New research is debunking myths about microfinance and showing how organizations can effectively address problems associated with poverty. Yale faculty Dean Karlan, Tony Sheldon, and Rodrigo Canales discuss the problems and the promise in the field of microfinance and the lessons for other kinds of social enterprise.
Q: Let's start with a definition. What is microfinance?
Tony Sheldon: Microfinance is financial services for poor and low-income communities, people who have been excluded from the mainstream financial system.
Dean Karlan: I would say that's the correct definition, but it's not the often-used one, which focuses only on small loans to poor individuals.
Sheldon: During 2005, the United Nations' "Year of Microcredit," there was a big push to expand the public understanding beyond microcredit because credit is often not the most important tool for poor households. But it's so much easier to talk about microcredit than the complexities of microfinance that the two have become blurred.
Q: Could you talk about the excitement around the idea of giving loans to poor people? Why have people seen that as a powerful tool? Why is it something so many people have invested in? And what are the main criticisms?
Rodrigo Canales: Part of what makes microfinance, or microcredit, rather, so appealing is this idea that we allow poor people to work themselves out of poverty. We loan them the little bit that gets them going; then they do it themselves. I think it's an especially American narrative.
When I started doing fieldwork in microfinance, I remember one of the most powerful things for those receiving loans was that somebody saw these poor individuals as creditworthy. All of a sudden they're thinking, if this organization sees me as creditworthy, maybe I'm not seeing something in myself. That has a big impact.
It used to be that when you visited clients' homes or businesses in Mexico, you would find the original letter from the bank approving the first loan—they would frame it. I think that's one of the things that microfinance should do, when it's operating at its best. It should help create new expectations for destitute populations, expectations that they can live up to. I haven't seen that for a while.
When you look at what's actually happening on the ground, there are a lot of tensions that you cannot get rid of. The notion that you can help poor people without having to engage in important trade-offs is very appealing, but a lot of it ends up being false. We have made an assumption in microfinance that profitability is not at odds with having an impact, but in many cases it has to be. In many places it's very expensive to provide microcredit, so the interest rates that you have to charge in order to get the sustainable machine going end up negating a lot of the reasons why you even started doing it in the first place.
Sheldon: Microfinance has, in some ways, been more successful than a lot of people ever thought it could be. Before the term "social enterprise" had been coined, microfinance was the first field where the end clients were the very poor and the business model aimed to both be profitable and have a major social impact.
The idea was that by being profitable, you create a scalable institution that would be there in the long term, could borrow or attract investment, and would not be reliant on either the whims or the limited capital of donors. Microfinance has been grappling with those three key factors: financial sustainability, social impact, and significant scale, for 30 years. And those questions have been transposed onto social enterprise, more broadly.
Canales: We think more scale equals more impact, but we made up that equals sign in our minds. More scale does not necessarily mean more impact. Scale is going to mean lower cost. Lower cost does allow you to reach more people. But if you have a lower cost in your business model, you cannot provide more costly services. Then you've constrained your business model in a way that if there's a population that requires a more costly service, you're opting out of that.
It's a legitimate decision. But you have to be clear. And for the most part, microfinance companies haven't been clear about opting out of this entire population or service because of a decision we've made in our business model.
Sheldon: There are many who would still claim that the larger you are, the more profitable, and the bigger the impact. But I'd argue there are unintended consequences.
Tensions and trade-offs have erupted over the last several years as microcredit has become profitable and attracted private investors. We're not talking about social investors or foundations; we're talking about hedge funds and investment banks who want to buy stock, because where else can you get a 50% return on equity? But that means the nature of microfinance changes—who is attracted to do it, and who is attracted to invest in it—and that has consequences for the end client.
There's been a crisis of conscience within the microfinance community: how do we own up to our role in creating this, manage it now, and figure out a way forward.
Q: What are some of the specific issues being addressed?
Karlan: The question of who to reach. Despite the rhetoric, microfinance traditionally is not reaching the poorest of the poor. There are some exceptions, but those are just that, exceptions to the rule.
The question is, why? Is it a matter of cost? Micro-lenders or microfinance institutions are not willing to go that far downscale because the loan sizes and the savings amounts get to be so small. In most situations, working with the poorest, we also see unwillingness among borrowers to even participate—when people really have absolutely nothing, there's a fear of the formal institution. That's particularly true when there's a preference for those who are part of a group loan where people already have some sort of enterprise going on. The poorest people are individuals that don't have an activity that would even count as a microenterprise.
Tony and I are working together on a series of randomized trials in seven places around the world to evaluate the impact of a program that works with the people who are truly at the very bottom in any sort of poverty ranking.
It goes to this point: We need to get away from thinking about microenterprise lending as the model and just recognize that individuals that are in low-income households, whether they have salaried jobs or microenterprises, have many things in their lives they have to cope with. For some, insurance might be the best device. For some, saving might be the best way. And for some of them, if they don't have access to savings or insurance, then a loan is better than nothing.
Q: Does microfinance as a pioneering social enterprise have something to say about other areas of social enterprise and what the challenges are?
[This article has been reproduced with permission from Qn, a publication of the Yale School of Management http://qn.som.yale.edu]