What costs does microfinance reduce for the unbanked poor?

How much evidence do we have that the recently unbanked poor are getting a comparatively good deal from microfinance providers?

The most basic narrative of microfinance is that the poor are able to get loans from microfinance providers at substantially lower interest rates than are charged by local moneylenders.  This assertion may seem obviously true, but for the Evidence Project of Freedom from Hunger we can’t take anything for granted.  What is the evidence of lower interest rates?

Consider the benefit of a microfinance institution entering the scene where there was none before.  We might assume this MFI would displace the moneylenders as the preferred alternative to family and friends as lenders.  In Chapter Two, Portfolios of the Poor reports interest charged by a couple of moneylenders in South Africa as 20% and 30% per month.  Considering that MFIs would not dare charge more than 5% (including fees and such) per month in any country, the poor should be getting a much better deal from the MFI.  For a $100 loan held for one year, the borrower saves at least $180.  How can you beat that deal?

Well, the poor often prefer to take a loan for only one month, but the saving is still at least $15 – a lot of money to save in one month.  However, microfinance institutions usually do not offer one-month loans; more often four months minimum, sometimes nothing less than one year.  The interest differential doesn’t look so persuasive, given that moneylenders offer one-month and even shorter loans.

But why would the poor go to moneylenders or MFIs when they can get interest-free loans from friends and family?

My starting point for exploring how financial services help the poor is Portfolios of the Poor.  This book and its financial diary method helps us understand what the poor are doing, not just those who step forward to be clients of current microfinance services.  The book’s orientation and messages liberate us from the institutional straightjacket to revisit fundamental questions of what we might do to help the poor help themselves deal with financial issues.  For me and my colleagues at Freedom from Hunger, and apparently for so many others, the book resonates with the studies and stories we’ve been hearing from clients for decades and gives us a broader perspective in which to situate those stories.

The relevance of Portfolios of the Poor may depend on whether we see the target market for microfinance as the budding micro-entrepreneurs or as the households struggling to have enough food to eat every day.  Of course, there is broad overlap between these two types (how broad the overlap is still an open question).  While the authors of Portfolios did not explicitly focus on the latter group, their financial diary households were clearly struggling to stretch their tiny and unpredictable incomes to make sure they eat every day.  Of course, this is the kind of household that Freedom from Hunger wants to focus on.  When we ask whether the poor get a better deal from microfinance providers, we are asking about households like the ones featured in Portfolios of the Poor.

So what do we learn from Portfolios of the Poor?

First of all, it is clear that these food-insecure households need both loans and savings, not one rather than the other.  They are borrowing and saving big time (a technical term) but in tiny amounts and mostly for short periods.  Of all borrowing, well over ninety percent in the poorest part of the three-country sample was from informal sources.  And the great majority of the informal sources of loans are not moneylenders but family and friends – interest-free.  Even where microfinance institutions are readily available, as in Bangladesh, these diary households were depending primarily on interest-free loans from informal providers.

So what costs does microfinance reduce for the poor?  The answer is beginning to look pretty complicated.

From Portfolios, “The time, energy and emotional toll of borrowing informally appear to be global phenomena.” (p. 55 in the paperback)  Tim Ogden confirms and extends the conclusions of the Portfolios authors: “Looking at the financial services that the poor actually use the world over, from savings clubs to prepaid cards to microcredit to payday loans, there are a few common themes. Perhaps most important is that the poor are willing to pay relatively high explicit costs to offset implicit psychological and behavioral costs: shame, convenience, and temptation.” Imagine the stress of having to piece together the sum of money you need by going to people who know you socially.  The amounts and timing of these loans are unreliable, certainly not private, and subject to arbitrary and often unforeseen terms.

In contrast, microfinance institutions are reputed to offer reliable, rule-bound and relatively impersonal, private and transparent access to credit (and increasingly, saving services).  But they offer a truly superior deal to the poor only if they also offer the flexibility of terms and close-to-hand, any-time-of-day convenience of borrowing from friends, family, neighbors, shopkeepers and employers.  Moneylenders are reputed to offer more privacy and reliability than friends and family, along with the requisite flexibility and convenience – for a phenomenal fee which is bearable only for short periods.

Now we see that a “better deal” is not simply a matter of relative price.  The other dimensions we have to look at are amounts that can be borrowed or deposited, flexibility and reliability and transparency of terms, convenience and reliability of access, and privacy of transactions.  We have to compare microfinance (and similar) institutions, moneylenders and family/friends/shopkeepers/employers on these dimensions.

What does the evidence tell us?  Can you suggest other dimensions or types of providers for comparisons?  What about costs other than financial costs, like health costs and opportunity costs?  Can you provide leads to more evidence?  Please let us know what you know by leaving a comment.  If you know of some good studies or other sources of relevant evidence, I’ll invite you to do a guest post for this blog.

  • http://www.freedomfromhunger.org Megan Gash

    I am curious to know if there are qualitative studies or testimonials documented about moneylender use. First, what is the decision-making process to seek out a money lender? Maybe the poor normally go to family and friends first, unless it is for an expense that they don’t want the family to know about. I assume that the poor know a lot of information about the costs and benefits of all the options (familyand friends, MFIs, moneylenders), and make decisions based on needs and trade-offs. I think there are hand ful of reasons why they do use moneylenders, and that they do when it is logical for the situation. But I think it would be really interesting to hear personal perspectives about the experience. For instance, are people essentially ok with using them when they need to? Do they appreciate their existence as an option? Are they seen as a necessary evil?

    • http://freedomfromhunger.org Chris Dunford

      Thanks, Megan! Nice way to frame and deepen the questions. Answers/evidence, anyone? I note your assumptions that decisions are based on a lot of info and logic. These beg for evidence in themselves. Perhaps Portfolios of the Poor and other financial diaries support these assumptions?
      - Chris

  • http://www.bamboofinance.com Ximena Escobar de Nogales

    Thank you Chris for initiating this quest for evidence blog. Very timely, very important. As impact investors, we too aim to better understand what works and what not in microfinance and in the broader impact investing sector (housing, clean energy, livelihoods, education etc.). Resources are scarce, we all need to identify and support investments that deliver results. Concretely, on your question regarding the dimensions on which microfinance should be assessed, I would add the MFI’s Social Performance. This includes aspects you mention such as transparency of terms and privacy of data, but goes beyond this. Examining the social perfomance of an MFI allows you to assess the MFIs overall coherence from its stated social objectives product offer, and ultimately its outreach. An example is the incentive scheme of a loan officer. This provides a quick view into what the MFI is really promoting. Are bonus schemes linked only to disbursements and portfolio growth? Or does the scheme reflect more balanced social objectives? Great progress has been made (thanks to the SPTF) in understanding social performance. It is increasingly for many MFI’s an important differentiator.

    • http://freedomfromhunger.org Chris Dunford

      Thanks, Ximena, for introducing social performance into the discussion. Excellent! I totally agree with your points. We value social performance indicators because we think they are associated with greater value for clients. However, it is the peculiar (perhaps irritating) lens of this Evidence Project that it asks for some sort of credible confirmation that a typical client gets “a better deal” from an MFI that attends to its own social performance by offering transparency of terms, privacy of data, etc., with field officers incentivized to make sure clients actually get such benefits. Let me turn it around to look at social performance not from the investor’s viewpoint or even the MFI’s but from the potential client’s viewpoint. Do we know of any evidence that clients experience and value the difference enough that they choose to go to such an MFI rather than another that doesn’t attend to its social performance (or to a moneylender or a neighbor) to get a loan or to safe-guard some money? I know this seems so obvious, but we have to ask the question and see what kind of answers we get. Do you know of any good evidence? See my most recent post on “What constitutes good evidence.” See also Bobbi Gray’s lengthy comment below.
      - Chris

      • http://www.bottombillionfund.org Tom Coleman

        THIS KEEPS COMING BACK TO THE FUNDAMENTAL POINT OF CLIENT BENEFITS AND CHANGES IN CLIENTS LIVES.

        “The twentieth century will be chiefly remembered in future centuries not as the age of political conflicts or technical inventions, but as an age in which human society dared to think of the welfare of the whole human race as a practical objective.” – Arnold Toynbee

        This is an incredibly bold statement about a century that contained two world wars; dozens of regional conflicts; the end of the Cold War and the fall of the Soviet Union and communism; the worst reported genocides in history; and world changing technical inventions ranging from computers, the internet, and telecommunications to human genetics and space travel.

        If the twentieth century was the first century in which “human society dared to think of the welfare of the whole human race as a practical objective”, such as the Millennium Development Goal of halving extreme global poverty between 1990 and 2015, could the 21st century prove to be the first century in which human society successfully acts on such thoughts and actually eradicates extreme global poverty?

        CAN MF PLAY A MEASURABLE ROLE IN THIS?

        Whether of not we can answer this question, how can we help MF do the most it can to help end extreme poverty?

        • http://freedomfromhunger.org Chris Dunford

          Tom, I won’t reply directly now to your other two recent comments, because they go to the heart of the matter in ways I hope to pick up in my posts yet to come. However, I will reply directly to this comment. While I am open to finding otherwise as The Evidence Project unfolds, I’ll share that I am fairly well convinced by evidence to date that microfinance indeed can play a measureable role in ending extreme poverty globally. The operative words are in italics. “Measurable” allows a lot of latitude, from statistically significant but not programmatically significant to being a major factor in moving the needle. And “extreme” refers to the absolute poverty that manifests as inability to meet the most basic human needs consistently through the year. We’ll always have “relative” poverty, but I’m convinced that absolute or extreme poverty can be dramatically reduced (but never eradicated as long as there are natural and man-made disasters and more subtle evils stalking the world – we won’t have to go to a museum to find it, but theoretically it could be rare). Microfinance, even if it does nothing more than help the poor smooth consumption and achieve food security, is very likely to be an important, if not major, contributor. Right now, I’d bet a lot of money (I’ve already bet my career!) that the evidence will eventually show that it will be major. However, there is a lot that must be done to and with microfinance to make its role in poverty reduction major, not just barely measurable.
          - Chris

  • http://www.mficonnect.com Haley Priebe

    The documentary Living On One Dollar also roots itself in Portfolios of The Poor and provides a great anecdotal perspective on the question explored here!

    Check it out: http://www.livingonone.org/

    Perhaps they could do a guest blog??

    • http://freedomfromhunger.org Chris Dunford

      Thanks, Haley. Great idea. I’ve reached out to Chris Temple to see if he or Zach would contribute a comment, if not a guest post.
      - Chris

  • http://freedomfromhunger.org Chris Dunford

    Thanks, Bobbi! Good mix of stories and survey data. Indications of the importance of implicit costs that seem to be reduced by going to an MFI rather than family or friends.
    - Chris