Can Microfinance Work?
by Lesley Sherratt
(Oxford University Press, 2016)
The Eighth Book of Ovid's Metamorphoses tells the story of Icarus, son of Daedalus. The two sought to flee imprisonment on Crete, propelled through the air by wings of feathers that Daedalus had made. Ignoring his father's advice to steer a middle course, Icarus flew too close to the sun: the wax that held his wings together melted, and he fell to his death in the Mediterranean Sea.1
The microfinance movement and its leaders have recently tumbled into an ocean of controversy, having earlier soared in the sunlight of approbation. Once heralded for its transformational impact as a tool for global development, the claims made for the achievements of microfinance are now melting under the heat of critical scrutiny. Its reputation is drowning, albeit without attracting much attention beyond the microfinance movement itself, much like Icarus in Breughel's famous painting.
Pieter Breughel, Landscape with the Fall of Icarus,
Musées Royaux des Beaux-Arts de Belgique, Bruxelles.
In her recently published book, Lesley Sherratt reviews the evidence for the successes and failures of microfinance, and proposes a series of reforms that would achieve a better balance between its ethical and economic goals.2 This is an exercise in applied philosophy, an attempt to measure the performance of a diverse, global movement of companies that provide financial services to the poor, against both economic metrics and ethical norms. Sherratt's conclusion, in brief, is that microfinance fails to deliver much in terms of development and fails to treat its customers fairly: it falls short, in other words, on both economic and ethical grounds.
For many years the microfinance movement has claimed to make significant improvements to the lives of the individuals and communities to whom credit was provided. Many of these improvements were illustrated by touching anecdotes and poorly constructed impact studies, which celebrated good news and made no effort to check whether this news was true, or whether it was the whole story. Bad news about microfinance was notable mostly by its absence. More recently, as Sherratt explains, a series of Randomised Control Trials (RCTs) have measured the economic impact of microfinance in India, Morocco, Mongolia, Bosnia, Ethiopia and Mexico. Sherratt summarises the conclusions of these RCTs: "Microfinance is not transformative. It facilitates an increase in business investment and activity; but not necessarily a profitable one, not one that has an impact in reducing borrower's poverty" (p.32).3
The advent of large impact studies with more rigorous methodologies and measurement techniques should be welcomed by microfinance practitioners. Nonetheless, like all research methodologies, RCTs have their weaknesses. There are commentators who worry about their status within medical research;4 others who have reservations about their applicability to social policy making;5 and others who consider the data analysis of the published studies to require improvement.6
A complete assessment of the impact of microfinance cannot rely simply on a handful of RCTs, whose results do not generalise easily across geographies, cultures and economies: they provide important evidence but they do not tell the whole story. A balanced assessment of the positive and negative impacts on human well-being would require qualitative as well as quantitative research: being poor is not the same as being sick, and treating poverty is more complex that treating sickness: microfinance is not just another drug trial.
Sherratt's critical examination of the carelessness, the exaggerations and the hubris of much research into the impact of the microfinance movement are justified and timely. Nevertheless, her reference to RCTs as "the recognised gold standard for studies in medicine" should alert us to the limitations of this research, since in monetary policy the gold standard has long been abandoned. The results of the six RCT studies she describes are, by themselves, insufficient to support her claim that microfinance in general has "no impact" on the eradication of poverty, not least because her account lacks specificity regarding what poverty means to different people in different places and at different times.
Sherratt's account of the ethical failings of microfinance include the claims that microfinance companies often exploit their customers by charging excessive rates of interests and hidden loan-arrangement fees; that they coerce individuals to participate in shared-liability lending groups that frequently lead to the unjust treatment of those who cannot repay their loans; and that they often lend money to individuals or businesses in the informal economy whose economic activities are anti-social (such as the production of illicit alcohol) or which breach best practice in labour standards, for example by the use of child labour. The evidence for these claims is well documented and the ethical concepts involved - exploitation, coercion, cruelty - are well described.
Her principal claim is that the price of microfinance loans is often unacceptably high, and that this demonstrates that many microfinance companies are acting exploitatively and, therefore, immorally. In the penultimate chapter, sub-titled "How to Practice Microfinance Ethically", the first proposal for reform is to "Establish an ethical, nonexploitative interest rate and curtail lending above it" (p. 168). What would an ethically acceptable interest rate be? If the answer to this question is numerical rather than conceptual, then it is far from clear how the "ought" could be derived. Taking mainstream lending rates and adding a small margin assumes both that mainstream rates are themselves normatively acceptable, and that we can determine with some precision what level of margin would be morally justified. Neither assumption is plausible.
Sherratt's recommendation - that we use as our benchmark the cost of providing credit to a borrower who is not exploited through exclusion from mainstream financial services - would almost certainly make microfinance unsustainable in all markets in the world. Since the purpose of the microfinance movement is to provide financial services to those who are excluded from the mainstream, it seems odd to require that microfinance prices should not exceed those observed in the mainstream: if it were possible to lend profitably to excluded people at those prices, the mainstream institutions would do it.
Most of Sherratt's other proposals to improve the ethical character of microfinance - ending group-liability, more tailored products, better client protection, better screening to prevent the use of credit for illegal activities - would all tend to increase the operational costs of providing credit, as would the introduction of stronger internal compliance and governance processes and tougher external regulation, which she also advocates. If microfinance is to be provided "ethically" - as Sherratt desires - then it must charge prices that are "exploitative" in her terms. Good microfinance therefore becomes a practical impossibility.
There is good reason to criticise the bad behaviour of microfinance companies, but the level of interest rates charged seems the least interesting from an ethical standpoint. If credit is to be provided appropriately - taking account of the ability and the willingness of the borrower to repay, with transparency around costs and repayment schedules, and delivered with high levels of customer service - and if microfinance companies are to be sustainable - earning enough to pay their staff and to fund their operational costs - then the price of a loan must be set high enough to cover these costs. Interest rate levels in microfinance are residual outcomes of the design of the business model; they are determined by ethical choices but they are not themselves an ethical choice.
Sherratt's book offers a corrective to the cheerleading that has accompanied the growth of the microfinance movement over the past two decades. But setting an unreasonably narrow measure for what counts as evidence of impact together with an unattainably low cost-ceiling for what counts as ethical service delivery, does not provide the foundation for a truly ethical business model.
There are dangers in flying too close to the sun. Flying too close to the sea, as Daedalus noted, is equally risky.
1 Ovid, Metamorphoses, VIII 273-276, trans. Arthur Golding, Folio Society, London, 2007. (First published in English in 1567).
"I warn thee", quoth he, "Icarus, a middle race to keep
For if thou hold too low a gait, the dankness of the deep
Will overlade thy wings with wet. And if thou mount too high
The sun will singe them. Therefore see between them both thou fly."
2 Lesley Sherratt, Can Microfinance Work? How to Improve its Ethical Balance and Effectiveness, Oxford University Press, 2016.
3 For a summary of the results of these six RCTs, see Abhijit Banerjee, Dean Karlan & Jonathan Zinman, 'Six Randomized Evaluations of Microcredit', American Economic Journal: Applied Economics 7:1, p.1-11, 2015. In the abstract to this paper the authors state: "Summarizing and interpreting results across studies, we note a consistent pattern of modestly positive, but not transformative, effects. "
4 For example, Nancy Cartwright, 'The Art of Medicine: A philosopher's view of the long road from RCTs to effectiveness', The Lancet, 377, p.1400-1401 (23 April 2011).
5 For example, Maria May, 'RCTs: All that glitters is not gold', Stanford Social Innovation Review (28 August 2012).
6 For example, recent work by Rachel Meager at http://economics.mit.edu/grad/rmeager/research.