In 1983, Mohammed Yunus founded the Grameen Bank. His idea was simple: the bank would grant tiny loans, often no more than $100, to women in rural Bangladesh who had no access to credit. In the following decades, repayment rates for some schemes were as high as 98%, and Yunus attracted major funds from backers such as the Ford Foundation. In 2020, more than $50 billion of credit was being given to the poor – this time, by giant global banks, like Morgan Stanley and Citigroup. And yet, randomised studies throughout the last decade have in fact shown that microcredit caused little to no reduction in poverty. What went wrong?

Initially, there appeared to be a strong argument for the role that microfinance could play in reducing poverty. In the developing world, there is no shortage of entrepreneurs: between 30 and 50 percent of people are self-employed compared to only 10% in most developed countries. And for rural women, whose husbands tend to work in manual labour, there is a definite opportunity to start a business. It was decided therefore that the reason why these hundreds of millions of entrepeuners remained in poverty was credit. Banks refused to give out loans in such small amounts because of the high percentage of overhead, and they certainly wouldn’t give one to a poor woman without a credit score.

Microfinance banks offered solutions to these problems. First, they gave a lump sum of cash (tiny amounts to a bank, but enough for borrowers to start a business) to groups of women. Then, the whole group would make repayments each week to a debt collector. By spreading the loan, the risk of default drops; but more importantly, each woman relies on the others to pay their share. In rural communities where contract rights are often weaker, a system of trust is generally relied upon, with the collateral being alienation from the community, and refusal to provide future help for the wrongdoer. Therefore, by taking advantage of the power of reputation in such villages, the Grameen Bank was able to reach very high rate of repayment; take Opportunity International, another microfinance institution, which found that 98% of their loans were repaid.

However, decades after the initial experiment, economists have found that the more extreme predictions – that microcredit would lift the developing world from poverty – have proven to be entirely false. In randomised field tests, where a selection of villages from Chile to Mongolia that received microcredit were compared to a selection of control villages that didn’t, the microcredit had little effect on poverty, income and wealth. Neither was there a clear impact on consumption.

Since the 2000s, repayment has fallen in developing countries, while volume and interest have shot up – to over 200% in some cases. Some have found themselves in a cycle of debt, as the social requirement to pay back loans creates unbearable pressure; around 200 people in debt to microfinance institutions committed suicide between 2017 and 2020.

So what went wrong? For one, the idea that credit is the only barrier to unlocking rural entrepreneurs’ full potential has proven to be overly simplistic. As most citizens in rural communities live on a subsistence wage, there is little room for demand for new products (the field tests found no clear impact on consumption). All that can happen is for consumers to substitute between different staple goods elsewhere, meaning increases in some incomes cause decreases in others. Moreover, a lack of skills has also meant people can do little with their credit. One example of this is Grameenphone, a company which provided mobile phones to villages in Bangladesh. Telenor, a Norwegian telecommunications company, collaborated with the Grameen Bank to loan Bangladeshi women funds to buy the phones. People in the village could in turn rent them from the women. Initially, the mobile phone providers saw their incomes shoot up; but as more and more women took loans to become phone providers, their incomes dropped to 15% of the national average.  

Finally, the high discount rate for desperate people has meant that debtors just won’t start businesses. Short term needs for basic provisions are more important than uncertain future income. As a result, microcredit entrepreneurs have faded, and microfinance is increasingly used to cover sudden spikes in costs – family illness, for example. As a result, the hope for soaring entrepreneurial growth, or a sudden disappearance in poverty has vanished. As economist Bruce Wydick argues, “when they introduced credit cards in the US, so that almost everybody had access to a credit line, did that put millions of people out of poverty?”

On the other side, there is a significant struggle to make profit on such small loans. In particular, fixed costs, such as the salaries of weekly loan collectors, make up a large percentage of the small loan. This shifts supply to the left, leading to high prices (interest) on the credit. Incomplete information, from both sides, has additionally compounded interest rates: for lenders, the lack of credit score has meant that high risks for microfinance remain, shifting supply further to the left. On the other hand, debtors are often unaware of the meaning and risks of micro finance deals. This makes it easier for creditors to exercise price control, leading to even higher prices through higher interest and collateral. In Mexico, Compartamos have been found to charge unpayable prices, such as 100% yearly interest (institutions are legally required to price responsibly, but this has been no barrier); in Cambodia, creditors such as LOLC have been accused of intimidating debtors, and setting exorbitant rates in order to seize the land used as collateral. Far from democratising credit, for-profit microfinance has left entrepeuners crippled with debt far higher than their rates of return, even if they do use that money to become entrepeuners.

This is not to say that microfinance has no role to play in development. More than microcredit, micro-savings have played an important role in countries such as Mongolia; by allowing individuals to save money for emergencies, micro-savings have helped victims of poverty spread out these costs over a long period of time, without having to resort to high interest and often exploitative loans. Micro-insurance has also found some success in improving living standards in Mali: insurance shares the risk of extreme events (such as illness, destruction of crops and damage to property) which would otherwise be detrimental to individual members of the rural poor, in excess of the distributed cost of premiums. Significantly, most banks would be unwilling to provide these services. Where normal savings accounts will require a minimum deposit of up to $100, no minimum is required to open to a micro-savings account. Similarly, micro-insurers are willing to insure for much lower premiums and payouts than banks, covering property as cheap as livestock or huts. Microcredit, as well as microsavings and microinsurance, all have a role to play in the developing world: However, it seems unlikely that microfinance will start an entrepreneurial revolution any time soon.