What Impact Investors Can Learn from Microfinance

Feb 2015
Global, February, 18 2015 - Estimates vary widely, but 300 million people are estimated to be direct beneficiaries of the microcredit movement, and more than $68 billion may be currently invested in the industry, according to a 2010 estimate from the Consultative Group to Assist the Poor, a unit of the World Bank.

From one perspective, microfinance is the model that makes the case for impact investing: billions in capital mobilized from private investors to scale up delivery of beneficial products and services that reach hundreds of millions of poor people around the world. But having scaled successfully, questions arise: What has all this money bought for so many people? Has the incidence of poverty measurably declined? Can it be said that these hundreds of millions of individuals and their families have lifted themselves out of poverty on the basis of the microloans they have received?

Sadly, the answer to these questions is no. Without doubt, microcredit has helped millions of families through times of trouble or tragedy and has enabled many microbusinesses to boost their owners’ income. It also seems likely that a modest number of poor families have vaulted themselves into the middle class through shrewd and successful entrepreneurial ventures aided by microloans. However, the overwhelming majority of businesses financed with microcredit have had only marginal impact on their borrowers’ income — and, according to the best estimates available, most microloans extended through the industry have been to finance consumption, not business ventures.

Microcredit offers a valuable service to poor people whose incomes fluctuate and who face unexpected financial needs and crises, but it’s only a way of reducing some of the stress of poverty, not of eliminating it.

The signature success of the microfinance industry has been its ability to marshal billions of dollars in capital, much of it from mainstream capital markets, to address the challenge of poverty. This is a huge achievement. Never before has so much capital been directly targeted at the bottom of the pyramid, relying significantly on market mechanisms rather than governments. But why haven’t microfinance institutions had impact on the poor that’s commensurate with the capital invested?

We believe there is a simple and straightforward answer to this question. However, its origins lie in the evolution of the microfinance industry.

The evolution of microfinance

Microfinance surfaced on the public consciousness only after Muhammad Yunus and Grameen Bank won the Nobel Peace Prize in 2006, and most casual observers assumed that Yunus originated the concept. However, as early as 1953, an Ontario-based charity known as Mennonite Economic Development Associates began issuing small business loans in developing countries, a program that evolved into a microcredit program in Colombia beginning in 1973. Around the same time, microfinance sprang into being independently in both Asia and elsewhere in Latin America, with initiatives undertaken in 1972-73 by U.S.-based Acción in Brazil and the Self-Employed Women’s Association in India. Yunus began his work in 1976 in Bangladesh and founded Grameen Bank in 1984.

At the outset, and for many years thereafter, microcredit primarily took the form of lending small sums to groups of individuals, nearly always women, with the loans designated to fund microbusinesses through which borrowers could raise their families’ income. Microfinance was trumpeted to the world as the answer to global poverty. However, it wasn’t long before careful observers of the practice noted that very few of the microcredit-funded ventures increased families’ income enough to permit them to rise out of poverty.

Nonetheless, millions of people at the bottom of the pyramid were clearly benefiting to some degree, and the anecdotal evidence of apparent success helped to feed the movement’s growth worldwide through the 1980s and 1990s, especially in Latin America and South Asia.

By the mid-90s, efforts to improve operating efficiency, transparency, and comparative performance data provided a basis for practitioners to dramatically increase scale — defined as numbers of clients served — by raising funds from new types of investors. Often this effort involved converting from nonprofit to for-profit institutions, with boards of directors representing the interests of new types of shareholders: commercial banks, private equity investors and wealthy individuals.

It wasn’t long, though, before controversy reared its head — most dramatically in Mexico and India. In both countries, large commercial microcredit ventures — Compartamos in Mexico, SKS Microfinance in India — went public, raising hundreds of millions of dollars from initial public offerings funded by new investors. The founders and early investors were enriched — to an extent that triggered controversy and fueled damaging reactions in some countries, including India and Nicaragua, according to a 2008 Council of Microfinance Equity Funds paper.

These episodes drew the spotlight to the high interest rates that persisted in some countries, despite the widely trumpeted efficiency gains, and to overborrowing by some clients, who found themselves overwhelmed by multiple loans from multiple institutions, according to a 2011 Center for Global Development study. All too often, customers simply borrowed more money to pay off their original loans.

Today, microfinance is estimated to be a $68 billion industry worldwide, with a track record of substantial private investment now stretching ten years or more. Large, for-profit Microfinance institutions now dominate the field while some microcredit programs, often swimming against the tide to remain nonprofits, continue to pursue the original vision of loaning money to empower poor people through business.

However, as the lion’s share of microcredit loans are dedicated to buying food to stave off starvation after a bad harvest; paying for hospital care and pharmaceuticals because of a health emergency; paying a bride price or hosting a religious festival; or other forms of current consumption, the impact of the industry on the incidence of poverty remains strictly limited.

Where microfinance fell short

What went wrong? How did a movement dedicated to ending poverty fall so far short of that goal after nearly forty years? And is there any reason to think that other well-intentioned mission-driven businesses won’t find themselves heading down the same path?

We see two features of microfinance that combined to produce the disappointing result:

1. First practitioners and then the impact investors who together propelled microfinance to scale assumed that it would reduce poverty and have other social benefits, and so they never saw the need to specify the metrics and benchmarks that would demonstrate when that was or wasn’t the case. Most investors consider any involvement with microfinance as impact investment and do not demand evidence of the social impact of the companies they back.

2. The shift from nonprofit to for-profit vehicles, while helpful in attracting capital and scaling up, encouraged the industry to evaluate its success in terms of profitability and other financial indicators, rather than preserving the focus on poverty and lasting impact on the lives of people at the bottom of the pyramid.

In fact, as six decades of failed “development” initiatives show, the only surefire way to enable the poor to lift themselves out of poverty is to help them increase their incomes: by loaning the capital for them to start or expand income-enhancing businesses, by employing them in steady jobs at fair wages, or by selling them truly affordable products and services that provide the wherewithal to increase their incomes. For the world’s poor — the 2.7 billion people now living on $2 a day or less — to escape from poverty, they must invest their own time and money.

If microfinance is to help end poverty, it must devote the lion’s share — 70 percent, 80 percent or more, rather than the estimated 10 percent — to funding income-generating businesses owned by people living on $2 a day or less, or owned by village entrepreneurs who create new jobs for those who live on $2 or less per day. This is not say that microfinance can’t help the poor better their lives in many other ways, but if there is one thing we have learned it is that microfinance — and all mission-driven businesses — must be clear about their social goals and held accountable for their success.

There is no reason why profitable, shareholder-funded microfinance companies can’t set clear goals for social impact and be held accountable for the number of businesses they create or expand, the income and wealth they increase, the health they improve, the schooling they extend, or other measures of social impact.

Is it possible for the microfinance industry to attract enough capital if its mission and objectives were refocused along these lines? To answer that question, we need to examine microfinance in the context of impact investment. We’ll address that in an upcoming column.

Source : Devex

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