Microcredit has been in the spotlight lately. This innovative banking program, pioneered by Professor Muhammad Yunus, has created the option for millions of poor people, especially women, to become self-employed entrepreneurs. By empowering women, microcredit has created opportunities to lift countless families out of abject poverty. Clearly, this has been a net gain for society. Yet current criticism of microcredit points to its failure to alleviate poverty, high indebtedness of borrowers, high interest rates, coercive loan-collection tactics, lack of transparency in public fund management, and uncertainty of succession in leadership.
True, the concept of microcredit has been abused, as the recent experience in Andhra Pradesh, India demonstrates. But such cases do not justify banning support for microcredit altogether; rather, they suggest the need to better understand its dynamics. Millions of borrowers cannot be wrong who seek microcredit support worldwide. Microcredit eases a binding credit constraint, which facilitates optimal resource allocation by reducing inefficiency, thus raising income and productivity and reducing poverty. But other factors—from entrepreneurship to features of production systems and government institutions—also determine how much the poor benefit.
A lack of entrepreneurship, combined with insufficient product demand, may lead to diminishing returns on micro-investment. When returns fall short of expectations, micro-entrepreneurs may depend on repeated loans, creating a vicious cycle of debt dependency. Unfavorable conditions for economic growth and public infrastructure investment, including marketing facilities, may also cause indebtedness, in which case microcredit may create the conditions for market saturation, exhibiting negative externalities and thus zero or negative returns. Still another cause of indebtedness is inadequate insurance to protect the poor against economic and natural disasters.
High interest rates—up to 40 percent in some cases—are another major concern. Lenders, who view interest rates as returns to capital and a screening device for identifying creditable borrowers, usually set rates without considering the purpose of a loan; yet this is what determines a borrower’s willingness to accept a certain rate. If the goal is to support an income-earning activity, the rate of return (often extremely low) determines how much the borrower is willing to pay. However, if the goal is to smooth consumption or absorb certain types of shocks, she might be willing to take on a higher rate. Rates should be set according to the loan’s purpose.
If high interest rates are due to the commercialization of microcredit using donor funds, the practices of such institutions should be questioned. Charging high premiums on donor-supported micro-loans meant for poverty reduction must be curbed via a regulatory framework. Capping lending rates is one way to regulate exorbitant rates, but it should not stifle the incentive to lend.
Similarly, the mechanism under which public funds are transferred to the poor must be transparent and ensure the long-term sustainability of both borrowers and lenders. If microfinance institutions divert public funds to diversify the microfinance portfolio, then the poor must own, or at least accrue the dividends from, such ventures. Transparency in running publicly-funded organizations—including policies and practices on the question of leadership succession and ownership—is also required.
The lesson from experimentation over the last three decades is clear: It is possible to deliver credit to potential entrepreneurs with no access to mainstream financing to effect a social transformation that lifts people out of poverty. At the same time, microcredit can never be a magic formula for all-out poverty reduction in any country; providing financial services to the poor is a means to an end and should be implemented as part of an overall poverty-reduction strategy.
What the microfinance industry needs today is government support and regulation, not strangulation. Both borrowers and lenders require protection. This means setting appropriate interest rates, ensuring better access to subsidized funds to support innovation, and protecting the poor and their savings entrusted to microcredit institutions from any coercive practices by such institutions. The question of leadership succession must also be resolved amicably. A precipitate institutional takeover by government for political reasons would be counterproductive.
For more information on the topic, read the post: Microcredit Deserves Support, Not Suppression 
The views expressed herein are those of the author and do not necessarily reflect those of the World Bank.