Borrowers of the Grameen Bank congregate to discuss the status of loans. Photo credit: Flickr.

An estimated 4 billion USD is invested annually in microfinance around the world. But while microfinance institutions must have strong business models in order to survive, they face the challenge of making profits while creating lasting social change. A new study co-published by the ILO provides practitioners and policy makers with guidance on how to deal with the issue of balancing business and poverty reduction by defining criteria for supporting microfinance institutions.



Muhammad Yunus had a small and beautiful idea, an idea that was celebrated globally by the Nobel Peace Prize in 2006. Yunus showed that poor households in his native Bangladesh could be reliable bank customers, and, with that, he promised a new way to open opportunities for the excluded and to attack entrenched poverty. Small loans, he argued, could nourish the tiny, capital-starved businesses of the poor and create lasting improvements in living conditions. But he had more than an idea: "microfinance" became the foundation of Grameen Bank, a financial institution that today serves over 7 million customers. Other pioneers in Latin America, Africa, and elsewhere in Asia have made microfinance a global phenomenon.

One of Yunus's remarkable qualities is making all of this sound easy. But, in truth, it is not. Despite the microfinance success stories, practitioners and policy-makers continue to struggle with hard questions. Most important: how can the microfinance "industry" grow while institutions remain committed to their missions over time?

The Double Bottom Line

Microfinance institutions must have strong business models in order to survive over time, but the challenge is raised by the fact that most microfinance institutions have "double bottom lines" - they are not just working to make profits. Inspired by Yunus and others, they are "social businesses" in part working to create lasting social change, and in that pursuit, donors - whether governments, foundations, or individuals - are helping with subsidized resources. Experts estimate that investments in microfinance average around 4 billion USD annually, much of that invested with social aims. A recent analysis of 94 million microfinance borrowers shows that over 80 percent are served by non-licensed institutions like NGOs or government banks, set up in part with social missions. The idea is clear, but how, in practice, can social businesses do justice to both the social side and the business side?

Inspired by Yunus and others, they are "social businesses" in part working to create lasting social change, and in that pursuit, donors are helping with subsidized resources.

A new book by an international research team headed by the International Labour Office, and funded by the Geneva Institute of Development Studies, the European Union and the Ford Foundation, surveyed 45 well-established microfinance institutions in 24 countries. They found one important strand that cut through all of these organizations: the importance of efficiency - the ability to use scarce resources to most effectively reach thousands of customers, deliver quality services, and close the biggest gaps between the supply and demand of basic financial products for the poor. In microfinance, efficiency means using the least amounts of inputs - particularly staff time and capital - to produce the greatest number of loans, reach under-banked clients, and deliver a range of valued services.

The researchers found that institutions operate with greatly varying degrees of efficiency after taking into account their location, legal form, delivery techniques, subsidies received and staff structure. The first group is markedly inefficient - both in terms of social and financial performance - relative to what has been achieved by other similar institutions. The second group serves many poor households but is weak on financial measures. The third group does well on profitability, but less well in terms of social impact. And the fourth group performs well in both respects. There are institutions that manage to reach very poor households and still break even, but others cater to a better-off clientele, enjoy a relative monopoly and fail to do well financially.

The biggest lesson is that profitability does not necessarily mean efficiency. Too often, institutions operating as monopolists charge high prices and earn tidy profits, but pass on the costs of their inefficiencies to their poor customers. A second lesson is that the successful outreach to the poor should not be used as an excuse for inefficiency which limits the scale of outreach and the quality of services, again leading to lost possibilities.

Some institutions operate efficiently but fail to break even due to local market conditions (particularly high wage costs and low population density) or due to strategic decisions not to raise interest rates and other fees.

Smart Subsidy

Every single one of the 45 institutions reviewed in the survey has a donor partner that provides some form of subsidy - seven institutions had one donor partner, 15 institutions two or three and 20 of them more than three. The use of subsidies decreased in 12 institutions from 1999 to 2003, but in fourteen the share of subsidies on total liabilities increased.

So far, however, the decision of governments or donors to grant subsidies is not based on considerations of efficiency but other factors. Too often, current practices of subsidization lead to market distortions and unfair competition, as well as undermining accountability in the management of institutions. Focusing on efficiency, conditional on the type of institution, is an important way forward.

Too often, institutions operating as monopolists charge high prices and earn tidy profits, but pass on the costs of their inefficiencies to their poor customers.

A starting point is to better understand the drivers of efficiency. In part, managers of microfinance institutions must deal with the markets they are in, and have to take the nature of regulation and the structure of costs and wages as given constraints. But managers also have discretion; they can improve incentive contracts for loan officers, modify loan delivery techniques (e.g., choose between individual versus group transactions), adjust collateral requirements, choose combinations with non-financial services, and develop strategic partnerships with local groups and associations.

The new book advocates a more transparent and contractual use of subsidies in microfinance. At the center are fairly long term, stable "performance-based contracts" between donors and microfinance institutions that are geared towards efficiency targets in areas for which managers can be held accountable. Whether this will work or not hinges largely on efforts by donors and governments to not undermine each other - success depends on working together to promote principles of transparency and incentive-based support.

Given the mixed track record of subsidies to support microfinance so far - or in the entire financial sector of many countries, for that matter - some scepticism is justified. Which types of subsidies are "smart" and which are not? The form, intensity, timing, duration, transparency, conditionalities and magnitude of subsidies can make all the difference to market distortion, impacts, and institutional incentives. It is time to examine and debate these issues in an open way - and to keep a sharp eye on efficiency as a critical element of the bottom line.




Contributed by Bernd Balkenhol and Jonathan Morduch. Bernd Balkenhol heads the Social Finance Programme at the International Labour Office. Jonathan Morduch is Professor of Public Policy and Economics at Wagner Graduate School at New York University. Reprinted with permission from The International Labour Office.

To read another Global Envision article about microfinance, see The Online Funding Revolution.



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