Myths of Microfinance

THE TOP 10 MYTHS OF MICROFINANCE

By: James Beshara

Co-Editor of TheMiFiReport.com

Microfinance has been a social buzzword in the West for a few years now, and it has really made strides in making its push toward even mainstream social, issue-du-jour conversations.

Sadly, many still see extreme poverty as an unfortunate, but ultimately incurable truth of our world. However, in many respects, microfinance and microcredit can be credited with slowly changing that perception as they have been dubbed the most effective tools in the eradication of extreme poverty (Mohammad Yunus winning the Nobel Peace prize jointly with his Grameen Bank in 2006 didn’t hurt the PR for microfinance either).

But, with its widespread appeal have come widespread assumptions and expectations that have largely gone unaddressed as these “myths” either serve to bolster the critics’ arguments or serve to further the microfinance organizations’ attraction.

The fact is that there is real appeal to microfinance as a tool of fighting poverty AND there are real criticisms to its practice. Whichever side of the aisle you are on, whether it be with the side that is pro-everything-micro, the devil’s advocate that plays the caution card, or the masses that are a combination of both, there are certain myths that many find favorable in perpetuating to promote their respective agenda.

We will address those myths here in an effort to clear up the many assumptions, expectations, and ultimate confusion with the practice of microfinance and microcredit.

MYTH 1: The poor would benefit more from a donation than a loan…

            This is one of the very first notions that comes to people’s minds when explaining microfinance. At times, it has even become an exhausting endeavor to try to change people’s views on this issue, but it is wrong to throw up your arms and cry ignorance toward your given audience. It is better to take the time to really expose the differences between a loan and a dole.

            No one likes being given charity when they could have assistance. With a loan, comes responsibility and empowerment. With charity, comes a feeling of helplessness. Access to credit can be implemented far more effectively than access to charity, and at the end of the day, there are not enough donations in the world to ever meet the need. If you give the average poor entrepreneur a loan, they are empowered by the prospect of a steady line of credit access, and they are motivated to pay that loan back to ensure that the access to credit stays open. This in turn, motivates the entrepreneur to use their loan for revenue generating activities to be able to make their periodic installments instead of just spending the money for consumptive purposes.

If given a dole of $100, with no sign of ever seeing a continuous stream of funds, the average poor person (or any person, for that matter) will see it as disposable cash and spend a great majority of that $100 for immediate consumption. This, of course, would be justified in most cases, i.e. for necessary things such as food for the family, sending a child to school, etc. until the money is all gone. A loan, on the other hand, carries the necessary pressure for an entrepreneur to generate revenue, and ultimately, create wealth.

This myth, that centers around the assumption that the poor shouldn’t be banked and should rather be seen as charity cases, is one of the MOST debilitating and handicapping assumptions toward the poor, and it is the main reason their market has been underserved for such a long, long time. Though the intentions behind this assumption may be good, this notion has hurt generations upon generations of poor entrepreneurs because it has been a large stone in the wall that blocks them from access to reasonable credit.

MYTH 2: Making money “off the poor”= Exploiting the poor

            A friend of mine recently asked, “So microfinance banks make money off the poor??” What she was really asking was, “So microfinance banks exploit the poor?”

            Every bank on every street corner makes loans and charges interest. To put it simply, banks sell a product called “cash now” for the designated price of “cash later”. Like every business, banks charge you money for their product, and therefore, “cash later” amounts to more than “cash now”. That is understood, and you and I agree to it because we see “cash now” as worth, or worth more, to us than “cash later”. We don’t cry exploitation, because we are the ones that sought their product (had a “bank” come in to your house and say, “We have “cash now” that can cover medical costs for your daughter so that she survives, but we will charge you 1000% for it,” then that is exploitation, and we conventionally call those “organizations” loan sharks and not banks).

            If banks provide a product that a person seeks and sees the product as worth the price, then we can compare it to more orthodox product-providers.

            In the township of Khayelitsha, outside of Cape Town, South Africa where we worked and provided loans, you can see vendors everywhere that sell Coca-Cola and you can see Coca-Cola sponsored advertisements. No one would accuse Coke of “exploiting” the poor just because they were servicing that market with their product. The cokes and other products that these vendors sell are slightly more expensive than in the store down the street from my house to cover the extra cost of distribution, the overhead of the vendors, and, as one specific vendor told me, to cover the cost of having almost his total inventory of goods stolen last month (covering previous and future costs such as this are commonly referred to as “risk”).

            Coke was making money “off the poor”, certainly and unapologetically. They were not, however, “exploiting” the poor and my friend readily agreed. They were simply supplying a demand in the market. There aren’t any critics up-in-arms claiming that Coke should provide free products to these people. If the vendors or Coke charged too much for their product, then the consumer would eventually either buy Pepsi, go to another vendor, or decide he/she doesn’t see the benefits of a soda meeting the costs.

            Now think of the other “product-oriented” business we described, known as banking. These microfinance banks provide a product, service a market, supply a demand, etc. etc. and operate much like the vendors or Coca-Cola operates. Fortunately for clients, many poor regions of the world have multiple microfinance centers, with the number growing, that provide the clients/consumers a choice in who to get the product from. If bank “A” charges too much for their product, than the consumer can choose bank “B” or bank “C”.

            Like any other bank, microfinance organizations, both for-profit and non-profit, provide a product at a given price. Their market, just like the vendors in Khayelitsha or any other township, happen to be poor, but the demand is still there, and effectively supplying that demand creates a mutually beneficial relationship. To say the poor are too poor to be provided a service or product they demand is like assuming some people are so poor that they shouldn’t be offered Cokes.

MYTH 3: Microfinance is the panacea for poverty eradication that we have all been looking for…

            Proponents for microfinance may delight in the first two myths, but the realists are very aware of this third. For as much good and needed attention that microfinance has gotten over the past few years, it needs to be reiterated that access to credit alone does not eradicate poverty. It is an integral part, but it is only a part. Governments and aid agencies cannot, and many justly don’t, expect to ride the coattails of microfinance until extreme poverty is a thing of the past. Infrastructure, access to full markets, education, and proper healthcare are all issues that must be addressed among others.

I will say that the bottom-up approach of microfinance has appropriately made it one of the most effective tools in poverty eradication, and I believe it will play one of the largest roles for years to come in ending extreme poverty.

MYTH 4: Default and late payments occur with frequency…

This assumption may have been the largest contributor to this market being so under-supplied for so long. Fortunately, this misconception is being disproved everyday with many microfinance banks reaching repayment rates of over 95%  and higher (higher than even student-loan and credit card rates in the US). Yunus’ Grameen Bank has even shown repayment rates of 97-98%. Though the accusation of “fudging” the numbers has been the mud on some walls for sometime now, even scrutinized figures show many repayment rates well north of 90%, with many still breaking that 95% mark.

This is perhaps the most unexpected finding in the “experiment” of microfinance; the poor are viable candidates for loans. However, repayment rates such as this are only seen when microfinance is executed correctly, efficiently, and most effectively (involving group-lending models, social collateral systems, short and frequent repayment schedules, sufficient general loan and business education and consultation, etc.).

MYTH 5: Microfinance is not a truly profitable sector…

See the oft-cited capital raised by Mexico’s Banco Compartamos’ IPO in 2007… north of $450mil.

“Social venture” meet “business venture”.

MYTH 6: Microfinance is everywhere…

            First, you are blown away by the idea. Then, you are intrigued by how successful it can be. Then, you think the market demand is finally being met, and underserved banking for the poor is a thing of the past. Hooray!!

            That is the typical stream of consciousness, simplified, for someone hearing of microfinance for the first time.

            The truth is that, sadly, microfinance is not everywhere, not by a long shot. Estimates range from 8-14% of the market demand for microfinancing being met. That means that of the proposed 400-600 million people that could use microcredit, only about 60-90 million have even remote access to it. The market is far from being adequately supplied. The good news is that this sector is seeing healthy growth.

Of the 2-3 billion people that could use microinsurance (life, health, etc) and microsavings accounts, this market is only seeing 3-4% being met.

            Unfortunately, it will be a long time before the lack of financial tools at the disposal of the poor is a thing of the past.

MYTH 7: Non-profit microfinance banks are BETTER for their respective communities than for-profit microfinance banks…

            The titans of microfinance clash over this hotly debated topic often. But the fact is this, and excuse me Mr. Yunus if I disagree with you, but this notion is dead wrong.

            I can readily say that benevolent/altruistic, completely socially-oriented, for-profit microfinance banks are hard to find, since if they are for-profit, most of the time, their ultimate concern is just that, profit (whether it is long-term or short-term maximization of that proponent). However, when these for-profit banks exist in areas where there are also non-profit banks, they are subject to the same competition than any other sector exhibits. This is good for the client because it gives them choice, and it serves to motivate the for-profit microfinance bank to provide their scaleable products as efficiently as possible in order to compete with the non-profit bank that does not have shareholder interests as added costs.

            People understandably fear microfinance banks squeezing their clients of every dime in order to ensure higher profits, and this is warranted in areas where microfinance banks only have to undercut the local loan shark to get a few clients, but the proof of this is not ‘in the pudding’ for most situations. Microfinance banks, whether for-profit or non-profit, see their effectiveness maximized (whether their goal is helping the most people or getting the most revenue) when they scale their product and supply it to the goal-maximizing demand. This requires mutually beneficial business relationships, mutually appreciative parties, and proper service.

            Saying blindly that microfinance centers that are for-profit are likely to eventually charge an arm and a leg on the interest for their loans is like worrying that tomorrow, McDonald’s will charge $10,000 for a Big Mac. If the market is opened up and free for the entry of both non-profit and for-profit microfinance banks, then supply will meet demand at the appropriate equilibrium price, or at least close to it, and the market will determine a “price” for the bank’s respected products that provides mutual beneficial welfare levels.

            Furthermore, in many cases, for-profit microfinance banks are actually preferable to their non-profit counterparts. I have started a non-profit organization myself, and I have also seen non-profit microfinance banks up-close, very up-close. My experience has taught me a valuable lesson; non-profits, by and large, are run like non-profits. When a for-profit in a competitive market minimizes cost, they are, in due course, minimizing the cost of their product for their customers/clients. Unfortunately, many non-profits never focus on minimizing cost. This is because minimizing costs has little benefit for them, as they, personally and generally, take home the same amount of dough at the end of the day either way. This is not to suggest that all non-profit microfinance institutions or non-profits in general are run inefficiently, it is only meant to suggest that the vast, vast, vast majority of them are.

(Maybe I will publish this article anonymously so that I don’t get the amount of negative “feedback” that I am sure to receive for some things written.)

MYTH 8: What works “here” will work “there”…

            Microfinance has had many success stories in recent years, and many banks have been lauded for their achievement (whether it be for its social or financial achievements). But there is no real formula for the method of each banks’ success in each banks’ respective region.

            Earlier in the article, I spoke of executing microfinance “correctly”. This is only meant to imply that the success of repayment rates and the ultimate success of the bank is due to proper diligence in finding what system and model will work best in their country or region. This is not meant to imply there is a black and white “correct” and “incorrect” way to run a microfinance bank.

            The fact is that what works in Dhaka does not seem to work well in Chiapas. What works in India is not automatically transferable to Peru and vice versa. It is not certain as to the exact reasons for the different disparities, but it is mainly attributed to cultural/societal, economic, and structural differences. In country X, it may be perfectly fine to lend to a group of wives that live quite close to each other. In country Y, potential clients may not live in densely populated villages, husbands may feel uncomfortable having their wives take out loans and expanding their businesses, and neighbors may be weary of borrowing altogether, not to mention a group-structured loan.

            For these and many, many other reasons, we have seen microfinance flourish in some countries and struggle to start in others. This isn’t to say microfinance will not work in this or that country, it is to say that microfinance banks in different regions may need to reinvent and pioneer the most efficient practices that work best for the clients that they serve.

MYTH 9: Microfinance is a volatile market and highly subject to the macroeconomic shocks of a particular region…

            This assumption is one that everyone and their mothers expect when they hear of microfinance, but the facts say otherwise. Data, though limited due to how recent the widespread practice is, has shown that microfinance is not highly subject to macroeconomic shocks at all, and in many cases, has performed better than other banking sectors during recessions and shocks, as was the case in Bolivia from 1998-2001.

MYTH 10: These are the only myths heavily circulated in the world of microfinance…

            Far from it, but I have gone well over my word limit. So you will have to check out TheMiFiReport.com for more; where the latest assumptions and confusion of microfinance are cleared up on a daily basis.

-James Beshara, a native of Texas, currently works with The Kuyasa Fund in Cape Town, South Africa. He is the editor of TheMiFiReport.com, and is developing an online comprehensive microfinance capital-portal, called Dvelo.org (launch coming in late 2008). He is also the co-founder of DveloFund.org, a registered 501(c)3 that provides grants for college students to conduct research in developing countries.