Microfinance and Economic Inequality: A Comprehensive Overview

Introduction to Microfinance

Microfinance is broadly understood as the offering of financial services, products, and support to poorer populations — including both individuals and entrepreneurs — in order to present them with opportunities that would otherwise be inaccessible. Historically, microfinance targeted women and aimed to support social development. In recent years, however, it has become a noteworthy investment, capable of generating profit and attracting commercial investors.

As Roy (2010) observes:

"While the Grameen Bank promises to alleviate poverty and empower women through a non-profit model of financial services, new models of microfinance institute strict norms of financial sustainability and emphasize profits rather than human development. This […] is the microfinance revolution. It bears a new promise: that the bottom billion — the world's poorest — will serve as a frontier market, opening up new horizons of capital accumulation. Microfinance is no longer the sole domain of non-profit organizations such as the Grameen Bank; it is the domain equally of commercial banks, investment vehicles, and money makers."

Founders and Institutional Landscape

Microfinance has traditionally emerged through donations and sponsorships, but it gradually advanced to a new level in which institutions were formed and specialized in the field of financial aid to the poor. Emphasis was traditionally placed on domestic operations and lending, with less focus on international operations and resources.

The landscape of funding options in microfinance is highly dynamic and complicated. Existing funders range from those with primarily a social mission to alleviate poverty — such as international donor agencies and foundations — to those with more commercial motivations, including commercial investors and domestic capital markets, with many options in between (Helms, 2006).

One notable founder within the microfinance community is the Grameen Bank in Bangladesh, which began lending to the poor without requiring collateral and gradually inspired other players in the region to support poor people's access to borrowed financial resources. International financial institutions and private funds have since emerged as significant investors in microfinance as well (Helms, 2006).

Poverty Reduction, Political Perspectives, and Gender

Microfinance and Poverty Reduction

The central goal of microfinance operations is to reduce poverty and decrease the income gap between the rich and the poor. The underlying principle is the need of poor populations to gain greater access to funds, combined with recognition of the diverse needs of poor individuals. The major advantage microfinance holds over other types of borrowing is the flexibility involved — such as the absence of a collateral requirement and the personalization of loan terms based on each borrower's particular circumstances (Johnson and Rogaly, 1997).

Global Approach

At a global level, microfinance is broadly based on the centralization of funds to support poor populations' access to loans. Generally, emphasis is placed on domestic sources, but international microfinance institutions are also gaining momentum. Notably, microfinance solutions differ from one region to another, and one criterion generating these differences is the level of economic development. As Marguerite S. Robinson (2002) observes: "My impression is that microfinance in former centrally planned economies is somewhat different from microfinance in most developing economies."

The United States

The United States possesses one of the most developed credit markets, which strives to serve the needs of as many citizens as possible. A question therefore arises as to why microfinance should intervene in such credit markets. The answer lies in the continued failures of the existing system to attend to the needs of the poor. Even with government support, these failures have persisted. As Armendariz de Aghion, Armendariz, and Morduch (2007) explain:

"Good intentions often went awry as state-owned development banks mismanaged resources and interest rate restrictions prevented banks from operating viably in poor areas. Against this background, microfinance emerged as an especially promising way to rethink banking for the poor."

Four Political Economy Perspectives

Similar to any other economic concept, microfinance is subject to the influences of four perspectives of political economy: the conservative, classical liberal, modern liberal, and radical perspectives, which can be placed at the intersections of four different values — individualism, community, equality, and hierarchy (Clark, 1998).

The Conservative Perspective. At the conservative level, the central role in economic development is represented by hierarchy and community. Community harmony is essential for development, but progress is sustained through a hierarchy that promotes individuals with leading skills and abilities (Clark, 1998).

The Classical Liberal Perspective. The classical liberal perspective centers on both individualism and hierarchy. In its earliest stages, economists in this tradition advocated for equality among individuals, but concluded that inequalities and hierarchies were necessary to stimulate economic growth and development (Clark, 1998).

The Modern Liberal Perspective. The modern liberal perspective holds equality and individualism to be of equivalent importance. Economists aligned with this perspective believe that equality and liberty protect human dignity and economic prosperity. Supporters acknowledge potential conflicts between the two values but argue that such disputes can be settled constructively, and they insist that this combination of principles is essential for economic development (Clark, 1998).

The Radical Perspective. Finally, the radical perspective combines commitment to community with commitment to equality among community members. The underlying idea is that economic wealth and prosperity are to be attained at the community level, and only when community members unite to support this development (Clark, 1998).

Microinsurance

As the field of microfinance developed, increasing emphasis came to be placed on microinsurance. Microinsurance products offer coverage to low-income households, providing protection to individuals who have little savings, and are tailored specifically for lower-valued assets and compensation for illness, injury, or death (Investopedia, 2011).

The Role of Gender

Microfinance institutions were traditionally established to serve women. While they do not exclude men, an estimated 80 percent of microfinance institution customers are female. The Grameen Bank, for instance, commenced by serving mostly men, but today approximately 95 percent of the bank's customers are women. De Aghion, Armendariz, and Morduch (2007) argue that this shift has resulted from changing roles of women within impoverished communities. Modern women are less likely to have large numbers of children and focus more on education and career, leading them to seek financial aid from microfinance institutions.

From a financial standpoint, the focus on women also stems from empirical findings: women demonstrate higher loan repayment rates, and lending to women — rather than to men — appears to improve household living standards more broadly (de Aghion, Armendariz, and Morduch, 2007).

Empirical Evidence and Management of MFIs

Empirical Evidence of Effectiveness

The number of studies providing empirical confirmation of microfinance's effectiveness is relatively limited, and most research projects focus exclusively on one country at a time. In a context where variables differ across situations, the results of individual studies are insufficient to confirm or refute the theory that microfinance reduces the income gap.

Hisako Kai (2009) has developed one of the most comprehensive approaches to this problem, collecting evidence from 61 countries and finding that, with few exceptions, microfinance operations do indeed support a reduction in income inequality:

"This paper provides a cross-country empirical study of 61 developing countries, concerning the impact of microfinance on inequality. We show that microfinance plays an important role in creating a financial system endowed with the equalizing effect. Until now, only a few single-country analyses of the impact of microfinance on inequality have been performed; a cross-country analysis has not been conducted thus far. To the best of our knowledge, our study is the first one to indicate the universality of the equalizing effect of microfinance by applying the cross-country methodology. Moreover, we contribute to the research accumulation of the impact assessment of microfinance at the macro level, which has seldom been analyzed" (Kai, 2009).

Management of MFIs

The management of microfinance institutions (MFIs) is increasingly complex, owing to these entities' dual focus. On one hand, they serve the poor population's need for access to loans, giving their operations a selfless, social-welfare orientation. On the other hand, they are for-profit economic agents that must generate revenues and remain financially self-sustainable — a requirement that is especially pressing for institutions with shareholders to whom they must demonstrate returns on equity investment. In this context, emphasis is often placed on recovering incurred costs.

The efficiency of managerial activity at microfinance institutions is generally measured using the operational self-sufficiency ratio, which indicates whether lenders are able to cover their costs. Some institutions, however, are only able to cover 60 percent of incurred expenditures. The means by which institutions manage this shortfall vary, but the prevailing trend is to reduce per-borrower costs and minimize expenses associated with managing overdue loans (de Aghion, Armendariz, and Morduch, 2007).

Group vs. Individual Lending

Group lending is characterized by the fact that group members — generally between three and fifty women, depending on the case — seldom possess collateral and share the risks associated with repayment problems. The success of these groups depends on regular meetings and a sense of mutual responsibility embedded among the members (de Aghion, Armendariz, and Morduch, 2007).

Group lending can also be understood as a model in which a microfinance institution provides funds to a group of individuals who collectively use and repay the money. Individual lending, by contrast, occurs when an institution grants a loan to a single person. Maria Lehner (2009) found that microfinance institutions generally prefer individual loans but will offer group loans under specific circumstances: when the size of the loan is increased, or when competition among microfinance institutions is low and refinancing costs are high. As access to capital markets grows and competition intensifies, Lehner expects individual loans to become more prevalent.