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What Ails Microfinance? (Forbes India)

February 14, 2012

Senior fellow David Roodman was mentioned in a Forbes India article on microfinance.

From the article:

There is no proof that microcredit alleviates poverty; on the other hand, it can make the already risky lives of the poorest even riskier, says researcher David Roodman.

In the post-implosion analysis of the microfinance sector in Andhra Pradesh, one entity came out virtually unscathed—the idea that microfinance is basically a force for good. The argument was that microfinance has the potential to alleviate poverty and empower people, and the real problem is with a few unscrupulous or greedy microfinance organisations. The solution therefore was better regulations—such as capping the interest rates and increasing transparency.

Muhammad Yunus, founder of Grameen Bank and winner of the Nobel Prize, for instance, has put the blame squarely on the profit-seeking microfinance companies and their compulsions to grow fast at any cost. In an interview to Microfinance Focus recently, he argued that commercial firms should not use the term microfinance, so that customers know it’s different from the ones offered by social enterprises. A few days later, P.N. Vasudevan, MD of Equitas, a microfinance company, defended for-profit companies saying the problem had nothing to do with the constitution of a company, but with how they behave on ground. The underlying assumption is that microfinance per se is good, but there could be rogue or fair Microfinance Institutions (MFIs).

It’s easy to see why this assumption is prevalent. Literature on microfinance is full of anecdotal evidence of how customers started small businesses, earned more, sent children to school and so on. The view even had an academic backing. A study by Mark Pitt of Brown University and Shahidur Khandker of the World Bank, supported these conclusions. There were many stories that showed women—the predominant customers of MFIs—felt empowered by the access to credit.

Yunus captured both the mood and the argument in his Nobel Prize lecture. He first felt the power of microcredit when he helped about 40 women who were struggling to repay loans, by paying an amount of $27. “The excitement that was created among the people by this small action got me further involved in it. If I could make so many people so happy with such a tiny amount of money, why not do more of it?”

Over the last 10 years, a researcher, David Roodman, now a senior fellow at Washington D.C.-based Center for Global Development, has been looking at the phenomenon of microfinance across the world. What he brought to the table was a good amount of scepticism, and what he found might not go down well with many in the industry. He looked at microfinance using three frameworks: Development as escape from poverty, development as freedom and development as industry building. Roodman found that there was no evidence for the first, mixed results for the second, and a strong case for the third.

Roodman started his inquiry into microfinance by looking at the study by Pitt and Khandker. When he tried to replicate the study, along with New York University professor Jonathan Morduch, he found that the widely cited paper did not succeed in proving that microcredit alleviated poverty. Two further randomised evaluations made by others did not find any impact on poverty for 12 to 18 months. There was a lot of hype, but little evidence of microfinance raising people out of poverty. “India is improving economically, and that’s not because of tiny loans, but because of the broader changes in the economy. I don’t think we should believe that financial services to the poor is going to be economically transformative,” he told Forbes India.

But proponents of microfinance have argued that access to credit empowers women, and that’s a worthy goal too. Roodman found the evidence to be mixed. Some women found doing business in public liberating. But those who failed to repay loans, found the peer pressure too constraining. “It appears to me, the kind of microcredit model that has dominated in India, the group-based microcredit is the most problematic in development as freedom,” he said. Microcredit is like any other loan. If you take it in moderation, it helps, but when you take it in excess, it actually reduces your freedom.

Where microfinance works best is in industry building—not in turning clients into entrepreneurs, but in building microfinance institutions that compete, innovate, create jobs and cater to the poor. Roodman cites KGFS (Kshetriya Gramin Financial Services), a low-cost, branch-based model being piloted by Chennai-based IFMR (Institute for Financial Management and Research) Trust. KGFS doesn’t just give microcredit, but also a range of financial services including savings and insurance. It offers savings product in the form of money market mutual fund and by innovating on the process, bringing the transaction costs close to zero.

That is a key learning—to move beyond credit and offer other products. MFIs that offer both savings and loan products tend to behave more responsibly, and avoid excessive growth. Perhaps, the most important contribution made by Roodman to this field is the nuanced way he urges one to think about microfinance. The question to ask is where microfinance works best. Conventional wisdom says it is good at reducing poverty and empowering women. But, he argues with evidence, that it’s actually good at building dynamic industries that offer inherently useful financial services to the poor.

Roodman’s recommendations for aid agencies and policymakers flow from this conclusion. He discourages lending efforts to the poorest saying credit would make their already risky lives even riskier. Since access to finance is inherently useful, he urges supporting any move into taking deposits, insurance and money transfers. At the same time, since too much credit comes with risks both to customers and the organisations, he suggests reducing support for microcredit.

Given these views, one would have expected a staunch supporter of microcredit like Yunus to vehemently disagree. Yet, when Roodman published a book, Due Diligence: An Impertinent Inquiry into Microfinance, in January 2012, one of the most enthusiastic endorsements came from the Nobel laureate. In the world of ideas, there is always a demand for cool, evidence-based analysis.

Read it here.