Evidence from a range of contexts has shown that while microfinance does not have transformative impacts on lifting people out of poverty, it can greatly benefit specific borrowers such as experienced entrepreneurs.
Issue 3 of our VoxDevLit on Microfinance is out now! In this episode of VoxDevTalks, Senior Editors Jing Cai, Muhammad Meki and Simon Quinn join us to discuss their review of the evidence on microcredit, what we have learned from research on this topic, and the key questions for policymakers that remain.
What is microfinance? Understanding the basics
Microfinance provides financial services like small loans, savings accounts, and insurance to individuals and small businesses who lack access to traditional banking. As Jing Cai explains, it has traditionally focused on marginalised populations, such as women, rural communities, and informal sector workers, and often uses group lending models where borrowers are jointly responsible for repayments. This podcast, reflecting the focus of the VoxDevLit, focuses specifically on microcredit.
The roots of microfinance are deeper than the well-known Grameen Bank, established by Muhammad Yunus in 1983. Jing highlights pre-modern practices dating back to 17th-century Ireland and Benjamin Franklin’s initiatives in the US, which helped small borrowers with collective loan guarantees.
“The challenges and innovations in addressing financial exclusion are not new, but part of a centuries-long evolution in economic systems.” Jing Cai
Measuring the impact of microfinance: A complex task
Evaluating microfinance is challenging due to selection biases on both the demand and supply sides. Borrowers who opt for microcredit differ from non-borrowers, and lenders target specific regions or customers, making causal analysis difficult.
"One key challenge of randomised evaluations of microfinance is that it's only feasible to randomise in places where microfinance is expanding to new markets, or is expanding to new borrowers in the existing locations." Jing Cai
Despite these challenges, there is now a large body of evidence on the impacts of microfinance, which allows us to judge how successfully it has lifted people out of poverty - one of the original goals.
"What we find from the literature over the last 20 years is that... the standard model of microcredit does not have transformational benefits on average." Simon Quinn
Whilst this be a sobering result compared to some of the narratives we hear, it is important to unpack this average overall effect. Simon highlights that microcredit does have some valuable benefits, such as improving liquidity, which is very beneficial to households even if it is not transformative.
Who benefits most from microfinance?
A key result from research has been that microfinance’s impact varies across borrower types. While the average effects may not be transformational, subgroups like established entrepreneurs often see significant benefits.
"What we need to think about is who is borrowing and what are they borrowing for." Simon Quinn
It was also hoped that microfinance could be an important tool for empowering women. Yet the evidence shows that it has not been deeply empowering for women across the board. It has, though, demonstrated potential for women’s empowerment under specific circumstances. For example, a study in Pakistan which shows that microfinance increased household spending on education, and the education of girls.
The role of group lending and dynamic incentives
Group lending has historically been a hallmark of microfinance that has been seen as a way of reducing risks for lenders.
"by holding these small groups jointly liable for each other, this group lending model incentivises peers to screen each other, to monitor the activities and also possibly to enforce" Muhammad Meki
However, challenges like free-riding and excessive peer pressure persist. Interestingly, recent evidence has show that removing the formal joint liability requirement might not negatively impact repayment rates, which is consistent with the move towards individual liability by microfinance institutions.
Dynamic incentives, where future loans depend on current repayment behaviour, have also been effective in reducing defaults.
"the empirical evidence supports this idea that dynamic incentives can indeed reduce default rates" Muhammad Meki
However, their success depends on factors like competition among lenders, which can weaken borrower commitment if they can easily take a loan from another lender.
Flexibility in loan repayment: Timing matters
"the timing and frequency of loan disbursement and repayment schedules can really be quite important for the effectiveness of microcredit" Muhammad Meki
Rigid repayment structures can limit the benefits of microfinance, especially for borrowers in seasonal industries or those making large investments. Muhammed highlights that traditional models often require repayment within one or two weeks, which instills discipline but can constrain borrowers with long-term investments.
Flexibility, such as grace periods or deferrable payments, has shown significant benefits. For example, loans timed to agricultural cycles can help farmers avoid selling crops at low prices during harvest.
Innovations in microfinance: Asset-based lending and digital tools
Asset-based microfinance, where loans are tied to specific investments, is a promising innovation.
"these financial products allow borrowers to acquire larger productive assets, such as transportation vehicles or water tanks that can be used to generate income for households, or even housing, which can improve living conditions" Muhammad Meki
Digital tools are also transforming microfinance. For example, digital collateral, where assets can be temporarily locked instead of repossessed, reduces default risks while expanding access to credit. Additionally, AI-based tools and mobile platforms are improving credit scoring and reaching previously excluded populations.
The commercialisation of microfinance: Opportunities and Challenges
The shift towards for-profit microfinance has enabled scale and innovation but also raises concerns about mission drift.
"the pursuit of profitability can lead to a focus on wealthier clients at the expense of the poorest borrowers" Muhammad Meki
He adds that subsidies may still be crucial to ensuring inclusion, despite their cost.
While commercialisation has spurred advancements like digital payments, it has also led to high interest rates that deter borrowing. Muhammad notes that:
“Borrowers are quite sensitive to rates, and demand can reduce significantly when interest rates are high.”
Future directions: Tailored products and broader impacts
The future of microfinance lies in creating tailored products for diverse borrower needs.
“A one-size-fits-all model doesn’t effectively serve all borrowers.” Muhammad Meki
For example, larger loans for experienced entrepreneurs or performance-contingent financing tied to borrower outcomes could improve outcomes.
Digitisation offers exciting possibilities for improving credit allocation and tailoring financial products, and thereis the potential of using granular data to address seasonality and liquidity shocks. Additionally, researchers are increasingly exploring microfinance’s broader effects on local economies, labour markets, and competition.