How can you make a profit with microfinance

Microfinance: a panacea for poverty?

Microfinance - the granting of microloans to people who are not serviced by banks because of their poverty - is praised as a "panacea" for fighting poverty. There are now hundreds of microfinance institutions around the world, most recently also in Eastern Europe and Central Asia. Eva Terberger, Professor of Business Administration at the University of Heidelberg, takes a critical look at how justified the hopes are that are placed in the "Microfinance Promise", not least by the poor themselves.


The financing offers of the microfinance institutions are intended to improve the living conditions of micro-entrepreneurs and smallholders, create jobs and promote economic growth.

More than a billion people worldwide live on an income of less than one US dollar a day. Halving the number of these people living in extreme poverty by 2015 is the goal that the international community committed to at the United Nations Millennium Summit in September 2000. So that it does not stop at lip service, action plans are adopted at national level. The German federal government led the way with its 2015 Action Program, which anchors poverty reduction as a task for all political departments and calls on the civilian population, the private sector and science to work together.

Despite these appeals and activities, many experts are skeptical. Especially in the last few years, setbacks in the fight against poverty had to be accepted due to economic and political crises; the financial resources for development cooperation are tending to decline; the efforts made so far - according to the results of the World Food Summit in June 2002 - are nowhere near enough to make the halving of hunger and poverty by 2015 appear realistic.

But there are also hope for poverty reduction, and microfinance is one of them. Hailed by experts from politics and practice as a kind of panacea against poverty, it attracts large sums of funding. The basic idea of ​​microfinance is very simple: Sections of the population who are not served by banks because of their poverty are to be given access to banking services, in particular to microcredits, through the establishment of specialized financial institutions. Comparable to the role played by German savings banks and credit unions in the 19th century, this financing offer is intended to enable micro-entrepreneurs and smallholders to invest in their family businesses and to lead them out of the shadow of the subsistence economy, which hardly ensures survival. This would not only improve the living conditions of micro-entrepreneurs and their families, but also create jobs and promote economic growth. But that's not all: funding for microfinance also promises to be a cost-effective approach to poverty reduction, and this is perhaps its most compelling asset. Should it be possible to organize the lending to poorer sections of the population in such a way that the loans are also repaid, the interest collected covers the costs of the microfinance institution and even a profit is made, this would result in a "win-win situation": On the one side benefit the poor. They receive permanent access to the financial market and can escape poverty through this help for self-help. On the other hand, the public coffers or even commercial providers benefit if the microfinance institution proves to be viable on the market. The most popular example of a microfinance institution is the Grameen Bank in Bangladesh. Founded in 1976, it now has two million women among its customers and is regarded as a showcase for successful poverty reduction. What is less well known is that there are hundreds of microfinance institutions around the world. In Latin America, the cradle of microfinance, in Asia, in Africa and, most recently, in the transition countries of Eastern Europe and Central Asia, the establishment of microfinance institutions is being promoted as a promising way out of poverty and towards economic development. But how justified are the hopes that are placed in the "Microfinance Promise", not least by the poor themselves?

There is no doubt that microfinance projects have been successful. By learning from failures in the 1970s and 1980s, a lending technique was developed that actually makes it possible to extend loans to the target group of the poor, which are properly returned and thus available for re-disbursement. Small (very) entrepreneurs do not have the usual bank collateral that limits the risk of default. But this can be offset by granting group loans in which the borrowers are jointly and severally liable, or by a careful analysis of the borrower's budget's ability to repay. Coupled with intensive loan monitoring and collection, the most successful microfinance institutions can limit their loan default rates to below three percent. The evidence that poverty cannot be equated with poor creditworthiness has therefore been provided.

At the same time, however, it has been shown that the creation of access to financial services for poorer sections of the population is administratively complex and therefore expensive in relation to the small volumes that are in demand. Interest rates for microloans of three percent per month, i.e. over 40 percent p.a., and above are not uncommon. The demand for microcredit usually does not suffer because the informal moneylender as an alternative source of finance demands even more. Still, these loans are not for the poorest of the poor who lack opportunities to earn income. Rather, households are served that have the potential to repay. This alone makes microfinance customers one of the beneficiaries among the poor.

Despite concentrating on the less poor and despite high interest rates, many microfinance institutions are unable to cover their costs on their own. Only a few microfinance institutions in the world that were built with subsidies are now really making a profit. Most institutions could not survive without ongoing grants or are at least dependent on subsidies in the form of cheap refinancing through endowed equity or low-interest refinancing lines. The dream of a win-win situation, in which the private sector becomes the decisive engine in the fight against poverty, does not seem to be coming true at least on a large scale and not everywhere.

    Given these mixed experiences, which dampen hopes for a panacea for poverty, two key research questions arise for science, which is paying increasing attention to microfinance:
  • How effectively can microfinance fight poverty? Even if microfinance institutions cannot do without permanent subsidies, this approach to poverty reduction could be superior to other, more cost-intensive measures.
  • How can the establishment of a financing offer for sections of the population who are excluded from the formal financial market be designed more efficiently? If it is possible to provide microfinance more cheaply, more customers can be reached with limited funding, the range of services improved and subsidies discontinued more quickly.

To answer the first question about the impact and outreach of microfinance, i.e. about the depth and broad impact of poverty reduction, reports from individual customers about how their families' lives have changed for the better as a result of access to credit - even if they did Such life stories shape media reporting and thus the positive opinion of the public. Rather, it must be demonstrated that the living conditions of the population groups that are served by a microfinance institution have developed better than those of a comparison group that has no access to this offer. The result would have to be compared with that of studies on the effectiveness of other poverty reduction measures in order to have empirically sound criteria for the use of funds.

Initial research results on this question have been presented. They tend to indicate positive effects of microfinance on customer income. In these studies, however, it was also shown that a "selection bias" can easily lead to an overestimation of the effect. A bias arises, for example, from the fact that microfinance institutions consciously select customers within the framework of the creditworthiness check who are able to repay their loan, so that a positive selection already takes place here with regard to the initial conditions. Such distortions in the empirical data can be filtered out through the use of econometric methods. In the foreseeable future, however, a scientifically reliable measurement is not to be expected that shows how much poverty reduction can be achieved by using one US dollar to promote microfinance compared to using it to promote education, nutrition, etc. . On the one hand, there is a lack of solid data on this, and on the other hand, the phenomenon of poverty is extremely complex. Poverty cannot be measured in terms of income alone, and little is known about the interactions between access to food, health services, education and finance. The group of researchers, which focuses on the second question of the best way to set up microfinance institutions, draws on findings from financial theory, banking management and organizational theory and makes them usable for existing and newly established microfinance projects.

Diverse problem areas of "Institution Building" as the core of "New Development Finance" are in the foreground, ranging from the design of the product range to the appropriate "Corporate Governance Structure" to the regulation of microfinance institutions. An example of one of the questions we are dealing with in Heidelberg is the question of the appropriate governance structure, in which a choice has to be made between the structure of a non-profit organization and a commercial for-profit organization.

Due to the history of microfinance development, non-profit organizations are the most common. Many microfinance institutions emerged from aid programs for the poor, which among other things included a credit component and were usually initiated and supported by non-governmental organizations (NGOs). In the course of so-called upscaling, i.e. by concentrating on the financial business and professionalization, these programs were expanded into small banks specializing in the target group of the poor, some of which - in Bolivia, for example - are now making profits and are subject to banking supervision.

However, it is precisely their non-profit character that has proven to be an obstacle to the growth and the safeguarding of the viability of these institutions, because this means that there is a lack of a "real" owner who is interested in the economic use of the funds deployed, i.e. the goal of cost recovery, which ensures sustainability and making a profit, pay attention. Not least for this reason, some microfinance institutions have meanwhile been converted into stock corporations in order to assign the rights and obligations to specific owners who exercise their control function on the supervisory board.

Inspired by the success that individual microfinance institutions achieved in providing a cost-covering financing offer for the poor, but also by the difficulties in binding NGOs to business goals, the idea arose of setting up microfinance departments in already existing (private) commercial banks as part of downscaling to promote. The main problem with this approach is to bind the owners and management of commercial banks to the targeted customer group of small (and) entrepreneurs - precisely the goal of microfinance, which was far less problematic in the upscaling approach. The evaluation of the downscaling experiments suggests that this approach has little promise in countries where financial markets are less competitive and the focus on larger customers is the far more lucrative business. In contrast, in the transition countries of Eastern Europe and Central Asia, where the financial markets are developing rapidly and many young small businesses are looking for financing, for example in Ukraine and Kazakhstan, downscaling projects are proving to be quite successful. Private banks are interested in participating in microfinance projects and have already issued a number of loans.

A third funding approach, the establishment of micro-banks, has only been experimented with for a few years. It is intended to combine the advantages of upscaling and downscaling with regard to the dual objective of "reaching the target group of poorer sections of the population" and "sustainability through cost recovery". These banks are founded from the start with a banking license and in the commercial legal form of a stock corporation. However, the owners who provide venture capital are primarily donor institutions, for example the "Kreditanstalt für Wiederaufbau" as part of German development cooperation or the "International Finance Corporation" as part of the World Bank group, but occasionally also private investors, such as a German commercial bank and one on development finance Specialized consulting company and its employees who are indirectly involved through a kind of venture capital fund for micro-banks. Such banks were set up in Albania, Bosnia, Georgia, Kosovo, but also in Haiti, Ghana and Mozambique. They actually seem to come close to the goal of cost recovery within a comparatively short period of time, not least because the management of these banks is initially provided by the consulting firm, which in turn is involved as the owner. Whether the ideal corporate governance structure for microbanks has been found through such institutional innovations or whether this opens up new incentive problems, whether the success of these banks still points to financial market development worthy of funding to combat poverty or rather to distortion of competition through subsidies, as the German savings bank association from Brussels is accused of today are research questions that need to be clarified in the future.

One thing is already certain, however: microfinance is not a panacea for poverty, because the poorest of the poor cannot be helped through loans. Still, opening a funding offering to groups excluded from formal banking can make an important contribution. Even if the direct impact of microcredit on poverty is difficult to measure - improving the functionality of financial markets at both the micro and macro level serves economic development. And this is the necessary prerequisite for effectively fighting poverty.

Prof. Dr. Eva Terberger,
Chair of General Business Administration, Credit Management and Financing,
Alfred Weber Institute,
Grabengasse 14,
69117 Heidelberg,
Telephone (06221) 54 31 74, Fax: (06221) 54 31 13,
e-mail: [email protected]