Has microfinance worked? The power of randomised trials

Being poor and living in a developing country makes it hard to borrow funds to start or grow a business.

For example:

• Suppose you borrow to buy a house, for example with a mortgage. If too many payments are missed, the lender (often a bank) can seize the house. Yet in the case of a poor borrower, there are no assets (collateral) against which you can borrow.
• Suppose debt repayments are missed. How should a lender track down a borrower, when it is unclear where the borrower lives?
• Banks may have little data (credit history) on whether someone is likely to repay a loan. Facing higher uncertainty, banks may charge higher interest rates to borrow money.
• Higher interest rates for lending in developing countries in turn make it costly to borrow.
• As a result, a large proportion of the population cannot access loans in some developing countries. Alternatively, they resort to “loan sharks” who lend at exorbitant interest rates.

Enter “microfinance”.

How would microfinance improve upon traditional lending?

Microfinance involves giving small loans to businesses who typically do not receive much financial support.

Microfinance often involves lending to groups of entrepreneurs. Groups could hold each other accountable for repayments. If one member of the group fails to repay, the whole group can lose their loan. A kind of “peer pressure”.

Loans can be used for small businesses but also to put children through education or for health bills. In theory, this should boost investment and productivity.

Other examples of uses for the microloans include paying for seeds and fertiliser, starting sewing or cosmetics businesses or buying Nokia phones.

One of the most famous examples of microfinance is the “Grameen Bank” in Bangladesh. Grameen Bank reported a 98% repayment rate on its microfinance loans. 95% of its clients were women.

Microfinance generated a wave of support initially and was the basis for the 2006 Nobel Peace Prize.

Criticisms of microfinance

Nevertheless, several criticisms exist.

In particular, while microfinance sought to reduce the problems of indebtedness and loan sharks, it may have exacerbated this very problem.

Moreover the social pressure from coercion within microfinance groups can lead to people being ostracised from communities or making poor financial decisions.

What if the lending market is already functioning well, before microfinance? In this scenario, microfinance could simply “crowd out” other sources of lending, resulting in less of an increase in overall borrowing.

Are the problems from microfinancing down to a lack of regulation or an industry-wide problem?

Economists’ evidence – the randomised control trial

Imagine you wanted to test the effects of microfinance. How would you do it?

One way is to design a randomised control trial (RCT). An RCT would randomly offer microfinance loans to some people in the sample (the “treatment group”). Meanwhile, the “control group” would not receive any microfinance.

This randomisation allows us to ensure a fair test, so we can observe the true impact of microfinance.

The 2019 Economics Nobel Prize for Banerjee, Duflo and Kremer was awarded exactly for this kind of work – conducting RCTs in developing countries to test what interventions will help people out of poverty.

In the case of microfinance, what did economists find?

Well the evidence is mixed.

A review of six studies by Banerjee et al. (2015) finds there is evidence of positive effects, but not larger transformative ones. This includes:

• Positive effects of microfinance on investment.
• Increases in business income (but this may be offset by lower wage income). While income may not increase overall, microfinance may allow more choice in occupation and self-reliance.
• Little change in overall consumption. But a decrease in spending on temptation goods, recreation and entertainment. Is this coming from greater self-discipline or somewhere else?

In summary, microfinance may be part of the solution but it is not a “cure-all”. Research continues on microfinance and other poverty reduction policies.

Questions to consider

• Which effects of microfinance have not been considered above?
• What other poverty interventions might you want to test in an RCT?
• What are the limitations of RCTs?

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