Microcredit has become increasingly popular ever since the 90s when the world started to recognize it as a viable poverty alleviation tool. Since then it’s proven to be an effective tool to provide economic opportunity to the poorest of the poor, reduce hunger and malnutrition, put kids in school, foster gender equality, reduce family size, and put power into the hands of the people, which has decreased government corruption and fostered stronger democracies.
Given the dramatic and broad impact that it’s had on the world, it’s no surprise that people are revering it as THE solution to poverty. Now with Bangladesh, the first country to create a micro-credit bank, becoming among the first of the countries in the underdeveloped world to eradicate extreme poverty and staying on track to be recognized as a “Developed Country” by the UN in 2030, it’s no surprise that people deem this as evidence that micro financing is the solution that poverty has needed all along.
It’s no surprise. With a track record like that, it’s easy to make micro-credit out to be the single miracle solution to all of the developing world’s problems—but it’s not. The truth is that micro-credit is very helpful in a handful of narrow scenarios, but it has serious limitations to how much it can actually help. By exploring these limitations we’re able to reveal the frontier of developing economics and set goals for what still needs to be done in order to eradicate extreme poverty.
10 Limitations of Micro-Loans
1. Interest Rates
The micro-finance revolution didn’t put credit into the hands of the poor for the first time, it put affordable credit into the hands of the riskiest borrowers for the first time. Historically there were banks, who viewed poor people as “banking untouchables” and there were predatory money lenders who would give risky loans to the poor that were near impossible to pay back. Then, when people couldn’t pay, the money lenders would threaten the borrowers with physical threats and go after everything they own (including their land). So poor people never borrowed money unless they were in a serious crisis.
What the Yunus model of micro lending did was it made it economically sustainable to lend to the poorest people in the world. In most of Asia and South America, poor people now have access to small amounts of capital at interest rates of 20-30%, but in the less developed economies of Sub-Saharan Africa, interest rates are still floundering around 45-65%. The higher the interest rate the more confident and business savvy the borrower must be in order to successfully turn a profit. If interests rates get too high, which for many people in Africa they are, then some people will be too afraid to take out a loan. For someone who has never held more than a few dollars in their hands their entire life, a $90 loan will feel like an impossible amount to pay back. Add a high interest rate on that and then it really feels impossible and in interest rates are high and the education or business savviness of the borrower is low (as it is for the poorest of the poor), then all the profit that they should have made would go into paying off the interest on the loan.
This really shouldn’t be a limitation to micro financing though. Obviously it’s a lot cheaper to borrow money among the not so poor and the repayment rates are surprisingly high (no matter where you are in the world repayments rates are typically higher than 98%). So the reason for high interest rates must be due to some inefficiency in the marketplace. There are two inefficiencies that are happening simultaneously: The first and easiest to solve is to fill the $500 billion gap between the need and access to credit. It’s the biggest unmet demand in the world's financial markets right now and it’s generating savvy investors profits excess of 30% return on investment. The solution to this is simple: invest more heavily into micro-finance institutions in Sub-Saharan Africa. By the simple economics of increasing the supply of capital, prices will drop.
The second problem is the inefficient means of vetting new clients and distributing capital. Microfinance institutions (MFIs) have to conduct background checks on each borrower. When someone borrows $90 at a 21% interest over 6 months (which are our loan terms) the bank makes only $18 gross profit on the loan. Then you add in the cost of the background check and the cost of traveling long distances to collect the money from borrowers each week and all of a sudden the profit on that loan gets sucked up and the bottom line approaches zero. In order to eliminate this inefficiency, several companies are focusing on groundbreaking mobile applications that will allow even the poorest most distant borrowers to borrow money without becoming too costly to lend money to at the true cost of capital.
2. Loan Size
Microcredit is really good for helping the poorest people in the world jump up an income class or two. This could mean someone who makes $1/day now makes $4/day or someone making $4/day now makes $10/day. Over time with a series of loans, people will continue to grow their incomes, but in Uganda I’ve never seen a borrower exceed earning $21/day. Why do people’s incomes taper off around $20 per day?
The reality of micro-lending is that once someone makes $20 a day, another micro loan does very little to expand their business—what they really need is a small business loan. This is a very important characteristic of micro-lending because it demonstrates it’s biggest limitation. Micro-loans only help an underemployed person become self-employed. They don’t help fuel enterprises that go onto create jobs, which is important for a healthy economy.
As any entrepreneur ever could tell you, starting a business is stressful and risky. When you’re living in extreme poverty life is already so stressful and so risky that being self-employed isn’t exactly a dream to live up to. Poor people are entrepreneurs out of necessity, but what most people would rather have is a stable job working in a factory or a government office—the most stable and secure, the better.
What happens when economies don’t produce jobs? Well look at any developing nation’s street markets. There will be several stands all in a row, selling the same stuff. You’ll have three shop owners just a few feet away from each other all selling tomatoes when clearly one person could operate all three of their tomato stands and the other two shop owners could be off doing other income generating work. A self-employed economy may be an equal one, but it’s extremely inefficient and it yields low profits. If we want to create healthy economies, then we need to find a way for the top performing micro entrepreneurs to get access to the small and medium enterprise loans (SMEs) that they need in order to grow their businesses into job producing enterprises—unfortunately micro credit is not the solution.
3. Lending Terms
The rules that made the micro lending revolution possible are the same rules that have made the terms of micro lending so rigid—pushing some people back to money lenders. Let’s break them down. For one, you have to join a Women’s Trust Group. This has a number of consequences. First off, there is an incredibly high level of social pressure to not take risks, because if you do, then your peers will have to pay on your behalf (which will lead to them kicking you out of the group), which disincentives true entrepreneurship, so businesses play it safe (ie. why micro lending isn’t a solution for small business loans). Secondly, it makes it hard for newcomers to join a group. Why would we allow this newcomer into our group when we’re doing just fine without the extra liability?
Micro lending terms also have to be easy to understand and pay, so payments are weekly and they start the week after you get the money. In most micro finance institutions there is no wiggle room for other terms at all. This works well for working capital loans (loans to buy inventory for a shop), but it doesn’t fill the other needs of the poor. If someone in their family gets sick and they need money to pay a hospital bill, then their only option is still the predatory money lenders.
Lastly, it’s really important that the poor be held fully accountable to paying back their loans in full. The most important rule of micro financing is that you should never forgive loans. By forgiving a loan, you lose years of progress developing their mindset that they are not a beggar and they can be self-sufficient. You also break the social contract that makes women groups work. The social contract is group accountability so people only pay because everyone else is paying, but if we break that contract by forgiving some loans, then all the loans in a group will default. These harsh rules make micro financing work, but it also makes people resort to informal loans from their neighbors and if the situation is really bad, from predatory money lending.
If micro lending institutions truly want to act as the banker to the poor, then the rules need to be somewhat relaxed without breaking the social contract. We must allow people to pay late when they have a bad week, and we must allow loans with grace periods under certain circumstances. We’ve done this at Muvule and we’ve found that listening to our clients problems and relaxing their terms under good circumstances helps us create a very loyal client base. Our clients stay loyal to us because they know we care about them. Other MFIs should do the same.
4. Limited Financial Services
The simplest solution to the emergency micro loans dilemma would be to help people save. If they have an emergency savings account, then they wouldn’t need to borrow money when they have a bad week. Unfortunately most MFIs only distribute loans, they don’t accept deposits leaving their clients to save money in other creative ways, such as by building their houses brick by brick.
If you’ve ever been to a developing country before you’ve probably seen unfinished houses with metal rods sticking out of the top. Why don’t people ever finish their houses? One of the reasons why is because their house is their savings account. They save up some money and then buy 100 bricks and add a single wall at a time. Although this is a creative solution for the poor, it’s pretty inefficient. Wind and rain can easily damage a partially built house and buying only 100 bricks at a time is more expensive than buying all the bricks you need at once. So why wouldn’t people just build the whole house at once?
The biggest reason why people buy 100 bricks at a time is because they don’t trust themselves to keep cash on hand. It’s the same psychological factor that the US Government doesn’t trust you the manage either. That's why they take their share of taxes and social security before the money ever hits your pocket. People realize that they are their own worst enemy, so they save up enough for a wall, then they buy the bricks and build their wall before their money can disappear on something else.
One downside to this is of course inefficient houses, but also, what about those shocks we just talked about? What if you need to tap into your savings? You can’t just liquidate a brick wall that’s attached to your house. You would have to go to a money lender (or a generous MFI) for a loan or you might end up homeless again. So it’s not that great of a savings strategy. What MFIs can do is they can help people save. They’re already positioned as the natural banker to the poor, why not allow them to open savings accounts. It wouldn’t create that much more work considering loan officers are already meeting with their clients on a weekly basis to collect money anyways—why not collect their payment plus any savings they might have.
Some MFIs have realized the benefits of help their clients save and some have even gone so far as to do a forced savings plan. That way you have a pot of emergency money ready for when the big shocks in life happen. Other MFIs do the same, but they never let you touch the savings. Instead it sits for 10 years in the bank until it becomes a sufficient amount of money for a monthly pension plan—a comforting social security net for poor people once they retire. There’s a huge need for these types of financial services among the poor and they can help the MFI too. Starting a savings account isn’t free for the bank, it requires overhead costs, but holding savings allows MFIs to reinvest the capital in the accounts instead of borrowing it from investors. This not only allows the bank to charge lower interest rates, because that capital is free for them to use, but it would also create a money multiplier in the economy speeding up the pace of commerce.
5. The Lack of Insurance
Let’s go back to talking about the risky lives of poor people. The purpose of insurance is to mitigate risk, right? So, given that poor people suffer from the most risk of anyone in the world, doesn’t this seem like a natural market for insurance agencies? Yeah — it is. In fact Forbes called it one of the largest untapped markets in the world. There are 3 billion people worldwide who need insurance and aren’t getting it. Even a small profit on each premium would become a huge market.
Think about this for a second. Let’s say you give a poor farmer a loan for fertilizer and genetically modified seeds. They buy the fertilizer, they plant the seeds and then… a drought hits. The farmer makes no money and you as the banker, have to give them a grace period and longer loan terms on their first loan, and let them borrow a second loan so that they can make money some other way without defaulting. You lose money, they lose money — all because nobody’s risk was insured. Same thing with cows, you give a loan to a farmer, they buy cattle, then the cow gets sick and dies. Same thing could happen with housing loans, boom a flood hits and both their house and your collateral get washed away. There are unlimited ways that insurance could benefit both parties and the premiums could just get baked into the cost of the micro-loan. Seems easy enough, so why hasn’t anyone solved this?
There are three big reasons. First is moral hazard. Once you give someone an insurance policy, their behavior becomes riskier, which makes means you have to charge more for the premium. This is an inherent problem associated with all insurance, it should be easy enough to fix. The second, harder problem, is fraud. The cow insurance policy I mentioned has already been tested in Kenya and all it did was create a market for cow ears. Insurance companies needed proof that a cow died, so they told farmers to send their cow’s ears in as proof. Why didn’t this work? Because people who didn’t have policies would sell their dead cow’s ears to farmers whose cows were insured. The policy quickly became unprofitable and the insurance company pulled the plug on the product.
Lastly, there’s adverse selection. If you’re selling health insurance, then people who know they need to go to the doctor are likely to come buy a policy and others who never get sick are unlikely to ever buy one. This is why Obamacare wanted everyone to buy health insurance, because if healthy people don’t buy it, then sick people can’t afford it. The adverse selection problem makes MFIs a natural vendor for insurance because they have an unbiased pool of applicants. People come to them to get loans, not health insurance—so all we have to do is bake in health insurance into their policy right? Ideally, yes, but it’s bad for business and people will leave for our competitors. All these obstacles are surmountable, but their solutions are beyond the scope of this article. All you need to know is that micro-finance institutions can’t solve this problem on their own, in order to fix this problem it’s going to require government intervention.
I sat down the other day with Jon Bishop, the CEO of Envest Microfinance, and he asked me what got me into micro financing. I told him I wanted to help entrepreneurs and so we started an MFI giving out income generating loans. I went on to explain how my business partner wanted to also give people loans for school fees and housing, but I explained how that’s not my goal. I just want to help people start businesses to escape poverty. After hearing his take on the issue, my opinion turned around 180 degrees.
"Can’t you see people need other stuff than just business loans?” he asked me.
“Well, yeah, but that’s not my passion” I replied. As soon as those words left my mouth I realized that I was too focused on my own goals and that I should give up my own desires in the pursuit of the larger mission of helping people increase the quality of their lives—the way they see fit. This paternalist mindset — making decisions from the top and sending resources down — is why aid created more poverty than it eradicated through the 70s and 80s.
“When people get a loan to build a concrete floor in their house” he went on, “their health quality goes up. They don’t sleep with nasty bugs that cause disease” and quickly I realized that he was right. There are lots of ways micro lending helps that don’t involve starting a business.
Micro-lending started out with the purpose of poverty eradication and many micro-lending institutions still don’t allow people to spend their money on anything other than income generating assets. This is out of fear that if the money doesn’t go towards an income generating asset, people won’t be able to afford to pay it back. But it’s been proven that that’s not actually the case. The new focus of micro finance should be the general goal of helping the poor achieve a higher quality of life—in ways that make sense to them. For example, most women who take out loans have the same top three priorities. First they spend money on food staples to feed their family, then they make sure to pay school fees so that their kids can go to school, and if they have any money left over, they will put it into their house.
If our clients have used their income generating loans wisely enough to get to the point where they’re thinking about making housing upgrades (buying utensils, a fridge, repairing a leaky roof, etc) then shouldn’t we help them achieve their life goals even if it doesn’t align with our selfish passions (of helping people start businesses). The second big reason why this makes sense is because MFIs have large first time costs of vetting the credit worthiness and doing background checks on new clients. So it makes sense that once you get a client, you would want to serve them with all their banking needs since the hard part is already over with.
Unfortunately, paternalism lives on among the people with the money and it’s one of the big limitations of micro financing. Microfinance investment funds have the conflicting values of not wanting to tell MFIs what to do with their money, but also the people investing their money typically have a single specific cause in mind that they want to help with (hunger, poverty, education, gender equality, housing, etc). In reality by imposing limitations on the types of loans that we allow our money to go to, we’re not helping our borrowers, we’re more focused on helping ourselves.
7. Private Capital
Some people are pro aid and say we shouldn’t be making a profit off of the poor, instead we should just give money away. Jeffrey Sachs is famous for saying that a $200 billion donation is all the world needs in order to eradicate poverty forever—but few people think thats actually the case. Most people think the opposite—that we should never give money away because it creates dependency and turns people into beggars. What most rational economists believe now is that there is a time and a place for different kinds of money.
Governments, especially in poor countries like Uganda (which is already borrowing more money than it should) needs to invest it's money into long term tax generating projects: roads, hospitals, schools, and other infrastructure projects. No private company is going to build a road, but by building a road, commerce happens faster and thus more tax dollars flowing back into the Ugandan government’s hands.
Non-profits and charities also have their place. This can be really useful for cases like fighting global warming (which has no immediate economic benefit) or research that may or may not produce a result. The Gates Foundation has spent billions of dollars researching vaccine treatments that turned into dead ends, but that’s okay because the purpose of that money wasn’t to generate a profit—it was to explore possibilities.
Finally there is the private sector — which is the biggest pool of money and it's made up of investors who expect to make a profit. Economists argue that whenever a project has a revenue generating model and can make a profit, it should tap into private capital rather than competing for scarce government and non-profit dollars. The only problem is that the private sector is traditionally where people go to maximize their profits. Asking people to accept a lower return in exchange for social good seems to make people want to put less money into it than if it were merely non profit or merely for profit.
So although social profit companies can tap most of their money from the private sector, governments and non-profits should give tax breaks and donations to social enterprises to increase investor returns so that it can pursue its social goals (of lowering interest rates and giving to the poorest of the poor) without becoming non-competitive with exclusively for-profit companies. Until then, the profit motives of micro finance will be in a constant tug of war with the desire to do good.
8. Access to the Poorest of the Poor
When micro financing was first tested by Muhammad Yunus, he made sure to give money to people who were at the absolute bottom of the pyramid—those making less than $2/day. But at that time, the money he was using was government money, it wasn’t from the private sector. As non-profits and governments left more and more responsibility for MFIs to get their funding from the private sector, the motives changed from serving the poorest to serving poor people who are less risky.
Private MFIs aren’t giving enough money to widows, single moms, and other decrepit people are particularly high risk. These people are the $1-2 per day earners who suffer from higher rates of child mortality, malnutrition related diseases, complete lack of education, extreme gender inequality, and a perpetual cycle of generational poverty. By giving money to people who earn $4/day instead of $1/day, MFIs mitigate their riskiest clients, but they also don’t help the 700 million people in the world who are still suffering from these inhumane problems.
This leaves a gap for some companies, like Muvule, to different ourselves by making +85% of our clients the most decrepit possible, but it still shouldn’t be this hard for other MFIs to carry forward the mission that Muhammad Yunus has initially envisioned for the micro credit industry. What’s even worse is that governments emphasize this problem even more by forcing MFIs to become government managed banks.
In Uganda the NGO BRAC was recently forced into becoming a bank by the Ugandan government. Part of this requires the adoption of Ugandan Banking policies, which turned their poorest clients back into “Banking Untouchables”. We’ve made it our mission to serve the very bottom of the pyramid despite the higher risk associated with serving them and we haven’t seen the higher rates of default that most MFIs fear. Super poor people realize that a micro loan is their only chance out of poverty, so they make every effort possible to pay back their loan so that they can continue to have access to credit. We’ve served over 1,000 clients so far and we’ve never had a default—yet most MFIs don’t make the poorest of the poor their priority, because they are still for-profit businesses. If we want to end poverty, it’s our duty to serve those most in need and in order to do that we need the financial markets and governments working with us not against us.
9. Education & Skilled Labor
It’s also important to realize that giving a poor person making $1/day a loan will alleviate some financial burden, but the cap on their earnings may be a lot less than the $20/day that we saw in our example earlier. The reason why is because poor uneducated people make for good market vendors, but in order to make $20/day you need some kind of skill like sewing, farming, or carpentry. With some kind of skill, you can then buy raw materials and do something with it creating a lot more marketplace value.
Everyone has a "survival skill”, which could be separating rice from rice paddies or weaving baskets, which are super low income skills and by providing someone with a loan they may go from separating rice from rice paddies for someone else to buying their own rice paddies and increasing their income 4x (this is a true story by the way). All that poor person needs enough money to buy their own rice paddies and their income will jump from $1/day to $4/day, which is still a whole different income class, but it’s just going from decrepit to poor. Without some kind of skill, people can’t go from poor to middle class.
The lady I mentioned earlier who went from $3/day to $21/day in just a few months was able to do that because she had a valuable skill of knowing how to sew, she just needed the cloth in order to leverage her skill. If people don’t have any skills at all because they don’t have any kind of education, then they will continue to work hard for very little money. More money than before, but by no means a middle class standard of living. The good news is that the mom who went from making $1/day to $4/day can now send her kids to school and her kids will go on to learn a skill that will be able to fully leverage the power of micro financing.
10. Political Traps
It’s extremely hard to run a business with an unstable government or streets full of crime. In a non-democratic political atmosphere or a political environment that purposely keeps their people poor, micro financing will be a source of symptom alleviation, but it won’t be a cure. There are several examples of governments trying to squander micro-finance institutions. In Bangladesh in 1991, the government nearly bankrupted Grameen by forgiving all loans under $135, which was pretty much all their loans. In India, local government officials made it illegal for farmers to pay back their loans to Spandana in attempt to bankrupt the organization.
Why would governments actively work against the most effective tool to helping poor people escape poverty? Well, why does any level of corruption happen? For money and power. Corrupt governments have an incentive to keep their people poor, because poor, powerless, uneducated, and disorganized people can’t form a coalition to overthrow the government. Once people start becoming wealthier, more educated, and more organized (through women’s groups), they become a threat to the power structure of corrupt governments.
On the other hand, in countries that have a democracy, even if it’s a faux-democracy like Bangladesh in the 90s, micro finance can help reduce corruption at the margins by putting power into the hands of the poor. In the early 90s, Grameen Bank borrowers organized and outvoted local leaders, and replacing the corrupt officials with people from their women groups. As corruption dropped, the poor masses gained a larger and larger voice until a true democracy was established.
Many economists agree that bad government leads to poverty traps, but overthrowing them is also not an option. It’s easier to come in and overthrow a corrupt government—like what we did in Iraq, but that leaves behind power vacuums that pave the way to terrorist organizations like ISIS. Instead, we need to decrease corruption by empowering the poor and keeping a closer eye on the flow aid. A simple newspaper article listing all the public school funding dollars sent by the Central Ugandan Government to the districts reduced stolen dollars from 80% to 20%. By continuing to keep officials in check and providing the poor people in corrupt countries with social power via capital, complete democracies can be established where faux democracies rule, but under dictatorships, we can do very little good.
Last year I was having breakfast with my business partner at a hotel in downtown Kampala. We were discussing our plans to expand our micro-finance operation while serving ourselves a classic Ugandan breakfast from the hotel’s buffet.
The room was quite empty and pretty quiet. Quiet enough that the handful of tables that were occupied could overhear bits of our discussion. By the time we had finished our breakfast, someone from each of the three occupied tables in the room had approached us asking if we’re giving out micro-loans. Of course they knew we were so they would then go on to tell us they have a group of women who would benefit tremendously from micro-loans.
Each of them talking with the same enthusiasm that micro loans would be their ticket out of poverty—are they wrong? No they’re not wrong, it can lift individuals out of poverty by providing them with the opportunity to become self-employed, but at the same time, we can’t forget that microcredit is a new industry. It started in the 90s and wasn’t really taken seriously until just 15 years ago.
There is so much more work to be done in this space in order to provide equal opportunity to the poorest people in the world. The miraculous effects we’ve seen so far is only the beginning, and by understanding where micro loans fail to work, we’re able to look forward and work towards the next major developing economics revolution.