Microfinance: Where Did It Go Wrong?
Microfinance arose in the 1980s in South Asia as a way to provide small loans to entrepreneurs who had no access to capital from conventional banks. It was heralded as an innovative approach to poverty reduction. Over the years, however, the early leaders were pushed to the periphery by the same commercial financial institutions that had previously avoided the field. Queen’s School of Business doctoral student Derin Kent and strategy professor Tina Dacin explain why: the perceived need to justify the industry in conventional financial terms led the early microfinance practitioners to import business “logics” that would eventually win out over development principles.
The story of microfinance has more twists than a pretzel. In 1983, American-trained economist Muhammad Yunus founded Grameen Bank to offer small loans to rural Bangladeshis who generally had no collateral, to the delight of the development community and the scorn of big banks. More than 30 years later, microfinance is a financially efficient industry led by for-profit banks yet questioned about the social good it offers.
This dramatic reshaping of microfinance in a fairly short period of time intrigued Derin Kent, Queen’s School of Business doctoral student, and Tina Dacin, Professor and E. Marie Shantz Chair of Strategy & Organizational Behaviour and Director of Queen's School of Business Centre for Responsible Leadership.
How is it, they ask in a paper published in the Journal of Business Venturing, that “poverty alleviation practitioners who established modern microfinance are being pushed to the periphery of their field – economically and ideologically – by the very same commercial financial institutions that had earlier avoided poverty lending?”
Their conclusion: the perceived need to justify the industry in conventional financial terms led the early microfinance practitioners to import business “logics” that would eventually win out over development principles.
Social Capital Was Guiding Force
In the beginning, it was only nongovernment organizations making loans to small groups of people. The idea was that if one member of the group did not repay, then the microfinance institution (MFI) would refuse to loan to anyone in the group, substituting social capital for legal tender.
But as the industry grew and expanded out of South Asia, the QSB researchers note, it began targeting a wider range of customers. More loans were made to wealthier people, urban customers, and individuals rather than groups. Financial institutions and fully licensed banks entered the scene and new financial products such as insurance and savings accounts came online.
Microfinance also developed an infrastructure: umbrella organizations, rating agencies, and “best practices.” Kent and Dacin say the field came to focus on “sustainability” — being financially self-sufficient — and “outreach” — getting more clients.
Yunus’s original innovation was to fuse the logic of banking and development when he created microfinance. Banking’s logic is based on sharply defined, widely accepted concepts such as mission statements, reports, and loan agreements. Development is guided by fuzzier logic. Even the term “poverty alleviation” means different things to different practitioners. It’s also more difficult to measure social results than financial.
The loss of street credibility and mission drift happened gradually. Simply put, the “logic” of development lost out to the “logic” of banking
“This new hybrid logic was effective in renewing hope in the poverty alleviation field,” say Kent and Dacin. It put NGOs front and centre rather than the government organizations that “were viewed with suspicion.” Poverty alleviation advocates were also sympathetic to Yunus’s belief that the poor were natural entrepreneurs who knew best for themselves.
Results also seemed to justify microfinance in both banking and development terms. The high repayment rate meant solid recovery of lending costs that bankers seek and was also taken to be a sign of increased wealth of the borrowers.
This and other balance sheet metrics provided justification for the nascent field. MFI umbrella organizations and the rating agency MIX Market, for example, provided similar assessments on financial metrics alone. It would have been difficult and expensive to go into the rural communities of borrowers and track social results for the millions of MFI clients.
Ways to Protect Against Mission Drift
The legitimacy that the financial metrics conferred made microfinance an attractive target to chase. Yet, as financial legitimacy of microfinance attracted conventional banks, social legitimacy suffered.
As Kent and Dacin note, “Since the 1990s skeptics in media, government, and academia have mounted attacks on a number of fronts claiming that microfinance does not lead to economic development, does not spur the creation of legitimate entrepreneurial ventures, is not sustainable, does not enhance women's status, and is engaged in aggressive lending to uninformed clients.”
The loss of street credibility and mission drift happened gradually, say Kent and Dacin. Simply put, the “logic” of development lost out to the “logic” of banking. Development can be an ambiguous concept, riven by ambiguities and competing theories and approaches. Banking does not suffer from such ambiguities. In the rush to justify the field of microfinance, the clear and evidence-based banking concepts won out.
If a focus on poverty alleviation is to return to microfinance, Kent and Dacin suggest that re-inventing the MFI umbrella organizations may be a good place to start. They point out that new fields aim to succeed by the metrics imposed on them.
“When microfinance organizations measure and are judged according to their repayment rates, they become exceedingly effective at improving their repayment rates,” they say. “If social metrics are made to count as much as financial ones, we suggest that microfinance organizations can eventually develop the capacities to succeed on them as well.”
Other young fields wishing to avoid losing control of their missions can learn from the experience of microfinance. Setting up strong institutions to enforce boundaries — what is acceptable practice and what is not, for example — and developing metrics of success that are unambiguously tied to the desired goal will help prevent mission drift or a soft takeover.