Micro-credit revolutionized rural economic development. While micro-credit institutions such as the Grameen Bank were heavily subsidized in the past, the current view among policy makers is that self-sustainability is needed to add to the impact of these institutions. However, some of Grameen Bank’s goals, such as fighting poverty and increasing the standard of living of the poorest people in Bangladesh, run against profit maximization principles that would lead to self-sustainability. This article will argue that to alleviate poverty and increase standards of living, it is necessary to strike a balance between subsidization and the quest for profit.
Matthias Zirngibl, Piggy banks, 2007
Certains droits réservés.
Near the end of colonialism, most economists thought that the only way to economic development in rural, economically depressed areas was the classical top-down approach based on institutional planning. This approach meant tight control of the economy on the part of the State, as well as the imposition of institutional and policy reforms by international donors as a pre-condition for subsidies. If developing countries could reform their institutions to allow for an Industrial Revolution, as was experienced by the West at the end of the 18th and into the early 19th century, development, it was thought, would be possible and millions of people would be raised above the poverty level. Multilateral development banks applied this paradigm in the 1960s and 70s. They channeled subsidies through state-run development banks in order to reach the poor. However, these programs were poorly designed, and political interference and corruption, together with bad management, soon became apparent.The microfinance model was a reaction to the failure of both governments and international institutions to implement economic development programs efficiently. Microfinance institutions instead provided small loans to poor people who would not otherwise have access to loans from traditional banks. Traditional commercial banks require that certain pre-conditions be met in order for borrowers to receive loans. In addition, micro-lending addressed a major shortcoming of the state and institutional planning approach by channeling money directly to those who needed it most, while avoiding corrupt intermediaries. Because it became possible for the poor to become entrepreneurs, the micro-enterprises that were at the root of their economic subsistence improved.
The Bank’s Model
Acción International launched the first micro-credit organization in Recife, Brazil, although several others followed, such as Bank Rakyat in Indonesia and BancoSol in Bolivia. The Grameen Bank in Bangladesh is only one of these initiatives. It’s founder Mohammed Yunus, an Economics professor at Chittagong University in 1976, started lending money out of his own pocket to nearby villagers in order to support their crafts’ businesses. He later supported the craftsmen to get a traditional bank loan by acting as their guarantor (1). Yunus realized that his experiment resulted in substantially higher standards of living for borrowers, and that the majority of villagers repaid their loans. To expand his lending system, Yunus created the “Grameen Bank Project” in 1976 and turned it into a financial institution in 1983.
The Bank’s lending system, based on the functioning of market-based credit institutions, was adapted to break down barriers that had previously prevented access to credit by the poorest people. The Bank provided small amounts of credit at low interest rates without the need for paperwork or the provision of collateral. Instead, the Bank required group-lending with joint liability. Five people had to associate in order to receive a loan. Each person in the group would be responsible for the repayment of each others’ loans. If one person in the group did not pay, the other four would not be able to receive further loans (2). The delivery system for the loans and payments also differed from that of regular financial institutions. Instead of having to travel to a branch to do business, eight groups of five people met with a bank officer every week for a village “centre meeting,” where payments were processed and loans handed out.
Contributions of the Bank
The Bank addressed some structural determinants of poverty that were major impediments to rural economic development. For example, the Bank allowed rural entrepreneurs to successfully create new opportunities for themselves through self-employment, thereby dismantling the fallacious “entrepreneurial gap.” It was thought that rural areas lacked the entrepreneurial spirit necessary to raise the standard of living of villagers in developing countries (3). The Bank showed that when the focus was placed on developing the right environment, poor villagers could put their ideas to work and contribute to the development of their communities.
The Bank also addressed the lack of investment by financial institutions in rural areas as well as the restricted access to financial services by poor people which hampered development in these areas. A unique methodology was used where loan officers visited villages instead of forcing borrowers to travel to the closest branch to work out the conditions of a loan. Having bank officers travel directly to the villages not only improved access to financial services, but it also minimized the risk of dealing with corrupt intermediaries.
Women also benefited from the establishment of microfinance in Bangladesh. The Bank targeted female lenders, and therefore improved their economic and social status. More than 96% of Yunus’ borrowers are women. With this, Yunus not only contributed to the economic development of rural areas, but also to the increased economic contribution of women to their communities, to women’s improved sense of self-worth, higher community respect and increased financial independence.
The Bank chose to work in sectors where females were the decision-makers, such as craft-making and processing. Women, who are more vulnerable than men due to a lack of alternative business options, as well as a comparatively higher shame of non-compliance, were found to be more likely to pay back their loans (4). In addition, by targeting women Yunus substantially corrected the overrepresentation of women amongst the poorest villagers. An unexpected added benefit was that money obtained by women was more likely to be spent on the needs of the family. Therefore, not only did the standard of living of the villagers improve from the borrower’s investment return per se, but also from the subsequent use of the money made by them.
The Controversy
In the 1950s, applied welfare economics was the leading paradigm for rural development policy analysis. This model assumed that subsidization was necessary and the allocation of subsidies would be determined after a cost-benefit analysis to identify where this funding would have the highest impact for the greatest number of people. The current view is that, in order to reach the greatest number of poor people, banks need to have access to capital that is only accessible to traditional banks. Therefore, financial self-sustainability becomes imperative.
Supporters of commercialization argue that self-sustainability will better serve the interests of lenders, borrowers and private investors alike, and that donor support threatens transparency and accountability standards. They further argue that dependence on subsidies distracts the attention and allocation of resources towards fund-raising rather than catering to client demand. In other words, in the new context of microfinance, subsidies would only be envisaged as start-up expenses. Alternatively, for those who believe in continued subsidization, the search for full self-sustainability jeopardizes the very objective of micro-credit institutions: to provide both loans at competitive interest rates and social services to the poorest borrowers.
In this emerging environment, the Bank understood that claiming self-sustainability was key to attract support. The Bank has reported a slight profit and return rates for its loans of above 98% for the majority of years since its founding. The claim of potential self-sustainability prompted enthusiastic support from international donors and local governments, which paradoxically continue to subsidize microfinance initiatives around the world. Nevertheless, some micro-lenders such as Bank Rakyat Indonesia and BancoSol have pursued the for-profit path.
Has the Bank truly attained a level of self-sufficiency in the last 30 years? If not, would this justify freezing subsidies to micro-credit programs? Although the Grameen Bank reports have shown a profit and extremely high rates of return, a study comparing the Bank’s Annual Reports against accounts of typical commercial banks showed that the Bank could not have made claims of sustainability when the Bank’s data was adjusted for comparison (5). In the study, the recovery rate remained in the 92-95% range after the adjustment was made. This slight difference, however, could considerably affect the Bank’s balance sheet and bring it into default, were it not subsidized.
Even if micro-credit institutions cannot achieve self-sustainability (6), the social gain of subsidizing micro-lenders needs to be taken into account and compared to other programs by international donors (7). The benefits of program participation in bridging the gap between, on the one hand the interest of financial organizations in minimizing transaction costs and lending to less risky borrowers and, on the other, that of the poorest people to get loans adapted to their daily realities, should be considered. Therefore, the risks and benefits of complete commercialization need to be weighed against those of subsidization. It may be unrealistic to expect full sustainability from micro-credit institutions whose goals have larger implications than mere profit maximization (8). The methodological approach espoused by these institutions, a key to their success, is simply more expensive.
At the end of the day, a balance should be struck between the different sources of funding available to Grameen Bank. If it is true that market incentives may make the Bank more responsive to client demand, it is also true that increased sources from private funds may negatively impact the reach of the Bank. If a move towards increased private funding results in making it more difficult to reach the poorest borrowers, institutions like Grameen Bank need to stay away from full self-sustainability. As soon as a micro-credit institution becomes fully commercialized there is a risk that the incentive may lie in leaving behind the riskiest borrowers. Access to the poorest people is the sine qua non of micro-credit institutions; taking the path to self-sustainability would threaten the very objectives they seek to achieve.
References
(1) Voices of Innovation Section, “Nobel Winner Yunus: Microcredit Missionary”, Business Week, 26 December 2005 <http://www.businessweek.com/magazine/content/05_52/b3965024.htm>
(2) Beatriz Armendáriz de Aghion and Jonathan Morduch “Microfinance: Where do we stand?” page 137, in Charles Goodhart, editor “Financial Development and Economic Growth: Explaining the Links,” Basingstoke, Hampshire, UK: Palgrave Macmillan, 2004. Although with the Bank’s reform in 2002 this structure has been modified to allow for individual lending, most replicating institutions do apply the old model based on joint-liability.
(3) Supra [1].
(4) Supra [2] page 143. Several studies from different regions in the world show that women have less repayment problems and are more likely to repay loans in full and on time.
(5) Jonathan Morduch “The Role of Subsidies in Microfinance: Evidence from the Grameen Bank” (1999) Journal of Development Economics Vol. 60, page 232. For example, the way the Bank calculates repayment rates are skewed by the fact that the total amount due to be repaid is accounted for after it has been due for at least a year. But this amount is divided by the current total amount of loans outstanding. Therefore, if a loan is taken on year X and it is due in X+1 and calculated as unpaid in X+2, the total amount unpaid to the Bank is calculated as a fraction of total loans outstanding in X+2, not X. Therefore, if the Bank increases its lending over time, the resulting data may lead to mistaken conclusions regarding the repayment rate. In a recalculation of overdue loans calculated using the loan outstanding at the time of disbursement, ie. year X, the recovery rate dropped to 92-95% from 98% over the period from 1985 to 1994.
(6) Most microfinance programs targeting the poorest borrowers only cover 70% of their full costs.
(7) Khanker, S. “Fighting Poverty with Microcredit: Experience in Bangladesh,” New York: Oxford University Press for the World Bank, 1998. Khandler reported a net social gain of 0.09$ per dollar spent in the Bank.
(8) The Bank’s objectives are to raise the standard of living of the poorest people in Bangladesh.