

This deal differs from the collateralized

debt obligations that Blue Orchard Loans for

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Data taken from MIX Market analysis of the top 100 MFIs;

www.mixmarket.org.

See BRAC’s economic development and microfinance information

at www.brac.net/microfinance.htm.

CitiGroup: “Innovative BRAC Microcredit Securitization honored

in Bangladesh,” accessed 1/16/07; www.citigroup.com/citigroup/

press/2007/070116b.htm.

Development issued in April 2006, in which

funding for 21 MFIs from 12 countries was pack-

aged into a $99.1 million commercial investment.

The main difference between a CDO and securi-

tization is that a CDO relies on the ability of the

MFI to repay the loan, unlike a securitized loan

that relies on the underlying borrowers to repay.

A CDO is another vehicle to bring mainstream

investors to microfinance, but is still limited by

the ability to rate the creditworthiness of differ-

ing MFIs. To help with this issue, S&P released a

rating methodology for microfinance in June 2007.

By applying a common methodology, S&P will

be able to send a stronger signal to potential

investors about the quality of MFI investments.

It is unclear yet whether the 2007 subprime mort-

gage meltdown in the United States will have an

effect on investors’ risk appetites for more collat-

eralized securities and whether microfinance

securities will be viewed as “subprime” loans.

Walter and Krauss (2006) argue that the

opposite should be true—namely, that microfi-

nance can reduce portfolio volatility—and their

empirical tests show that microfinance institu-

tions have a low correlation to general market

movements. They suggest that this phenomenon

is brought on by the continuous and diverse fund-

ing through international donor agencies and

because micro-entrepreneurs may be less inte-

grated into the formal economy. When markets

enter a downturn, micro-entrepreneurs may expe-

rience a countercyclical effect, as consumers

shift their consumption downward to cheaper

goods.

Outside of international credit markets,

microfinance has continued to receive grassroots

support and popular media coverage. Organiza-

tions such as Kiva.org serve as intermediaries

and connect individual donors with micro-

entrepreneurs. Kiva.org allows individuals to

choose a business, originate their own micro-loan,

and in return receive electronic journal updates

and payments from their borrower. Most loans are

small, between $50 and $100 and have repayment

terms from six months to a year, but the lender

does not receive any interest on their loan. Rather,

journal updates and progress reports serve as

interest, letting lenders know that their money

has been put to good use. At the end of the year,

providers can start the cycle anew or withdraw.

To date, 128,547 individuals have lent over $12

million with a self-reported repayment rate greater

than 99 percent. Popular media outlets such as

the Wall Street Journal (September 23, 2007,

August 21, 2007, October 21, 2006), New York

Times (March 27, 2007, December 10, 2006),

National Public Radio (September 7, 2007,

June 19, 2007, April 6, 2007), and others have

given Kiva.org frequent and broad exposure, mak-

ing the microfinance movement as accessible to

lenders as the Grameen Bank made microcredit

accessible to borrowers.

CONCLUSION

With the recognition of the Nobel Peace Prize

in 2006, Muhammad Yunus’s vision of extending

credit to the poor has reached a global level.

Microfinance is not a panacea for poverty allevi-

ation; but, with committed practitioners, a wealth

of theoretical work, and a surging demand for both

international and individual investment, micro-

finance is a poverty-alleviation tool that has

proven to be both effective and adaptable. Through

innovations in group lending and dynamic incen-

tives, MFIs have been able to successfully lend to

those traditionally ignored by commercial banks,

because of their lack of collateral and credit scores.

The poor have responded in kind, by repaying

their loans with significant repayment rates. As

MFIs have grown and reached new clients, they

have continued to innovate by offering individual

loans, savings options, and life insurance and

seeking new forms of capital in domestic and

international markets. Microfinance has spread

to five continents and hundreds of countries, yet

its success in U.S. markets has been ill-defined,

as lenders struggle with higher transaction costs

of offering loans and starting micro-enterprises.

As more and more MFIs become self-sufficient

and continue to expand their client base, it will

be the duty of all parties concerned with poverty

relief to look for other ways to innovate. For now,

microfinance remains a viable solution to eco-

nomic development and poverty alleviation, both

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in Bangladesh and around the world. With more

transparency from institutions and better rating

standards, the influx of investment capital from

international markets will continue to drive

microfinance toward Yunus’s goal of a poverty-

free world.

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