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Microfinance As Development:A Critique of the ‘Financial Systems Approach’

to Microfinance in Developing Countries

Peregrine Willoughby-Brown

This dissertation is submitted in partial fulfilment of the requirements for the degree of MSc in Globalisation and Development of the School of Oriental

and African Studies (University of London).

Date of Submission: September 15th, 2009

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I undertake that all material presented for examination is my own work and has not been written for me, in whole or in part, by any other

person(s). I also undertake that any quotation or paraphrase from the published or unpublished work of another person has been duly

acknowledged in the work which I present for examination.

Peregrine Willoughby-BrownSeptember 15th, 2009

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Acknowledgements

I would firstly like to thank God, my parents and Rosalie Nugent. Without the help of these three people and one omniscient deity, nothing that I have accomplished in my life would have been possible. I would also like to extend sincere thanks to Dr. Carlos Oya and Jack Footitt at the School of Oriental and African Studies, as well as Professor Deborah Burand of the University of Michigan, for their valuable assistance and guidance during the preparation of this work. I also offer my thanks to Dr. Dae-Oup Chang, Ms. Alessanda Mezzadri, Professor Christopher Cramer, Dr. Giuseppe Caruso and Mr. Ben Whiston for all they have taught me during my time at the School and all the guidance they have given me.

Finally, I would like to thank three of the leading figures in the promotion of the financial systems approach to microfinance: Dr. Marguerite Robinson, Dr. Robert P. Christen of the Gates Foundation and Professor Claudio Gonzalez-Vega of Ohio State University. I had the pleasure of studying under all three of these distinguished individuals at the 2009 ILO / Boulder Institute Microfinance Training Programme, and despite the fact that their work provided me with much of the ammunition used in this piece, their unfaltering commitment to improving access to financial services has brought positive change to the lives of many people across the developing world. It is this author’s sincere hope that their good work will continue, just as I hope that their viewpoints and those of others in the field of microfinance will continue to be subject to ongoing critical appraisal and revision. Given the right conditions, microfinance has great potential as a tool for enabling economic and social development. This is not to say, however, that microfinance can or should rely on its past achievements to justify its own existence. There is a huge amount of work to be done on improving microfinance operations in developing countries, and it is only through ideological flexibility, in addition to continuous revision of accepted practices, that microfinance institutions and donors can continue to improve the ways in which they serve the needs of the world’s poor.

To conclude, I offer the following message to the microfinance industry: It is only through dialogue and pragmatism, as opposed to stagnant ideological imperialism, that more of microfinance’s potential for relieving poverty will be realised in the future. And it is my sincere hope that the various actors in the microfinance industry will realise this soon, lest we miss what is indeed a great opportunity to have a positive impact on the lives of people who deserve a better hand than that which fate has dealt them.

In Loving Memory of Rosalie Nugent

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Abstract

Microfinance is lauded by many as one of the greatest innovations to appear in the field of international development in the last forty years. In the last two decades, however, a rift has appeared between those who adhere to a ‘welfarist approach’ to providing credit and other financial services to the poor, and those who follow what is increasingly referred to as the ‘financial systems approach’. This ‘financial systems approach’ has gained an almost hegemonicstatus as the dominant paradigm, yet it is based on a series of assumptions which, despite being based on some empirical evidence, are portrayed as universally applicable ‘truths’. This is despite the fact that there is a substantial body of evidence that indicates they may not be universally accurate. In this piece, the author will outline the history of microfinance to illustrate how theorists and practitioners have arrived at this juncture, before outlining several key tenets of the ‘financial systems approach’ which are in many ways derived from this historical experience. As the latter part of this work will show, however, the widespread belief in these guiding principles rests on a foundation comprised of several assumptions, many of which are largely unjustified if one considers the empirical evidence. The nature of these assumptions, as conceptions based on theory, rhetoric and selective use of evidence, also bears more than a passing resemblance to larger debates in development concerning neoliberal globalisation. Indeed, it may not be outside the realm of possibility that the ‘great schism’ in microfinance is but one facet of ongoing debates about the nature of global economic integration and development.

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Table of Contents

Chapter 1: Introduction………………………………………………………………6

Chapter 2: Literature Review………………………………………………………14

Chapter 3: A Brief History of Microfinance………………………………………..17

Chapter 4: Towards a Definition of the Financial Systems Approach………….21

Chapter 5: The Financial Systems Approach: 5 Key Assumptions…………….26

Chapter 6: How is the Financial Systems Approach Related to Neoliberal Globalisation?............................................35

Chapter 7: Conclusions…………………………………………………………….37

Bibliography………………………………………………………………………….38

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Chapter 1:Introduction

In the decades that have passed since the end of the Second World

War and the widespread decolonisation that followed, those who work in the

field of international development have experimented with numerous different

strategies aimed at improving the lives of poor people in developing countries.

In the current age there is a previously unparalleled array of strategies for

donors and practitioners to choose from, some of which are likely destined to

be little more than passing fads. Others will achieve a longevity which, some

might say, surpasses that which their measurable impacts would justify. The

ever-growing field of microfinance is one strategy which has grown in

prominence in recent years, yet it remains unclear whether it is entirely

successful in delivering all that it promises.

What is clear, however, is that there is growing scepticism amongst

donors about the logic of pouring aid money into other kinds of interventions

that do not yield results, and microfinance is increasingly coming to be seen

as a useful tool for fostering sustainable economic and social development.

Indeed, by 2006 the international donor community was spending between

$800 million and $1 billion per year on microfinance, and it is being accorded

an ever greater level of attention and public recognition. [CGAP 2006: 1]

Microfinance institutions [MFIs] have appeared in almost all parts of the world,

and although they appear in different forms and guises, they have largely the

same objective; to alleviate poverty through providing microcredit and other

financial services to poor people. The world of microfinance is not, however,

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the harmonious entity that some have attempted to portray, and there is a rift

between two main schools of thought regarding its orientation and future.

To use the terminology used by Morduch [2000] and Woller et al.

[1999], this ‘microfinance schism’ pits the followers of the previously-popular

‘poverty-focused approach’1 against adherents to the now-dominant ‘financial

systems approach’.2 In some respects, including their stated objective of

poverty reduction, these two philosophical orientations are not mutually

exclusive, yet they differ wildly in how they intend to achieve these objectives.

The poverty-focused approach will not be discussed in detail here, but it is

sufficient to state briefly that it is concerned with directly increasing incomes at

household level by providing subsidised credit and other inputs to poor

people. The financial systems approach, however, purports to be able to

increase incomes (and perhaps, by extension, welfare) amongst the

‘economically-active’ poor through the provision of small-scale, but

commercially-oriented, unsubsidised financial services.

The viability of microfinance inspired by the financial systems approach

as a tool for relieving poverty is supported by a wealth of anecdotal evidence,

as well as a few passable attempts at quantitative research. On the whole,

however, there seems to be a heavy reliance on anecdote and rhetoric

amongst its adherents, and a shortage of meaningful impact assessments.

1 This approach is also sometimes referred to as the ‘poverty lending approach’ [Robinson 2001: 2], or the ‘welfarist approach’. [Moon 2007: 3]2 This school of thought is also sometimes referred to as the ‘minimalist approach, [Mutua 1994] or the ‘institutionalist approach’. [Woller et al. 1999: 1] In this piece, the author will use the term ‘financial systems approach’, as employed by Robinson [2001] and other leading figures involved in its formulation. A discussion of what the ‘financial systems approach’ entails can be found in Chapter 4.

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And it is this reality which reveals the underlying problems with the financial

services approach, as a body of theory which relies on several key

assumptions about the ways financial markets function in developing

countries, as well as unrealistic expectations about what can be achieved

simply through the provision of financial services to the poor.3

In this piece, the author intends to demonstrate that much of the theory

which constitutes the financial systems approach is faulty, based more on

anecdotal evidence and selected empirical examples than on universally

applicable truth. In Chapter 2, we will examine some of the literature which

has led the microfinance industry to accept such a paradigm, as well as some

of the works which have discussed conceptual and practical problems with it.

There is, in fact, a fairly select group of people and organisations that have

been responsible for arguing in favour of a financial systems approach to

microfinance, and the identity of some of these gives some insight into why

they have pushed so hard to make theirs the dominant paradigm in the field.

In Chapter 3, ‘A Brief History of Microfinance’, the author will outline the

historical trajectory of the microfinance industry. From its beginnings as simply

microcredit offered by large-scale, state-sponsored rural development banks

in the 1970s, microfinance has changed over time through experimentation

with various models and techniques. The ‘discovery’ of group lending

3 It should be noted here that the financial systems approach does not claim to be able to address the needs of people who are destitute (i.e. completely economically inactive). Even Marguerite Robinson, one of the main proponents of such an approach, concedes that “Commercial microfinance is not appropriate… for extremely poor people who are badly malnourished, ill, and without skills or employment opportunities… Such people do not need debt. They need food, shelter, [and] medicines… for which government and donor subsidies are appropriate.” [Robinson 2001: 8]

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techniques in the late 1970s and 1980s had a huge impact on development

practitioners’ and theorists’ conceptions of the kinds of credit services that

could be provided to low-income people, and in the 1990s the field advanced

further with the introduction of new savings and other financial products. It

was also during the 1990s, however, that the microfinance schism began to

manifest itself, as the appearance of research discussed in Chapter 2 began

to pave the way for the emergence of the financial systems approach. This

approach is, it must be pointed out, derived from the experiences of the early

microcredit programmes. Yet it was not long before the financial systems

approach started to take on a life of its own, as a holistic ‘grand theory of

microfinance’ which purported to hold the answers to how developmentally-

beneficial financial services could be offered sustainably.

Chapter 4 seeks to unbundle the key principles of this paradigm, and

although it is not an exhaustive list by any means, the author has identified

four ideas which constitute the strategic backbone of the financial systems

approach. Firstly, microfinance institutions must be able to offer a range of

products to clients; microcredit alone is not sufficient. Secondly, these

products must be offered to people who do not already have access to formal

financial services. Third, these financial services must be offered on a

potentially profit-generating, self-sustainable basis. And finally, the financial

systems approach promises that if the three aforementioned goals are

achieved, this will have a positive developmental impact on households.

These guiding principles seem simple enough in theory, but as will be

illustrated in the following chapter they are anything but simple in practice.

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In Chapter 5, the author identifies five key assumptions which underpin

the faith placed by donors and others in the principles of financial systems-

inspired microfinance. Taking these principles as sturdy guidelines assumes

that these assumptions always hold true, yet the author will demonstrate

using empirical evidence from different contexts across the developing world

that in many cases they are not universally applicable. Does offering a range

of formal financial products to clients increase their incomes more than

informal alternatives? There is a growing strand of literature which illustrates

the pervasiveness of informal financial services, as well as questioning

whether or not they are actually as inefficient as proponents of the financial

systems approach would care to admit. Is there demand for formal financial

services amongst people who do not already have access? Despite

frequently-cited vague estimates of the market for credit and savings services

amongst low-income people which point to huge unmet demand, new

estimates of the demand for microcredit in particular have cast doubt on

previous assumptions about the potential size of the market. Advocates of the

financial services approach look down with disdain on government-subsidised

credit and savings services, frequently pointing out how historical examples of

these were corrupt and did little to help the poor. Yet is commercially-oriented,

self-sustainable microfinance inherently better for clients than government-

subsidised alternatives? Indeed, is it even possible for microfinance

institutions to achieve the kind of cost-covering self-sustainability valued so

highly by the financial systems approach? The author intends to present

empirical examples to illustrate that the answer to both of these questions is,

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in fact, negative; there are examples of state-subsidised credit institutions

which have had positive impacts on borrowers, and self-sustainability of the

kind described by Robinson [2001] and others remains little more than a

theoretical objective for most microfinance institutions, if indeed it is even

something that they wish to achieve at all. The final key assumption that will

be addressed in Chapter 5 concerns the means with which the financial

systems approach purports to demonstrate its impacts. Those who follow

such an approach put forward that impact can be measured at the level of the

microfinance institutions themselves, which is to say that it is their view that if

an institution is covering its own costs, repayment rates are sufficiently high,

and a sufficient percentage of clients are sufficiently poor, the institution in

question must be having an impact. This belief that impact can be measured

at the level of the institution rather than the client, however, ignores the

fundamental problem of the fungibility of capital. Just because a borrower is

poor and manages to repay a microloan does not mean that their

circumstances have improved, and the author will demonstrate how this is

often not the case; microfinance clients borrow money from one another to

repay loans, and those who may appear to be in control of their own finances

(either within a lending group or within a household) are often not so. So how

is it that such a dominant, even hegemonic paradigm has taken such a firm

hold on the microfinance industry when it is based on so many potentially

unsound principles?

In Chapter 6, the author will attempt to answer this question by relating

the debate about approaches in microfinance to larger debates about the

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prevailing neoliberal globalised system. This is not intended to be a critique of

neoliberalism, but it is worthwhile to explore the striking similarities between

the financial systems approach and neoliberal ideologies. The language they

use is similar; both describe their hegemony as justified by ‘consensus’ when

in fact even a quick perusal of the relevant literature will reveal that in both

cases this ‘consensus’ is anything but. There are also deeper linkages

between the two bodies of theory, however, and there is a growing body of

academic work which conceptualises microfinance as simply another part of

the global neoliberal project.

To summarise, this work is intended to cast some doubt on some of the

key principles and assumptions on which the financial systems approach is

based. It is not the author’s objective to present a comprehensive rebuttal of

the theory; in fact it is his belief that to do so would be impossible since the

theory is based on past experiences in specific contexts. It is, however, the

author’s intention to, in words borrowed from Dichter [2007: 2], “deflate the

least warranted of the growing number of over-inflated expectations”

regarding what microfinance is capable of achieving under a policy regime

based on the financial systems approach. Microfinance as a broad field does

have considerable potential to help many low-income people get access to

financial services, which in turn has the potential to help many of those people

improve their lives. There must be, however, some ideological flexibility and

consideration of context if this potential is to be realised and the mistakes of

previous ‘cookie-cutter’ interventions, such as structural adjustment

programmes, are to be avoided. The financial systems approach,

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unfortunately, is as inflexible as the neoliberal ideology that inspired faith in

structural adjustment, and when so much evidence exists which runs contrary

to its underlying assumptions, it is difficult to see how it will be successful on a

global scale in the way that its proponents like to suggest.

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Chapter 2:Literature Review

In this chapter, the author will briefly review the various streams of

literature that pertain to our critical appraisal of the financial systems approach

to microfinance. These will be divided into a conceptual dichotomy: on one

side, those who have worked to propagate the financial systems approach,

and on the other side critical viewpoints on the approach, and criticism of

microfinance in general.

It is significant to note at this point that despite the fact that the theories

which constitute the financial systems approach began to emerge in the late

1980s, it was not until the late 1990s that commentators began to remark on

the split between the financial services and welfarist approaches. The first two

pieces which pointed at the widening gap between the two perspectives were

Woller et al.’s Where to Microfinance? [1999], which presented an argument

similar (though not identical) in its reasoning to that which is presented in this

dissertation, and Morduch’s The Microfinance Schism [2000], which

conceptualised of a ‘schism’ between “rhetoric and action – and between

financially-minded and socially-minded programs…” [p. 618]. These two

papers also mark some of the earliest attempts to draw attention to the

fallibility of some of the key principles of what would later come to be referred

to as the financial systems approach.

With regards to the approach itself, there is a small group of individuals

and organisations which have been largely responsible for conducting

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research and formulating the theories that have come to form the school of

thought we now recognise. Research conducted in the 1980s and 1990s at

the Ohio State University by Gonzalez-Vega [1993,1994] on state-subsidised

rural finance initiatives began to illustrate how some of them had been

inefficient, and also how the high transaction costs associated with serving

poor rural clients could be mitigated by a more commercially-oriented

institutional mindset. Other works by Christen et al.[1994] and Otero & Rhyne

[1994] began to lay the groundwork for what would become the financial

systems approach. Each of these writers also instilled their belief in such an

approach into the organisations that employed them; Christen took his

viewpoint to the Gates Foundation when he became the head of their

inclusive finance programme, further research from Ohio State’s Rural

Finance Program continued in the same vein under Claudio Gonzalez-Vega,

and Maria Otero and Elisabeth Rhyne became the figureheads for the

financial systems approach pursued by their organisations (ACCION

International and USAID, respectively). Two other key texts which illustrate

the financial services approach are CGAP’s Good Practice Guidelines for

Funders of Microfinance [2006] and Marguerite Robinson’s seminal work The

Microfinance Revolution [2001]. One need only cast a glance at the glowing

praise for Robinson’s work that appears just inside the front cover to

understand the full extent of the ideological homogeneity of this group; it

contains quotations from Rhyne, Otero and Christen, who calls The

Microfinance Revolution “a major work that will unquestionably lie at the very

centre of microfinance literature for years to come”. [Robinson 2001] Also

accounted for amongst those who heap praise on Robinson’s work, which is

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itself almost a ‘Bible’ of financial systems approach-inspired microfinance, is

Jacob Yaron, another key contributor to the literature advocating for the

financial systems approach.

On the other side of the coin, however, are those both inside and

outside the field of microfinance who have expressed concern over the

commercialisation of development finance, and microfinance in particular.

Fernando [2006] and Dichter & Harper [2007] are both edited volumes of

essays which in many cases are critical of overly doctrinal approaches to

microfinance, and in some cases discount the potential of microfinance as a

developmental tool altogether. Other critical works include Buckley [1997] and

forthcoming works from Roodman [2009, forthcoming] and Bateman & Chang

[2009]. These are critical of microfinance in general, with Bateman & Chang

putting forward an argument which suggests that microfinance in its current

form is actually bad for clients.

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Chapter 3:A Brief History of Microfinance

The roots of microfinance, as previously mentioned, can be traced

back to government-sponsored rural credit programmes initiated in the years

following World War 2. In keeping with the dominant development paradigms

of the time, these were largely aimed at fostering macro-level economic

growth by providing credit to rural people (who often also happened to be

poor) which, it was assumed, they could use to purchase seeds, fertilizers and

other agricultural inputs. These were often heavily subsidised, with interest

rates usually not only below commercial rates but often below inflation. In the

Philippines, for example, interest rates were capped at 16% p.a. until 1981,

despite the fact that average annual inflation hovered around 20%. In India,

the rural credit programme was targeted towards ‘disadvantaged’ groups in

society, such as women and ‘unfavourable’ castes, and was also subsidised.

[Armendariz de Aghion & Morduch 2005: 8,9]

The inefficiencies of some aspects of these programmes began to be

exposed by the Ohio State University research programme, however, and

many of these programmes were abandoned. At the time (and today, in fact)

people wrote that these rural development programmes were loss-generating,

had low repayment rates, depressed local savings and channelled funds

towards richer and/or politically powerful segments of the population, amongst

other criticisms. [Robinson 2001: 7] Larger shifts in development theory

towards poverty alleviation in the 1970s began to set the stage for the

emergence of what we could now call microfinance [Dichter 1996: 261], and

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the first microfinance institutions began to emerge in the late 1970s in

Bangladesh. These were spearheaded, of course, by Muhammad Yunus and

his Grameen Bank, which grew exponentially after he demonstrated that his

group lending model encouraged higher repayment rates from poor female

borrowers than many had thought was possible.

In the 1990s, the transition began from microcredit to microfinance, as

NGOs and others began to see the benefits of offering a selection of different

financial products to clients, and the early contributions to the development of

the financial systems approach began to appear. NGOs began to give in to

donors’ demands for sustainability, and as a few showed results many more

began trying to enter the growing microfinance sector. [Dichter 1996: 263] As

the decade progressed, more and more microfinancial service providers

started entering the market, although on the theoretical side a debate was

raging between those who favoured greater outreach and those who

emphasised self-sustainability. [Dichter 2007: 4] It is in this debate that the

current microfinance schism began to emerge, although with the creation of

the Consultative Group to Assist the Poor (CGAP) at the World Bank in 1995

those on the sustainability side began to take control. CGAP has become the

world’s leading support organisation for microfinance, and its ideological roots

are very much on the sustainability side of the microfinance debate which

started in the mid-1990s.

By the 2000s, microfinance was becoming a mainstream idea, with

Grameen Bank founder Yunus as its figurehead. Politicians and celebrities

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around the world began to speak out about the promise of microfinance, and

in the language of the financial services approach it was a wonderful promise

indeed. There was no more need for expensive aid programmes which cost

millions (or billions) and sometimes showed little results, since now it was

possible to give a loan of only $150 dollars to a Bangladeshi textile worker

and she would be able to use it to increase her household income

dramatically, providing a better life for her and for her family. The hype

surrounding microfinance came to a head in the middle of the decade, with

the United Nations declaring 2005 the ‘International Year of Microcredit’, and

the Nobel committee awarding the 2006 Nobel Peace Prize jointly to Dr.

Yunus and the Grameen Bank. By 2006, the emerging microfinance industry

boasted an impressive annual growth rate of 37%, and had reached in excess

of 67 million clients worldwide. [Fernando 2006: 1]

Throughout this period, many people in development circles (and many

more lay people) waxed lyrical about the promise of this new means for

achieving truly ‘sustainable’ development. And if anecdotal evidence was

correct, there was a market of between a billion and 3.5 billion people [CGAP

2003][Fernando 2006: 17] waiting to receive the financial services that would

lift them out of poverty, at little or no cost to donors since repayment rates

were always exceptionally high and all microfinance institutions were able to

cover their own costs. The Grameen Bank, joined now by Indonesia’s BRI and

Mexico’s Compartamos, amongst others, provided illustrations of the interest

rate-insensitive demand for credit and other microfinancial products,

maintaining high repayment rates whilst charging interest rates high enough

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to cover their very high costs. And whilst it may have been true that these

banks were able to present themselves as subsidy-free through clever

accounting practices (in the case of Grameen Bank, which claims to have

turned a profit in every year of its existence despite ongoing reliance on

grants, which it lists as income) or selective forgetfulness (in the cases of BRI

and Compartamos, which benefitted from significant political support and

start-up subsidies, respectively), the reality was that the schism which

Morduch [2000] described, between rhetoric and action, was now firmly

established. More and more donors and MFIs were championing

microfinance, the new, improved, and sustainable poverty-alleviation tool that

promised so much. Yet in reality, as the three examples above illustrate,

many of these organisations themselves were unable to live up to their own

hype when subjected to scrutiny.

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Chapter 4:Towards a Definition of the Financial Systems Approach

In this Chapter, the author will deconstruct the financial systems approach into

several key principles. Until now, the approach has been described in vague

terms, as it often is in the literature, where it becomes a holistic

conceptualisation which means different things depending on which aspect of

it is relevant to the author. It is possible, however, to unbundle the various

aspects of this approach to microfinance into 4 key components which will be

briefly outlined here.

The financial systems approach to microfinance involves, in general terms:

Offering a range of products, not just credit…

As specified in CGAP [2006] and Robinson [2001], creating financial systems

involves offering savings, insurance and other products, alongside more

traditional microcredit. It is also estimated that there is demand for such

products, with theorists using examples from developing country contexts

where people make use of sometimes less efficient informal financial

services. As the rhetoric goes, savings, insurance and loans combined help

poor people ‘smooth’ consumption and mitigate risks, leading to improved

incomes and greater welfare. [Robinson 2001: 9]

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Offering these products to people currently unserved by formal financial

systems…

Estimates abound regarding the number of people who do not have access to

formal financial services, and with the exception of those who live in absolute

poverty it is assumed that most of these people would take advantage of

formal financial services if they were available. The typical indictment of

informal financial services provided by advocates of the financial systems

approach points to the insecurity of saving at home, due to theft or

environmental conditions which cause the physical cash to deteriorate, and

cites the high interest rates charged by informal lenders as evidence of why

people would want to make use of formal microfinancial services. Armendariz

de Aghion & Morduch [2005] provide a review of some findings gathered by

previous studies of moneylenders’ interest rates, and the results are indeed

shocking. In Thailand, one study showed that typical annualized interest rates

of 60%, whilst another study of informal lenders in Pakistan recorded some

annualized interest rates as high as 120%. [Armendariz de Aghion & Morduch

2005: 28] These numbers are high indeed, yet when placed in some context

(as they will be in the following Chapter) they do not necessarily mean what

advocates of the financial services approach would attempt to indicate.

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Offering these products in a commercially-orientated, institutionally self-

sustainable manner…

As mentioned in the previous Chapter, the roots of the financial systems

approach lie in the sustainability versus outreach debate that divided

microfinance in the 1990s. At that time it was believed that in order to serve

poor clients, microfinance institutions would have to rely on subsidies since

the transaction costs associated with providing services to poor (especially

rural) people would make cost recovery impossible. Clients would surely be

unwilling to pay the exorbitant interest rates that institutions would have to

charge them, and there would be no demand. Yet examples from recent

history illustrate that demand for microcredit especially may not be as

sensitive to interest rates as was previously imagined. Compartamos, for

example, is widely known to charge poor borrowers annualized interest rates

in excess of 100% with no decline in aggregate demand. In fact, their already-

sizeable client base continues to grow. [Armendariz de Agion & Morduch

2005: 17] Indeed, neoclassical economics tells us that poor people should be

able to achieve a marginal return on loan capital that is significantly higher

than what we could hope to achieve in developed countries, so why should

they be concerned about higher interest rates? Robinson [2001] and other

proponents of the financial systems approach hypothesise that it is only

through charging high interest rates to cover costs that microfinance

institutions can increase their outreach, since to rely on subsidy is to rely on

what they perceive is an inherently limited and unstable revenue stream. As

she writes in The Microfinance Revolution [2001], “…Government and donor

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funds cannot possibly finance microcredit on a global scale…” [Robinson

2001: 8]

If the above conditions are met, this will have a positive developmental

impact…

The rhetoric of the financial systems approach evokes images of market

sellers and other microentrepreneurs who are able to increase their

household income (and by extension, welfare) through the use of credit and/or

savings to purchase income-generating assets. This, it is often said, has

further knock-on effects on families and communities, particularly when the

borrowers/savers are women, as they often are.

Yet it is on this last point that the financial systems approach begins to

unravel. Theorists take these benefits for granted, but there is little or no

attempt made to measure them. This lack of impact assessment can be

partially attributed to the difficulties in measuring and attributing the impact of

microfinance4, yet it is also a fundamental aspect of the financial systems

approach. This approach assumes that if a microfinance institution covers

costs, solicits sufficient repayment from borrowers and mobilises sufficient

savings, and that at least some of the borrowers are poor, there is no need to

demonstrate impacts because financial service provision is the endgame and

there are no donors who require justification for ongoing subsidy. It is

4 For more on issues related to impact assessment in microfinance, see Hulme, D. [2000] Impact

Assessment Methodologies for Microfinance: Theory, Experience and Better Practice. World Development, Vol. 28, No. 1, pp.79-98.

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precisely this kind of assumption, however, which is based on the faulty logic

that characterises the financial systems approach. The following Chapter will

outline 5 key assumptions on which the financial systems approach is based,

and illustrate with empirical evidence how they cannot be held as universal

truths.

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Chapter 5:The Financial Systems Approach: 4 Key Assumptions

As Roodman [2009, forthcoming] points out, the majority of popular tales

about microfinance begin with a story. And so the author would like to share

an anecdote from his own experience in the world of microfinance. In July

2009, at the annual gathering of development and microfinance practitioners

hosted each summer by the Boulder Institute of Microfinance, in conjunction

with the ILO in Turin, Italy, Robert Christen of the Gates Foundation answered

a question from an audience member after one of his lectures. The attendee,

a man from West Africa, asked Dr. Christen how he could be so certain that

simply providing financial services to the poor would result in an increase in

their income. Dr. Christen had just finished giving a talk about the pecuniary

advantages of keeping savings with an MFI instead of in the home or with an

informal savings collector of the type popular in West Africa, and he

responded by asking the audience whether they thought their lives would be

easier or harder if they did not themselves have access to electronic banking

and other modern financial conveniences. Most of the people in the audience

agreed with his inference that their lives would be more difficult if they did not

have ATM cards or chequebooks, yet there were more than a few participants

who expressed concern afterwards that Dr. Christen had been able to answer

such a complex question with such a simple answer. In fact, their suspicion

was justified, since it wasn’t really an answer at all. The financial lives of

people in developed countries and wealthier people in developing countries

are structured in such a way that they are accustomed to having these

conveniences, for to do without them would put such people at a

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disadvantage since they would be unable to interact fully with their economic

environments. For people living below the poverty line in the majority of

developing countries, however, items such as cheque books and ATM cards

are of little or no use. What good is an ATM card, or a card reader for that

matter, to a market seller in Accra? Her clients do not have these, and it is

unlikely that her suppliers are accustomed to using them either. And to simply

say that because ‘it works for us here’ that it will necessarily reduce

transaction costs and improve incomes in a completely different economic

context is an assumption that cannot be made. Assumptions of this kind will

be addressed in this Chapter, as we identify and analyse five key

assumptions implicit in the financial systems approach that do not hold up to

consideration in the light of empirical evidence:

Key Assumption #1: Offering formal financial services to poor people in

developing countries will necessarily increase incomes and provide a

better level of service than previously existing informal alternatives…

To start, this assumption is based on studies like those mentioned above

which detail the high costs charged to borrowers by informal lenders, as well

as a belief in the inherent insecurity of informal financial services. Evidence

shows, however, that neither of these is necessarily true. As far as informal

moneylenders are concerned, the comparison of annualised interest rates

charged in the informal sector with those charged in the formal sector is

invalid, simply because the term of most informal loans is significantly shorter

than a year, and is sometimes as short as a few days. Informal moneylenders

- 28 -

face high transaction costs just as microfinance institutions do, and the

necessity of charging higher interest rates can be very real if loan amounts

are low and terms are short, as they often are. Studies also indicate that the

cost of attending group meetings (a condition imposed on borrowers under

group lending models like that employed by the Grameen Bank) can be very

high, both in terms of time and opportunity cost, as well as transport costs in

some contexts. [Armendariz de Aghion & Morduch 2005: 30, 100] Data from a

new series of studies by Collins et al. [2009] also indicate that, at least in the

context of Bangladesh, the form of credit (formal or informal) most commonly

used by the poor was informal loans from family or friends, which usually

came at no added cost whatsoever to the borrower since they were interest-

free. [Collins et al. 2009: 9,46] Evidence from India shows us that people

continue even continue to use informal credit services in environments where

microfinance institutions are present, because informal moneylenders provide

more personalised, flexible loan products for various uses (weddings, for

example) which microfinance institutions are unwilling to finance. [Moseley

1996: 267]

Informal savings services, derided by those who adhere to the financial

systems approach as unreliable and open to fraud, may also provide services

that are more conveniently situated closer to clients than microfinance

institutions. This lowers transaction costs for savers. [Rutherford 2005: 18-20]

These savings services often do not pay interest, but their greater flexibility

when compared to the often rigid savings products offered by microfinance

institutions makes them an attractive option for poor people who want to save.

- 29 -

The assumption that formal savings services are ‘safer’ than informal services

is also questionable, since there is still a risk of fraud in the formal financial

sector and, as Biety [2005] admits, errors by MFI staff are ‘inevitable’. [Biety

2005: 241] This may be due in part to the fact that MFIs are forced to hire staff

with low levels of education to keep costs down, since offering savings

products to low-income people is an expensive business. [Hirschland 2005:

153] There are further risks to savers who engage with formal microsavings

schemes as well. In high-inflationary environments, which are all too common

in developing countries, people with monetarised savings will actually see the

value of their savings decrease with time, something which could be avoided

if they kept their savings in kind. [McKee 2005: 37] There is also always the

risk of default on the part of the MFI, a risk which is all too real in contexts

where MFIs employ fractional-reserve banking methodologies in order to keep

costs down and meet the lofty target of self-sustainability prescribed by the

financial systems approach. [Biety 2005b: 277]

As far as microinsurance is concerned, the assumption that such

financial stability cannot be offered by the informal financial system is patently

untrue. The previously-cited study by Collins et al. [2009] discovered a unique

funeral insurance system at work in South Africa which functions on a

principle of informal reciprocity. Members of an ‘insurance group’ do not meet

regularly or pay any premiums, in fact the transaction cost to members is zero

except when another member dies and they contribute their share towards the

funeral expenses. [Collins et al. 2009: 77]

- 30 -

As these examples have demonstrated, there is no shortage of

efficient, low-cost informal financial services available to poor people in

developing countries. And whilst that does not necessarily prove that an MFI

could not offer a better service, there is no reason to believe that that must be

the case simply because they offer a service which forms part of a more

formal financial system.

Key Assumption #2: There is demand for formal financial services

amongst people who do not already have access to them…

In some contexts this may be true, but a universally-applicable fact it is

not. As far as savings is concerned, the prohibitive transaction and

administrative costs to MFIs of offering the kind of flexible, ‘demand deposit’

savings products to savers with low balances may prevent them from offering

these products, [Hirschland 2005: 139] meaning that there will always be

demand for informal savings collectors such as the Susu of West Africa or

their equivalent in other parts of the developing world. In Ghana, for instance,

Susu collectors provide a level of service (albeit with higher costs to savers)

that no microfinance institution could ever hope to achieve; the collector visits

the saver on a daily basis at their home or workplace, and can provide a

payout from their savings at a day’s notice. Few microfinance institutions can

even offer such a quick return of deposits, and almost none (if any) would be

capable of visiting clients on a daily basis to collect sums sometimes no

greater than a few pence.

- 31 -

In terms of microcredit, the belief that poor people can afford to pay

more interest on a loan because their marginal return on capital is greater

than people in developed countries may be true, but it is not necessarily so.

This assumption is based, as previously mentioned, on a belief that demand

for microcredit is insensitive to interest rates because of the higher marginal

return on capital to be found in developing countries. Estimates of increased

marginal return in developing countries fall into a neoclassical economics trap,

however, of assuming that all other factors remain the same, and they do not

take into account the fact that poor people in developing countries to not have

the same levels of education, health or the access to business networks that

are enjoyed by even non-wealthy people in developed countries. If low-

income people’s capacity for converting loan capital into income-generating

assets is not necessarily any higher than those of wealthier individuals in

developed countries, why is it acceptable to charge them interest rates which

would be considered usurious in Europe or North America? The answer, once

again, is that the financial services approach places such a great emphasis on

self-sustainability through cost recovery from borrowers that MFIs cannot

charge any less and still recover the high transaction and administrative costs

associated with providing the kinds of microloans that poor people can

feasibly service with their own earnings. And this realisation should lead us to

question another, even more fundamental assumption on which the financial

services approach to microfinance is based.

- 32 -

Key Assumption #3: Revenue-generating MFIs are capable of offering

financial services on a self-sustainable basis…

If we have established that high interest rates are not necessarily

justified by greater marginal return on capital, the proposition that

microfinance institutions can sustain themselves through their own revenue-

generating activities must also be called into question. It is certainly true that

there are some examples of MFIs that achieve sustainability, most notably

BRI in Indonesia and Compartamos in Mexico, yet as mentioned earlier both

of these institutions have made use of subsidies at one time or another.

Compartamos received significant financial subsidies when it commenced

operations, and BRI, often held up as one of the guiding lights of the financial

services approach by writers such as Robinson [2001](who played a

significant role in guiding the Indonesian government during BRI’s

reorientation into a commercial MFI) received significant political capital in the

form of guidance and support from the Indonesian government.

On the whole, subsidy remains the reality for the vast majority of MFIs

around the world, and it has been a long-held belief amongst those within the

world of microfinance that in fact it is unlikely that more than 5% of

microfinance programmes will ever be financially sustainable. [Morduch 2000:

618] In the meantime, most MFIs pursuing a financial systems approach aim

for operational self-sustainability rather than financial self-sustainability,

meaning that they won’t finish a fiscal year with a loss on the books, but are

only able to achieve this through listing grants and interest-free loans (which

- 33 -

are effectively forms of subsidy) as revenue. They do not generate enough

income from their financial intermediation activities to cover their own costs,

and despite the insistence of people like Robert Christen, who in another of

his lectures in Italy effectively used both forms of sustainability

interchangeably, there are many in the microfinance industry who do not feel

that operational self-sustainability is an accurate measure of sustainability.

[Nathan Lawless, Interview by Author: July 2009]

There is also an assumption amongst those who support the financial

services approach to microfinance that subsidised credit programmes are

inherently worse than self-sustainable ones, and there is some historical

evidence to say that this has often been the case. There is also evidence to

suggest, however, that their dismissal of government-subsidised credit may

not be fair. Indeed, to present one basic example, research published in 2002

showed that Indian state-subsidised rural credit has had a net positive

average impact on the poor. [Armendariz de Aghion & Morduch 2005: 11]

Key Assumption #4: Developmental impact can be proven by measuring

financial performance and client outreach at the institutional level…

Another point touched on earlier in Chapter 4 concerns the means by which

MFIs pursuing a financial systems approach prove their impact. They believe

that it is sufficient to measure repayments rates and indicators of outreach

(such as percentage of clients who have a household income below national

poverty lines) to establish that their operations have had a developmentally

- 34 -

positive impact. Yet this is a fallacy, and on closer examination it becomes

almost ridiculous to suggest that simply because a poor person took out a

loan and was able to pay it back that their income has increased. This

completely ignores evidence from numerous sources which indicate that

institutional success is not an indicator of poverty reduction, that high

repayment rates amongst women does not mean that they have any more

control over their financial resources, and that loan repayment in contexts

where credit bureaus are absent doesn’t mean that the borrower hasn’t just

taken another microloan or informal loan from somewhere else to pay the MFI

back. [Fernando 2006: 1][Weber 2006: 53][Collins et al. 2009: 166]

These assumptions, when untested, provide an engaging basis for the

principles of the financial services approach as outlined in Chapter 4. Yet on

closer examination many of them are as fundamentally flawed as they are

fundamentally important in enabling acceptance of the key tenets of the

financial systems approach. Why, then, do they persist?

- 35 -

Chapter 6:How Is the Financial Systems Approach Related to Globalisation?

The question asked at the end of Chapter 5 is difficult to answer, but in

this Chapter the author will briefly relate some of the larger debates about

neoliberal globalisation to the discussions we have had here about the

financial services approach to microfinance.

On a visceral level, the two schools of thought bear more than a

passing resemblance to each other. Both speak of ‘consensus’, in the case of

microfinance through CGAP’s Consensus Guidelines and in the case of

neoliberalism through the infamous ‘Washington Consensus’. Both attempt to

portray themselves as universally applicable paradigms that need no careful

analysis because they are common sense, and both have attained an almost

hegemonic status in their respective arenas. The financial systems approach

is the dominant paradigm in the international microfinance industry, just as

neoliberalism is the dominant paradigm in the world political and economic

system.

Yet on a deeper level is it not possible, as Bateman & Chang [2009]

have theorised, that the reason why the financial services approach to

microfinance and neoliberal globalisation seem to fit so well together is that

they are in fact part of the same phenomenon? It is outside the scope of this

piece to fully investigate this, but there is a growing body of critical literature

on microfinance which conceptualises of financial systems approach-based

microfinance (and microcredit in particular) as just another vehicle for

- 36 -

neoliberalism, opening up the local economies of the developing world to

international economic forces that they may be unable to control.

- 37 -

Chapter 7:Conclusions

As stated in Chapter 1, the purpose of this piece was not to launch a

comprehensive rebuttal of the financial services approach to microfinance.

That would be prohibitively difficult, and certainly outside the scope of a work

such as this. What the author has demonstrated, however, is that by

decompiling the various elements of the financial systems approach, we can

see clearly the assumptions that underlie its crude reliance on anecdote and

rhetoric. The approach is based on past experience, that is true. And as such

there are lessons which can be derived from it that can give insight into how

to improve the financial services offered to poor people in the future.

There are certainly assumptions made by the financial systems approach that

do not hold up to scrutiny, however. Interest-insensitive demand, the

fetishisation of unachievable financial self-sustainability, and the belief that

informal or subsidised credit or other financial services are inherently worse

than those that can be offered to clients by MFIs have been exposed as

flawed assumptions at best.

The appeal of microfinance is likely to continue, however, but the agenda for

the future must focus on mitigating some of the theoretical excesses of the

financial systems approach up to this point. We must also begin learning from

informal and other forms of financial intermediation, some of which may hold

clues as to how those who work in microfinance can better serve the needs of

the poor in the future.

- 38 -

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Interview

Nathan Lawless – Capital Advisory Associate, Unitus Inc., Seattle WA.

Conducted by the author in July 2009, Turin, Italy.