Microfinance: Dream vs. Reality

Microfinance started as a simple idea: to provide loans to poor entrepreneurs.  Today it is a much more diverse and dynamic sector, and includes institutions that provide savings and remittance services, sell insurance, and offer loans for a wide range of purposes.  The idea now is to focus on bringing a range of financial services to the underserved.  The institutions that focus on this mission vary in the income levels of the customers they serve, their use of subsidies, and the breadth and quality of services offered.  This diversity also presents microfinance providers new opportunities as well as trade-offs.

When Muhammad Yunus and Grameen Bank won the Nobel Peace Prize in 2006, the world community celebrated the ways that expanding financial access can improve the lives of the poor.  Many microfinance “insiders” have been working toward a second goal as well: to find ways to provide microfinance on a commercial basis, without long-term subsidies.  The argument that microfinance institutions should seek profits has an appealing “win-win” resonance, admitting little trade-off between social and commercial objectives.  Should institutions move up-market to provide larger loans and improve financial performance?  Is deposit-taking feasible at such scales?  Can socially-minded institutions survive commercial competition and regulation without re-defining their mission?

Robert Cull, Jonathan Morduch and I have been analyzing a global survey of microfinance institutions compiled by the Microfinance Information Exchange (MIX) to try and answer some of these questions.  The data set includes microfinance banks and credit unions which tend to be for-profit.  Nongovernmental organizations (NGOs) have non-profit status.  And there are also non-bank financial institutions, a category that includes both for-profits and non-profits.

So what do the data tell us?

• Microfinance banks make up 10 percent of the institutions in our sample, but they are large, accounting for over half of the assets.  NGOs are smaller, and although they make up 45 percent of the institutions, they only have 21 percent of the assets.  NGOs reach more of the borrowers, though – they serve over half of the borrowers in the sample as opposed to the quarter served by microfinance banks.
• Financial self-sustainability and serving poor households are not necessarily incompatible.  But most institutions serving the poorest customers earn profits too small to attract investors seeking purely commercial returns.  This accounts for the continued importance of subsidies and noncommercial funding to NGOs.  Still, a substantial share of "non-profits" in fact earn profits, even if they are relatively small.  Nevertheless, a typical larger and older institution in our sample does not achieve profitability and deep outreach simultaneously.
• Non-profits do not duplicate the work of commercial lenders: they tend to make far smaller loans on average and serve more women as a fraction of customers, relative to commercialized microfinance banks.  On average, commercial microfinance banks make loans that are about four times larger than loans from NGOs, suggesting that they tend to serve a substantially better-off group of borrowers. As a group, NGOs charge interest rates roughly double the size of those charged by commercial microfinance banks.
• These findings suggest that the poorest customers tend to pay the most for loans.  As a group, NGOs make the smallest loans and, hence, face the highest costs per loan. To break even, NGOs must then charge the highest interest rates.  Raising interest rates improves profitability for many institutions but, after a point, higher rates are associated with increased loan delinquencies and diminished profits.
• Rigorous and regular supervision is critical for deposit-taking institutions, but it is costly; regulatory supervision thus tends to push institutions to serve relatively better-off customers as a way to maintain profitability.  Regulatory supervision is indeed associated with larger average loan sizes and less lending to women.  Supervision is also associated with having a higher share of staff concentrated in the head office, a natural response to reporting requirements and formalization.
• Competition, or potential competition from mainstream formal-sector banks, appears to steer microfinance institutions toward serving poorer customers as reflected by smaller average loan sizes and greater outreach to women, with little effect on their profitability.
   

Overall, microfinance promises to correct market failures by expanding the opportunities of the underserved.  For some, the microfinance dream is also to reach the world’s poorest and lift them out of poverty.  But evidence suggests it is difficult to realize both goals at the same time.  In reality, microfinance often entails distinct trade-offs between meeting social goals and maximizing commercial outcomes.  Reaching the very poor with small-scale services remains a tough business and often entails charging high fees or depending on steady subsidies. 

Further reading:

Cull, Robert, Asli Demirguc-Kunt, and Jonathan Morduch. 2007. "Financial performance and outreach: A global analysis of leading microbanks." Economic Journal 117(517): F107-F133.

Cull, Robert, Asli Demirguc-Kunt, and Jonathan Morduch. 2009a. "Microfinance meets the market." Journal of Economic Perspectives 23(1), Winter: 167-92.

Cull, Robert, Asli Demirguc-Kunt, and Jonathan Morduch. 2009b. "Does regulatory supervision curtail microfinance profitability and outreach?" World Development, forthcoming. (See the Policy Research Working Paper version.)

Cull, Robert, Asli Demirguc-Kunt, and Jonathan Morduch. 2009c. "Banks and micro-banks." Working Paper.

Cull, Robert, Asli Demirguc-Kunt, and Jonathan Morduch. 2010. “Microfinance Tradeoffs: Regulation, Competition, and Financing.” Handbook of Microfinance, edited by Beatriz Armendariz and Marc Labrie, forthcoming. (See the Policy Research Working Paper version.)