Microfinance As Development

Microfinance As Development: A Critique of the ‘Financial Systems Approach’ to Microfinance in Developing Countries

Peregrine Willoughby-Brown

This dissertation is submitted in partial fulfilment of the requirements for the degree of MSc in Globalisation and Development of the School of Oriental and African Studies (University of London).

Date of Submission: September 15th, 2009

-1-

I undertake that all material presented for examination is my own work and has not been written for me, in whole or in part, by any other person(s). I also undertake that any quotation or paraphrase from the published or unpublished work of another person has been duly acknowledged in the work which I present for examination.

Peregrine Willoughby-Brown September 15th, 2009

-2-

Acknowledgements I would firstly like to thank God, my parents and Rosalie Nugent. Without the help of these three people and one omniscient deity, nothing that I have accomplished in my life would have been possible. I would also like to extend sincere thanks to Dr. Carlos Oya and Jack Footitt at the School of Oriental and African Studies, as well as Professor Deborah Burand of the University of Michigan, for their valuable assistance and guidance during the preparation of this work. I also offer my thanks to Dr. Dae-Oup Chang, Ms. Alessanda Mezzadri, Professor Christopher Cramer, Dr. Giuseppe Caruso and Mr. Ben Whiston for all they have taught me during my time at the School and all the guidance they have given me.

Finally, I would like to thank three of the leading figures in the promotion of the financial systems approach to microfinance: Dr. Marguerite Robinson, Dr. Robert P. Christen of the Gates Foundation and Professor Claudio GonzalezVega of Ohio State University. I had the pleasure of studying under all three of these distinguished individuals at the 2009 ILO / Boulder Institute Microfinance Training Programme, and despite the fact that their work provided me with much of the ammunition used in this piece, their unfaltering commitment to improving access to financial services has brought positive change to the lives of many people across the developing world. It is this author’s sincere hope that their good work will continue, just as I hope that their viewpoints and those of others in the field of microfinance will continue to be subject to ongoing critical appraisal and revision. Given the right conditions, microfinance has great potential as a tool for enabling economic and social development. This is not to say, however, that microfinance can or should rely on its past achievements to justify its own existence. There is a huge amount of work to be done on improving microfinance operations in developing countries, and it is only through ideological flexibility, in addition to continuous revision of accepted practices, that microfinance institutions and donors can continue to improve the ways in which they serve the needs of the world’s poor.

To conclude, I offer the following message to the microfinance industry: It is only through dialogue and pragmatism, as opposed to stagnant ideological imperialism, that more of microfinance’s potential for relieving poverty will be realised in the future. And it is my sincere hope that the various actors in the microfinance industry will realise this soon, lest we miss what is indeed a great opportunity to have a positive impact on the lives of people who deserve a better hand than that which fate has dealt them.

In Loving Memory of Rosalie Nugent

-3-

Abstract Microfinance is lauded by many as one of the greatest innovations to appear in the field of international development in the last forty years. In the last two decades, however, a rift has appeared between those who adhere to a ‘welfarist approach’ to providing credit and other financial services to the poor, and those who follow what is increasingly referred to as the ‘financial systems approach’. This ‘financial systems approach’ has gained an almost hegemonic status as the dominant paradigm, yet it is based on a series of assumptions which, despite being based on some empirical evidence, are portrayed as universally applicable ‘truths’. This is despite the fact that there is a substantial body of evidence that indicates they may not be universally accurate. In this piece, the author will outline the history of microfinance to illustrate how theorists and practitioners have arrived at this juncture, before outlining several key tenets of the ‘financial systems approach’ which are in many ways derived from this historical experience. As the latter part of this work will show, however, the widespread belief in these guiding principles rests on a foundation comprised of several assumptions, many of which are largely unjustified if one considers the empirical evidence. The nature of these assumptions, as conceptions based on theory, rhetoric and selective use of evidence, also bears more than a passing resemblance to larger debates in development concerning neoliberal globalisation. Indeed, it may not be outside the realm of possibility that the ‘great schism’ in microfinance is but one facet of ongoing debates about the nature of global economic integration and development.

-4-

Table of Contents Chapter 1: Introduction………………………………………………………………6 Chapter 2: Literature Review………………………………………………………14 Chapter 3: A Brief History of Microfinance………………………………………..17 Chapter 4: Towards a Definition of the Financial Systems Approach………….21 Chapter 5: The Financial Systems Approach: 5 Key Assumptions…………….26 Chapter 6: How is the Financial Systems Approach Related to Neoliberal Globalisation?............................................35 Chapter 7: Conclusions…………………………………………………………….37 Bibliography………………………………………………………………………….38

-5-

Chapter 1: Introduction In the decades that have passed since the end of the Second World War and the widespread decolonisation that followed, those who work in the field of international development have experimented with numerous different strategies aimed at improving the lives of poor people in developing countries.

In the current age there is a previously unparalleled array of strategies for donors and practitioners to choose from, some of which are likely destined to be little more than passing fads. Others will achieve a longevity which, some might say, surpasses that which their measurable impacts would justify. The ever-growing field of microfinance is one strategy which has grown in prominence in recent years, yet it remains unclear whether it is entirely successful in delivering all that it promises.

What is clear, however, is that there is growing scepticism amongst donors about the logic of pouring aid money into other kinds of interventions that do not yield results, and microfinance is increasingly coming to be seen as a useful tool for fostering sustainable economic and social development.

Indeed, by 2006 the international donor community was spending between $800 million and $1 billion per year on microfinance, and it is being accorded an ever greater level of attention and public recognition. [CGAP 2006: 1] Microfinance institutions [MFIs] have appeared in almost all parts of the world, and although they appear in different forms and guises, they have largely the same objective; to alleviate poverty through providing microcredit and other financial services to poor people. The world of microfinance is not, however, -6-

the harmonious entity that some have attempted to portray, and there is a rift between two main schools of thought regarding its orientation and future.

To use the terminology used by Morduch [2000] and Woller et al.

[1999], this ‘microfinance schism’ pits the followers of the previously-popular ‘poverty-focused approach’1 against adherents to the now-dominant ‘financial systems approach’.2 In some respects, including their stated objective of poverty reduction, these two philosophical orientations are not mutually exclusive, yet they differ wildly in how they intend to achieve these objectives.

The poverty-focused approach will not be discussed in detail here, but it is sufficient to state briefly that it is concerned with directly increasing incomes at household level by providing subsidised credit and other inputs to poor people. The financial systems approach, however, purports to be able to increase incomes (and perhaps, by extension, welfare) amongst the ‘economically-active’

poor

through

the

provision

of

small-scale,

but

commercially-oriented, unsubsidised financial services.

The viability of microfinance inspired by the financial systems approach as a tool for relieving poverty is supported by a wealth of anecdotal evidence, as well as a few passable attempts at quantitative research. On the whole, however, there seems to be a heavy reliance on anecdote and rhetoric amongst its adherents, and a shortage of meaningful impact assessments.

1

This approach is also sometimes referred to as the ‘poverty lending approach’ [Robinson 2001: 2], or the ‘welfarist approach’. [Moon 2007: 3] 2 This school of thought is also sometimes referred to as the ‘minimalist approach, [Mutua 1994] or the ‘institutionalist approach’. [Woller et al. 1999: 1] In this piece, the author will use the term ‘financial systems approach’, as employed by Robinson [2001] and other leading figures involved in its formulation. A discussion of what the ‘financial systems approach’ entails can be found in Chapter 4.

-7-

And it is this reality which reveals the underlying problems with the financial services approach, as a body of theory which relies on several key assumptions about the ways financial markets function in developing countries, as well as unrealistic expectations about what can be achieved simply through the provision of financial services to the poor.3

In this piece, the author intends to demonstrate that much of the theory which constitutes the financial systems approach is faulty, based more on anecdotal evidence and selected empirical examples than on universally applicable truth. In Chapter 2, we will examine some of the literature which has led the microfinance industry to accept such a paradigm, as well as some of the works which have discussed conceptual and practical problems with it.

There is, in fact, a fairly select group of people and organisations that have been responsible for arguing in favour of a financial systems approach to microfinance, and the identity of some of these gives some insight into why they have pushed so hard to make theirs the dominant paradigm in the field.

In Chapter 3, ‘A Brief History of Microfinance’, the author will outline the historical trajectory of the microfinance industry. From its beginnings as simply microcredit offered by large-scale, state-sponsored rural development banks in the 1970s, microfinance has changed over time through experimentation with various models and techniques. The ‘discovery’ of group lending

3

It should be noted here that the financial systems approach does not claim to be able to address the needs of people who are destitute (i.e. completely economically inactive). Even Marguerite Robinson, one of the main proponents of such an approach, concedes that “Commercial microfinance is not appropriate… for extremely poor people who are badly malnourished, ill, and without skills or employment opportunities… Such people do not need debt. They need food, shelter, [and] medicines… for which government and donor subsidies are appropriate.” [Robinson 2001: 8]

-8-

techniques in the late 1970s and 1980s had a huge impact on development practitioners’ and theorists’ conceptions of the kinds of credit services that could be provided to low-income people, and in the 1990s the field advanced further with the introduction of new savings and other financial products. It was also during the 1990s, however, that the microfinance schism began to manifest itself, as the appearance of research discussed in Chapter 2 began to pave the way for the emergence of the financial systems approach. This approach is, it must be pointed out, derived from the experiences of the early microcredit programmes. Yet it was not long before the financial systems approach started to take on a life of its own, as a holistic ‘grand theory of microfinance’ which purported to hold the answers to how developmentallybeneficial financial services could be offered sustainably.

Chapter 4 seeks to unbundle the key principles of this paradigm, and although it is not an exhaustive list by any means, the author has identified four ideas which constitute the strategic backbone of the financial systems approach. Firstly, microfinance institutions must be able to offer a range of products to clients; microcredit alone is not sufficient. Secondly, these products must be offered to people who do not already have access to formal financial services. Third, these financial services must be offered on a potentially profit-generating, self-sustainable basis. And finally, the financial systems approach promises that if the three aforementioned goals are achieved, this will have a positive developmental impact on households.

These guiding principles seem simple enough in theory, but as will be illustrated in the following chapter they are anything but simple in practice.

-9-

In Chapter 5, the author identifies five key assumptions which underpin the faith placed by donors and others in the principles of financial systemsinspired microfinance. Taking these principles as sturdy guidelines assumes that these assumptions always hold true, yet the author will demonstrate using empirical evidence from different contexts across the developing world that in many cases they are not universally applicable. Does offering a range of formal financial products to clients increase their incomes more than informal alternatives? There is a growing strand of literature which illustrates the pervasiveness of informal financial services, as well as questioning whether or not they are actually as inefficient as proponents of the financial systems approach would care to admit. Is there demand for formal financial services amongst people who do not already have access? Despite frequently-cited vague estimates of the market for credit and savings services amongst low-income people which point to huge unmet demand, new estimates of the demand for microcredit in particular have cast doubt on previous assumptions about the potential size of the market. Advocates of the financial services approach look down with disdain on government-subsidised credit and savings services, frequently pointing out how historical examples of these were corrupt and did little to help the poor. Yet is commercially-oriented, self-sustainable microfinance inherently better for clients than governmentsubsidised alternatives? Indeed, is it even possible for microfinance institutions to achieve the kind of cost-covering self-sustainability valued so highly by the financial systems approach? The author intends to present empirical examples to illustrate that the answer to both of these questions is,

- 10 -

in fact, negative; there are examples of state-subsidised credit institutions which have had positive impacts on borrowers, and self-sustainability of the kind described by Robinson [2001] and others remains little more than a theoretical objective for most microfinance institutions, if indeed it is even something that they wish to achieve at all. The final key assumption that will be addressed in Chapter 5 concerns the means with which the financial systems approach purports to demonstrate its impacts. Those who follow such an approach put forward that impact can be measured at the level of the microfinance institutions themselves, which is to say that it is their view that if an institution is covering its own costs, repayment rates are sufficiently high, and a sufficient percentage of clients are sufficiently poor, the institution in question must be having an impact. This belief that impact can be measured at the level of the institution rather than the client, however, ignores the fundamental problem of the fungibility of capital. Just because a borrower is poor and manages to repay a microloan does not mean that their circumstances have improved, and the author will demonstrate how this is often not the case; microfinance clients borrow money from one another to repay loans, and those who may appear to be in control of their own finances (either within a lending group or within a household) are often not so. So how is it that such a dominant, even hegemonic paradigm has taken such a firm hold on the microfinance industry when it is based on so many potentially unsound principles?

In Chapter 6, the author will attempt to answer this question by relating the debate about approaches in microfinance to larger debates about the

- 11 -

prevailing neoliberal globalised system. This is not intended to be a critique of neoliberalism, but it is worthwhile to explore the striking similarities between the financial systems approach and neoliberal ideologies. The language they use is similar; both describe their hegemony as justified by ‘consensus’ when in fact even a quick perusal of the relevant literature will reveal that in both cases this ‘consensus’ is anything but. There are also deeper linkages between the two bodies of theory, however, and there is a growing body of academic work which conceptualises microfinance as simply another part of the global neoliberal project.

To summarise, this work is intended to cast some doubt on some of the key principles and assumptions on which the financial systems approach is based. It is not the author’s objective to present a comprehensive rebuttal of the theory; in fact it is his belief that to do so would be impossible since the theory is based on past experiences in specific contexts. It is, however, the author’s intention to, in words borrowed from Dichter [2007: 2], “deflate the least warranted of the growing number of over-inflated expectations” regarding what microfinance is capable of achieving under a policy regime based on the financial systems approach. Microfinance as a broad field does have considerable potential to help many low-income people get access to financial services, which in turn has the potential to help many of those people improve their lives. There must be, however, some ideological flexibility and consideration of context if this potential is to be realised and the mistakes of previous

‘cookie-cutter’

programmes,

are

to

interventions, be

avoided.

such The

- 12 -

as

financial

structural systems

adjustment approach,

unfortunately, is as inflexible as the neoliberal ideology that inspired faith in structural adjustment, and when so much evidence exists which runs contrary to its underlying assumptions, it is difficult to see how it will be successful on a global scale in the way that its proponents like to suggest.

- 13 -

Chapter 2: Literature Review In this chapter, the author will briefly review the various streams of literature that pertain to our critical appraisal of the financial systems approach to microfinance. These will be divided into a conceptual dichotomy: on one side, those who have worked to propagate the financial systems approach, and on the other side critical viewpoints on the approach, and criticism of microfinance in general.

It is significant to note at this point that despite the fact that the theories which constitute the financial systems approach began to emerge in the late 1980s, it was not until the late 1990s that commentators began to remark on the split between the financial services and welfarist approaches. The first two pieces which pointed at the widening gap between the two perspectives were Woller et al.’s Where to Microfinance? [1999], which presented an argument similar (though not identical) in its reasoning to that which is presented in this dissertation, and Morduch’s The Microfinance Schism [2000], which conceptualised of a ‘schism’ between “rhetoric and action – and between financially-minded and socially-minded programs…” [p. 618]. These two papers also mark some of the earliest attempts to draw attention to the fallibility of some of the key principles of what would later come to be referred to as the financial systems approach.

With regards to the approach itself, there is a small group of individuals and organisations which have been largely responsible for conducting - 14 -

research and formulating the theories that have come to form the school of thought we now recognise. Research conducted in the 1980s and 1990s at the Ohio State University by Gonzalez-Vega [1993,1994] on state-subsidised rural finance initiatives began to illustrate how some of them had been inefficient, and also how the high transaction costs associated with serving poor rural clients could be mitigated by a more commercially-oriented institutional mindset. Other works by Christen et al.[1994] and Otero & Rhyne [1994] began to lay the groundwork for what would become the financial systems approach. Each of these writers also instilled their belief in such an approach into the organisations that employed them; Christen took his viewpoint to the Gates Foundation when he became the head of their inclusive finance programme, further research from Ohio State’s Rural Finance Program continued in the same vein under Claudio Gonzalez-Vega, and Maria Otero and Elisabeth Rhyne became the figureheads for the financial systems approach pursued by their organisations (ACCION International and USAID, respectively). Two other key texts which illustrate the financial services approach are CGAP’s Good Practice Guidelines for Funders of Microfinance [2006] and Marguerite Robinson’s seminal work The Microfinance Revolution [2001]. One need only cast a glance at the glowing praise for Robinson’s work that appears just inside the front cover to understand the full extent of the ideological homogeneity of this group; it contains quotations from Rhyne, Otero and Christen, who calls The Microfinance Revolution “a major work that will unquestionably lie at the very centre of microfinance literature for years to come”. [Robinson 2001] Also accounted for amongst those who heap praise on Robinson’s work, which is

- 15 -

itself almost a ‘Bible’ of financial systems approach-inspired microfinance, is Jacob Yaron, another key contributor to the literature advocating for the financial systems approach.

On the other side of the coin, however, are those both inside and outside the field of microfinance who have expressed concern over the commercialisation of development finance, and microfinance in particular.

Fernando [2006] and Dichter & Harper [2007] are both edited volumes of essays which in many cases are critical of overly doctrinal approaches to microfinance, and in some cases discount the potential of microfinance as a developmental tool altogether. Other critical works include Buckley [1997] and forthcoming works from Roodman [2009, forthcoming] and Bateman & Chang [2009]. These are critical of microfinance in general, with Bateman & Chang putting forward an argument which suggests that microfinance in its current form is actually bad for clients.

- 16 -

Chapter 3: A Brief History of Microfinance The roots of microfinance, as previously mentioned, can be traced back to government-sponsored rural credit programmes initiated in the years following World War 2. In keeping with the dominant development paradigms of the time, these were largely aimed at fostering macro-level economic growth by providing credit to rural people (who often also happened to be poor) which, it was assumed, they could use to purchase seeds, fertilizers and other agricultural inputs. These were often heavily subsidised, with interest rates usually not only below commercial rates but often below inflation. In the Philippines, for example, interest rates were capped at 16% p.a. until 1981, despite the fact that average annual inflation hovered around 20%. In India, the rural credit programme was targeted towards ‘disadvantaged’ groups in society, such as women and ‘unfavourable’ castes, and was also subsidised.

[Armendariz de Aghion & Morduch 2005: 8,9]

The inefficiencies of some aspects of these programmes began to be exposed by the Ohio State University research programme, however, and many of these programmes were abandoned. At the time (and today, in fact) people wrote that these rural development programmes were loss-generating, had low repayment rates, depressed local savings and channelled funds towards richer and/or politically powerful segments of the population, amongst other criticisms. [Robinson 2001: 7] Larger shifts in development theory towards poverty alleviation in the 1970s began to set the stage for the emergence of what we could now call microfinance [Dichter 1996: 261], and

- 17 -

the first microfinance institutions began to emerge in the late 1970s in Bangladesh. These were spearheaded, of course, by Muhammad Yunus and his Grameen Bank, which grew exponentially after he demonstrated that his group lending model encouraged higher repayment rates from poor female borrowers than many had thought was possible.

In the 1990s, the transition began from microcredit to microfinance, as NGOs and others began to see the benefits of offering a selection of different financial products to clients, and the early contributions to the development of the financial systems approach began to appear. NGOs began to give in to donors’ demands for sustainability, and as a few showed results many more began trying to enter the growing microfinance sector. [Dichter 1996: 263] As the decade progressed, more and more microfinancial service providers started entering the market, although on the theoretical side a debate was raging between those who favoured greater outreach and those who emphasised self-sustainability. [Dichter 2007: 4] It is in this debate that the current microfinance schism began to emerge, although with the creation of the Consultative Group to Assist the Poor (CGAP) at the World Bank in 1995 those on the sustainability side began to take control. CGAP has become the world’s leading support organisation for microfinance, and its ideological roots are very much on the sustainability side of the microfinance debate which started in the mid-1990s.

By the 2000s, microfinance was becoming a mainstream idea, with Grameen Bank founder Yunus as its figurehead. Politicians and celebrities

- 18 -

around the world began to speak out about the promise of microfinance, and in the language of the financial services approach it was a wonderful promise indeed. There was no more need for expensive aid programmes which cost millions (or billions) and sometimes showed little results, since now it was possible to give a loan of only $150 dollars to a Bangladeshi textile worker and she would be able to use it to increase her household income dramatically, providing a better life for her and for her family. The hype surrounding microfinance came to a head in the middle of the decade, with the United Nations declaring 2005 the ‘International Year of Microcredit’, and the Nobel committee awarding the 2006 Nobel Peace Prize jointly to Dr. Yunus and the Grameen Bank. By 2006, the emerging microfinance industry boasted an impressive annual growth rate of 37%, and had reached in excess of 67 million clients worldwide. [Fernando 2006: 1]

Throughout this period, many people in development circles (and many more lay people) waxed lyrical about the promise of this new means for achieving truly ‘sustainable’ development. And if anecdotal evidence was correct, there was a market of between a billion and 3.5 billion people [CGAP 2003][Fernando 2006: 17] waiting to receive the financial services that would lift them out of poverty, at little or no cost to donors since repayment rates were always exceptionally high and all microfinance institutions were able to cover their own costs. The Grameen Bank, joined now by Indonesia’s BRI and Mexico’s Compartamos, amongst others, provided illustrations of the interest rate-insensitive demand for credit and other microfinancial products, maintaining high repayment rates whilst charging interest rates high enough

- 19 -

to cover their very high costs. And whilst it may have been true that these banks were able to present themselves as subsidy-free through clever accounting practices (in the case of Grameen Bank, which claims to have turned a profit in every year of its existence despite ongoing reliance on grants, which it lists as income) or selective forgetfulness (in the cases of BRI and Compartamos, which benefitted from significant political support and start-up subsidies, respectively), the reality was that the schism which Morduch [2000] described, between rhetoric and action, was now firmly established.

More

and

more

donors

and

MFIs

were

championing

microfinance, the new, improved, and sustainable poverty-alleviation tool that promised so much. Yet in reality, as the three examples above illustrate, many of these organisations themselves were unable to live up to their own hype when subjected to scrutiny.

- 20 -

Chapter 4: Towards a Definition of the Financial Systems Approach

In this Chapter, the author will deconstruct the financial systems approach into several key principles. Until now, the approach has been described in vague terms, as it often is in the literature, where it becomes a holistic conceptualisation which means different things depending on which aspect of it is relevant to the author. It is possible, however, to unbundle the various aspects of this approach to microfinance into 4 key components which will be briefly outlined here.

The financial systems approach to microfinance involves, in general terms:

Offering a range of products, not just credit‌

As specified in CGAP [2006] and Robinson [2001], creating financial systems involves offering savings, insurance and other products, alongside more traditional microcredit. It is also estimated that there is demand for such products, with theorists using examples from developing country contexts where people make use of sometimes less efficient informal financial services. As the rhetoric goes, savings, insurance and loans combined help poor people ‘smooth’ consumption and mitigate risks, leading to improved incomes and greater welfare. [Robinson 2001: 9]

- 21 -

Offering these products to people currently unserved by formal financial systems‌

Estimates abound regarding the number of people who do not have access to formal financial services, and with the exception of those who live in absolute poverty it is assumed that most of these people would take advantage of formal financial services if they were available. The typical indictment of informal financial services provided by advocates of the financial systems approach points to the insecurity of saving at home, due to theft or environmental conditions which cause the physical cash to deteriorate, and cites the high interest rates charged by informal lenders as evidence of why people would want to make use of formal microfinancial services. Armendariz de Aghion & Morduch [2005] provide a review of some findings gathered by previous studies of moneylenders’ interest rates, and the results are indeed shocking. In Thailand, one study showed that typical annualized interest rates of 60%, whilst another study of informal lenders in Pakistan recorded some annualized interest rates as high as 120%. [Armendariz de Aghion & Morduch 2005: 28] These numbers are high indeed, yet when placed in some context (as they will be in the following Chapter) they do not necessarily mean what advocates of the financial services approach would attempt to indicate.

- 22 -

Offering these products in a commercially-orientated, institutionally selfsustainable manner‌

As mentioned in the previous Chapter, the roots of the financial systems approach lie in the sustainability versus outreach debate that divided microfinance in the 1990s. At that time it was believed that in order to serve poor clients, microfinance institutions would have to rely on subsidies since the transaction costs associated with providing services to poor (especially rural) people would make cost recovery impossible. Clients would surely be unwilling to pay the exorbitant interest rates that institutions would have to charge them, and there would be no demand. Yet examples from recent history illustrate that demand for microcredit especially may not be as sensitive to interest rates as was previously imagined. Compartamos, for example, is widely known to charge poor borrowers annualized interest rates in excess of 100% with no decline in aggregate demand. In fact, their alreadysizeable client base continues to grow. [Armendariz de Agion & Morduch 2005: 17] Indeed, neoclassical economics tells us that poor people should be able to achieve a marginal return on loan capital that is significantly higher than what we could hope to achieve in developed countries, so why should they be concerned about higher interest rates? Robinson [2001] and other proponents of the financial systems approach hypothesise that it is only through charging high interest rates to cover costs that microfinance institutions can increase their outreach, since to rely on subsidy is to rely on what they perceive is an inherently limited and unstable revenue stream. As she writes in The Microfinance Revolution [2001], â€œâ€ŚGovernment and donor

- 23 -

funds cannot possibly finance microcredit on a global scale‌� [Robinson 2001: 8]

If the above conditions are met, this will have a positive developmental impact‌

The rhetoric of the financial systems approach evokes images of market sellers and other microentrepreneurs who are able to increase their household income (and by extension, welfare) through the use of credit and/or savings to purchase income-generating assets. This, it is often said, has further knock-on effects on families and communities, particularly when the borrowers/savers are women, as they often are.

Yet it is on this last point that the financial systems approach begins to unravel. Theorists take these benefits for granted, but there is little or no attempt made to measure them. This lack of impact assessment can be partially attributed to the difficulties in measuring and attributing the impact of microfinance4, yet it is also a fundamental aspect of the financial systems approach. This approach assumes that if a microfinance institution covers costs, solicits sufficient repayment from borrowers and mobilises sufficient savings, and that at least some of the borrowers are poor, there is no need to demonstrate impacts because financial service provision is the endgame and there are no donors who require justification for ongoing subsidy. It is 4

For more on issues related to impact assessment in microfinance, see Hulme, D. [2000] Impact Assessment Methodologies for Microfinance: Theory, Experience and Better Practice. World Development, Vol. 28, No. 1, pp.79-98.

- 24 -

precisely this kind of assumption, however, which is based on the faulty logic that characterises the financial systems approach. The following Chapter will outline 5 key assumptions on which the financial systems approach is based, and illustrate with empirical evidence how they cannot be held as universal truths.

- 25 -

Chapter 5: The Financial Systems Approach: 4 Key Assumptions As Roodman [2009, forthcoming] points out, the majority of popular tales about microfinance begin with a story. And so the author would like to share an anecdote from his own experience in the world of microfinance. In July 2009, at the annual gathering of development and microfinance practitioners hosted each summer by the Boulder Institute of Microfinance, in conjunction with the ILO in Turin, Italy, Robert Christen of the Gates Foundation answered a question from an audience member after one of his lectures. The attendee, a man from West Africa, asked Dr. Christen how he could be so certain that simply providing financial services to the poor would result in an increase in their income. Dr. Christen had just finished giving a talk about the pecuniary advantages of keeping savings with an MFI instead of in the home or with an informal savings collector of the type popular in West Africa, and he responded by asking the audience whether they thought their lives would be easier or harder if they did not themselves have access to electronic banking and other modern financial conveniences. Most of the people in the audience agreed with his inference that their lives would be more difficult if they did not have ATM cards or chequebooks, yet there were more than a few participants who expressed concern afterwards that Dr. Christen had been able to answer such a complex question with such a simple answer. In fact, their suspicion was justified, since it wasn’t really an answer at all. The financial lives of people in developed countries and wealthier people in developing countries are structured in such a way that they are accustomed to having these conveniences, for to do without them would put such people at a - 26 -

disadvantage since they would be unable to interact fully with their economic environments. For people living below the poverty line in the majority of developing countries, however, items such as cheque books and ATM cards are of little or no use. What good is an ATM card, or a card reader for that matter, to a market seller in Accra? Her clients do not have these, and it is unlikely that her suppliers are accustomed to using them either. And to simply say that because ‘it works for us here’ that it will necessarily reduce transaction costs and improve incomes in a completely different economic context is an assumption that cannot be made. Assumptions of this kind will be addressed in this Chapter, as we identify and analyse five key assumptions implicit in the financial systems approach that do not hold up to consideration in the light of empirical evidence:

Key Assumption #1: Offering formal financial services to poor people in developing countries will necessarily increase incomes and provide a better level of service than previously existing informal alternatives‌

To start, this assumption is based on studies like those mentioned above which detail the high costs charged to borrowers by informal lenders, as well as a belief in the inherent insecurity of informal financial services. Evidence shows, however, that neither of these is necessarily true. As far as informal moneylenders are concerned, the comparison of annualised interest rates charged in the informal sector with those charged in the formal sector is invalid, simply because the term of most informal loans is significantly shorter than a year, and is sometimes as short as a few days. Informal moneylenders

- 27 -

face high transaction costs just as microfinance institutions do, and the necessity of charging higher interest rates can be very real if loan amounts are low and terms are short, as they often are. Studies also indicate that the cost of attending group meetings (a condition imposed on borrowers under group lending models like that employed by the Grameen Bank) can be very high, both in terms of time and opportunity cost, as well as transport costs in some contexts. [Armendariz de Aghion & Morduch 2005: 30, 100] Data from a new series of studies by Collins et al. [2009] also indicate that, at least in the context of Bangladesh, the form of credit (formal or informal) most commonly used by the poor was informal loans from family or friends, which usually came at no added cost whatsoever to the borrower since they were interestfree. [Collins et al. 2009: 9,46] Evidence from India shows us that people continue even continue to use informal credit services in environments where microfinance institutions are present, because informal moneylenders provide more personalised, flexible loan products for various uses (weddings, for example) which microfinance institutions are unwilling to finance. [Moseley 1996: 267]

Informal savings services, derided by those who adhere to the financial systems approach as unreliable and open to fraud, may also provide services that are more conveniently situated closer to clients than microfinance institutions. This lowers transaction costs for savers. [Rutherford 2005: 18-20] These savings services often do not pay interest, but their greater flexibility when compared to the often rigid savings products offered by microfinance institutions makes them an attractive option for poor people who want to save.

- 28 -

The assumption that formal savings services are ‘safer’ than informal services is also questionable, since there is still a risk of fraud in the formal financial sector and, as Biety [2005] admits, errors by MFI staff are ‘inevitable’. [Biety 2005: 241] This may be due in part to the fact that MFIs are forced to hire staff with low levels of education to keep costs down, since offering savings products to low-income people is an expensive business. [Hirschland 2005: 153] There are further risks to savers who engage with formal microsavings schemes as well. In high-inflationary environments, which are all too common in developing countries, people with monetarised savings will actually see the value of their savings decrease with time, something which could be avoided if they kept their savings in kind. [McKee 2005: 37] There is also always the risk of default on the part of the MFI, a risk which is all too real in contexts where MFIs employ fractional-reserve banking methodologies in order to keep costs down and meet the lofty target of self-sustainability prescribed by the financial systems approach. [Biety 2005b: 277]

As far as microinsurance is concerned, the assumption that such financial stability cannot be offered by the informal financial system is patently untrue. The previously-cited study by Collins et al. [2009] discovered a unique funeral insurance system at work in South Africa which functions on a principle of informal reciprocity. Members of an ‘insurance group’ do not meet regularly or pay any premiums, in fact the transaction cost to members is zero except when another member dies and they contribute their share towards the funeral expenses. [Collins et al. 2009: 77]

- 29 -

As these examples have demonstrated, there is no shortage of efficient, low-cost informal financial services available to poor people in developing countries. And whilst that does not necessarily prove that an MFI could not offer a better service, there is no reason to believe that that must be the case simply because they offer a service which forms part of a more formal financial system.

Key Assumption #2: There is demand for formal financial services amongst people who do not already have access to them…

In some contexts this may be true, but a universally-applicable fact it is not. As far as savings is concerned, the prohibitive transaction and administrative costs to MFIs of offering the kind of flexible, ‘demand deposit’ savings products to savers with low balances may prevent them from offering these products, [Hirschland 2005: 139] meaning that there will always be demand for informal savings collectors such as the Susu of West Africa or their equivalent in other parts of the developing world. In Ghana, for instance, Susu collectors provide a level of service (albeit with higher costs to savers) that no microfinance institution could ever hope to achieve; the collector visits the saver on a daily basis at their home or workplace, and can provide a payout from their savings at a day’s notice. Few microfinance institutions can even offer such a quick return of deposits, and almost none (if any) would be capable of visiting clients on a daily basis to collect sums sometimes no greater than a few pence.

- 30 -

In terms of microcredit, the belief that poor people can afford to pay more interest on a loan because their marginal return on capital is greater than people in developed countries may be true, but it is not necessarily so.

This assumption is based, as previously mentioned, on a belief that demand for microcredit is insensitive to interest rates because of the higher marginal return on capital to be found in developing countries. Estimates of increased marginal return in developing countries fall into a neoclassical economics trap, however, of assuming that all other factors remain the same, and they do not take into account the fact that poor people in developing countries to not have the same levels of education, health or the access to business networks that are enjoyed by even non-wealthy people in developed countries. If lowincome people’s capacity for converting loan capital into income-generating assets is not necessarily any higher than those of wealthier individuals in developed countries, why is it acceptable to charge them interest rates which would be considered usurious in Europe or North America? The answer, once again, is that the financial services approach places such a great emphasis on self-sustainability through cost recovery from borrowers that MFIs cannot charge any less and still recover the high transaction and administrative costs associated with providing the kinds of microloans that poor people can feasibly service with their own earnings. And this realisation should lead us to question another, even more fundamental assumption on which the financial services approach to microfinance is based.

- 31 -

Key Assumption #3: Revenue-generating MFIs are capable of offering financial services on a self-sustainable basis‌

If we have established that high interest rates are not necessarily justified by greater marginal return on capital, the proposition that microfinance institutions can sustain themselves through their own revenuegenerating activities must also be called into question. It is certainly true that there are some examples of MFIs that achieve sustainability, most notably BRI in Indonesia and Compartamos in Mexico, yet as mentioned earlier both of these institutions have made use of subsidies at one time or another.

Compartamos received significant financial subsidies when it commenced operations, and BRI, often held up as one of the guiding lights of the financial services approach by writers such as Robinson [2001](who played a significant role in guiding the Indonesian government during BRI’s reorientation into a commercial MFI) received significant political capital in the form of guidance and support from the Indonesian government.

On the whole, subsidy remains the reality for the vast majority of MFIs around the world, and it has been a long-held belief amongst those within the world of microfinance that in fact it is unlikely that more than 5% of microfinance programmes will ever be financially sustainable. [Morduch 2000: 618] In the meantime, most MFIs pursuing a financial systems approach aim for operational self-sustainability rather than financial self-sustainability, meaning that they won’t finish a fiscal year with a loss on the books, but are only able to achieve this through listing grants and interest-free loans (which

- 32 -

are effectively forms of subsidy) as revenue. They do not generate enough income from their financial intermediation activities to cover their own costs, and despite the insistence of people like Robert Christen, who in another of his

lectures

in

Italy

effectively

used

both

forms

of

sustainability

interchangeably, there are many in the microfinance industry who do not feel that operational self-sustainability is an accurate measure of sustainability.

[Nathan Lawless, Interview by Author: July 2009]

There is also an assumption amongst those who support the financial services approach to microfinance that subsidised credit programmes are inherently worse than self-sustainable ones, and there is some historical evidence to say that this has often been the case. There is also evidence to suggest, however, that their dismissal of government-subsidised credit may not be fair. Indeed, to present one basic example, research published in 2002 showed that Indian state-subsidised rural credit has had a net positive average impact on the poor. [Armendariz de Aghion & Morduch 2005: 11]

Key Assumption #4: Developmental impact can be proven by measuring financial performance and client outreach at the institutional level‌

Another point touched on earlier in Chapter 4 concerns the means by which MFIs pursuing a financial systems approach prove their impact. They believe that it is sufficient to measure repayments rates and indicators of outreach (such as percentage of clients who have a household income below national poverty lines) to establish that their operations have had a developmentally

- 33 -

positive impact. Yet this is a fallacy, and on closer examination it becomes almost ridiculous to suggest that simply because a poor person took out a loan and was able to pay it back that their income has increased. This completely ignores evidence from numerous sources which indicate that institutional success is not an indicator of poverty reduction, that high repayment rates amongst women does not mean that they have any more control over their financial resources, and that loan repayment in contexts where credit bureaus are absent doesn’t mean that the borrower hasn’t just taken another microloan or informal loan from somewhere else to pay the MFI back. [Fernando 2006: 1][Weber 2006: 53][Collins et al. 2009: 166]

These assumptions, when untested, provide an engaging basis for the principles of the financial services approach as outlined in Chapter 4. Yet on closer examination many of them are as fundamentally flawed as they are fundamentally important in enabling acceptance of the key tenets of the financial systems approach. Why, then, do they persist?

- 34 -

Chapter 6: How Is the Financial Systems Approach Related to Globalisation?

The question asked at the end of Chapter 5 is difficult to answer, but in this Chapter the author will briefly relate some of the larger debates about neoliberal globalisation to the discussions we have had here about the financial services approach to microfinance.

On a visceral level, the two schools of thought bear more than a passing resemblance to each other. Both speak of ‘consensus’, in the case of microfinance through CGAP’s Consensus Guidelines and in the case of neoliberalism through the infamous ‘Washington Consensus’. Both attempt to portray themselves as universally applicable paradigms that need no careful analysis because they are common sense, and both have attained an almost hegemonic status in their respective arenas. The financial systems approach is the dominant paradigm in the international microfinance industry, just as neoliberalism is the dominant paradigm in the world political and economic system.

Yet on a deeper level is it not possible, as Bateman & Chang [2009] have theorised, that the reason why the financial services approach to microfinance and neoliberal globalisation seem to fit so well together is that they are in fact part of the same phenomenon? It is outside the scope of this piece to fully investigate this, but there is a growing body of critical literature on microfinance which conceptualises of financial systems approach-based microfinance (and microcredit in particular) as just another vehicle for

- 35 -

neoliberalism, opening up the local economies of the developing world to international economic forces that they may be unable to control.

- 36 -

Chapter 7: Conclusions As stated in Chapter 1, the purpose of this piece was not to launch a comprehensive rebuttal of the financial services approach to microfinance.

That would be prohibitively difficult, and certainly outside the scope of a work such as this. What the author has demonstrated, however, is that by decompiling the various elements of the financial systems approach, we can see clearly the assumptions that underlie its crude reliance on anecdote and rhetoric. The approach is based on past experience, that is true. And as such there are lessons which can be derived from it that can give insight into how to improve the financial services offered to poor people in the future.

There are certainly assumptions made by the financial systems approach that do not hold up to scrutiny, however. Interest-insensitive demand, the fetishisation of unachievable financial self-sustainability, and the belief that informal or subsidised credit or other financial services are inherently worse than those that can be offered to clients by MFIs have been exposed as flawed assumptions at best.

The appeal of microfinance is likely to continue, however, but the agenda for the future must focus on mitigating some of the theoretical excesses of the financial systems approach up to this point. We must also begin learning from informal and other forms of financial intermediation, some of which may hold clues as to how those who work in microfinance can better serve the needs of the poor in the future.

- 37 -

Bibliography Adams, D. & von Pischke, J.D. [1992] Microenterprise Credit Programs: Deja Vu. World Development, 20 (10), pp. 1463-1470.

Armendariz de Agion, B. & Morduch, J. [2005] The Economics of Microfinance. London: MIT. Bateman, M. & Chang, H.-J. [2009] The Microfinance Illusion. Unpublished.

Available: www.econ.cam.ac.uk/faculty/chang/pubs/microfinance.pdf.

Biety, M. [2005] Maintaining the security of client funds. In: Hirschland, M. (ed.) [2005] Savings Services for the Poor. Bloomfield, CT: Kumerian.

Biety, M. [2005b] Liquidity management. In: Hirschland, M. (ed.) [2005] Savings Services for the Poor. Bloomfield, CT: Kumerian.

Buckley, G. [1997] Microfinance in Africa: Is it either the problem or the solution?. World Development, 25 (7), pp. 1081-1093.

CGAP [2003] Donor Brief No. 11: Microfinance means financial services for the poor. Washington: CGAP, World Bank.

CGAP [2006] Good Practice Guidelines for Funders of Microfinance, 2nd Ed. Washington: CGAP, World Bank.

Christen, R. et al. [1994] Maximising the outreach of microenterprise finance.

Washington: IMCC Collins, D. et al. [2009] Portfolios of the Poor. Oxford: Princeton University Press.

Dichter, T. [1996] Questioning the Future of NGOs in Microfinance. Journal of International Development, 8 (2), pp. 259-269.

Dichter, T. [2007] Introduction. In: Dichter, T. & Harper, M. (eds.) [2007] What’s Wrong With Microfinance?. London: Practical Action Publishing.

Dichter, T. & Harper, M. (eds.) [2007] What’s Wrong With Microfinance?.

London: Practical Action Publishing.

Fernando, J. [2006] Introduction. Microcredit and Empowerment of Women: Blurring the boundary between development and capitalism. In: Fernando, J. (ed.) [2006] Microfinance: Perils and Prospects. London: Routledge.

Fernando, J. (ed.) [2006] Microfinance: Perils and Prospects. London: Routledge.

- 38 -

Harper, M. [2007] What’s wrong with groups?. In: Dichter, T. & Harper, M. (eds.) [2007] What’s Wrong With Microfinance?. London: Practical Action Publishing.

Hirschland, M. (ed.) [2005] Savings Services for the Poor. Bloomfield, CT: Kumerian.

Hirschland, M. [2005] Savings Products. In: Hirschland, M. (ed.) [2005] Savings Services for the Poor. Bloomfield, CT: Kumerian.

Hulme, D. & Mosley, P. (eds.)[1996] Finance Against Poverty Vol. 2. London: Routledge.

Hulme, D. [2007] Is microdebt good for poor people?. In: Dichter, T. & Harper, M. (eds.) [2007] What’s Wrong With Microfinance?. London: Practical Action Publishing.

Karim, L. [2008] Demystifying Micro-Credit: The Grameen Bank, NGOs, and Neoliberalism in Bangladesh. Cultural Dynamics, 20 (5), pp. 5-29.

Matin, I. et al. [2002] Finance for the poor: From microcredit to microfinancial services. Journal of International Development, 14, pp. 273-294.

Matthaus-Maier, I. & von Pischke, J.D. (eds.)[2009] New Partnerships for Innovation in Microfinance. Frankfurt: KfW. McKee, K. [2005] Prerequisites for Intermediating Savings. In: Hirschland, M. (ed.) [2005] Savings Services for the Poor. Bloomfield, CT: Kumerian.

Moon, B. [2007] The Great Divide in Microfinance: Political Economy in Microcosm. [Unpublished draft.] Available: http://www.lehigh.edu/~bm05/research/The%20Great%20Divide%20in%20Mi crofinance%20-%20B.%20Moon.pdf Morduch, J. [2000] The Microfinance Schism. World Development, 28 (8), pp.617-629.

Mosley, P. [1996] India: The Regional Rural Banks. In: Hulme, D. & Mosley, P. (eds.)[1996] Finance Against Poverty Vol. 2. London: Routledge.

Mutua, A. [1994] The Juhudi Credit Scheme: From a traditional integrated method to a Financial Systems Approach. In: Otero, M. & Rhyne, E. (eds.)[1994] The New World of Microenterprise Finance. London: IT Publications.

Otero, M. & Rhyne, E. (eds.)[1994] The New World of Microenterprise Finance. London: IT Publications.

- 39 -

Richardson, D. & Hirschland, M. [2005] The Keys to Cost Recovery. In: Hirschland, M. (ed.) [2005] Savings Services for the Poor. Bloomfield, CT: Kumerian.

Robinson, M. [2001] The Microfinance Revolution: Sustainable Finance for the Poor. Washington: World Bank.

Roodman, D. [2009] Introduction [Unpublished draft] Available: http://blogs.cgdev.org/open_book/category/about-the-bookoutline/1introduction Rutherford, S. [2005] Why do the poor need savings services?. In: Hirschland, M. (ed.) [2005] Savings Services for the Poor. Bloomfield, CT: Kumerian.

Von Pischke, J.D. [2009] New Partnerships for Sustainability and Outreach.

In: Matthaus-Maier, I. & von Pischke, J.D. (eds.)[2009] New Partnerships for Innovation in Microfinance. Frankfurt: KfW. Weber, H. [2006] The global political economy of microfinance and poverty reduction: Locating local ‘livelihoods’ in political analysis. In: Fernando, J. (ed.) [2006] Microfinance: Perils and Prospects. London: Routledge.

Woller, G. et al. [1999] Where to microfinance?. International Journal of Economic Development. Available: http://www.gdrc.org/icm/where-to-mf.html

Interview Nathan Lawless – Capital Advisory Associate, Unitus Inc., Seattle WA. Conducted by the author in July 2009, Turin, Italy.

- 40 -