Profits from poverty: How microfinance has gone astray

The social mission has drifted under a financial services push

From its exuberant beginnings a few decades ago, microfinance as a means of alleviating poverty in developing nations has experienced mixed fortunes.

There were heady early days, celebrated with the recognition of “micro-credit” pioneer Muhammad Yunus and the Grameen Bank as recipients of the Nobel Peace Prize in 2006, and countless inspiring tales of poor individuals being lent small sums to start their own businesses and to improve the lives of their families and wider communities.

Those good news stories have recently given way to media criticism and negative reports on the impact of microfinance, notes Jaco Lok, a professor in the school of management at UNSW Business School. In the wake of concerted efforts by the World Bank and numerous aid organisations to adopt a financial services approach to microfinance, it has inadvertently lost its way.

The global effort to financialise microfinance has caused mission drift and tarnished its reputation, prompting hot debate over the best way forward for microfinance organisations across the world.

In its attempts to organise or provide best practice standards to a fragmented field of mostly non-profit microfinance organisations, the World Bank standard-setting spin-off, the Consultative Group for Assisting the Poor (CGAP) established in 1995, has become a dominant force, promoting a philosophy for creating financially sustainable microfinance organisations that would return profits.

“Its idea was that microfinance organisations could turn to the capital markets for funding. CGAP believed the only way to grow microfinance fast enough and to reach enough poor people was through private funding sources because charity was never going to be available to reach all of the poor,” says Lok.  

“The thinking was that by making microfinance organisations behave like banks and generate profits their reach could be massively scaled up and it would be much more effective in alleviating poverty.” 

‘In their efforts to become sustainable and under pressure to adopt the best practice standards, microfinance organisations began talking more like banks’

JACO LOK

Mission drift

Strict practice standards, according to CGAP, would deliver the best for both worlds. To make this happen, it wrote best practice principles and guidelines that were widely adopted, and also trained thousands of microfinance practitioners to work in the field. 

“While the primary aim was poverty alleviation, it was through sustainable finance,” Lok observes. 

Underpinning CGAP’s strategy was the notion that market mechanisms would take care of high interest rates to borrowers as more and more lenders would start competing for their business.

Yunus and the Microcredit Summit notably opposed such approaches, pointing out that they turned microfinance from its primary mission to alleviate poverty into a money-making enterprise. Mission drift was the core of Yunus’s concern as he pointed to the risk of microfinance organisations operating for their own sakes. 

While Grameen Bank typically charged interest rates to lenders in the low 20%+ range in order to recover the relatively high transaction costs associated with micro-loans, there was an upsurge of for-profit microfinance organisations, with some charging up to 100% or more, which created clear tensions with microfinance’s original goal of alleviating poverty, says Lok.

“In their efforts to become sustainable and under pressure to adopt the best practice standards, microfinance organisations began talking more like banks, applying financial metrics, risk ratios and break-even points. The organisations began to focus more and more on meeting their financial targets over and above their original social aims.”

Unintended consequences

Growth in microfinance was certainly achieved, says Lok, who has compared some of the effects of the competing logics of CGAP and the Yunus-supported Microcredit Summit in a recent working paper, 'The nature and limits of co-optation as a basis for unifying complex fields', co-authored with Swinburne University’s Amer Khan. 

The paper notes how the power of the rhetoric around microfinance meant even organisations that disagreed with the CGAP standards adopted its goals and language, though they may not have adhered to them.

Lok and Khan’s study of the financial flows into microfinance shows for-profit assets shot from $3 billion in 2002 to around $48 billion in 2010, and way outstripped not-for-profit microfinance assets.

However, this phenomenal growth gave rise to many unintended consequences. Stories from India of overly aggressive loan recovery practices by for-profit organisations included reports of suicides.

Microfinance loans were often issued to community groups. “If one person defaults everyone has responsibility to make sure the loan is repaid. In a village, that person could quickly become a social pariah,” says Lok.

With the proliferation of for-profit microfinance organisations came another problem as more for-profit banks entered the field. Borrowers were now confronted with multiple lenders and, as a result, many poor people took out multiple loans, an activity that went largely untracked. 

One consequence was the collapse of the South African microfinance market – its biggest microcredit lender, African Bank, succumbing in 2014 as people defaulted en masse. 

‘We see mission drift where people started pursuing financial metrics for their own sake and the original social aims start moving to the background’ 

JACO LOK

Portfolio creep

Microfinance’s increasing legitimacy problem is also highlighted by Lok and Khan with an analysis of articles published by The New York Times on the topic revealing one in 10 were negative about microfinance in its formative days, but this evolved to 50% in 2008 and 80% in 2011, paralleling the growth of the financialisation of the field.

“The financialisation trend has major consequences that microfinance continues to struggle with,” Lok says. 

“We see mission drift where people started pursuing financial metrics for their own sake and the original social aims start moving to the background. From mission drift comes portfolio creep – in becoming risk-averse, microfinance organisations have started to focus on the not-so-poor clients, avoiding the riskiest who are the poorest because the poorest were considered not bankable.”

Notably, CGAP, the Consultative Group to Assist the Poorest, changed its name to the Consultative Group to Assist the Poor quite soon after it was established.

Hybrid organisations

The plight of microfinance highlights the complexity of making hybrid organisations work, in particular in bringing together a social mission with financial targets.

“Moving away from the original purpose can be a common problem in social purpose organisations,” says Kristy Muir, associate professor of social policy at the Centre for Social Impact. 

“In some cases the mission or the purpose is not clearly defined in the first place. In other situations, organisations move away from their purpose to become financially sustainable. It’s important for these organisations to set boundaries around this. How far away from purpose can or should organisations move to meet financial goals? 

“The challenge for microfinance organisations is that by definition their goal is to provide financial services to vulnerable individuals or groups that have no other means to access those services, but those organisations also need the financial means or sustainability to provide those services.” 

Measuring social impact

Compared with more easily measured financial metrics and ready-made templates for financial management, a broadly accepted way to measure often qualitative social impact outcomes has long been acknowledged as difficult to find, according to Lok.

So, should microfinance organisations be measured on the number of jobs provided, or could improved nutrition through microfinance due to the ability to smoothen seasonal variance in income be sufficient? And how would you compare the relative impact of both?

The big challenge for the future of microfinance, according to Lok, is “not to throw the baby out with the bath water”. For example, CGAP has been working on borrower protection for lenders in recent years. 

Muir sees a potentially positive outcome from revisiting the business model and adopting a more hybrid approach to funding where sustainability may be achieved by combining income from activities of the organisation itself, with philanthropy and government support.

One mooted solution at the organisational level may be in reconsidering who works for microfinance organisations, suggests Lok, because the tensions between bankers who want financial return and those focused on social impact often lead to collapse.

“The way to avoid this is to have a strong organisational identity which says we can do both and it often involves hiring young people who are neither socialised in the banking world nor in pure development, but who are young enough to consider how to combine the two from scratch,” Lok says.