Microfinance: Where do we stand 20 years on from the Nobel Peace Prize?

Microfinance, once hailed as a miracle cure for poverty, has not lived up to its transformative promise according to two decades of randomised evaluations.

Can microfinance really help people escape poverty?

Twenty years ago, Muhammad Yunus and the Grameen Bank were awarded the Nobel Peace Prize for their pioneering work on microfinance. The idea held enormous promise: give people excluded from traditional banking access to small loans, which they could use to invest, build businesses, and improve their lives. But two decades of economic research have complicated that story.

In this episode of Economics Unpacked, Simon Quinn and Muhammad Meki explore the origins of microfinance, how the Grameen Bank model works, and what randomised controlled trials around the world have taught economists about its impact on poverty.

The evidence suggests that traditional microfinance is no miracle cure. While some borrowers benefit, a one-size-fits-all approach does not work for everyone. We look at how new technology and better data could enable more flexible financial products tailored to the needs of poorer households and small businesses – and why the next generation of microfinance may look very different from the last.

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Transcript

Twenty years ago, Muhammad Yunus and the Grameen Bank were awarded the Nobel Peace Prize for pioneering microfinance as a route out of poverty. But has it lived up to its promise? To understand what happened, we need to go back to the beginning.

Welcome to Economics Unpacked, a VoxDev series where we try to answer the big questions in development.

Simon Quinn: So, one of the problems that every household and every business faces in different ways is that they need access to money. One way that we can do it is that somebody might give it to you. And in plenty of different settings, we have friends and family who might contribute to help us to make a purchase in life. Another way is that we might be able to save. So we might be patient enough to put aside, for example, some of our income each month in order to eventually accumulate a larger sum. Another way that we can do it is that we can take a loan. So we might go to a bank. We might ask for a large sum that we will then repay over time. Now, part of the problem in dealing with banks is that in many settings banks are unwilling or unable to deal with poorer households or smaller firms. And that’s where microfinance enters the picture.

But the fact that banks struggled to have enough information on poor households isn’t a new problem. Nor is microfinance a new idea.

Simon Quinn: Many people don’t know this. As early as the 1790s, Benjamin Franklin was pioneering provision of credit to try to help business growth in the United States. Some of the themes here are quite universal. So one of the most prominent early examples of microfinance was the Grameen Bank in Bangladesh. And the Grameen Bank, to their great credit, pioneered a model that had a few key features. Essentially, it was primarily targeting women and it was joint liability. In other words, women would receive individual loans, but they would each be liable if a member of their lending-borrowing group did not repay. So you’ve got some interesting features there. You’ve got the fact that there’s group lending or group liability, the fact that there are frequent repayments, which can help us with financial discipline – we get into a routine or a habit of repaying a loan – and then we’ve got the opportunity through that to invest, or to build up a useful lump sum. And essentially it’s designed to tackle a couple of the key problems. First is how do we help poor households to accumulate what we sometimes call ‘usefully large sums’? In other words, a lump sum that might be useful for making an investment in a business, maybe paying a household bill like school fees, and so on.

Microfinance was on the rise, and for a while seemed to be the most promising idea in poverty eradication.

Muhammad Meki: Many people had very high expectations for microfinance. In fact, the term ‘miracle cure’ was sometimes used, and the evidence suggests that it’s not a miracle cure.

Economists set out to capture the impact of microfinance in communities around the world. But the results painted a sobering picture.

Simon Quinn: About twenty years ago, a number of different economists in a number of different settings launched a series of randomised control trials. These were trials that sought to measure the impact of being provided access to microfinance, and many of those trials were thinking particularly about this kind of traditional model that the Grameen Bank had pioneered. Now, what did those studies show? Well, a number of different things. First, the headline result is that microfinance does not seem to have transformative effects, at least according to that traditional model.

So what went wrong?

Simon Quinn: Part of the original idea of microfinance is that we have this one kind of contract, and it’s going to be quite transformational. It’s almost the idea that one size fits all. But part of what we learned from those initial studies is that actually some borrowers seem to benefit from this contract, but many borrowers do not. And this immediately asks a really interesting question: what if one size does not fit all in the microfinance space?

So is microfinance not useful at all?

Muhammad Meki: The fact that the average effect isn’t transformative does not mean that microfinance is useless. The fact that it isn’t a miracle cure to poverty, again, doesn’t mean that it’s useless. It means that we need to think more carefully about the design of microfinance and the exact population that we’re focusing on.

Simon Quinn: Part of what these initial studies have done is to bring a sobering dose of reality to thinking about microfinance on the whole, while also encouraging us to think in more nuanced ways about how microfinance works, for whom microfinance can work, and in which ways microfinance can work better.

So how can the next generation of microfinance overcome previous issues of data availability on poor households and small businesses?

Muhammad Meki: The modern wave of microfinance research, and the frontier, is thinking about how technology and data can improve financial access, reduce the number of excluded borrowers, excluded groups, and also improve the products that we provide to borrowers – improve the diversity of products available to them. We have lots of data for small businesses from their transactions, and so we know much more about the income and expenditures of these small businesses.

Simon Quinn: That kind of data can be really useful for structuring the next generation of flexible microfinance contracts. And, one way or another, those contracts are going to look more like the equity contracts that large firms often seek when they need to make a much larger investment. That’s to say, they will be contracts in which the repayment that is owed to the capital provider will differ based on whether the business has had a good month or a bad month.

Muhammad Meki: It’s definitely a source of optimism that the data that we now have can be used to design better financial products that are better suited to borrowers and allow them to significantly improve their lives.

After twenty years of research, what are the key lessons?

Muhammad Meki: Economics suggests that often we need a big push to improve people’s lives significantly, and the reality is that microfinance can be too micro to really help people move out of the situation that they’re in. And so data can allow us to understand more about the exact financing needs that people have, and what kind of financing amount and financial structure of product may best enable them to improve their lives significantly.

You can find out more about this research at the link in the description. You’ve been watching Economics Unpacked. If you enjoyed this episode, please like, share, follow, and subscribe.