By Harry Toube, Economics Undergraduate at King’s College London
In recent decades, Socially Responsible Investing has become an essential component of many firms’ financial strategy. The CFA Institute estimates that in 2022, funds targeting responsible investments reached almost $6 trillion of assets under management. Microfinance is one such socially conscious investment. Beginning in Bangladesh in the 1990s, this enterprise-oriented solution to low-income credit access has grown into a $58 billion industry, giving rise to the 2006 Nobel Peace Prize and contributing to the 2019 Nobel Prize in Economics. For many neoclassical advocates, these small, joint liability loans demonstrate the ability of local, market-based solutions to overcome persistent development problems without the need for government intervention. However, critics observe that microfinance interventions often yield mixed results, poor long-term performance, and can develop into predatory lending.
If microfinance ‘works’, then it could be the magic bullet for ethically-conscious firms who want to maximise their social impact whilst making sustainable profits. But, any promises of such proportion must be fully scrutinised with reference to the existing evidence. In this paper, we elaborate on the central case for microfinance and consider what the unfolding evidence reveals about its successes and failures. Ultimately, we suggest that microfinance is an excellent local solution to credit access. However, it works best under selective conditions.
- Why Microfinance?
The developing world is plagued by extremely limited access to institutional sources of credit. As a result, low-income borrowers are often denied entrepreneurially-necessary loans or forced to turn to high-interest, dangerous local lenders. There are three causes of this problem which are relevant to our discussion: limited collateral, a weak rule of law, and adverse selection.
Collateral
Financial institutions extend loans when they expect that doing so will give them a net return on their investment. Typically, a loan is offered to an individual with a ‘principal’ loan amount and a rate of interest to be paid on this principal. Borrowers with a business plan take this loan, generate returns from their investment, and use it to pay back the principal with the agreed interest. However, if the borrower faces unexpected shocks to their venture or chooses to ‘strategically default’ – taking the principal and not making his repayments, the creditor will make a net loss. In order to prevent strategic default and cover the risk to the creditor, lenders often request some form of collateral. This collateral is transferred to the lender in the event of a default. Strategic bankruptcy is discouraged, and the lender covers his losses.
Whilst this sort of collateral is common in developed countries, it is much harder to obtain in the developing world. As a result, competent entrepreneurs with good business plans are removed from the pool of potential borrowers simply due to the excessive risk to the financier of extending them credit.
Rule of Law
In a similar vein, risk to lenders increases if they cannot rely on the state to punish defaulters. These punishments may help the creditor to mitigate losses – seizing a share of profits, enforcing collateral contracts, enabling the firm to identify past defaulters – or discouraging strategic default with more punitive measures. Additionally, without rule-of-law solutions, firms may need to incur high monitoring costs to ensure that their borrowers are, in fact, following a path that will lead to repayment. In developing countries with limited infrastructure, weak state capacity, and rampant corruption, these rule-of-law solutions are hard to rely on. This problem becomes even larger as borrowers move outside of urban centres where the police force has less authority, and lenders find it more difficult and expensive to monitor how their money is spent. In these situations, monitoring costs and the difficulties of enforcing contracts lead firms to deny access to credit to large parts of the population.
Adverse Selection
Finally, limited collateral and a weak rule of law can lead to the loan market becoming saturated with high-risk borrowers. Borrowers without collateral or state penalties will always pay the same cost in the event of default. This cost does not scale with the riskiness of the enterprise and cannot be escalated by the lender. Moreover, once the borrower has gone bankrupt, his personal liability remains the same, no matter how large the losses are. As a result, rational borrowers will systematically choose riskier projects – receiving larger expected returns in the event of success but not seeing much of an increase in the expected cost of default.
Lenders are aware of this selection problem, but are unable to distinguish properly between risky and safe borrowers. They respond by limiting the volume of loans they give out and constraining loan sizes at any given interest rate. Additionally, they must incur significant monitoring costs in order to ensure that their loans are invested in projects which the creditor expects to gain from.
These three problems combine to significantly restrict the extension of loans to low-income borrowers whilst imposing high monitoring costs on creditors who do choose to lend to poor clients.
- The Microfinance Solution
Microfinance firms offer loans to large groups of individuals. These borrowers receive the loan collectively and are jointly liable for its repayment. The firm issues a range of contracts with associated interest rates and penalties for default. High interest loans with low penalties are preferred by risky borrowers and low interest loans with high penalties are preferred by safe borrowers. Since individuals are jointly liable for repayment, safe borrowers will only choose to partner with other safe borrowers – leaving the risky to match with the risky.
These loans overcome the three aforementioned barriers to credit access. Firstly, whilst any one individual lacks the collateral to support his loan, the individuals can collectively supply collateral for which they are jointly liable. This collective collateral pairs with the role of social capital. Individuals are strongly incentivised to work hard, choose feasible projects, and not strategically default since their friends and family will be on the line for their failures. Secondly, even in poor rule-of-law situations, joint liability shifts monitoring costs away from distant creditors and towards local peer-to-peer monitoring. This monitoring is cheaper, more regular, and more rigorous. Additionally, whilst it may be difficult to enforce a contract on one particular individual, it is easier to enforce a contract on at least one individual from a large group. Finally, adverse selection becomes impossible since safe borrowers will always be able to select into low-risk groups. This group self-selection allows the creditor to produce multiple contracts which provide credit access to both safe and risky borrowers on terms which are profitable for both types without the risk of being duped into giving a favourable loan to a risky customer.
Through the provision of multiple, self-selecting, jointly-liable loan types, microfinance allows low-income individuals to 1) use social and collective capital as collateral, 2) reduce monitoring costs through peer-to-peer monitoring, and 3) distinguish themselves from riskier borrowers. Through these effects, microfinance helps to overcome the limitations placed on credit access.
- Evidence: Where it fails
Whilst this model presents microfinance as a complete solution to limited credit access, the evidence on the instrument is mixed in practice. On the basis of the academic literature, we identify four essential failures of microfinance: 1) Mass Defaults, 2) Minimum Efficient Scale, 3) Predatory Lending, and 4) Mixed Evidence of Transformative Effects. In response to these failures, we advise socially responsible firms to 1) Diversify across regions, 2) Mix microfinance with Small and Medium Enterprise (SME) investment, and 3) Vet microlenders whilst avoiding predatory countries.
Mass Defaults
Microfinance loans rely on a joint liability system. In principle, joint liability discourages individuals from strategically defaulting. However, if individuals already expect their co-borrowers to default, joint liability gives them an even stronger incentive to default as well.
This logic is empirically examined by Gine, Krishnaswamy, & Ponce (2012) using the case study of the Indian town of Kolar. Kolar is a town in the state of Karnataka that is composed of significant numbers of Hindus and Muslims. On January 28th, 2009, the Muslim Anjuman Committee of the town issued a fatwa declaring it to be haram to repay (usurious) microfinance loans. Once this fatwa had been issued, large numbers of microfinance groups around the town began to default. It is plain to see how this effect could have been driven among Muslims who prioritised respecting the fatwa over financial gain. However, the default effect was distributed infectiously across most groups in the region – affecting Hindus as well. The mechanism underpinning this event was clear. Prior to the fatwa, individuals were happy to work hard and make sure that their businesses met their interest payments. However, once the ruling had been made, some proportion of the Muslim members of these groups planned (or were suspected of planning) to default. Since the loans were under a joint liability system, otherwise financially healthy members of microfinance groups realised that even if their businesses prospered, they would still lose their profits and credit access as a consequence of the defaults of others. Consequently, even those borrowers who had no interest in the fatwa were effectively encouraged to join in with the defaults.
Whilst this wave of mass defaults was localised to a particular community, similar results have been found across a range of case studies. These include India, following the 2016 demonetisation policy, Bolivia, Nicaragua, Bosnia, Morocco, Nigeria, and Assam. In each region, the same joint liability mechanism that encouraged repayment under ordinary conditions became the cause of widespread structural nonpayment of loans. Cases like these are very rare. However, when they take place, they can seriously harm the profitability of microfinance funds. Whilst microlenders expect some level of default, they make profits based on the assumption that any loss will be made up for by tens of successful groups. If structural defaults occur, this ratio is disrupted, and the microfinance firm may go bankrupt.
As a result, we give our first piece of advice for Socially Responsible Investing with microfinance: diversify. Given the risk of any region experiencing mass defaults, the best policy is to spread this risk across a broad range of regions. Doing so also helps microcredit borrowers. Whilst little can be done to prevent mass defaults when they begin, diversification can help to ensure that these crises do not destroy the existing microfinance institutions in the area.
Minimum Efficient Scale
Bateman and Chang (2012) argue that “Microfinance creates Microenterprises”. These microenterprises can be productive at the local level. However, their size prevents them from taking advantage of serious economies of scale and ever reaching the ‘Minimum Efficient Scale’ necessary to compete in the challenging national environment. The authors claim that this is a serious problem for microfinance development strategies since ten microenterprises without scaling advantages will generally be less productive than a single small or medium enterprise. Unfortunately, because these SMEs must operate in a more competitive environment than microenterprises, they typically generate lower profits. Consequently, investment funds systematically favour microlending at the expense of these firms. In a country with limited available capital, microfinance may actually divert scarce funds from more productive enterprises and stunt the growth of the economy overall. Whilst microfinance may help individual borrowers, it can harm the macroeconomy.
This criticism has real weight. However, its applicability to international Socially Responsible Investing can be mitigated by a number of important observations. Firstly, the problem of diverting national funds to less-productive enterprises does not apply if the source of funds comes from an investment fund based in a developed country. If such a fund were choosing where to engage in investment, choosing microfinance in a developing country would only be an additional capital inflow. Secondly, it may be ideal for an international firm to invest entirely in SMEs. However, with their lower profit margins, this may be incompatible with a sustainable ethical investment strategy. As such, microfinance can be understood as a Rodrik-style ‘Second Best Institution’ – not perfect, but still good. Thirdly, to maximise social impact, a socially responsible fund can use the higher profits from microfinance to enable it to mix some investment in low-profit SMEs into the overall portfolio.
Predatory Lending
Microfinance exists to provide lower-income borrowers with access to an institutional source of credit. This outcome is good for both practical and humane reasons. Firstly, individuals gain access to loans they would not otherwise have. Secondly, individuals in need of loans do not need to depend on informal, loan-shark-style local lenders. This second advantage has been seriously challenged by the reported behaviour of some microfinance firms. Investigative reports from Bloomberg, the Guardian, Al Jazeera, and others paint a picture of microfinance firms operating more like the loan sharks that they have replaced. The industry is significantly composed of profit-making businesses, with $60 billion of the $80 billion total loan portfolio accounted for by for-profit firms in 2018. These firms routinely charge annualised interest rates as high as 100%, force land sales to repay loans, and rely on borrowers taking out new microfinance loans to cover existing debts. In Cambodia, despite moderate regulation on interest rates, 50% of microfinance borrowers have secured their loans against land titles, and between 10 and 15% of farmers’ land has been lost in microfinance defaults. In Jordan, tens of thousands are wanted for the non-payment of small debts, and across Cambodia, Mexico, and Sri Lanka, hundreds have committed suicide in microfinance-related circumstances. Under these circumstances, it is difficult to see microfinance as simply a socially responsible investment option.
However, these problems only affect a subset of – mostly for-profit – microfinance firms. Moreover, they are more widespread in countries like Cambodia and Sri Lanka than in India, Bangladesh or Bosnia. Socially conscious investors should take these lessons on board, but not let them entirely discredit the microfinance option. To achieve maximum social impact, it is advisable for these funds to rigorously vet the firms they partner with, avoid countries where predatory lending is a particular problem, and strike an appropriate balance between for-profit and nonprofit agencies.
Mixed Results
Ultimately, the strongest claim against microfinance is that it does not succeed in improving the wealth or income of the poor. The literature substantiating this claim is broad and varied. In the first place, experimental papers like Banerjee, Duflo, Glennerster, and Kinnan (2015) find, with randomised microcredit trials in India, temporary consumption changes towards durable goods and away from tempting goods. However, there are no significant improvements in health, education, or female empowerment, and all advantages of earlier loan access are dissipated within two years of neighbours receiving loans. Meanwhile, experiments run in the Philippines raise uncertainty over whether joint liability loans really do increase repayment rates. Further researchers have argued that rather than encouraging investment, microloans are often used to finance large acts of private consumption (weddings, funerals, home expansion, grain storage, etc.) and to smooth consumption over time.
These critiques are important, and it is worthwhile for socially responsible investors to consider the contexts in which microfinance does not produce results. However, as we will see, many of the deficiencies of microfinance are reduced when loans are extended to the ‘right type’ of borrower. Moreover, whilst consumption-smoothing and private consumption acts are not typical investment activities, they are important tools for reducing the harshest effects of extreme poverty. Fixing a roof is not a profit-making investment, but it might still be socially responsible spending. Borrowing to avoid hunger is not ‘productive’, but it can be necessary.
- Evidence: How it Can Succeed
Despite some of the empirical critiques levelled above, the literature reveals that the performance of microfinance is very heterogeneous across borrower types. This heterogeneity suggests that a microfinance strategy can succeed under carefully managed conditions. We argue that maximising the social impact of microfinance requires carefully selecting the recipients of microloans. We advise socially responsible investors to prioritise three useful characteristics of borrowers: 1) Choose relatively culturally and geographically homogenous groups, 2) Prioritise loans for borrowers with existing businesses, and 3) Focus on countries with a weak traditional financial system.
Homogeneity
Microfinance thrives when default rates are low. This outcome indicates that borrowers are broadly succeeding in their entrepreneurial ventures and are not dragged down by failing co-borrowers. Karlan (2005) finds that among microborrowers in Peru, “individuals with stronger social connections to their fellow group members have higher repayment and higher savings”. These results hold for both geographical proximity and cultural closeness as the measure of ‘social connectedness’. Moreover, in more connected groups, individuals are more likely to monitor their group members and penalise them in the event of default. Similar results were found by Postelnicu and Hermes (2018) across 100 countries that are involved in microlending. These results reinforce the core thesis and mechanism of joint liability lending.
On a practical level, these papers suggest that microfinance is more successful when groups are formed locally with homogenous cultural characteristics. Responsible investors can incorporate these findings by focusing their microlending on more homogenous regions and groups. Doing so will help to reduce the social consequences of a lower repayment rate.
Business Owners
With every microloan comes the risk that the borrower will not put it to good use. This risk is informed by characteristics that are particular to the borrower. Customers who have already established businesses without microcredit are the least likely to carry these risky characteristics. As a result, we should expect microfinance extended to existing microenterprise owners to be the most effective. This reasoning is supported by Banerjee, Breza, Duflo, and Kinnan (2019). In this paper, the authors find that microfinance recipients who already run a business “have 35% more assets and generate double the revenues” as business owners who do not receive the credit. By contrast, non-business owners experience almost no change from microfinance. On the basis of this radical difference in outcomes, we suggest that socially responsible investors will see the highest social return on investment if they target their microloans towards existing business owners.
Weak Financial Sector
Finally, as we have shown above, the central goal of microfinance is to extend credit to borrowers who are barred from institutional finance. Naturally, it follows that microfinance is the most successful in regions where this traditional finance is missing. Vanroose (2012) studies over a thousand microfinance institutions and finds that microfinance spreads the fastest in countries with the worst access to institutional credit. Bruhn and Love (2013) show that, in Mexico, microfinance has been the most positively associated with income growth and labour market activity in the lowest-income areas with the worst pre-existing credit access. These findings indicate that microloans can have the greatest impact in areas with the least developed traditional financial sector. By extension, investors will do the most good if they direct their investments towards these credit-deprived regions.
- Concluding Remarks
Microfinance has the potential to be an extraordinary tool for ethical investing. By offering joint liability loans to low-income individuals, this financial instrument can overcome barriers to credit access and spur widespread local economic activity. Most importantly, these benefits can be produced whilst still maintaining high returns on investment. However, after almost 50 years of evidence, it is clear that there is a right and a wrong way to engage in microlending. On the basis of the evidence reviewed above, we advise six strategies to maximise microfinance’s social impact:
- Diversify lending
- Combine microfinance with Small and Medium Enterprise loans
- Vet microfinance institutions and avoid countries with bad reputations
- Favour culturally and geographically homogenous groups
- Focus on existing business owners
- Target regions with weak traditional financial sectors
With these six strategies, targeted microfinance can become a superb tool in any Socially Responsible Investment portfolio.
Harry Toube
Harry Toube is an undergraduate student of Economics at King's College London. Interests lie in Chinese development and market analytics and the political-economic relationship between representation and sovereignty.