The Microfinance Revolution: An Overview · FEDERAL RESERVE BANK OF ST. LOUIS REVIEW...

FEDERAL RESERVE BANK OF ST. LOUIS REVIEW JANUARY/FEBRUARY 2008 9

The Microfinance Revolution: An Overview

Rajdeep Sengupta and Craig P. Aubuchon

The Nobel Prize committee awarded the 2006 Nobel Peace Prize to Muhammad Yunus and theGrameen Bank “for their efforts to create economic and social development from below.” Themicrofinance revolution has come a long way since Yunus first provided financing to the poor inBangladesh. The committee has recognized microfinance as “an important liberating force” andan “ever more important instrument in the struggle against poverty.” Although several authorshave provided comprehensive surveys of microfinance, our aim is somewhat more modest: Thisarticle is intended as a non-technical overview on the growth and development of microcreditand microfinance. (JEL I3, J41, N80)

Federal Reserve Bank of St. Louis Review, January/February 2008, 90(1), pp. 9-30.

In its broadest sense, microcredit includesthe act of providing loans of small amounts, often$100 or less, to the poor and other borrowers thathave been ignored by commercial banks; underthis definition, microcredit encompasses alllenders, including the formal participants (suchas specialized credit cooperatives set up by thegovernment for the provision of rural credit)and those of a more informal variety (such as thevillage moneylender or even loan sharks). Yunus(2007) argues that it is important to distinguishmicrocredit in all its previous forms from thespecific form of credit adopted at the GrameenBank, which he calls “Grameencredit.” Yunusargues that the “most distinctive feature ofGrameencredit is that it is not based on any col-lateral, or legally enforceable contracts. It is basedon ‘trust,’ not on legal procedures and system.”For the purposes of this article and unless men-tioned otherwise, our use of the term microcredit

In 2006, the Grameen Bank and its founderMuhammad Yunus were awarded theNobel Peace Prize for their efforts to reducepoverty in Bangladesh. By providing small

loans to the extremely poor, the Grameen Bankoffers these recipients the chance to becomeentrepreneurs and earn sufficiently high incometo break themselves free from the cycle of poverty.Yunus’s pioneering efforts have brought renewedattention to the field of microfinance as a tool toeliminate poverty; and, since 1976 when he firstlent $27 to 42 stool makers, the Grameen Bankhas grown to include more than 5.5 million mem-bers with greater than $5.2 billion in dispersedloans. As microfinance institutions continue togrow and expand, in both the developing anddeveloped world, social activists and financialinvestors alike have begun to take notice. In thisarticle we seek to explain the rise in microfinancesince its inception in the early 1980s and thevarious mechanisms that make microfinancean effective tool in reducing poverty.1 We alsoaddress the current problems facing microfinanceand areas for future growth.

1 Other, more technical surveys of microfinance include Ghatak andGuinnane (1999), Morduch (1999), and Armendáriz de Aghionand Morduch (2005).

Rajdeep Sengupta is an economist and Craig P. Aubuchon is a research associate at the Federal Reserve Bank of St. Louis. The authors thankSubhayu Bandyopadhyay, Patrick Pintus, and George Fortier for helpful comments and suggestions.

© 2008, The Federal Reserve Bank of St. Louis. Articles may be reprinted, reproduced, published, distributed, displayed, and transmitted intheir entirety if copyright notice, author name(s), and full citation are included. Abstracts, synopses, and other derivative works may be madeonly with prior written permission of the Federal Reserve Bank of St. Louis.

will, for the most part, follow Yunus’s character-ization of Grameencredit.

Although the terms microcredit and micro-finance are often used interchangeably, it isimportant to recognize the distinction betweenthe two. As mentioned before, microcredit refersto the act of providing the loan. Microfinance,on the other hand, is the act of providing thesesame borrowers with financial services, such assavings institutions and insurance policies. Inshort, microfinance encompasses the field ofmicrocredit. Currently, it is estimated that any-where from 1,000 to 2,500 microfinance institu-tions (MFIs) serve some 67.6 million clients inover 100 different countries.2

Many MFIs have a dual mandate to providefinancial as well as social services, such as healthcare and educational services for the underprivi-leged. In this sense, they are not always perceivedas profit-maximizing financial institutions. Atthe same time, the remarkable accomplishmentof microfinance lies in the fact that some of thesuccessful MFIs report high rates of repayment,sometimes above 95 percent. This rate demon-strates that lending to underprivileged borrow-ers—those without credit histories or the assetsto post collateral—can be a financially sustainableventure.

Not surprisingly, philanthropy is not arequirement of microfinance—not all MFIs arenon-profit organizations. While MFIs such asBanco Sol of Bolivia operate with the intent toreturn a profit, other MFIs like the Grameen Bankcharge below-market rates to promote socialequity.3 As will be discussed below, this distinc-tion is important: As the microfinance industrycontinues to grow and MFIs serve a wider clientbase, the commercial viability of an MFI is oftenviewed as crucial for its access to more main-stream sources of finance. (We will return to thisand related queries in the “The Evidence of

Microfinance” section of this paper.) The nextsection offers a brief history of the Grameen Bankand a discussion of its premier innovation ofgroup lending contracts; the following sectionsdescribe the current state of microfinance andprovide a review of some of the common percep-tions on microfinance. The final section outlinesthe future of microfinance, particularly in thecontext of global capital markets.

A BRIEF HISTORY OF THEGRAMEEN BANK

The story of the Grameen Bank is a suitablepoint to begin a discussion of microcredit andmicrofinance. After obtaining a PhD in economicsin 1969 and then teaching in the United Statesfor a few years, Muhammad Yunus returned toBangladesh in 1972. Following its independencefrom Pakistan in 1971 and two years of flooding,Bangladesh found itself in the grips of a terriblefamine. By 1974, over 80 percent of the popula-tion was living in abject poverty (Yunus, 2003).Yunus, then a professor of economics atChittagong University in southeast Bangladesh,became disillusioned with economics: “Nothingin the economic theories I taught reflected the lifearoundme. How could I go on telling my studentsmake believe stories in the name of economics?”(See Yunus, 2003, p. viii.) He ventured into thenearby village of Jobra to learn from the poor whatcauses their poverty. Yunus soon realized that itwas their lack of access to credit that held themin poverty. Hence, the origins of “microfinance”emerged from this experience when Yunus lent$27 of his own money to 42 women involved inthe manufacturing of bamboo stools.4

Sengupta and Aubuchon

10 JANUARY/FEBRUARY 2008 FEDERAL RESERVE BANK OF ST. LOUIS REVIEW

2 Microfinance Information Exchange (MIX) lists financial profilesand data for 973 MFIs. The high estimate of 2,500 comes from asurvey conducted by the Microcredit Summit Campaign in 2002.

3 The social objectives of the Grameen Bank are summarized by the16 decisions in their mission statement. The statement is availableat http://grameen-info.org/bank/the16.html.

4 Yunus (2003) describes his conversation with Sufiya, a stool maker.She had no money to buy the bamboo for her stools. Instead, shewas forced to buy the raw materials and sell her stools through thesame middleman. After extracting interest on the loan that Sufiyaused to buy the bamboo that morning, the moneylender left herwith a profit of only 2 cents for the day. Sufiya was poor not forlack of work or skills, but because she lacked the necessary creditto break free from a moneylender. With the help of a graduate stu-dent, Yunus surveyed Jobra and found 41 other women just likeSufiya. Disillusioned by the poverty around him and questioningwhat could be done, Yunus lent $27 dollars to these 42 womenand asked that he be repaid whenever they could afford it.

Through a series of trials and errors, Yunussettled on a working model and by 1983, under aspecial charter from the Bangladesh government,founded the Grameen Bank as a formal and inde-pendent financial institution. Grameen is derivedfrom the Bengali word gram, which means village;grameen literally means “of the village,” an appro-priate name for a lending institution that requiresthe cooperation of the villagers. The GrameenBank targets the poor, with the goal of lendingprimarily to women. Since its inception, theGrameen Bank has experienced high growth ratesand now has more than 5.5 million members(see Figure 1), more than 95 percent of whom arewomen.5

Lending to poor villagers involves a signifi-cant credit risk because the poor are believed tobe uncreditworthy: That is, they lack the skillsor the expertise needed to put the borrowedfunds to their best possible use. Consequently,mainstream banks have for the most part denied

the poor access to credit. The Grameen Bank haschallenged decades of thinking and receivedwisdom on lending to the poor. It has success-fully demonstrated this in two ways: First, it hasshown that poor households can benefit fromgreater access to credit and that the provision ofcredit can be an effective tool for poverty allevia-tion. Second, it has proven that institutions donot necessarily suffer heavy losses from lendingto the poor. An obvious question, though, is howthe Grameen Bank succeeded where so many oth-ers have failed. The answer, according to mosteconomists, lies in its unique group lendingcontracts, which enabled the Grameen Bank toensure repayment without requiring collateralfrom the poor.

The Group Lending Innovation

This Grameen Bank lending model can bedescribed as follows: Borrowers organize them-selves into a group of five and present themselvesto the Bank. After agreeing to the Bank rules, thefirst two members of the group receive a loan. Ifthe first two successfully repay their loans, then



5 Grameen Bank, annual reports (various years). Data can be viewedat www.grameen-info.org/annualreport/commonElements/htmls/index.html.

0

1

2

3

4

5

6

1976 1981 1986 1991 1996 2001

Millions of Persons

Figure 1

Grameen Bank Membership

four to six weeks later the next two are offeredloans; after another four to six weeks, the last per-son is finally offered a loan. As long as all mem-bers in the group repay their loans, the promiseof future credit is extended. If any member of thegroup defaults on a loan, then all members aredenied access to future credit. Furthermore, eightgroups of Grameen borrowers are organized intocenters and repayment is collected during publicmeetings. While this ensures transparency, anyborrower who defaults is visible to the entirevillage, which imposes a sense of shame. In ruralBangladesh, this societal pressure is a strong dis-incentive to default on the loan. Initial loans aresmall, generally less than $100, and require weeklyrepayments that amount to a rate of 10 percentper annum.6 Weekly repayments give the borrow-ers and lenders the added benefit of discoveringproblems early.

Group lending—or the joint liability con-tract—is the most celebrated lending innovationby the Grameen Bank. Economies of scale moti-vated its first use, and Yunus later found that thebenefits of group lending were manifold. Undera joint liability contract, the members within thegroup (who are typically neighbors in the village)can help mitigate the problems that an outsidelender would face. Outside lenders such as banksand government-sponsored agencies face whateconomists call agency costs. For example, theycannot ensure that the borrowed money be put toits most productive use (moral hazard), cannotverify success or failure of the proposed business(costly state verification/auditing), and cannotenforce repayment. It is not difficult to see howpeers within the group can help reduce thesecosts, particularly in a situation where the prom-ise of future credit depends on the timely repay-ment of all members in the group. Joint liabilitylending thus transfers these agency costs fromthe bank onto the community of borrowers, whocan provide the same services more efficiently.

But perhaps the more difficult agency prob-lem faced by lenders is that of adverse selection—ascertaining the potential credit risk of the

borrower. Market failure occurs because safeborrowers (who are more likely to repay) have tosubsidize risky borrowers (who are more likelyto default). Because the bank cannot tell a safeborrower from a risky one, it has to charge thesame rate to all borrowers. The rate depends onthe mix of safe and risky borrowers in the popu-lation. When the proportion of risky borrowersis sufficiently large, the subsidy required (for thelender to break even on all borrowers) is so highthat the lender has to charge all borrowers a sig-nificantly high rate. If the rates are sufficientlyhigh, safe borrowers are unlikely to apply for aloan, thereby adversely affecting the compositionof the borrower pool. In extreme cases, this couldlead to market failure—a situation in whichlenders do not offer loans because only the riskytypes remain in the market!

Economic theory helps show how joint liabil-ity contracts mitigate adverse selection (Ghatakand Guinnane, 1999). Under group lending, bor-rowers choose their own groups. A direct way inwhich this might help is when a prospectivecustomer directly informs the bank about thereliability of potential joiners. Perhaps a moresurprising result is that the lender can mitigatethe adverse selection problem even when cus-tomers do not directly inform the bank but formthemselves into like groups (peer selection). Thatis, given a joint liability clause, safe customerswill more likely group together with other safecustomers, leaving the risky types to form groupsby themselves. This “assortative matching” miti-gates the adverse selection problem because nowthe risky borrowers are the ones whomust bail outother risky borrowers, while the safe borrowershave to shoulder a lesser subsidy. Consequently,all borrowers can be charged a lower rate, reduc-ing the likelihood of a market failure.

CURRENT STATE OFMICROFINANCE

Since the inception of the Grameen Bank,microfinance has spread to cover five continentsand numerous countries. The Grameen Bank has

6 See www.grameen-info.org/bank/GBGlance.htm. Other sourcesput the annual rates charged by MFIs at around 30 to 60 percent.



been duplicated in Bolivia, Chile, China, Ethiopia,Honduras, India, Malaysia, Mali, the Philippines,Sri Lanka, Tanzania, Thailand, the United States,and Vietnam; the microfinance informationexchange market (MIX) lists financial informationfor 973 MFIs in 105 different countries. SomeMFIs have also begun to seek out public andinternational financing, further increasing theiramount of working capital and expanding thescope of their operations. As MFIs have becomemore efficient and increased their client base, theyhave begun to expand their services through differ-ent product offerings such as micro-savings, flexi-ble loan repayment, and insurance. We discussthese three different product offerings below.

At the time of their inception, many MFIsincluded a compulsory savings component thatlimited a borrower’s access to deposited funds.This promoted long-term savings, but ignoredthe fact that many poor save for the short term tosmooth consumption during seasonal lows of pro-duction. Figure 2 provides a look at the distribu-tion of voluntary MFI savings by region. As MFIshave become better versed in the microfinancemarket, they have applied their innovations inlending to the collection of deposits. One of theleading examples is SafeSave, located in Dhaka,

Bangladesh, which uses the idea that frequentsmall deposits will guard against the temptationof spending excess income. To keep the transac-tion costs of daily deposits low, SafeSave hirespoor workers from within the collection areas(typically urban slums) to meet with clients ona daily basis. By coming to the client, SafeSavemakes it convenient for households to save; byhiring individuals from the given area, trainingcosts and wages are also kept low. With this effi-cient model for both the bank and individuals,SafeSave has accumulated over 7,000 clients insix years.7 Not surprisingly, microfinance deposits(like microfinance loans) break from traditionalcommercial banking experiences. The exampleof Bank Rakyat Indonesia (BRI) suggests that thepoor often value higher liquidity over higher inter-est rates on deposit products. In 1986, after a yearof field experiments, they offered two depositproducts: The TABANAS product offered a 12percent interest rate but restricted withdrawalsto twice monthly, whereas the SIMPEDES prod-uct offered an interest rate of zero but allowedunlimited withdrawals. The SIMPEDES programsaw the largest gain in popularity and to this day



7 See www.savesafe.org.

Africa, 8.4

S. Asia, 10.6

Latin America, 6.8

Eastern Europe/C. Asia, 2.7

E. Asia Pacific, 32.6

953 MFIs Reporting, July 200761 Million Savers

Figure 2

Savings by Region

SOURCE: Microfinance Information Exchange Network; www.mixmarket.org.

still offers a lower interest rate but maintains moreaccounts than the TABANAS program.8

The original Grameen Bank was one of thefirst MFIs that incorporated a compulsory savingsrequirement into their lending structure. Everyclient was required to make a deposit worth 5percent of their given loan, which was placedinto a group fund with strict withdrawal rules(generally no withdrawals before three years). In2001, the Grameen Bank reviewed both its lend-ing and savings policy and reinvented itself asGrameen II. At the heart of this change were moresavings options and more flexible loans, whichact as a form of insurance. New to Grameen II isa pension fund, which allows clients with loansgreater than 8,000 taka ($138) to contribute at least50 taka ($0.86) per month. The client receives 12percent per year in compound interest, earning a187 percent return after the mandatory 10-yearwait. This scheme allows Grameen II to earn moremoney in the present and expand services, whiledelaying payment in the near future.

Grameen II serves as a good example of a sec-ond innovation in microfinance: flexible loanrepayment. Group lending still exists and is anintegral part of the process, but Grameen II intro-duced a flexi-loan that allows borrowers multi-ple options to repay their loan on an individualbasis. Yunus (2002) stated that “group solidarityis used for forward-looking joint actions forbuilding things for the future, rather than for theunpleasant task of putting unfriendly pressure ona friend.” The flexi-loan is based on the assump-tion that the poor will always pay back a loan andthus allows the poor to reschedule their loanduring difficult periods without defaulting. Ifthe borrower repays as promised, then the flexi-loan operates exactly like the basic loan, usingdynamic incentives9 to increase the size of theloan after each period. If the borrower cannotmake her payments, she is allowed to renegotiateher loan contract rather than default. She can

either extend the life of the loan or pay only theprinciple for an extended period of time. As apenalty, the dynamic incentives of her loan arereset; she cannot access larger (additional)amounts of credit until the original loan is repaid.Because her default now poses no threat to thegroup promise of future credit, each member isaccountable only up to their individual liabilities.

The third offering is the addition of insuranceto microfinance loans. The most basic insuranceis debt relief for the death of a borrower, offeredby many MFIs, including Grameen. Other MFIshave begun experimenting with health insuranceand natural disaster insurance. As with lending,agency problems present a dilemma for micro-insurance. To this end, some groups such asFINCA Uganda require life insurance of all bor-rowers, including “risky” and “healthy” alike andthus avoid the adverse selection problem. Otherideas include providing rain insurance to guardagainst catastrophes. This relies on the assumptionthat crop yields (and much of the developingeconomy) are tied to seasonal rain cycles. Thisinnovation eliminates the problem of moral hazardassociated with a crop loan. By tying performanceto rain cycles, a farmer has no incentive to takecrop insurance and then fail to adequately pro-duce a crop during a season of adequate rainfall.

A more recent phenomenon in microfinanceis the emergence of foreign investment in MFIs.As more andmoreMFIs establish positive returns,microfinance is being seen by many professionalinvestors as a profitable investment opportunity.One of the most important developments for theMFIs was the June 2007 release of Standard &Poor’s (S&P) report on the rating methodologyfor MFIs. By applying a common methodology,S&P will be able to send a stronger signal to poten-tial investors about the quality of MFI investments.The process of debt offerings and securitizationin the microfinance sector will be covered ingreater detail below.

MICROFINANCE AROUND THEWORLD

As Yunus and the Grameen Bank began toprove that microfinance is a viable method to

8 The SIMPEDES program does also use a lottery system to giverewards, often worth 0.7 percent of deposits. More details areavailable at the BRI web page: www.bri.co.id/english/mikrobank-ing/aboutmikrobanking.aspx.

9 Dynamic incentives threaten to exclude defaulted borrowers fromfuture loans.



alleviate poverty, their methodology and programbegan to spread around the world. It is difficultto know exactly how many MFIs there currentlyare, but Microfinance Information Exchange (MIX)estimates range from 1,000 to 2,500 serving some67.6 million clients. Of these 67 million, morethan half of them come from the bottom 50 per-cent of people living below the poverty line.That is, some 41.6 million of the poorest peoplein the world have been reached by MFIs. MFIshave expanded their operations into five differ-ent continents and penetrated both rural andurban markets. They have achieved success witha variety of credit products and collection mech-anisms. Table 1 provides a comparison of severalgroups from around the world.

Banco Solidario (Bolivia)

Banco Solidario originally existed as theFundacion para Promocion y el Desarrollo de laMicroempresa (PRODEM), a non-governmentalorganization (NGO) in the mid-to-late 1980s andprovided small capital loans to groups of threeor more people dedicated to entrepreneurial

activities. By 1992, PRODEM serviced 17,000clients and disbursed funds totaling $4 milliondollars. Constrained by the legal and financialregulations governing an NGO, the board ofdirectors decided to expand their services andPRODEM became the commercial bank, BancoSolidario, later that year. Currently, Banco Solhas 48 branches in seven cities with over 110,000clients and a loan portfolio of more than $172million. As of March 31, 2007, Banco Sol reporteda past-due loans level of only 1.78 percent. Animportant distinction between Grameen andBanco Sol is the latter’s emphasis on returning aprofit with poverty alleviation stated only as asecondary goal.

Banco Sol offers credit, savings, and a varietyof insurance products. Their initial loan offeringwas based on Grameen-style joint-liability lend-ing, offering a maximum of $3,000 per client togroups of three or four individuals with at leastone year of experience in their proposed occupa-tion. Using dynamic incentives, the size of theloan is gradually increased based on good repay-ment history. Annual interest rates average



Table 1Characteristics of Select Microfinance Institutions

EnterpriseGrameen Bank, Banco Sol, Compartamos, Development Group,

Bangladesh Bolivia Mexico Washington, D.C.

Established 1983 1992 1990 1993

Membership 6,948,685 103,786 616,528 250

Average loan balance (US$) $69 $1,571 $440 $22,285**

Percent female 96.70% 46.40% 98.40% 30.00%

Group lending contracts? Yes Yes Yes No

Collateral required? No No No No

Portfolio at risk >30 days ratio 1.92% 2.91% 1.13% N/A

Return on equity 1.95%* 22.81% 57.35% N/A

Operational self-sufficiency 102.24%* 120.09% 181.22% 53%**

NOTE: *12/31/2005; **2004.

SOURCE: Data for this table come from the Microfinance Information Exchange (MIX) Network, which is a web-based platform:www.mixmarket.org. Information was provided for the Enterprise Development Group because it is the only U.S.-based MFI thatreports data on the MIX network. Some of the information for EDG was taken from their 2003/2004 annual report, available atwww.entdevgroup.org. Comparable information is not available for the Southern Good Faith Fund, as the scope of their mission haschanged and expanded to more training-based programs. A more comprehensive summary chart exists in Morduch (1999).

between 12 and 24 percent and can be anywherefrom 1 to 60 months in length (120 months for ahousing loan).10 With these higher interest rates,Banco Sol does not rely on subsidies and, at theend of 2006, posted returns on equity of 22.8percent.

Compartamos (Mexico)

Compartamos is the largest MFI in Mexico,servicing some 630,000 clients with an activeloan portfolio of $285 million. Located in MexicoCity, Compartamos is active in 26 Mexican statesthroughout the country and services primarilyrural borrowers. Compartamos was founded in1990 and began by offering joint-liability loansto female borrowers for income-generating activ-ities. Compartamos has only recently expandedtheir services to allow men to borrow throughtheir solidarity group and their individual creditprogram; still, around 98 percent of their borrow-ers are female. In 1998, Compartamos formed astrategic alliance with Accion International andtransformed into a regulated financial institution,called a Sociedad Financiera de Objeto Limitado(SFOL). In 2002, Compartamos took a unique stepfor a MFI and became one of the first MFIs to issuepublic debt, listing themselves on the MexicanStock Exchange. As an SFOL, Compartamos waslimited to only offering credit for working capital.In order to offer more services, such as savingsand insurance programs, Compartamos became acommercial bank in 2006.

Compartamos was one of the first MFIs toraise additional capital funds through the sale ofdomestic bond issuances. In 2002, Compartamoswas the first MFI in Mexico and one of the firstin Latin America to offer a bond sale. Becausethis was Standard and Poor’s first attempt at rat-ing a microfinance bond, they adapted their cur-rent methodology and rated the bond using theirMexican scale and assumed local buyers. S&P wasimpressed with the diversified portfolio of debtand offered Compartamos an MXA+ (MexicanAA) rating. Reddy and Rhyne (2006) report thattheir most recent bond was rated an MXAA

through the use of credit enhancements, allow-ing them to place the bond with institutionalinvestors. Their fifth issue to date was three timesoversubscribed with 70 percent of the bond pur-chased by institutional investors. By accessingthe commercial market, Compartamos has beenable to lower the cost of obtaining funds and, inturn, offer better services to their borrowers, suchas absorbing the costs of providing life insurancefor all clients. Their efforts to improve operationalefficiency have also created a self-sufficient MFIthat has existed without subsidies for over adecade.

Good Faith Fund (United States)

The Good Faith Fund was modeled after theGrameen Bank and was one of the first MFIs tobe established in America. In 1986, while gover-nor of Arkansas, Bill Clinton invited MuhammadYunus to visit and discuss microfinance. Theinitial program was started as the Grameen Fund,but the name was later changed to better reflectthe fund’s commitment to providing loans tomicro-entrepreneurs. Loans weren’t securitizedwith collateral; rather, they were guaranteed on“good faith” (Yunus, 2003, p.180).

As the Good Faith Fund grew, practitionersand academics alike began to question the effec-tiveness of a pure Grameen-style program in theUnited States. Much like the original GrameenBank, the Good Faith Fund has relied on innova-tion and change to apply microlending to therural economy of Arkansas. Taub (1998) arguesthat the Good Faith Fund is a successful povertyalleviation program, but that it is a poor eco-nomic development program. In Taub’s words,“the Good Faith Fund has never been able todeliver a meaningful volume of customers, pro-vide substantial loan services to the really poor,or achieve anything close to institutional self-sufficiency.” He argues that important social dif-ferences arise because rural Arkansas isinherently different from rural Bangladesh andthat these social differences cause the grouplending model to fail.

Group lending failed for several reasons, butforemost was the inability of potential borrowersto form a group. In Bangladesh, where poverty

10 Banco Sol, accessed July 27, 2007; www.bancosol.com.bo/en/intro.html.



rates and population density are much higherthan the those in the United States, potentialborrowers can more readily find other entrepre-neurs. However, a close network of social tiesamong the poor does not exist in rural Arkansas.In response to this problem, Good Faith Fundpersonnel established a mandatory six-weektraining program for individual new membersand then created groups from the training pro-grams. These newly formed groups of relativestrangers lacked the social cohesion to enforcecontract payments, unlike groupmembers in ruralBangladesh, who often live in the same villageand have family/community histories together.Consequently, group lending was slowly phasedout of the Good Faith Fund. Today, the Good FaithFund focuses mainly on career training throughtheir Business Development Center and AssetBuilders program. They have also found a nichein loaning larger amounts of money to small- andmedium-sized enterprises that are underservedby the commercial banking center. These loansprovide the same service, but at $100,000 or more,they can hardly be considered “micro” credit.

THE EVIDENCE ONMICROFINANCE

In this section, we review some of the impor-tant questions on microfinance. Our assessmentis based on numerous studies, technical surveys,and newspaper reports on microfinance. Theattempt here is to be illustrative rather than pro-vide a comprehensive review of microfinance.

Is Microfinance a Desirable Alternativeto Informal, Exploitative Sources ofFinance?

The spread of microfinance and the successof MFIs in various countries around the worldprompts a question: Who served the poor beforethe microcredit revolution? It is well known thatconventional banks, which act as creditors to mostentrepreneurial activity in themodernworld, havelargely avoided lending to the poor. Instead, creditto the poor has been provided mostly by localmoneylenders, often at usurious rates. Conse-

quently, moneylenders are typically perceivedas being exploitative, taking advantage of poorvillagers who have no other recourse to loans.Therefore, it is not surprising that microfinancehas been welcomed by most as an alternative tothe abusive practices of village moneylenders.However, this common perception requires amore careful study: Why don’t mainstream bankslend to the poor? In the banks’ absence, do localmoneylenders have monopoly power? Moreimportantly, are these high interest rates chargedby moneylenders welfare reducing?

We begin by listing the difficulties that arisein lending to the poor. First, early studies believedthat poor people often lack the resources neededto invest their borrowings to the most productiveuse. In short, the poor borrow mostly to financeconsumption needs (Bhaduri, 1977; Aleem, 1990).Second, even if loans could be earmarked forinvestment purposes, commercial banks wouldfind it difficult to lend: Lack of credit historiesand documented records on small entrepreneursor farmers make it difficult for the bank to assessthe creditworthiness of the borrower. Finally, thereis the inability of the poor to post collateral onthe loans. This reduces the bank’s recourse to asaleable asset once the borrower defaults on theloan. Therefore, it is not difficult to see why com-mercial banks have avoided lending to the poor.

On the other hand, it is believed that localmoneylenders could mitigate the problems facedby outside banks in lending to the poor. Localmoneylenders are arguably better informed ofborrower quality and have more effective meansof monitoring and enforcing contracts than out-side banks. In short, because of their social ties,information, and location advantage, these mon-eylenders are in a unique position to lend to thepoor. Some observers argue that usurious interestrates in these markets can be explained by this“monopoly” that the local moneylenders enjoy.Several researchers have studied the marketstructure of rural credit markets in developingcountries. Some argue that rural credit marketsare more competitive than previously imaginedbecause there is free entry for local moneylend-ers if not outside banks. While there is no broadconsensus yet, most observers believe that despite



free entry in these markets, moneylenders oftenenjoy some form of local monopoly power (in themanner of monopolistic competition), at least inthe short run.

However, there are other reasons why money-lenders charge high interest rates. First, money-lenders have to compensate for the hightransaction costs of issuing and servicing a smallloan. Second, some observers believe that thesefunds have high “opportunity costs”—that is,moneylenders can earn high returns by investingin their own farms. Finally, and this is despitetheir local informational advantage, moneylendersface some of the same problems as commercialbanks in identifying risky borrowers and securingcollateral, particularly in poor rural areas. Asimple numerical example helps illustrate thisresult11: Consider two lenders with the same costof funds. Suppose now that the first lender oper-ates in a prime market where borrowers faithfullyrepay all of their loans at 10 percent, giving himan expected 10 percent return. However, the sec-ond lender operates in a poor rural market whereborrowers arguably have a higher rate of default,say 50 percent.12 Consequently, her expected netreturn is thus [�1 + interest rate� * �1 – probabilityof default� – 1]. Therefore, for the second money-lender to earn the same 10 percent return, shemust charge an interest rate equal to 120 percent:�1 + 120%� * �1 – 50%� – 1 = 10%. This is not tosay that some moneylenders don’t engage inprice setting, but it does give a simple examplein which a moneylender can be competitive butstill charge extremely high interest rates.

Do moneylenders reduce welfare becausethey charge high interest rates? To the extent thatborrowers willingly accept these loan contracts,the answer is no.13 These loan contracts do gen-erate a positive surplus ex ante. That is, only thoseborrowers who expect to generate a rate of returnfrom their investment that is higher than that

charged by the moneylender will enter into thesecontracts. Clearly, this situation can be improvedupon by offering lower rates: This would allowmore borrowers—i.e., those who expect to gener-ate a lower rate of return on their investment—toenter into loan contracts. However, this does notmean that a high interest rate per se reduces wel-fare. On the contrary, getting rid of moneylendersor preventing them from offering loans at thesehigh rates can be welfare reducing; in theirabsence, entrepreneurs with the highest returnson their projects have no recourse to loans.

In contrast, MFIs can often offer lower interestrates than local moneylenders because of theirhigher efficiency in screening and monitoringborrowers, which results from both their economyof scale (serving more borrowers) and their use ofjoint liability lending mechanisms. This lowersthe MFI’s cost of lending relative to that of thelocal moneylender. To the extent that MFIs canprovide loans at a lower rate than moneylenders,enabling more and more borrowers to enter thecredit market, is an argument for both the effi-ciency (because of the reduced cost of funds) andwelfare enhancement (because of an increase inthe borrower pool) of microfinance.

How High are the Repayment Ratesfor MFIs?

This is widely regarded as the greatest achieve-ment of microfinance. Many MFIs report highrates of repayment, often greater than 90 percent.These claims have driven considerable academicinterest in why and how microfinance works.Furthermore, these repayment rates are widelycited in popular media (Business Week, July 9and 16, 2007;Wall Street Journal, September 23,2007) and have been one of the reasons for therecent interest generated by microfinance in finan-cial markets worldwide. Although the theories ofjoint liability contracts, progressive lending,14

frequent repayments, and flexible collateral ade-quately explain these high rates of repayment,Morduch (1999) raises the important issue of



14 Progressive lending is a type of dynamic incentive in whichaccess to larger amounts of credit becomes available after eachsuccessfully repaid loan.

11 This example in Armendáriz de Aghion and Morduch (2005) isdrawn from the early work of Bottomley (1975).

12 Of course, Yunus believes that this wrong assumption is the rootof all the problems that the poor have in obtaining credit.

13 Bhaduri (1973) points to some degree of coercion in rural creditmarkets, particularly in situations where landlords double asmoneylenders.

validation. Because many of these repaymentrates are self reported, it is important to under-stand the methodology used to calculate theserepayment rates.

Morduch studies the repayment rates for theGrameen Bank for the 10-year period of 1985 to1996. During this period, Grameen’s average loanportfolio grew from $10 million to $271 millionand membership expanded more than 12-fold toinclude 2.06 million members in 1996. For thisdecade, Grameen reports an average overdue rateof only 1.6 percent.15 Morduch’s contention isthat the Grameen Bank does not follow conven-tional accounting practices and calculates theoverdue rates as the value of loans overdue (formore than one year) divided by the current port-folio, instead of dividing by the size of the port-folio when the overdue loans were issued. Becausethe size of the loan portfolio expanded 27-foldduring this 10-year period, the loan portfolio issignificantly larger at the end of any one year thanat the beginning. Morduch finds the adjustedaverage default rate to be 7.8 percent for the same10-year period. He makes the point that “the rateis still impressive relative to the performance ofgovernment development banks, but it is highenough to start creating financial difficulties”(Morduch, 1999, p. 1590).

As for these financial difficulties, Morduchthen focuses on reported profits, taking specialcare to examine the provision of loan losses. Hefinds that the bank is slow to write off bad loans,dropping only a modest 3.5 percent of its portfolioevery year, again overstating the amount of profit.He calculates that instead of posting a total of$1.5 million in profits, the bank would haveinstead lost a total of $18 million. The implica-tions to Morduch’s findings are as follows: In theearly 1990s, to operate without subsidies, theGrameen Bank would have had to raise interestrates on its general product from 20 percent to50 percent, and this would have raised the aver-

age interest rate on all products to 32 percent.Morduch is careful to point out that it is unknownwhether or not borrowers would defect, becausefor most borrowers the alternative is either noloan or an even higher interest rate on loans froma moneylender.

Although there is an apparent disagreementbetween Morduch’s adjusted rates of repaymentand the Grameen Bank’s self reported rates, thisalone does not mean that Grameen is a financialfailure. In one case, the modest write-offs of badloans offer proof of Yunus’s organizational com-mitment to the poor and the belief that, given time,they will repay a loan. The since-implementedGrameen II Bank builds on this concept andallows borrowers to restructure a loan into smallerpayments or to take a scheduled amount of timeoff, rather than default. Yunus describes the dif-ference: “[The] overarching objective of the con-ventional banks is to maximize profit. TheGrameen Bank’s objective is to bring financialservices to the poor, particularly women and thepoorest and to help them fight poverty, stay prof-itable and financially sound. It is a compositeobjective, coming out of social and economicvisions.” Given that the Grameen Bank’s focus islargely on social objectives and not profit maxi-mization, some have argued that it is not obligatedto adopt standard accounting procedures. Whatis important is that Grameen is among the fewtransparent microfinance organizations andresearchers have been able to review and evaluatetheir financial statements.

An important consideration here is that MFIsare known to charge considerably higher ratescompared with similar loans from conventionalbanks. In their celebrated work, Stiglitz andWeiss(1981) showed that the high interest rate that alender charges may itself adversely affect repay-ment rates by either discouraging creditworthyborrowers (adverse selection) or tempting theborrowers to opt for riskier projects (moral hazard).Consequently, the coexistence of high repaymentrates (around 95 percent) and higher interest rates(a 30 to 60 percent interest rate is common) inmicrofinance has “puzzled” economists.

One explanation offered by some economistsis that MFIs face an inelastic demand for loans.



15 In comparison, nonperforming loans averaged between 1 and 1.5percent for all U.S. commercial banks for the decade of 1995 to2005. (Source: Federal Financial Institutions Examination Council.)Braverman and Gausch (1986) found that government credit pro-grams in Africa, the Middle East, Latin America, South Asia, andSoutheast Asia all had default rates between 40 and 95 percent.

However, in a recent empirical study on theSafeSave program in Dhaka slums, Dehejia,Montgomery, and Morduch (2005) show that theelasticity of demand for microcredit may be sig-nificantly negative even though certain groupsof borrowers (particularly the wealthier ones) donot reduce their demand when faced with higherinterest rates. However, Emran, Morshed, andStiglitz (2006) offer a more promising explanationfor this puzzle. Departing from the traditionalfocus on credit markets in studies of microfinance,the authors examine the implications of missingor imperfect labor markets for poor women indeveloping countries (the typical customers ofMFIs in Bangladesh). Emran, Morshed, andStiglitz (2006, p. 4) demonstrate “the critical roleplayed by the structure of the labor market inmaking the small-scale household-based invest-ment projects ‘credit worthy’ in the face of veryhigh interest rates, especially for the poor house-holds with little or no collaterizable assets.”

Is There More to Microfinance thanGroup Lending or Joint LiabilityContracts?

The success of microfinance in generatinghigh repayment rates led many economists toinvestigate the reasons behind this success. Themid-to-late 1990s witnessed a large increase inthe number of journal articles on group lendingcontracts, as economists sought to explain howmicrofinance “succeeded” where traditionalforms of lending had failed. Joint liability con-tracts were seen as the break from traditionallending mechanisms and economic theory wasused to readily explain how these contractshelped to improve repayment rates. The growthof the literature on group lending contracts in themid-1990s offers the impression that all MFIsoperate as such, but the reality is that MFIs use avariety of lending techniques, such as dynamicand progressive loans, frequent repayment sched-ules, and nontraditional collateral to ensure highrepayment rates among poor, underserved borrow-ers. These mechanisms were either introducedindependently or in conjunction with joint liabil-ity programs such as Grameen’s and in many cases

operate alongside group contracts. Practitionersand theorists alike have now realized that thesemechanisms can operate with individual contractsand in certain cases (e.g., in areas of low popula-tion density) offer better repayment results thangroup lending schemes.

The mechanism of progressive lending guardsagainst the borrower’s strategic default at the endof a loan cycle, because by definition she has littleor no collateral to be seized in the event of default.Instead, MFIs have offered small initial loans,with the promise of future credit for timely repay-ment. The offer of future credit serves as a power-ful incentive for a micro-entrepreneur trying togrow her business. In this scenario, a borrowerwill default only if her current income is greaterthan her future expected profits. With a small ini-tial loan for a beginning entrepreneurial venture,this is unlikely. To further increase the likelihoodof repayment, MFIs use dynamic lending, inwhich the size of the loan is gradually increasedwith each successive loan repayment. Now, theexpected future profits are almost certainlygreater than current earned income because thesize of the loan continues to grow.

Another mechanism used by MFIs is that offrequent repayments, which often begin even theweek after the loan is disbursed. By requiringsmall repayments before the business venturehas reach maturity, MFIs are essentially requiringthat borrowers have a second source of incomeand, hence, borrow against their current consump-tion. This allows MFIs to screen against high-riskborrowers from the beginning because borrowerswill be able to repay the loan even if their venturefails. Indeed, weekly repayments give the borrow-ers and lenders the added benefit of discoveringproblems early. Armendáriz de Aghion andMorduch (2005) also suggest that frequent repay-ments provide better customer service, contraryto the belief that more repayments raise the trans-action costs for the borrower by requiring moretravel to and from payment centers. Instead, fre-quent repayments help borrowers with savingsconstraints such as seasonality of income, familymembers dropping by to borrow funds, or discre-tionary spending by one or more of the familymembers. When coupled with dynamic incen-



tives, frequent loan repayments begin to resemblesavings deposits that will be paid with interest(the graduated size of the next loan). This allowsfamilies to break free of certain savings constraints(such as those noted above) because the loan ispaid each week, before the money can be spenton anything else.

The final mechanism is the requirement ofnontraditional collateral, which was introducedby banks such as Bank Rakyat Indonesia (BRI).This feature breaks from the commercial practicethat collateral submitted must have a resale valueequal to the loan. In a group lending contract,joint liability often serves as collateral, but BRIoperates on the “notional value” of an item andallows collateral to be any item that is importantto the household, regardless of market value. Thismay include the family’s sole domestic animal,such as a cow, or it may be land that is not securedby title. Neither item could be sold for much of aprofit without significant transaction costs to thebank, but both items would be even more difficultand costly for the family to do without.

Armendáriz de Aghion and Morduch (2000)offer evidence of the success of individual loansthat use progressive/dynamic incentives, frequentrepayments, and nontraditional collateral toguarantee a loan. Using data from Eastern Europeand Russia, they demonstrate that individualloans can generate repayment rates greater than90 percent (and above 95 percent in Russia). Inindustrialized settings, borrowers are more likelyto face more competition, making it more costlyto form a borrowing group. In this scenario, loanproducts will go to different entrepreneurs, withdifferent expected payoffs—hence, necessitatingdifferent loan amounts. A group contract can beinefficient because it imposes a ceiling on theloan size equal to that given to the smallest mem-ber of any potential group. They conclude bysuggesting that in areas that are relatively indus-trialized, individual loan models may performbetter than traditional group lending models.

Is Microfinance an Important Tool forPoverty Alleviation?

Microfinance started as a method to fightpoverty, and although microfinance still fulfills

this goal, several institutions have sought to makea distinction between the “marginally poor” andthe “very poor.” The broadest definition distin-guishing these two groups comes from theConsultative Group to Assist the Poorest (CGAP),which defines the poor as individuals livingbelow the poverty line and the poorest as thebottom half of the poor. TheWorld Bank estimatesthat in 2001, some 1.1 billion people had con-sumption levels below $1 and another 2.7 billionlived on less than $2 per day.16 As microfinancecontinues to grow, questions have started to focuson who is the optimal client. Should microfinancetarget the marginally poor or the extremely poor?

Morduch (1999) tries to answer this questionby considering two representative microfinanceclients, one from each poverty group describedabove. The first client belongs to a subsidizedmicrofinance program and her income is only 50percent of the poverty line. The second clientbelongs to a financially sustainable program thataccordingly charges higher interest rates. Toensure repayment of the loan at the higher rate,the second borrower is chosen to be marginallypoor, that is, with an income of 90 percent of thepoverty line. Using the widely used “squaredpoverty gap” (Foster, Greer, and Thorbecke, 1984)measure of poverty, Morduch suggests that adollar increase in income for the very poor bor-rower has a five times greater impact than thesame dollar for the marginally poor borrower.

This simple example would suggest that, interms of poverty alleviation, MFIs should focuson the poorest borrowers first, but this is notalways the case. As MFIs seek to become finan-cially independent, they find themselves servingonly the marginally poor. This is an importantdistinction between Grameen and Banco Sol ofBolivia: The latter’s emphasis is on returning aprofit, and alleviating poverty is seen only as asecondary goal. Not surprisingly, Banco Solcharges higher interest rates,17 does not rely on



16 World Bank, “Poverty Analysis”; data can be viewed athttp://web.worldbank.org.

17 Annual interest rates average between 12 and 24 percent and canbe anywhere from 1 to 60 months in length (120 months for ahousing loan). The data are from Banco Sol, accessed 7/27/07;www.bancosol.com.bo/en/intro.html.

subsidies, and at the end of 2006 posted returnson equity of 22.8 percent.18

This apparent dichotomy between financialindependence and poverty alleviation also getsto the heart of a different problem. At what pointdoes a successful MFI begin to look like a regularbank? If the MFI successfully serves poor clients,then those clients should be able to use their loansto lift themselves out of poverty. Because of thenature of progressive and dynamic loans, success-ful borrowers earn access to larger loans, helpingthem break free of poverty even faster.

The Grameen Bank has found a way to makethis dichotomy work for them and now uses theireconomy of scale to create a financially independ-ent bank without raising interest rates. In 1995,the Grameen Bank decided not to request anymore funds from donors and instead began tofund the bank from collected deposits. With morethan two decades of successful borrowers behindthem, Grameen has had a chance to build up sav-ings deposits slowly, to the point that it is nowself-sustainable, based on the amount of fundsprovided by members. In a rough sense, it is nowthe more-successful poor that are subsidizingnew clients. This is a significant step, especiallyconsidering that, from the decade of 1985 to 1996,Armendáriz de Aghion and Morduch (2005) cal-culate that Grameen accepted $175 million insubsidies, including both direct donations and“soft” donations such as soft loans, implicit sub-sidies through equity holdings, and delayed loanloss provision.

Is Microfinance Sustainable or EvenProfitable?

With all of the positive publicity surroundingmicrofinance, it may be surprising to learn thatnot all MFIs are sustainable or able to return aprofit. Despite their rapid growth and soundoperations based on strong theoretical platforms(such as using group loans, dynamic incentives,and frequent repayments), less than half of all

MFIs return a profit and most still require thehelp of donors and subsidies. A lack of financialsustainability doesn’t necessarily indicate a failingMFI, but rather raises questions about the missionand direction of that particular MFI. Even withsubsidies, many MFIs remain the most cost-effective method to alleviate poverty; and, as weargued previously, subsidies can help change theprofile of the targeted client from the poor to theextremely poor.

For an MFI to be sustainable can mean one oftwo things: The organization can be operationallysustainable or it can be financially sustainable.An MFI that is operationally sustainable raisesenough revenue to cover the cost of operatingthe business—paying loan supervisors, openingbranch offices, etc. Subsidies might still be usedto issue loans or cover defaulted loans. An insti-tution that is financially sustainable does notrequire any subsidized inputs or outside fundsto operate. Instead, it raises money through itslending operations. TheMicroBanking Bulletin(2003) surveyed 124 MFIs with a stated commit-ment to becoming financially sustainable. In theirsurvey, the Bulletin found that only 66 operationswere sustainable, a rate just slightly above 50percent. As Armendáriz de Aghion and Morduch(2005, p. 232) note, all 124 programs asked forhelp in managing their accounting standards and,hence, “in terms of financial management, [these124 programs] are thus skimmed from the creamof the crop.” Similar sustainability data do notexist for the other 2,000+ MFIs; but, without simi-larly strong commitments to financial sustain-ability, the percentage of sustainable operationsis likely to be much lower than 50 percent.

Subsidized credit is financed in a variety offorms, some of which have been discussed brieflywith the Grameen Bank example. MFIs also securefunds from donors, many of whom want to alle-viate poverty but have not seen strong returns inthe nongovernmental organization (NGO) or gov-ernment sector. For many, donations and subsidiesare intended as a method to get MFIs started. Butwithout any accountability or empirical research,it is difficult for donors to decide at what pointan MFI should forgo its dependence on outsidefunds. Lacking in this debate is a clear under-



18 MIX Market financial data are from BancoSol, accessed 8/2/07;www.mixmarket.org/en/demand/demand.show.profile.asp?token=&ett=280.

standing of how subsidies affect the supply anddemand of loans. Without subsidies, interest ratesmay rise; and, as standard demand theory sug-gests, fewer loans will be requested. Moreover,rising interest rates without subsidies may excludepoorer projects, thus raising average returns. But,they may also increase the moral hazard problem;at higher interest rates, only risky borrowersapply for a loan, thus increasing the default rateand lowering returns. Finally, it is unclear whataffect subsidized lenders have on the overallcredit supply. Do they segment the credit marketwhile serving the very poor or do they squeezeout other lenders, reducing overall efficiency forthe market?

In some instances, government institutionscollaborate with local MFIs; but, more often thannot, government organizations and MFIs are atodds with one another, despite the fact that bothshare the stated goal of reducing poverty. A primeexample of the failure of government subsidizedinitiatives in the market for microcredit is theIntegrated Rural Development Program (IRDP),which allocated credit based on social targets inrural India, giving 30 percent of credit to sociallyexcluded groups and 30 percent to women.Armendáriz de Aghion and Morduch (2005)report that between 1979 and 1989 IRDP offeredover $6 billion in subsidized credit but generatedloan repayment rates below 60 percent, with only11 percent of borrowers taking out a second loan.During the same decade, the Grameen Bank alsoaccepted subsidies in a variety of forms, but didnot change their lending model to include socialtargets. During this time, the Grameen Bank sawits membership grow to half a million members,with repayment rates above 90 percent. The expe-rience of the Grameen Bank and IRDP during thelate 1970s and early 1980s is important becauseof the similarities between regions. BothBangladesh and India are densely populated,rural, agrarian economies with high rates ofpoverty. Therefore, it is likely that the GrameenBank's comparative success during this period isindicative of a more efficient lending model ratherthan variances in their lending environment.

In sum, even if many MFIs are not financiallysustainable, the microfinance movement may

still be the best per-dollar investment for alleviat-ing poverty. Further research is needed to showwhether financial sustainability is even a desiredobjective, and future work could help understandhow different subsidy mechanisms can best bal-ance financial sustainability with the desiredsocial objectives.

Could Competition Among MFIs Leadto Better Results?

At first glance, standard economic theorysuggests that competition should improve theperformance of MFIs and lead to better serviceand lower interest rates. With such a large poorpopulation and high rates of growth, there is alsoa large market to support more MFIs. Historically,though, competition has failed to increase servicesand often decreases the rate of repayment. Whenclients have access to alternative sources of credit,MFIs lose the leverage they gain from dynamicincentives and progressive loans (i.e., future loansare contingent on repayment).

During the late 1990s, Bolivia and Banco Solexperienced a microfinance crisis. As the successof Banco Sol increased and commercial banksbegan to see the profitability in an MFI model,competition increased. General economic theorysuggests that competition is inherently good, butfor the early MFIs, competition reduced efficiencyby weakening the incentives: As credit optionsincreased for borrowers, the incentives inherentin a dynamic or progressive loan became weaker.This proved difficult for Banco Sol, whose modelrelies on group lending and dynamic incentives.The competition mainly came from Acceso FFP,a Chilean finance company that paid its employ-ees on an incentive system. Within three years,Acceso had 90,000 loans, and Banco Sol lost 11percent of its clients. Regulated MFIs in Boliviasaw their loan overdue rates increase from 2.4percent to 8.4 percent in just over two years.Because of the increased competition, Banco Solsaw its return on equity fall by 20 percentagepoints to only 9 percent in 1999 (Armendáriz deAghion and Morduch, 2005, p. 127).

In their study of 2,875 households from 192villages in Thailand, Ahlin and Townsend (2007,



p. F43) reach a similar conclusion. They note that,with increased access to credit, borrowers do notrespond to dynamic incentives. Moreover, strongsocial ties, such as the clustering of relatives in avillage, can also lower repayment rates in the samemanner of competition. In their words, “thisresult has not been seen in the previous empiricalresearch, nor focused on in the theoretical models.”

In the early years of competition in the micro-finance sector, MFIs struggled to maintain a credi-ble threat of denying future credit on default. Inrecent times, however, new regulation has helpedto promote competition in Bolivia as lendersstarted to share more information on borrowers.By law, Banco Sol and other regulated financialintermediaries are now required to report thename and national identification number ofdelinquent borrowers to the Superintendent ofBanks and Financial Institutions. This informa-tion is available to all financial intermediariesthrough both formal and informal agreements.This agreement helped to strengthen the threatof dynamic incentives, and, as a result, competi-tion among lenders has led to an increase in theirclient base.

Does Microfinance Have Any SocialImpact in Terms of FemaleEmpowerment and Education?

Any review of microfinance is incompletewithout a discussion of its impact on women.The Microcredit Summit Campaign Report (2000)lists over a thousand programs in which 75 per-cent of the clients were women. Yunus (2003)recounts the initial difficulties overcoming thesocial mores in rural Bangladesh and lending towomen in this predominantly Islamic nation.However, his efforts were rewarded and 95 per-cent of the Grameen Bank’s current clients arewomen.

This focus on women follows largely fromYunus’s conviction that lending to women has astronger impact on the welfare of the householdthan lending to men. This has been confirmedby a large volume of research on microfinance.In countries where microfinance is predominant,country-level data reveal signs of a social trans-

formation in terms of lower fertility rates andhigher literacy rates for women. Pitt andKhandker (1998) show that loans to women havea positive impact on outcomes such as children'seducation, contraceptive use, and the value ofwomen's non-land assets. Khandker (2005) findsthat borrowing by a woman has a greater impacton per capita household expenditure on bothfood and non-food items than borrowing by aman. Among other things, this also improvesnutrition, health care, and educational opportu-nities for children in these households. Smith(2002) validates this assertion using empiricaldata from Ecuador and Honduras to comparemicrofinance institutions that also offer healthservices with institutions that offer only credit.He notes that, “in both countries, health bankparticipation significantly raises subsequenthealth care over credit-only participation.” Inparticular, he found that participation in MFIsthat offer health services reduces the tendency toswitch to bottle feeding as incomes rise. He notesthat breast-feeding children under age two is akey health-enhancing behavior.

A pro-female bias in lending works well forthe MFIs. Practitioners believe that women tendto be more risk averse in their choice of invest-ment projects, more fearful of social sanctions,and less mobile (and therefore easier to monitor)than men—making it easier for MFIs to ensure ahigher rate of repayment. Various studies fromboth Asia and Latin America have shown thatthe repayment rates are significantly higher forfemale borrowers compared with their malecounterparts.

However, critics have argued that microfi-nance has done little to change the status ofwomen within the household. A much-citedpaper by Goetz and Gupta (1996) points to evi-dence that it is mostly the men of the householdand not the women borrowers who actually exer-cise control over the borrowings. Moreover, micro-finance does little to transform the status ofwomen in terms of occupational choice, mobility,and social status within the family. Therefore,microfinance hardly “empowers” women in anymeaningful sense. Although this may truly be



the case, there is no denying the fact that micro-finance has provided heretofore unrealized work-ing opportunities for women with limited skillsin traditional activities.

Can the Microfinance Experiment BeSuccessfully Replicated Anywhere inthe World?

Although the microfinance revolution hasrecorded success in most developing countriesof the world, it has achieved little success insome of the more developed nations. The mostnotable example here is the Good Faith Fund inArkansas, where microfinance has failed to deliverthe same rapid growth and poverty alleviation asit has in the developing world. This seems reason-able given the relatively smaller percentage ofthose living in poverty and the much larger safetynet afforded the poor through welfare and unem-ployment programs. As Yunus (2003, p. 189)states, “In the developed world, my greatestnemesis is the tenacity of the social welfare sys-tem…[M]any calculate the amount of welfaremoney and insurance coverage they would loseby becoming self-employed and conclude therisk is not worth the effort.” Yunus correctlyaddresses a motivating factor for the relativelyweak success of microfinance in the UnitedStates, but studies have found other reasons whymicrofinance has failed to deliver: e.g., a lack ofentrepreneur opportunities for the poor, lack ofgroup structure, and the multitude of optionsfacing the U.S. poor.

Why Did Microfinance Initiatives Fail inthe United States? In their study of U.S. micro-finance, Edgcomb, Klein, and Clark (1996) findthat micro-enterprise accounts for only 8 to 20percent of all jobs—because of the availabilityof wage jobs and public assistance. When com-pared with the 60 to 80 percent of jobs suppliedby micro-enterprise in the developing world,the pool of potential microfinance beneficiariesin the United States is substantially smaller.Schreiner and Woller (2003) make the point thatthe characteristics of the poor are different inthe two regions. In the developing world, jobsare relatively scarce and hence the unemployed

are more likely on average to include individualsthat are highly skilled or better motivated tobecome entrepreneurs. In contrast, in the UnitedStates, where poverty is much less prevalent,most individuals with the aforementioned char-acteristics can find jobs. Furthermore, the amountof small business regulation in the United Statesposes problems; a micro-entrepreneur must knowtheir proposed business but must also under-stand local and federal tax laws and regulations.To compete with much larger national markets,small business owners must further understandand excel at marketing their products in bothlocal and larger markets. The lack of highlyskilled or better-motivated workers among thepoor in the United States, combined with thehigher entry costs for successful micro-enterprise,makes successful microfinance initiatives moredifficult. Schreiner (1999) finds that, in absoluteterms, only one person in a hundred was able tomove from unemployment to self-employmentthrough micro-enterprise.

Taub (1998) offers a slightly different expla-nation: He found that the markets for the borrow-ers differed between regions. In Bangladesh, mostsmall entrepreneurs engage in goods-producingactivities that, when combined with their smalllocal markets, offers an almost immediate streamof revenue. This feature allows the Grameen Bankand others to require weekly repayments, whichis often cited as a primary reason for their highrepayment rates. In the United States, most entre-preneurs engage in service-producing activitiesbecause it is difficult to compete against theeconomies of scale in goods production and dis-tribution within the U.S. market. These servicebusinesses provide a relatively unreliable sourceof income, particularly in the early stages. Thisrisk, combined with the safety net afforded to thepoor through welfare, discourages many potentialentrepreneurs from starting a new venture. Insupport of this point, Taub found that the likelyborrower comes from a family with at least onesource of steady income, so that their new ven-ture is unlikely to substantially hurt their familyresources.

In the late 1980s, the Good Faith Fund demon-strated the difficulty of forming a cohesive group



structure to enforce joint liability loans. SchreinerandWoller (2003) offer four basic failures of groupformation in the United States. First, they suggestthat the impersonal nature of U.S. market inter-actions reduces the need for social reputationsand hence the group loses the ability to punishdelinquent borrowers. Second, the U.S. poor arediverse and hence it is difficult to find other poorpotential entrepreneurs to guarantee a group loan.In U.S. markets, there is also a limit to the poten-tial number of small-business ideas. In developingcountries, a group of borrowers may all enter thebasket-making market with success because of themuch larger local economy. The group guaranteesthe loan but also offers advice to help succeed inthe market. In the United States, the demand formicro-businesses is much smaller and diversegroups of people must start diverse business ven-tures. There is little value to the group outside ofa loan guarantee because group members don’tshare the same risk to their businesses. Third,defaults are often not enforced in group settings,as found by Hung (2003). Finally, groups oftenbreak down in the United States because the poorhave access to other forms of credit. This creditmay be more attractive because it doesn’t requirethe transaction costs of dealing with a group.

For the United States, pure Grameen-stylegroup lending schemes have failed to deliver sub-stantial results, but that is not to say they havenot benefited the poor. Rather, microfinance oper-ations in the United States have often switchedto individual lending operations that requireborrowers to attend mandatory small businesstraining programs or offer loans to attend spe-cialized schooling for particular professions. Afundamental difference is that microfinance inthe United States helps place the poor into exist-ing wage-earning jobs rather than create new jobs.The additional training substantially raises coststo the point that many U.S. MFIs are not self-sustaining, instead relying on grants and subsi-dies. Edgcomb, Klein, and Clark (1996) foundthat the average cost to make and service a loanwas $1.47 per dollar lent, with a range of costsfrom $0.67 to $2.95. Without charging usuriousinterest rates, it can be difficult to earn such asimilarly high return, particularly with the smaller

microfinance market. Taub (1998) reports thatfrom 1989 to 1992, the Good Faith Fund averagedonly 18 new loan customers per year.19 In thefollowing years, the average number of new loancustomers rose into the mid 20s, before a changein management and change in focus substantiallyreduced those numbers. With small loans, aver-aging just $1,600 per year for the first four years,it became impossible for the Good Faith Fund toeven come close to matching the combined staffsalaries of $450,000.

Due in part to these high-cost structures,Bhatt, Tang, and Painter (2002) found direct evi-dence that nearly a third of MFIs started inCalifornia in 1996 had ceased to exist by 1998.Instead of focusing on becoming self-sufficient,Schreiner (2002, p. 82) argues for more quantita-tive evaluation of MFIs. He claims that “the dirtysecret in micro-enterprise is that few evaluationsare really tests…[E]valuations were funded andconducted by people who already believed thatmicro-enterprise was worthwhile.” Schreinerthus concludes that a main goal in helping alle-viate poverty should be to evaluate the efficiencyof MFIs and, if need be, reallocate resources toother training programs that specialize in povertyalleviation, not economic development.

THE FUTURE OF MICROFINANCEThe number of MFIs has been growing

steadily, and the top 100 MFIs are increasingtheir client base at a rate of 26 percent per year.20

To fund this spectacular growth, MFIs have turnedto a variety of sources, many of which rely onfunding from local sources to guard against for-eign currency risk. MFIs are currently movinginto the international market and confrontingchallenges such as developing standard ratingmethods; guarding against foreign currency riskand country risk; and meeting the large volume



19 At the time of Taub’s study, population density in Bangladeshwas 814 per square kilometer, while the population densities ofArkansas counties served by the Good Faith Fund were only 36,9, 8, 9.1, and 10.33 per square kilometer (Jefferson, Lincoln,Desha, Chicot, and Ashley counties, respectively).

20 MIX Market analysis of top 100 MFIs; www.mixmarket.org.

requirements for an international offering. But,according to Reddy (2007) of Accion International,“Many believe that savings mobilized from localdepositors will ultimately be the largest sourceof capital for microfinance. Foreign capital pro-vides 22 percent of funding for the ‘Top 100’ MFIs,but savings is the first source of capital, represent-ing 41 percent of all assets in 2005.”21 ManyMFIshave a mandatory or suggested savings rate; and,for larger loans, MFIs will often require borrowersto deposit 5 percent of the loan back into a savingsaccount. Some, but not all, have restrictions onwhen and how that money can be accessed.

Although not the main source of funding,foreign capital still represents a significant por-tion of current funding for the top 100 MFIs. AsElizabeth Littlefield of CGAP found, U.S. invest-ment in foreign microfinance in 2006 was $4 bil-lion, which is more than double the 2004 total of$1.6 billion. This funding comes from two mainsources: international financial institutions andmicrofinance investment vehicles. To access thisforeign investment, MFIs are beginning to use newvehicles of debt-structured finance, includingcollateralized debt obligations (CDOs) andsecuritization.

To date, one of the most well-known interna-tional debt issues was structured by Blue OrchardFinance in 2004. This deal, worth $40 million,linked 90 investors with nine MFIs in LatinAmerica, Eastern Europe, and Southeast Asia.The main innovation of the Blue Orchard dealwas the introduction of a tiering system (of fivetranches) that allowed for different risk appetitesamong investors. Microfinance is also beginningto raise money in the equity market, throughorganizations such as Accion Investments, whichhas invested $12.4 million in five institutions(Reddy and Rhyne, 2006).

In 2006, the first securitized microfinancereceivables went on the market from theBangladesh Rural Advancement Committee(BRAC). BRAC is an NGO that lends money tothe extremely poor, focusing mainly on offeringwomen credit to develop their own income-

generating activities. The transaction was struc-tured by RSA Capital, CitiGroup, the NetherlandsFinancing Company, and KfW Bank of Germanyand has securitized $180 million in receivablesover a period of six years.

According to CitiGroup, 65 percent of theloans are to the extremely poor, who borrow from$50 to $100. BRAC offers three loans, based pri-marily on the land holdings of the borrower. Forthose with less than one acre of land, borrowerscan obtain from $50 to $500 at a flat 15 percentrate, payable over one year through 46 weeklyinstallments. The marginally poor, those whoown more than one acre of land and are involvedin agricultural enterprise, can qualify for loansbetween $166 and $833 with a flat 15 percentinterest rate. This product must be repaid in equalmonthly installments, with a 12- or 18-monthhorizon. Finally, BRAC offers larger loans to entre-preneurs to start their own business. These loansare monthly products (12, 18, or 24 months) witha 15 percent interest rate.22 BRAC employs adynamic lending scheme, wherein timely repay-ments guarantee future access to credit. Thismechanism is similar to a joint lending liability,except in this case borrowers are liable to theirfuture selves.

International Financing Review Asia honoredthe BRAC deal with the title of best securitiza-tion in Asia Pacific for 2006 because “one of themost impressive aspects of the transaction is theway that it deals with the sheer complexity of adynamic pool that will contain about 3.3 millionshort tenor loans for which the average outstand-ing principal is around US$95.”23 The securitywas given an AAA rating from the localBangladesh markets, with CitiGroup andNetherlands Financing Company each purchasingone-third of the certificates. The remaining one-third was split among CitiGroup Bangladesh andtwo local Bangladeshi banks.

This deal differs from the collateralizeddebt obligations that Blue Orchard Loans for



21 Data taken from MIX Market analysis of the top 100 MFIs;www.mixmarket.org.

22 See BRAC’s economic development and microfinance informationat www.brac.net/microfinance.htm.

23 CitiGroup: “Innovative BRAC Microcredit Securitization honoredin Bangladesh,” accessed 1/16/07; www.citigroup.com/citigroup/press/2007/070116b.htm.

Development issued in April 2006, in whichfunding for 21 MFIs from 12 countries was pack-aged into a $99.1 million commercial investment.The main difference between a CDO and securi-tization is that a CDO relies on the ability of theMFI to repay the loan, unlike a securitized loanthat relies on the underlying borrowers to repay.A CDO is another vehicle to bring mainstreaminvestors to microfinance, but is still limited bythe ability to rate the creditworthiness of differ-ing MFIs. To help with this issue, S&P released arating methodology for microfinance in June 2007.By applying a common methodology, S&P willbe able to send a stronger signal to potentialinvestors about the quality of MFI investments.It is unclear yet whether the 2007 subprime mort-gage meltdown in the United States will have aneffect on investors’ risk appetites for more collat-eralized securities and whether microfinancesecurities will be viewed as “subprime” loans.

Walter and Krauss (2006) argue that theopposite should be true—namely, that microfi-nance can reduce portfolio volatility—and theirempirical tests show that microfinance institu-tions have a low correlation to general marketmovements. They suggest that this phenomenonis brought on by the continuous and diverse fund-ing through international donor agencies andbecause micro-entrepreneurs may be less inte-grated into the formal economy. When marketsenter a downturn, micro-entrepreneurs may expe-rience a countercyclical effect, as consumersshift their consumption downward to cheapergoods.

Outside of international credit markets,microfinance has continued to receive grassrootssupport and popular media coverage. Organiza-tions such as Kiva.org serve as intermediariesand connect individual donors with micro-entrepreneurs. Kiva.org allows individuals tochoose a business, originate their ownmicro-loan,and in return receive electronic journal updatesand payments from their borrower. Most loans aresmall, between $50 and $100 and have repaymentterms from six months to a year, but the lenderdoes not receive any interest on their loan. Rather,journal updates and progress reports serve asinterest, letting lenders know that their money

has been put to good use. At the end of the year,providers can start the cycle anew or withdraw.To date, 128,547 individuals have lent over $12million with a self-reported repayment rate greaterthan 99 percent. Popular media outlets such astheWall Street Journal (September 23, 2007,August 21, 2007, October 21, 2006), New YorkTimes (March 27, 2007, December 10, 2006),National Public Radio (September 7, 2007,June 19, 2007, April 6, 2007), and others havegiven Kiva.org frequent and broad exposure, mak-ing the microfinance movement as accessible tolenders as the Grameen Bank made microcreditaccessible to borrowers.

CONCLUSIONWith the recognition of the Nobel Peace Prize

in 2006, Muhammad Yunus’s vision of extendingcredit to the poor has reached a global level.Microfinance is not a panacea for poverty allevi-ation; but, with committed practitioners, a wealthof theoretical work, and a surging demand for bothinternational and individual investment, micro-finance is a poverty-alleviation tool that hasproven to be both effective and adaptable. Throughinnovations in group lending and dynamic incen-tives, MFIs have been able to successfully lend tothose traditionally ignored by commercial banks,because of their lack of collateral and credit scores.The poor have responded in kind, by repayingtheir loans with significant repayment rates. AsMFIs have grown and reached new clients, theyhave continued to innovate by offering individualloans, savings options, and life insurance andseeking new forms of capital in domestic andinternational markets. Microfinance has spreadto five continents and hundreds of countries, yetits success in U.S. markets has been ill-defined,as lenders struggle with higher transaction costsof offering loans and starting micro-enterprises.As more and more MFIs become self-sufficientand continue to expand their client base, it willbe the duty of all parties concerned with povertyrelief to look for other ways to innovate. For now,microfinance remains a viable solution to eco-nomic development and poverty alleviation, both



in Bangladesh and around the world. With moretransparency from institutions and better ratingstandards, the influx of investment capital frominternational markets will continue to drivemicrofinance toward Yunus’s goal of a poverty-free world.

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