What Is Microfinance? Small Loans and a Reputation That Outran the Evidence

The classic design substitutes social mechanisms for the things a bank normally requires:

• •Group lending, in which five or so borrowers form a group and all are denied further credit if any defaults, which transfers screening and enforcement to people with local knowledge and social leverage
• •Very small loan sizes, typically enough to buy stock, a sewing machine, a mobile phone or livestock
• •Frequent repayment, often weekly and beginning almost immediately, which catches trouble early and imposes a discipline borrowers frequently cite as valuable in itself
• •Progressive lending, where a repaid loan unlocks a larger one, which gives a borrower a strong reason to repay even without collateral
• •Loan officers who visit rather than requiring visits, which is expensive and is where most of the cost sits
• •A predominantly female client base, on evidence that repayment rates are higher and that money reaching women is more likely to be spent on household welfare

Informal credit arrangements are ancient, and the modern movement dates to Muhammad Yunus, an economics professor in Bangladesh who in 1976 lent twenty-seven dollars of his own money to forty-two villagers making bamboo stools, who were losing almost all their margin to the traders who advanced them materials. He founded Grameen Bank, which became a large institution lending to millions, and he and the bank shared the Nobel Peace Prize in 2006. The model spread worldwide with enormous enthusiasm, with a United Nations year of microcredit in 2005, extensive donor funding, and a widespread belief that it represented a market-based solution to poverty. Related institutions developed independently, including Bolivia's BancoSol and the village banking movements, and several converted from charities into regulated banks in order to take deposits, which the original model could not.

The reputation was built before the evidence and the evidence, when it arrived, was sobering. Six randomised controlled trials in different countries, published together in 2015, found a consistent pattern: microcredit increases business investment and the size of existing enterprises modestly, gives borrowers more freedom in how they organise their work and consumption, and does not produce the transformative effects claimed, with no significant average increase in household income, consumption, health, education or women's empowerment measures. Subsequent work has broadly confirmed this. The interpretation that has emerged is that microcredit is a useful financial service rather than an anti-poverty programme: it helps households manage lumpy expenses and smooth irregular income, which is genuinely valuable, and it does not turn subsistence traders into growing businesses, because the constraint on most such enterprises is demand and market access rather than a hundred dollars of capital.

Several difficulties emerged as the sector grew and commercialised. Interest rates are high in absolute terms, frequently twenty to forty percent annually and sometimes far more, which is defended on the grounds that administering many tiny loans in remote places is genuinely expensive, and which nonetheless looks very different in a headline. Over-indebtedness appeared where multiple lenders competed for the same borrowers without shared credit information, producing borrowing to repay borrowing; the crisis in Andhra Pradesh in 2010, in which aggressive collection was linked to a series of suicides and the state government effectively shut the sector down, is the standard case. Group liability, the mechanism that made the model work, imposes real social pressure and can be coercive. And mission drift, as institutions converted to commercial operation and sought returns, moved several toward larger loans and better-off clients.

The response has been a shift in emphasis from credit to financial inclusion more broadly, on the evidence that the poor need savings, payments and insurance at least as much as loans. Commitment savings products have performed well in trials. Mobile money has been the largest single development, with the Kenyan system M-Pesa reaching most of the adult population and a widely cited study estimating that it lifted a substantial number of households out of poverty, primarily by making remittances and risk-sharing between households cheap and fast, which is a different mechanism from lending entirely. Microinsurance and index-based agricultural insurance are being trialled with mixed results. Direct cash transfers, unconditional and conditional, now have a far stronger evidence base than microcredit for reducing poverty, which has shifted a great deal of development funding. The honest summary is that microfinance solved a real problem, that its advocates oversold what solving it would achieve, and that the correction has produced better measurement across the whole field.

Microfinance replaces collateral with group liability, frequent small repayments, progressively larger loans and local loan officers, which made lending to people without assets viable and produced very high repayment rates. Six randomised trials published in 2015 found that it modestly increases business investment and gives borrowers more flexibility, without raising household income, health or education on average. Problems include high interest rates, over-indebtedness where lenders compete without shared records, and coercive group pressure, and the field has moved toward savings, mobile payments and cash transfers.