What If We Turn the Microfinance Theory of Change on Its Head?

After a hiatus of three weeks to catch up on my reading, it is time to start posting for Theme Four: to explore whether microfinance participation results in “more household savings and better consumption-smoothing.”

Theme Three explored the validity of the classic microfinance theory of change: people from poor households tap microfinance services (primarily loans and/or savings) to invest in microenterprises that yield sufficient return on investment to increase household income and consumption—leading to poverty reduction. Evidence to date makes this theory look problematic. First, many (perhaps half?) poor households don’t tap microfinance services even when they are locally available. Second, of those who do use microfinance services, many (perhaps half?) do not invest part or any of their loans and/or savings in microenterprises. Third, most of the microenterprises in which loans or savings are invested remain quite small with only modest returns on investment—generally not enough to lift the household out of poverty.

There are many, many well-documented cases in which poor households do in fact invest their loans or savings or both in microenterprises that do in fact grow and yield enough profit to substantially increase the household’s income and consumption, sometimes enough to rise above the national and international poverty lines. While these cases seem to constitute a sizeable minority of the households that participate in microfinance, they are still a minority, which challenges the classic microfinance theory of change as the overall rationale for investment in microfinance service infrastructure and operations.

Does this mean that microfinance is a failure? Of course not. It means the classic theory of change is inadequate. It doesn’t describe the full value of microfinance for the majority of poor households who participate. Yet participate they do! What’s going on?

Consider this quote from the March 2000 paper by Sebstad and Cohen (p. 101):

The use of loans to smooth incomes and the resulting impact on reducing the variability of consumption suggest the positive impact of microcredit on reducing the vulnerability of client households, but not necessarily their income poverty.

One explanation for greater impacts on vulnerability, as illustrated throughout this study,is that there are many channels through which microcredit can reduce vulnerability, but fewer channels through which it can single-handedly reduce poverty. Thus, the findings on greater impacts, in part, may be definitional—because the concept of vulnerability is broader than the concept of income poverty.

Nevertheless, it is clear, at least in the findings from Bangladesh, that impacts on income poverty are more conditional than impacts on vulnerability, which supports the finding that microfinance services have a greater impact on vulnerability than on income poverty.

In short, a lot of people use microfinance to reduce their vulnerability to (i.e., manage risk of) consumption interruptions and financial shocks for their households. Enterprise investment is one of a suite of tools that people use to reduce their vulnerability. Unlike other risk management tools, investment in microenterprise can have the happy consequence of actually raising total household income as well as smoothing income through the year as part of a diverse portfolio of revenue streams (“trickles” to be more accurate). However, as we’ve seen in Portfolios of the Poor and Poor Economics, most households are not counting on this poverty-reduction effect of microenterprise investment; they just do business as one of several ways (“channels”) to keep the wolves of hunger and ill health at bay, to clothe and shelter themselves, and to have a little enjoyment in their lives, too. Call this poverty alleviation—reducing the uncertainties and stress of being poor. Not so many are using microfinance in a way that will raise them from the ranks of the poor—poverty reduction—because there aren’t so many opportunities for thriving enterprise in the absence of robust local economic development.

It is notable that the quote above is from a paper released in March 2000, well before the recent round of RCTs, financial diaries, and research syntheses came to much the same conclusions (based on a firmer evidence base). We have known this truth about microfinance for some time now, but the dominant microfinance theory of change has been slow to yield to a more comprehensive theory of change that is in sync with the full range of motivations to use microfinance services.

What would be this more comprehensive theory of change? Try this on for size (with some wording from page 93 of the Sebstad and Cohen paper):

People from poor households tap microfinance services to smooth consumption and build assets to protect against risks ahead of time and cope with shocks and economic stress events after they occur—leading to poverty alleviation.

In the title of this post, I suggest this reformulation turns the classic theory of change on its head. Here’s what I mean. As I worked through the evidence for the classic theory, I repeatedly found authors saying that microfinance helps some clients to invest in microenterprise and thereby have a chance to escape from poverty, but the majority seems to benefit only from some positive effects on consumption- smoothing and/or reduction of vulnerability through more reliable risk management. The perspective seems to be that reduction of vulnerability to risk is a sort of consolation prize for those who were offering microfinance services to promote enterprise development for poverty reduction. Turning this on its head, what if we were seeking reduction of vulnerability to risk and were pleased to find that most clients have been using our services for just that, reduction of vulnerability to risk?  We would also be delightfully surprised to discover that a good number of our clients were actually using microfinance to build enterprises and some were thereby even escaping poverty?

Satisfaction is a function of expectation. In the microfinance world, our expectations were set by the origin of microfinance in the microenterprise development movement. The dominant perspective has long been that microfinance is an input for microenterprise development. While microfinance became the tail that wags the dog, it is still a dog’s tail. So the impact evidence to date is disappointing.

But it doesn’t have to be disappointing. If our perspective were that of the relatively new “resilience” movement, we would be celebrating. Most of us don’t know about the resilience movement, because its origin is in the humanitarian relief world. If you don’t think this movement is a big deal, check out the just-released “Communication from the Commission to the European Parliament and the Council” titled The EU Approach to Resilience: Learning from Food Security Crises and this definition of “resilience” on page 5:

Resilience is the ability of an individual, a household, a community, a country or a region to withstand, to adapt, and to quickly recover from stresses and shocks.

On the same page, the EU policy statement goes on to explain:

The concept of resilience has two dimensions: the inherent strength of an entity – an individual, a household, a community or a larger structure – to better resist stress and shock and the capacity of this entity to bounce back rapidly from the impact.

Increasing resilience (and reducing vulnerability) can therefore be achieved either by enhancing the entity’s strength, or by reducing the intensity of the impact, or both. It requires a multifaceted strategy and a broad systems perspective aimed at both reducing the multiple risks of a crisis and at the same time improving rapid coping and adaptation mechanisms at local, national and regional level. Strengthening resilience lies at the interface of humanitarian and development assistance.

Enhancing resilience calls for a long-term approach, based on alleviating the underlying causes conducive to crises, and enhancing capacities to better manage future uncertainty and change.

The “resilience” folks would be delighted by the reduction of vulnerability experienced by poor households taking advantage of reliable access to self-financing (market-based) microfinance institutions and similar entities. Not that they will be funding or incorporating or even become aware of the relevance of microfinance for building resilience anytime soon. The silo phenomenon in international relief and development is very strongly entrenched, for a whole lot of valid and invalid reasons. But this “resilience” perspective helps to show how the actual impacts of microfinance (compared to the hoped-for impacts) have great value.

Now, here’s the same old question: what is the evidence? What is the evidence that participation in microfinance actually generates these “resilience” benefits? This is the question I address in Theme Four. We have to revisit a lot of the same studies to see how solid is the evidence for consumption- smoothing and asset-building in poor households using microfinance services.


  • Robb Davis

    Chris – Thanks for an excellent reflection on the issue of vulnerability reduction.  I am very much looking forward to this series.  My own research (unrelated to micro finance) done years ago focused on how poor families build their “insurance” portfolio through various forms of gift giving.  I was amazed at the lengths to which people in a resource-poor environment would go to reduce uncertainty and risk.  I am glad to see an acknowledgement of how microfinance contributes to these efforts.  The link to the “resilience” literature will also be helpful.  Thanks.

  • Jan Maes


    I still have the Sebsted and Cohen paper in my reading stack too, and it is indeed remarkable that MF forgot about this (but then again, trying to sell increased reslience to donors is not the same as leaving poverty behind.   

    I think the “resilience” folks have been aware of that potential of microfinance for a long time. And speaking of silos, our colleagues in market facilication and value chain development have been talking for quite awhile about vulnerability instead of poverty, as they see reduced vulnerability as a necessary condition for poor households to engage in riskier (microenterprise) activities. Check out the value chain wiki on microlinks or the LIFT framework concept paper for instance.



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