Receive our newsletter - data, analysis and deep insights on FDI delivered to you
Business Activities / Finance

Trick or treat? Why microfinance requires a rethink

Microfinance can improve financial inclusion and help to alleviate poverty, but there are concerns at the negative impact this form of finance might have.

microfinance-developing-countries

A microfinance institution agency in Burkina Faso arranges a loan, but the industry’s ability to improve the lives of those living in developing countries is in question. (Photo by Godong/Universal Images Group via Getty Images)

Microfinance is an essential tool when it comes to providing access to banking services for people and companies that are locked out of traditional avenues to finance. Although not without its pitfalls, microfinance is effective at accelerating financial inclusion and empowering female and rural borrowers.

Indeed, data from the 2019 Microfinance Barometer reveals that of the 139.9 million borrowers who used microfinance institutions (MFIs) in 2018, 80% were women and 65% were based in rural areas.

White papers from our partners

Aditya Bhandari, partner and co-regional director for Asia at emerging markets-focused investment company Incofin Investment Management, stresses that microfinance is essential for rural borrowers. “It is the first entry point to support rural entrepreneurs coming out of the strangles of the informal credit system, where they are been taken for a ride with interest rates, transparency and ethics," he says. "Making the rural entrepreneur self sustainable leads to improvements in the lifestyle of rural households, [it makes families more likely] to send children to school. Better literacy, in turn, results in rural families coming out of poverty.”

Bhandari goes on to praise the Indian government for permitting 100% foreign direct investment (FDI) in microfinance in recognition of the social good it can do in improving financial inclusion in the country.

Why investors can no longer ignore microfinance

With the global microfinance market estimated to be worth $394.8bn by 2027, foreign investors are presented with a sector that offers opportunities to back investments that deliver social impact, while also generating strong returns.

The 2019 Microfinance Barometer states that between 2009 and 2018 “MFIs recorded an increase in their returns on assets [plus 1.3 points] and equity [plus 2.9 points]”.

On top of these impressive potential returns, the technological advances in microfinance present another attraction to investors. “Technologically advanced microfinance offerings are being developed at a faster rate, a lower cost and with greater reach and depth,” says Wahida Mohamed, founder of the Islamic Fintech Hub of sub-Saharan Africa. "While not everyone is adapting to the new forms of technology, the solutions presented have shaken some of the most established institutions by making financial services accessible 24/7, in areas where historically [these services] could simply not reach. This has made [foreign investors] sit up and take notice."

FDI can play a key role in the advancement of microfinance, as MFIs often require know-how when it comes to complying with sophisticated regulation and the supervision of institutions. Fulfilling this criteria is key for improving industry efficiency and sustainability. FDI can also help to create new jobs in the sector and an ecosystem that attracts further foreign assets to the host country.

The other side of the same coin

Despite microfinance's potential to bring greater financial inclusion, alleviate poverty and empower low-income populations, there are concerns that it can have a negative impact upon developing countries.

Emily Brearley, founder of Solution42.org, a consultancy that specialises in developing countries, believes that microfinance has scarred the development landscape due to rich donors' poor understanding of developing economics. “Poor people cannot get rich through entrepreneurship, nor can middle income people for the most part,” she says. Brearley adds that what is required in these countries is a basic safety net or a cash transfer programme, as this would constitute a much better use of the cash needed to subsidise interest rates for all microfinance programmes.

The 2019 Microfinance Barometer states that “the over-indebtedness of some of microfinance’s beneficiaries and the excessive profits generated by MFIs has paved the way to waves of criticisms of the sector". It goes on to say: "These episodes have revealed the dangers of an unchecked microfinance industry and the impact it can have on its beneficiaries when it is not managed responsibly. Self-regulatory measures have since been developed and ameliorated, demonstrating a willingness to professionalise this sector from within.”

Poor people cannot get rich through entrepreneurship, nor can middle income people for the most part. Emily Brearley, Solution42.org

Mohamed agrees that there has been a lot of criticism regarding microfinance in the past. However, she adds that the adoption of tech in the industry assuages much of this criticism, helps to rid the industry of some of its more unsavoury presences, and makes it easy for donors to monitor, record and report the impact of what an initiative is or is not achieving in real time.

Regulation that protects the borrower, strong competition within the market, and the lack of a single dominant microfinance institution are factors than can or do reduce risks within the industry, according to Neoklis Stamkos, chief operating officer at microlending specialist MicroStars.

Is there room for impact investing?

The World Bank estimates that globally there are more than 1.7 billion adults without access to a bank account. This number shows the level of opportunity for both the microfinance industry and foreign investors looking to change the world for the better.

“Financial exclusion means not being able to save money for an emergency, or for projects such as a child’s education," says Paul Hailey, head of sustainability and impact at asset manager ResponsAbility Investments. "It means not being able to access a loan to buy a house or start a business. It also means not having insurance, as natural disasters become more and more frequent due to the effects of climate change. Consequently, a financial sector that caters to everyone, not just the top 10%, is critical if we are to support development and improve the quality of life for low-income households in emerging markets.”

He adds that data from the International Finance Corporation estimates that there is an annual credit gap of between $2trn and $5trn to small businesses in the developing world. "Given that SMEs account for about three-quarters of the job creation in emerging markets, SME banks and SME finance will be a crucial component in boosting developing economies and helping them to rebound from the Covid-19 crisis," says Hailey.

As a result, this emerges as a key opportunity for investors to back projects in developing countries, which not only generate good returns but also provide societal impact, which is key for impact investing and for achieving the UN’s sustainable development goals. Microfinance might appear to others to be a treat or a trick; however, it remains a key tool for financial inclusion as it provides banking services to people and companies that otherwise would have no other access to financial services.

Microfinance isn't perfect, and many of the concerns voiced about the industry are legitimate. It is, however, one of the more effective tools the world has for improving financial inclusion, which in turn can help to bring people out of poverty and assist in reaching the UN's Sustainable Development Goals. On top of this, the opportunities it offers for investors looking to make a societal impact are plentiful. However, microfinance alone cannot resolve the issues facing developing countries, as there are concerns that simply giving someone living in poverty access to a bank account will not necessarily have any impact. The industry is but one piece of a large jigsaw when it comes to improving the lives of those living in developing countries.

Sofia Karadima

Sofia Karadima

Senior editor and researcher

Sofia Karadima is a senior editor and researcher at Investment Monitor, focusing on financial and business services, and ESG investing.