Microfinance is no economic miracle

The innovation called microfinance is actually an innovation in banking systems and processes to enable lenders to lend to the poor in a sustainable way. Here, the sustainability of the lender and not the borrower is the objective.

Bangladesh’s Muhammad Yunus filled the gaps in existing banking system in innovative ways such as replacing physical capital with social capital, doorstep banking, and weekly repayments to make the poor bankable without compromising on prudent banking rules.

The result was a business model that ensured repayment and approved of reasonable profit. This motivated many lenders to explore the market at the bottom of pyramid — a term that Yunus does not want to be associated with microcredit.

Various studies on the impact of microfinance have found that there is no transformative change in income and poverty levels despite the availability of credit.

Expecting a change as huge as pulling the poor out of poverty is turning a blind eye to the limitations of market-based solutions – such as microfinance .

Just as the availability of a ₹1 sachet cannot ensure hygiene for the poor in the absence of structural support such as water and sanitation facilities.

Similarly, providing the poor with small sums of credit cannot ensure reduction in poverty in the absence of holistic interventions. FMCG outlets selling these sachets and microfinance institutions (MFIs) are doing business at the bottom of the pyramid. An FMCG cannot and will not focus on substantially changing the hygienic condition of the poor, because that is beyond the scope of its business. Likewise, MFIs cannot necessarily create enabling conditions for growth, because that is none of their business.

MFIs are just commercial lenders (above 75 per cent of micro finance business is done by for profit NBFC MFIs). Financial institutions are not expected to bring about complete development and should not be judged on those criteria.

MFIs can be fairly assessed in their performance as lenders. A closer look at the policies, however, discloses that even as lenders, MFI policies are not designed to create an impact, and commercial considerations prevail over the needs of borrowers.

First of all, the selection criteria for clients are permanent residence in the area, ownership of a pakka (brick and cement) house, and the existence of an enterprise for at least a year. Those who have already invested and survived for a year get credit.

Though it makes good business sense to lend to a running unit, the claim of giving loans to the poor for asset creation and income enhancement is not validated.

Most often, clients use the credit as working capital. Not that working capital is not required but since investment is not enhanced, productive capacity is not enhanced; hence there cannot be transformative change.

In addition, this policy leaves out the very poor. Further, this approach limits the number of eligible borrowers. All MFIs target these comparatively fewer numbers of eligible borrowers. This, in turn, leads to client poaching and multiple borrowings.

Moreover, unlike a good lender, the MFI appraisal process does not have a provision for assessing enterprise need.

The present repayment capacity and not the projected income generation of the activity being financed are assessed.

There is no assessment of project cost, raw material or stock cost, gestation period, projected cash flow, prospective buyers, feasibility of project, and capital gap.

Instead, current assets, earnings and working members are recorded to ensure that the client is able to repay from household income.

Since enterprise need is not the focus, MFIs offer only one type of product. This product ranges between ₹10,000 and ₹20,000. The catalogue of MFIs may have a few more products but all clients are given a similar amount with similar repayment period and similar instalment amount.

This could be cost effective for the MFI, but clearly, the financial needs of the micro enterprise are ignored.

Different enterprises may have different needs: for example, the investment needs of a photocopier, a mechanic and a home-based tailor differ substantially, but the MFI will offer the same: ₹12,000 or ₹15,000. This leads the borrower to borrow more from outside sources at high cost or to utilise the money for non-productive purposes thus creating an extra interest burden.

Similarly units at the take-off stage that can grow with proper financial support and generate more employment remain outside the purview of this policy.

Further, the loan amount is too small to create an enduring asset. Barring a few low income-generating activities such as like home-based tailoring, no other investment can be done. Even a buffalo of average quality costs between ₹30,000 and ₹40,000.

Incidentally, this amount is not sufficient even as working capital to cater to a running and growing enterprise. Entrepreneurs have to depend on private sources for peak season work.

MFIs fill the void of formal lenders for a population with a constant cash crunch and as such are welcome.

But their lending policies are aimed at consumption smoothening, and nothing more. This is what all studies have found.

The writer is the former COO of Friends for Women World Banking