This blog post continues a series of excerpts from a conversation between Jonathan Morduch and Marc Labie, published in Mondes en Développement.
In this excerpt Morduch and Labie discuss trends in thinking around how microfinance has been delivered and funded over the past decades, including group lending, subsidies for microfinance, the tension between the need for discipline and flexibility, and how advances in technology are shaping the field:
ML: Historically, microfinance was often associated with group lending as this technique was supposed to be not only a good screening and enforcing mechanism but also an innovative way to provide collateral for a loan. Nowadays, group lending is still present of course, but it receives much less attention as many individual loans programs have proven to be as efficient if not more. In your opinion, what is still to be expected from group lending in microfinance?
JM: Group lending was the essence of microfinance, it was the beautiful idea behind everything. At least we thought so at first. The fact that microfinance can work without group lending says a lot about the overlapping (and often unheralded) mechanisms that actually drive microfinance. We now see the key roles played by dynamic incentives, alternative forms of collateral, and the installment structure of repayment schedules.
We have to remember that joint liability is, in large part, a way to punish people. To get loans repaid, lenders needed a way to punish defaulters who could not be punished in the usual way (by seizing their collateral). The problem is that joint liability pushed too much risk and responsibility onto customers, which could make the contracts both unfair and impossible to enforce. The contract was too blunt, and over time, especially as borrowers’ needs changed at different rates, the mechanism became less and less tenable. A conversation with Muhammad Yunus helped me see a positive side. He resisted my interpretation of group lending only as joint liability. He argued for seeing the group element socially, pointing out that group lending was valued for providing positive support and collective unity among customers. That seems particularly true for new borrowers, but experience shows that group meetings take valuable time from customers, and over time group meetings are fading. Group lending has also faded as microfinance has shifted away from a sharp focus on poorer communities. (footnote 4)
ML: Another major topic that received key attention is the role of subsidies in microfinance. Some have argued for getting rid of them as much as possible. Others defend the idea that they are absolutely necessary if we want microfinance to also pursue true social goals. And indeed, it has been shown at multiple occasions that it is feasible to work without any subsidy for a microfinance organization that is focusing on the provision of working capital loans to poor (but not the poorest) microentrepreneurs involved in activities characterized by a quick cash flow cycle in a densely populated area. But it has also been shown that in many cases, some of these characteristics are not present. In order to face this debate, you came up with the concept of smart subsidies. Could you remind us for this anniversary issue what you meant by that as it is clearly useful in microfinance but also in other fields of international development?
JM: Microfinance was for a long time dominated by an ideology which was very much against subsidy. Even some of the large donors, who were the main providers of subsidy, took anti-subsidy views. They argued that subsidy would undermine markets and hurt poor communities. But empirical research did not support the ideology. Practical experience did not support it. Modern economic theory did not support it—in fact, the economics of information showed that subsidy can be necessary to achieve economic efficiency in the presence of moral hazard.
Yet many microfinance experts held firm to anti-subsidy positions.(footnote 5) It is easy to see why the anti-subsidy idea was appealing. Subsidized state banks had a terrible record of inefficiency and misallocation. Repeating those mistakes would have been a disaster. Also, microfinance institutions require capital, and the supply is limited. So, yes, sometimes the choice is unsubsidized microfinance versus no microfinance at all.
A problem with the donors’ anti-subsidy stance was that, in practice, microfinance institutions were happily accepting the subsidy. The donors were then stuck without useful guidance for institutions on how to best use it. That led Frank DiGiovanni of the Ford Foundation to ask me to write on the idea of smart subsidy. The insights were not novel, but some ideas were new for microfinance. The approach involves embracing subsidy to as a way to expand access in poor communities and to crowd-in capital. Subsidized capital, for example, can absorb risk that commercial capital cannot. At the same time, “smart subsidy” avoids distorting markets by creating credible exit strategies and using social performance targets. (footnote6)
Looking back, the most important contribution was to show that it was possible to have a serious conversation about subsidy. Today, subsidy has been re-branded as “impact investing,” and no one worries about it in the same way.
ML: The microfinance organizations that have been successful have often relied on simple standardized procedures to serve financially excluded people. But today, becoming more flexible in the way to fulfill the needs of customers appears ever more essential. Is it an impossible dilemma or do you consider that it is a challenge that can and will be met in the future?
JM: Most poor people live with instability. And when you live with instability, you require flexibility. At the same time, behavioral economists have shown that flexibility can weaken resolve, and they argue for rigid rules and “commitment saving devices.”
So, there’s an inevitable clash. You cannot easily marry instability with rigid rules.
You have a very nice paper on this with Carolina Laureti and Ariane Szafarz, (2017) and I know that you have thought a great deal about the dilemma. I very much appreciate your work here, and you describe promising examples. Stuart Rutherford built flexibility into the DNA of the MFI SafeSave in Bangladesh. One recent paper documents the positive impact of a rule that allows borrowers two loan repayment installments that they may skip with no questions asked (Battaglia et al., 2021). The contract is standardized, but also flexible. On the other hand, recent work shows a case where flexibility can erode social norms. So, the last word has not been written, but the conflict that you describe runs deep (Czura et al., 2021).
ML: Another common characteristic of successful microfinance organizations is their proximity – geographically but also culturally and socially – with their customers/beneficiaries. But this fundamental characteristic is also often one of the major sources of administrative costs that microfinance organizations must bear. Some people believe that technology could help solving this dilemma. What is your opinion?
JM: Each question that you ask reveals another way that microfinance involves conflicts and dilemmas. Maybe those conflicts and ambiguities are what has held our interest over all these years!
Traditional microfinance was always “high touch”, and now people ask whether it can be “high tech” instead. Technology holds the promise of slashing costs through “low-touch” tools, and thus helping to democratize financial opportunity. Still, my sense is that technology remains most useful when layered on top of traditional engagements with customers, adding extra functionality. The cost advantages have been hard to reap since high tech is an imperfect substitute for high touch, especially when it comes to recruiting new customers, and especially in poorer communities. Technology will continue to shape the sector, but we need to proceed with open eyes. Evidence shows that tech creates biases in customer acquisition, in addition to creating well-known algorithmic biases. Of course, what is true today may not be true in five years. That’s the nature of technology. (footnote7)
ML: In banking, discipline is key, particularly in the management of loans portfolio and the protection of customers’ savings. In many cases, this discipline is obtained through constraints and negative incentives (no more credit if people don’t reimburse well; extra cost if they repay late; required savings to have access to services...) rather than through positive ones. Some argue that to experience a new revolution in the future, favoring positive incentives (e.g., allowing bonuses or advantages to those who comply with their commitment on time rather than punishing those that are late) should be considered a promising avenue. Yes or no?
JM: Can one choose both? You’ve nicely articulated a dilemma that opens possibilities. Yes to both, depending on the context—since negative incentives can still be helpful.
ML: In the early days of the industry, microfinance was developed mainly thanks to Saving and Credit Cooperatives and NGOs. Over time, Non-Banking Financial Institutions and commercial banks have clearly come to dominate the field as a result of the conversion of some major NGOs and the entry of commercial actors attracted by the potentially high profits that microfinance enables in certain circumstances. Besides, for the last few years, Fintechs seem more and more willing to get involved in topics related to financial inclusion. How do you see the future on this issue? What is the future of cooperatives and NGOs in microfinance?
JM: The microfinance narrative has long wrestled with two opposing views. One is that only commercialization will permit large scale by tapping the market. The other view is that only social businesses, which include NGOs and cooperatives within microfinance, have the social focus and incentives to pursue the greatest good without existential worry about financial bottom lines.
History has shown the power of the market in quickly getting to scale, but we also see that market solutions are not necessarily pro-poor and are sometimes actively anti-poor. And history has shown the continuing power of NGOs in staying committed to social missions.
I was just reading a recent paper on the impact of large capital loans given by Akhuwat in Pakistan, for example. Akhuwat is a nonprofit which provides Islamic Finance in the form of zero-interest loans, reporting having benefited over 5 million families (Bari et al., 2021). Cooperatives and NGOs like Akhuwat will continue to be an important source of finance, working in markets that commercial players have largely avoided so far. Even with the latest fintech innovations, I can’t imagine a world where NGOs and nonprofits are not vital to serving important parts of the market.
ML: Talking about markets, one of the major changes that the microfinance industry has experienced over the last twenty years or so is the connection to capital markets, mainly through Microfinance Investment Vehicles (MIVs). Now often included in the broader field of impact investments, they have clearly played a role in establishing norms for the sector. What is your opinion on this evolution?
JM: MIVs are an efficient way to invest in the microfinance sector. They move billions of dollars and are an important part of the infrastructure. But MIVs have narrowly financial concerns. When the pandemic hit, for example, the MIVs were not well-placed to help struggling lenders on their own. It was Development Finance Institutions – traditional public agencies – and national governments that had to step in to assist the sector (Rhyne, 2020).
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Read parts 1, 2 and 3 of the series, on how the birth and evolution of microfinance was shaped by broader currents in anti-poverty thinking, microfinance buzzwords, and women’s empowerment. You can also read the full article (gated).
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Footnotes
4 Looking back, group lending became an ongoing focus of my research. Karlan and Morduch describe the empirical literature as of about a decade ago in “Access to Finance” (In D. Rodrik and M. Rosenzweig, 2009). Armendáriz and Morduch (2000) described the overlapping contract mechanisms in “Microfinance Beyond Group Lending”. Cull et al. (2007), show that group lending is more likely to be used by lenders focusing on poor customers. Gine et al. (2010), designed lab experiments in Peru to show how risk is shifted onto borrowers.
5 This became the basis of my paper (Morduch, 2000) on the “the microfinance schism” and continuing work with Jonathan Conning.
6 In one way or another, the issue of subsidy has been a recurring theme in my research, starting with “The Role of Subsidies in Microfinance: Evidence from The Grameen Bank” (Morduch, 1999). Also : “Financial Performance and Outreach: A Global Analysis of Leading Microbanks” (with Robert Cull and Asli Demirgüç-Kunt, 2007) ; “Microfinance Meets the Market” (with Robert Cull and Asli Demirgüç-Kunt, 2009), “The Microfinance Business Model: Modest Profit and Enduring Subsidy” (with Robert Cull and Asli Demirgüç-Kunt, 2018.) ; “Do interest rates matter? Credit demand in the Dhaka Slums” (with Rajeev Dehejia and Heather Montgomery, 2012).
7 The state of play is nicely summarized by Todd A. Watkins, Paul DiLeo, Anna Kanze, and Ira Lieberman, 2017. https://www.centerforfinancialinclusion.org/fintech-in- microfinance-in-search-of-the-high-tech-high-touch-unicorn