By David Mehdi Hamam and Oliver Schwank

The honeymoon with microfinance is over. Since the idea of lending small sums of money to poor people was pioneered by Grameen Bank in Bangladesh, the approach has been taken up by many non-governmental organizations, donor agencies and the United Nations as an essential part of their poverty-reduction efforts. Microfinance has provided countless people with access to financial services.

But over-indebtedness of microfinance clients in Andhra Pradesh has recently led to numerous suicides and a political crisis in India’s fifth-largest state. And controversy has swirled in Bangladesh around Mohamed Yunus, Nobel laureate and founder of the Grameen Bank. Together, these events have generated a backlash for microfinance.

Should development practitioners now abandon efforts to bring financial services to the poor? Or should they seize on the interest generated by the recent troubles to reassess the strengths, weaknesses and potential of microfinance? Such a reassessment may be pertinent in Africa, where poor people’s access to formal financial institutions remains limited.

Incomes in poor households are typically low and irregular. Poor people need to smooth consumption flows or finance larger expenditures, but they generally lack access to banks and other formal facilities. Traditional financial institutions shy away from this market because they are unaware of it or because they deem it unprofitable.

Poor households and individuals have difficulty proving their creditworthiness because they lack clearly defined property titles and other acceptable collateral. They seek loans from informal moneylenders or draw on savings, options that are costly and risky.

The Grameen Bank, founded by Mr. Yunus in 1976, lent small amounts of money to villagers organized in voluntary groups. The critical innovation that allowed it to overcome the lack of collateral and grow rapidly was the “joint-liability condition.” Group members committed to support any member struggling to repay a loan, to avoid all members losing access to future loans. Built on the close social bonds within communities, the scheme sets incentives for those involved to admit new members carefully and to monitor and support each other, relying on peer pressure to ensure timely repayment.

Since then Mr. Yunus’s idea has spread all over the world, covering a much broader range of financial services for the poor. Microfinance — rather than just microcredit — includes savings and even insurance services for poor households. By 2007 more than 150 million clients worldwide had used the services of microcredit institutions. More than 100 million of them were among the poorest in their societies.

Despite microfinance’s global reach, the majority of its clients remain in Asia. In Africa the sector is growing quickly, but from a comparatively small base. At the end of 2008, microfinance institutions in sub-Saharan Africa reached 16.5 million depositors and 6.5 million borrowers.

With rapid growth comes closer scrutiny. Yet it has proven difficult to measure the actual impact on poverty. Proponents often rely on case studies and anecdotes. This has prompted leading scholars to conclude that “strikingly, 30 years into the microfinance movement we have little solid evidence that it improves the lives of clients in measurable ways.”1

Recent and well-publicized cases of over-indebted households and interest rates approaching those charged by loan sharks have contributed to a more critical view of microfinance — and of microcredit in particular.
There is also a more fundamental critique. Some argue that channelling scarce resources into unproductive micro-enterprises in the informal sector may actually be detrimental to sustainable development and industrialization. This is because tiny businesses contribute little to building an economy’s productive capacities, or to its structural transformation.

A recent study by the UN Office of the Special Adviser on Africa suggests that now is a good time to reassess the role of microfinance in Africa’s development.2 Drawing from experience elsewhere, it seems clear that on its own cannot fundamentally transform African economies held back by many structural constraints. Yet providing a whole range of financial services to the poor — including credit for small and micro-enterprises, savings facilities, insurance, pensions, and payment and transfer facilities — is clearly desirable and can contribute to the achievement of the Millennium Development Goals.

Africa has seen an increase in such services in recent years. Microfinance institutions offer a variety of products. Where such institutions do not reach, traditional and informal providers — such as the tontines in Cameroon, the susus in Ghana and the banquiers ambulants in Benin — continue to serve the poor. Their informality limits their potential to expand their activities, however, and they often charge high rates.
The spread of mobile phones in particular has transformed the sector, extending it to previously unbanked areas in Cote d’Ivoire, Ghana, Mali, Senegal and elsewhere. Most famously, Kenya has seen the world’s most rapid growth in the use of “mobile money.” Launched in 2007, the service known as M-Pesa by the end of 2010 had more than 13 million customers able to use their mobile phones to make payments and transfer money. Customers can now earn moderate interest on mobile bank accounts. Farmers can insure their crops against adverse weather conditions, with payouts made directly to their mobile accounts if weather conditions indicate crop failure.

Still, microfinance institutions in Africa lack the capacity to match the needs of the poor. They suffer from structural weaknesses. The support services for them are of uneven quality, if they exist at all. And supervisory and coordinating bodies often have only limited resources.

African governments, in cooperation with external development partners, could therefore play a fundamental role in consolidating and sustaining the microfinance sector by providing appropriate policies and regulatory and legal frameworks. They can also protect the poor and build confidence by establishing refinancing institutions and deposit insurance schemes.

It is unreasonable to expect microfinance to fundamentally transform African economies. And it cannot replace progressive social and economic policies for structural transformation, poverty reduction and job creation. But in light of the continent’s persistent poverty, it can play an essential part for the foreseeable future in providing basic financial services to the poor, and thereby help advance Africa’s development goals.

* David Mehdi Hamam is chief of the policy analysis and monitoring unit and Oliver Schwank is an associate expert at the UN Office of the Special Adviser on Africa.

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