Is small beautiful?

Thaddeus Best examines much-hyped microfinance. Is it all it's cracked up to be, or has the solution to poverty yet to be found?

Microfinance has been the darling of the aid community for the last few decades, lauded as a powerful weapon to help the poorest in society to break away from day-to-day hardship. The promise of escape from poverty has grabbed the public's attention and celebrities, rock stars and politicians have been quick to get behind the concept. The model has been widely praised, so much so that in 2006, Bangladeshi economist Muhammad Yunus and his flagship microfinance programme, Grameen Bank, were awarded the Nobel Peace Prize for their efforts. Now, over 25 years on from Grameen Bank's founding, as microfinance schemes start to claim greater and greater portions of aid budgets - has microfinance really tackled global poverty or has it been oversold?

Old tricks

Lending money to those who desperately need it is certainly not a new concept. Although traditional financial institutions have shied away from lending to the poor, there have always been alternative means of borrowing money. Pawnbrokers have thrived in Britain for over 500 years, offering a simple loan in exchange for collateral - often jewellery and other valuables. However, from pawnbrokers to loan sharks, one almost universal fact is that the rates of interest offered are usually extortionate compared to mainstream lenders, sometimes reaching rates of 10 per cent or more per month. These high interest loans have a tendency to trap those unfortunate enough to miss repayments in vicious cycles of debt, which become almost impossible to break as the debt and its interest rate swell.

Microfinance institutions (MFIs) essentially operate in a very similar manner to these lenders - extending credit to the poorest in society. The loans are a fraction of what mainstream lenders typically offer, often no more than around £60, according to Grameen Bank. However, microfinance differs significantly from the traditional financial institutions in that the loan is secured against the honour of a peer group, as opposed to collateral: if one person in the group fails to make repayments, the others in the lending circle may be denied credit in the future. Microfinancing generally offers a far lower rate of interest to the poor than they would otherwise be able to secure.

Making the distinction

So who qualifies as poor? This point is where microfinancing becomes more contentious. The poor are not an easily identifiable group. However, different levels of poverty are clearly visible to those who care to delve further. Whilst the so-called "entrepreneurial poor" stand to benefit from microfinance loans, it's clearly unsustainable to lend to those so destitute that they have no chance of repaying the loan. Most MFIs impose a cut-off level of wealth to ensure that only those regarded as truly deprived are eligible.

At a quick glance, the achievements of microfinance in aiding this section of society are impressive. Grameen Bank has disbursed more than £5 billion in unsecured loans to some of the poorest people in the world. Combined with a 98 per cent repayment rate, it's not hard to see why so many have claimed microfinance has lifted them out of the cycle of poverty. The success of Grameen Bank has been credited with triggering the explosive rise of microfinancing. There are now over 7000 microfinance institutions worldwide, many imitating the Grameen Bank model. However, good repayment rates don't necessarily equal self-sufficiency, and the lack of transparent and comprehensive studies undertaken on the impact of microfinance is a cause for concern among some.

Harsh Reality

While its pioneers expound microfinance's altruistic aims and present it as an unambiguous success story, there are those who argue that beyond the hype, microfinance has in reality changed little for the lives of the poor. Economic consultant Milford Bateman has been an outspoken critic of microfinance, blasting it in his recent book Why Doesn't Microfinance Work? Bateman points to new studies that show that over 80 per cent of microfinance is being used for consumptive credit and creates almost no new businesses, dismissing the romantic "rags-to-riches through enterprise" idealism that initially captured the public's imagination. Bateman goes so far as to suggest that microfinance could in fact be holding back developing nations' economies by promoting micro-enterprises that rarely grow beyond one person firms, restraining the development of proper industrial infrastructure.

Although long-term studies of microfinance's impact are lacking, the picture that emerges so far is one of people simply getting by, rather than escaping the clutches of poverty. Perhaps this isn't so surprising. After all, why should the simple extension of financial services suddenly provide the cure for poverty? Given that credit has the capacity to drag those who use it unwisely into cycles of deprivation, probably it's excessively optimistic to imagine that it could also be used to escape the very same fate.

But despite its detractors, it seems fair to say that microfinance has certainly improved the quality of life of millions of the world's poorest, even if just by providing them with access to low interest credit to escape the worst ravages of day-to-day poverty and misfortune. However, those looking for a magical development solution will be disappointed; microfinance may alleviate poverty to some extent, but it's unlikely to transform developing nations into industrial superpowers.

What is microfinance?

The provision of small loans and other financial services to low-income consumers - not just via credit, but also savings, insurance and other financial products.

Traditionally, this portion of society has been overlooked by the financial sector because the costs of managing these services to a client are largely fixed; it costs 100 times as much for banks to lend £1000 to 100 clients as it does to lend one client £100,000, yet the total revenue from both loans remains roughly the same to the bank, leaving little financial incentive to loan money to clients with little or no income.

In addition, the lack of collateral and previous lending history makes low-income clients a more risky prospect to potential mainstream creditors.

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