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Micro-finance from Bangladesh to the United States: beneficial or detrimental to nascent entrepreneurs?

INTRODUCTION

In recent years, the idea of providing micro-loans to potential small-scale entrepreneurs, in the third world and in other areas of poverty, has gained wide-spread notoriety and praise. Muhammad Yunus, considered the pioneer of this concept, started the movement by lending small amounts of funds to basket weavers in Bangladesh, and was awarded the Nobel Peace Prize in 2006 for his efforts.

The Nobel Peace Prize Committee, in presenting the award jointly to Mr. Yunus and to his Grameen Bank, stated:

"Lasting peace cannot be achieved unless large population groups find ways in which to break out of poverty. Micro-credit is one such means. Development from below also serves to advance democracy and human rights." (Norwegian Nobel Committee, 2006)

Yet today, in many countries, micro-finance has become a for-profit industry, with a large number of banks and financial institutions entering the field and often charging seemingly very high interest rates and earning large profits in the process. Even not-for-profit micro-finance organizations typically charge interest rates considerably higher than banks charge their large business clients and are often subject to criticism. The current controversy centers on the issues of appropriate interest rates and/or resulting profits. Do the small loan amounts and significant risks of non-repayment to the microlender justify such interest rates and profits? Has the micro-loan phenomenon become exploitative in some countries? Also, do micro-loans always lift people out of poverty?

While micro-finance in general, and this issue of appropriate interest rate levels in particular, have been subjected to a modest amount of scholarly investigation, most of these studies have focused on a few countries including Bangladesh, India, Mexico, Nicaragua, Nigeria and Peru, where possible exploitation has been identified. Although micro-finance programs exist in the United States as well, a search of the literature has identified very few prior academic investigations with a domestic focus on either the general topic or on the specific interest rate issue (Khavul, 2010). The objective of this article is to examine the status and nature of micro-finance throughout the world, including a specific focus upon the United States, to probe the costs of micro-finance to loan recipients, to better understand the strengths and weaknesses of third-world and American micro-loan programs, and to offer policy implications and guidance to governments, to small business owners, and to those who consult to and assist nascent entrepreneurs and other small businesspeople who might avail themselves of such financing.

While most micro-financing will continue to take place in developing nations, where poverty is most wide-spread, it is also important to understand the American micro-finance model. With a sub-set of the American population and economy subsiding at an economic level where micro-financing might be of value, and with the majority of this journal's readership being American, an understanding and analysis of American micro-finance should be of importance and value to those who study small business and entrepreneurship, to those who assist such small business owners, and to the owner/entrepreneurs themselves.

The remainder of this article will provide the following discussion: a) a brief history of micro-finance from its beginnings in Bangladesh to its growth into other countries and the resulting controversy; b) a review of prior research, especially scholarly research with a focus on the value and appropriateness of micro-finance; c) a discussion of micro-finance programs in the United States; d) an expanded discussion of the worldwide controversy regarding appropriate micro-finance interest rates and lender profits; e) a "policy and practice" discussion with regard to governments, for nascent entrepreneurs, and for those who advise them; f) a suggested agenda for further scholarly research; and g) conclusions.

HISTORY

Perhaps 45% of the world's population exists in extreme poverty, with 1.2 billion people living on less than less than $1.00 per day (Arch, 2005), and 2.8 billion living on less than $2.00 per day (Khavul, 2010). The history of Muhammad Yunus and the Grameen Bank is well known and a brief summary is sufficient for this article. Founded in 1976, the Grameen Bank is a microfinance organization which makes very small loans to very poor and underprivileged people (97% women) in rural villages in Bangladesh, generally for micro-business (one person) purposes. ("Grameen" means "of the village" in Bengali.) Grameen micro-loans do not require collateral but rather rely on a system of group-based credit and peer-pressure for repayment. Thus, for definitional purposes, a "micro-loan" is a very small loan to a current or aspiring micro-business owner. A "micro-lender" is the lender of such a loan. While the original definitions referred specifically to the Grameen model, the expansion of such loans to other lending models, both not-for-profit and for-profit, has also expanded these two definitions.

Writing recently about the Grameen Bank, Prof. Yunus identified five keys to the success of the bank: 1) challenging conventional thinking, 2) finding complementary partners and undertaking shareholders, 3) continuous experimentation, 4) recruiting social-profit-oriented shareholders, and 5) specifying social profit objectives clearly and early (Yunus, Moingeon & Lehmann-Ortega, 2010). As of 2010, the bank has disbursed loans of about $9.2 billion, of which $8.1 billion has been repaid (Grameen, 2011).

The Grameen Bank microfinance system originally involved joint liability group lending, in which a group of borrowers are jointly responsible for all the individual loans. Since then, the Grameen Bank has moved to the more commonly-used system today, individual liability group lending, in which the borrower alone is legally responsible for her or his loan. A third model in use is village banking, in which the loan is made jointly to a group of villagers, who then organize and administer allocations and repayments schedules (Gine & Karlan, 2008). All three models involve group dynamics for both support and repayment.

As microfinance has spread from Bangladesh to other countries, it has become clear that different country environments may better support one of these liability models better than the other two. For example, in some cultures obligations to spouse and children are stronger than obligation to one's self, while in other cultures the reverse is the case. Similarly, male cultural dominance and control over women varies considerably across countries and cultures. Individualism versus collectivism is another central characteristic of cultures which differs greatly between countries and cultures (Hofstede, 1993). And political environments may or may not support micro-financing and repayment of loans. Each of these variables will influence the motivation and ability of the micro-loan recipient (generally female with a spouse) to re-pay loans, with some cultures supporting individual payment obligation, others requiring loan-group pressure and support, and still others requiring peer pressure from an entire village, often with spousal or government pressures working for or against re-payment. Several of these cultural and political factors will be further discussed later in this article.

The current controversy involves the large number of banks and other financial institutions that have seen the success of Grameen, and have entered the field of microloans in a large number of countries, several quite recently through major IPO's (Strom & Bajaj, 2010). In some countries, the business model involves for-profit institutions making the loans, while in other countries, not-for-profit organizations solicit involvement by charitably minded individuals, who make the loans with the not-for-profit organization acting as the middleman. Regardless of the business model utilized, the current controversy involves two basic issues: 1) are such micro-loans truly effective and beneficial in terms of social profit (i.e. benefit to society), and 2) what interest rates (and profits, when applicable) are acceptable? (MacFarquhar, 2010). These two issues will be further discussed later in this article.

PRIOR RESEARCH

As discussed above, most of the past scholarly investigations of micro-finance have focused on countries other than the United States, and usually on underdeveloped countries where significant poverty and unemployment exist, and where most micro-finance programs exist. The most basic issues probed deal with the effectiveness of such programs. This section of the article focuses on much of the most recent scholarly literature. For example, Mahjabben (2008) recently studied the original Grameen program in Bangladesh and concluded that Grameen and subsequently established similar programs in that country have been successful in raising income and consumption levels of households, in reducing income inequality, and of other basic social policy goals. A year later, Carr and Rugimbana (2009), in editing a special issue of a journal, concluded that micro-finance is an effective and important component of public policy with the objective of reducing worldwide poverty.

However, some other recent studies paint a more complex picture of micro-loan effectiveness. Boudreaux and Cowen (2008) concluded that such programs do generally have positive impacts, but only moderately. While micro financing can make individuals' lives better, the loan recipients generally remain in poverty, but at a slightly higher income level. As an example, a micro-loan might raise a family's income level from the equivalent of two dollars a day to $2.50. In an undeveloped environment, such a seemingly minor income improvement might keep a child in school, enable a family member to visit a health clinic, or allow the family to build a little savings.

Similarly, Menon (2006) investigated the recent effects of the Grameen Bank in Bangladesh and found diminishing returns to group-member loan recipients over time. Specifically, looking at 24 villages, the greatest benefit of micro-finance programs was to smooth the effect of the seasonal economic shocks commonly found in poor rural agricultural environments, but this benefit begins to decline after approximately two years of membership, with virtually all benefits ending after four years. Thus the value of micro-finance may be short-term rather than long-term.

Still other analyses by Surowiecki (2008) and Banerjee et. al. (2009) concluded that micro-loan programs may be of value for those who require some form of self-employment in order to improve their household income, but generally because the alternative of employment by others is not available. In most third-world cases, and in other economic environments as well, employment rather than self-employment would be of greater benefit to most of the population.

There have been a few academic research studies which have focused on the cultural and/or political factors which support or hinder the effectiveness of micro-loan programs (as discussed earlier). Crabb (2008), analyzing a large sample of micro-loan programs in a variety of countries, posited that the success of such programs was strongly influenced by the political and economic environment of the country, with success more likely in countries with low degrees of economic freedom and/or high levels of government intervention in the economic system.

Epstein and Yuthas (2010) looked at how cultures vary in their attitudes toward the repayment of loans. They identified "cultures of non-repayment" which exist in some countries and cultures, which significantly work against the success of micro-loan programs. Unless micro-borrowers are likely to re-pay their loans, the programs cannot continue and succeed in the long run. These authors suggest a variety of strategies which both governments and micro-finance organizations might utilize to offset this cultural factor. Similarly, Kristof (2010) saw cultural impediments to micro-loan programs in countries where the culture often misplaces spending priorities; for example, where household income is spent on alcohol, tobacco and prostitution before it is spent on the education of children. Such a set of cultural attitudes is less likely to foster the establishment and success of micro-finance institutions.

Webb, Kristiani and Olaru (2009) conclude that a critical factor influencing micro-loan program success is the local image, reputation, and long-term sustainability expectations of the micro-lending organization. Because these institutions are targeting the poorest of the members of the population (the "bottom of the pyramid"), it is extremely important that the lending program be effectively explained and marketed to this segment of the population.

Still, on the whole, much is still unknown with regard to micro-finance. As will be discussed later in this article, further research is needed to strengthen micro-lending and better benefit micro-borrowers.

MICRO-FINANCE IN THE UNITED STATES

With the focus of micro-finance programs on the underclass and in underdeveloped countries, it might seem unlikely that such programs would have a place in the United States. Yet a small number of such programs have been established in this country, in areas where high levels of poverty exist, and where traditional sources of debt financing are not reaching these populations--both in urban inner cities and in poor rural areas. Obviously, the nature of the American economy dictates that the quantitative definition of a micro-loan is much higher in this country than in Bangladesh and other third-world countries.

The current range of micro-loan programs in the United States consists of a mixture of not-for-profit organizations which attempt to follow the Grameen model, and a larger number of micro-loan programs which follow a mixed or partial for-profit model. This latter micro-loan model often involves partnerships between community development agencies, the U.S. Small Business Administration and/or commercial banks. For example, the Valley Economic Development Center is a Los Angeles area not-for-profit organization which, in conjunction with the SBA and Bank of America, provides loans of $1,000 to $50,000 for new and growing businesses (vedc, 2011).

However, programs such as the VEDC program border on the mainstream lending model. Of greater relevance to the focus of this article are the relatively few totally not-for-profit programs in the United States which attempt to follow the Grameen model.

Although not the first or largest micro-loan provider in the United States, Grameen America is an affiliate of the original organization in Bangladesh. It established its first programs in a low-income area of Queens in New York City in 2008. Since then, it has made over $12 million in micro-loans to about 4700 people (Grameen America, 2011).

Both older and larger and a pioneer micro-finance program in the United States, ACCION USA was launched in Brooklyn in 1991 as the American arm of ACCION International, and similarly provides micro-loans as part of a broader community assistance network. With a number of separate ACCION programs around the United States, this organization has provided over $119 million via 19,500 individual microloans. Recently-started small businesses (at least six month in operation, but not yet profitable) may borrow up to $30,000; more established and profitable businesses are eligible for up to $50,000 in loans. Annual interest rates are currently about 9% to 16%, plus loan closing costs of 3% to 5% (Accion USA, 2011). Such borrowing costs, considerably higher than current commercial bank interest rates and other costs, are typical of most micro-finance programs in the United States. (In July 2011, the interest rate most American commercial banks were charging their best corporate customers was about 3.25%.)

Other micro-finance programs have been established in the past two decades in the United States, generally similar to the ACCION programs. Targeting small businesses in poor inner-city and rural areas, these programs tend to bundle micro-loans with other forms of assistance, such as business and financial education and training. Such a broader range of assistance services is needed in this country, in comparison to in third-world countries, because of the more complex financial and business environment that surrounds the nascent entrepreneur here--taxes, regulations, zoning laws, etc. and thus the need for greater financial and general management skills (Bernanke, 2007). For example, in 2010 the Center for Women, in Charleston SC, expanded their programs of support for disadvantaged women to include a pilot micro-loan program (Center for Women, 2011).

As discussed earlier, very few scholarly or other analyses of American micro-finance programs have been conducted and reported. A recent search of the literature found two studies: In a non-scholarly review of some of the recently established micro-financing programs in the United States, Powell (2009) cited some specific, but generally self-reported, successful examples. Hicks (2004), in a more scholarly and rigorous analysis of a single West Virginia rural micro-loan program, found mixed effectiveness and benefits of that program.

CONTROVERSY: INTEREST RATES AND LENDER PROFITS (AND POLITICS?)

As briefly discussed early in this article, the current controversy surrounding micro-finance involves the apparently very high costs to the borrowers. While the Grameen Bank and the organizations which originally admired and replicated the Bangladesh programs in other countries were primarily not-for-profit organizations, more recently micro-finance has outgrown its charitable roots, with for-profit banks and other lending institutions entering the field during the past decade and now accounting for about 60% of all micro-lending world-wide (Khavul, 2010; MacFarquhar, 2010). And due to the small sizes of all micro-loans (and the resulting poor lending economies-of-scale), both not-for-profit and for-profit micro-lenders charge interest rates that appear high in comparison to the rates commercial banks charge to medium and large businesses. Thus, part of the issue is whether "exploitation" is occurring. Are micro-loan interest rates high and necessary because of the need to cover lenders' inherently high risks and costs (and sometimes profits), or are these interest rates an unnecessary and exploitative component of the micro-lending model? "Exploitation" is generally defined as an unfair, selfish, or unethical action.

Another way to approach this issue is to ask whether some micro-loan interest rates constitute "usury"? "Usury" refers to lending money at an unreasonably high interest rate. In the United States, individual state laws determine whether an interest rate is usurious, and variation among the states is considerable (Usurylaw, 2011). Other countries may also have laws specifically denoting usurious interest rates and these laws vary too, in specificity and in enforcement.

Because for-profit lenders must include room in the interest rate for their profit, this controversy is most frequently focused on these lenders and the countries in which they are most prevalent. For example, Compartamos is a for-profit Mexican publically traded micro-lending institution, the largest in the country, which in 2009 had a loan portfolio of over $600 million, with the average loan being about $400 (Compartamos, 2010). Recent interest rates charged by Compartamos were about 82%.

Some other Mexican for-profit micro-lenders charge even higher rates. Te Creemos, another for-profit institution, currently charges about 125%. Other smaller lending institutions in that country tend to follow the larger lenders in setting their rates, although not always at quite such high levels. The average micro-loan rate in Mexico is about 70% (MacFarquhar, 2010).

Exploitation of micro-loan recipients also occurs in Nigeria. LAPO ("Lift Above Poverty Organization"), a major micro-finance institution there, engages in a questionable practice called "forced savings." LAPO's credit terms require that a portion of the loan be kept by the lender, supposedly teaching the borrower to develop saving skills. But interest is charged on the entire loan, thus raising the effective rate on the actual funds distributed, often as high as 126% (MacFarquhar, 2010).

Politics have also entered the picture. In Bangladesh, where the Grameen Bank was founded, and where the not-for-profit model remains dominant, the government has moved from enthusiastically supporting Grameen, to now criticizing and restricting it. Recently Bangladesh's Prime Minister stated that Grameen and other micro-lenders in the country were "sucking blood from the poor in the name of poverty alleviation" and the government has enacted laws constraining micro lending. Yet the basis for such a governmental turnaround may not be based on economic facts but rather on politics, as in 2007 Muhammed Yunus announced that he would start a political party in opposition to the current government (Bajaj, 2011a).

Similarly, In India, past government support for micro lending has turned to opposition. In this case, the target is a for-profit lender, SKS Microfinance, whose shares quickly rose 50% after its IPO in August 2010. Now the local state government has branded SKS and similar lenders as "greedy loan sharks" and the Indian central bank has restricted micro-loan annual interest rates to 26% and individual loans to a maximum of about $1100. Additional restrictive laws have threatened the entire Indian micro-lending industry. While the government has claimed a factual basis for these restrictions, the lending institutions claim political repression based on competition for the support of the poor (Bajaj, 2011b).

Another example of economic truths mixing with politics in influencing governmental action has occurred in Nicaragua, where President Daniel Ortega has supported a "no-pay movement" encouraging micro-borrowers to not re-pay their loans. Nicaraguan judges have joined in this movement and have ordered the liquidation of one of the country's leading micro-lenders.

In certain other countries, the micro-finance industry has been similarly taken over by for-profit banks, also with very high interest rates and other costs to the borrowers; and government officials have ended their earlier support for micro-lenders. These high interest rates provide the financial incentive for the large number of for-profit lending institutions to enter the market in many third-world countries, and the poor small business owners' lack of education and sophistication, along with a lack of transparency in the financial marketplace, allow such high costs to exist. Naturally, those who are most exploited are those who are the least educated and least sophisticated in financial matters. Sometimes these for-profit lenders have the strong support of government officials and sometimes this support has reversed itself, possibly for political reasons (Barth et. al., 2009). Whether the not-for-profit micro-lending model is "better" or "worse" is a complex question with no simple answer. While the not-for-profit model does not require an interest rate which must cover a profit for the lender, the for-profit model may attract a greater number of competing lenders, often with more experience and better total economies of scale, into the nation's economy and thus both keep interest rates down and provide a larger number of available micro-lenders.

POLICY AND PRACTICE

Several basic policy and practice questions and implications arise from the discussion to this point, and from research not yet cited. How can the costs to micro-loan recipients be kept reasonable? What interest rate levels are reasonable and appropriate for micro-loans? And should something be done to offset the rise in for-profit micro-lenders, or is this trend desirable?

Certainly national governments and other financial regulators, as well as the lending institutions themselves, can and should impose some level of consistent guidance and regulation (and self-regulation) so that both not-for-profit and for-profit micro-lenders can find a place in the financial marketplace. Such guidance and regulation must be devoid of political intrusion and should be based on economic facts. As discussed earlier, this has not always been the case in some third-world countries, where governments have often favored and assisted politically influential for-profit banks to control the micro-loan industry or have retracted their support for micro-lending for political reasons (Bajaj, 2011a, 2011b; Barth et. al., 2009).

Also, several studies have shown that micro-loan interest rates tend to be lower in markets where competition exists among micro-finance institutions. Here too government action and regulation can either support or discourage competition. If lending institutions are supported regardless of political influence or ties to party leaders and governmental officials, competition will be supported, to the benefit of micro-borrowers. Still other studies indicate that smaller banks tend to be more beneficial in their micro-lending to very small borrowing customers, evaluating potential borrowers at a more individual level. Thus, regardless of whether the micro-loan financial market model is not-for-profit or for-profit, governments might act to encourage a greater number of small lenders in the marketplace rather than a few larger ones (Cole, Goldberg & White, 2004; Schafer, Siliverstovs & Terberger, 2010).

Similarly, the lending institutions and their governments should work to foster transparency in the micro-loan marketplace. Lenders' interest rates and other charges should be easily available to prospective borrowers and their advisors, both on the internet and in written promotional materials (especially for those for whom internet access is difficult).

Implications also exist for the poor small business owner and for those who assist them. It is important that small business owners recognize that micro-loans are inherently expensive to the lender and thus to the borrower, with interest rates and other costs almost always higher than for larger loans from regular commercial lending institutions. Therefore small business owners should utilize micro-finance as a back-up source of funds, only if more traditional funding sources are not available.

Small business owners (and their advisors) should also educate themselves and do their homework prior to engaging in micro-borrowing. Are the potential micro-lenders for-profit or not-for-profit? What are the exact and total costs for the micro-loan being contemplated? Is the lending institution actually a "micro-lender"? (Because "micro-loan" has a positive cachet these days, many other types of lending institutions are labeling their small business loans as "micro.") Of course, if possible, more than one micro-loan option should be obtained, with rates and other payment terms compared.

Although difficult to answer, a final question is: What is a reasonable and appropriate interest rate for a micro-loan? Prof. Yunus has stated that micro-loan interest rates should be 10 to 15 percent above the actual cost to the lender to raise the money, and that any interest charge of over 30% is too high. And, as discussed earlier, it is reasonable for the lender to incur higher total percentage costs for smaller loans than for larger ones (due to economies of scale) and to more risky borrowers, and thus to charge interest rates and other costs accordingly (MacFarquhar, 2010). So, in the United States, a small business borrower would naturally benefit if he or she were eligible to borrow from a traditional lending institution at a rate of 5% to 10%, rather than to borrow from ACCION at a total annual cost of perhaps 12% to 21%. But if the latter choice is all that is available, the charges are probably supported by the institution's true costs and risks and thus not unreasonable. Beyond the United States and other developed countries, definitions of a "reasonable" interest rate and other lending terms become more complex and less definitive. Nascent entrepreneurs must weigh their business costs and the loan alternatives available and only borrow when it makes economic sense to do so.

AGENDA FOR FURTHER RESEARCH

Clearly, micro-finance is an institution in flux, both in developing countries and in developed nations such as the United States. Much more factual information must be developed through both academic and non-academic research. Under what circumstances does micro-finance benefit society and reduce poverty? What lending and borrowing models work best within different cultural and political environments? What interest rates can benefit micro-borrowers and also sustain micro-lenders in the long run? What government policies and actions will foster successful micro-finance and what will work against the success of micro-finance? How can both the not-for-profit and for-profit models be effective? Only with more clear research-based facts can governments and lending institutions support and fulfill the poverty-reduction potential of micro-finance. This need for research has been recently emphasized by the chief of the Washington-based Grameen Foundation: "Rather than make claims that get out in front of the research, we need to impose on ourselves a transparency about poverty reduction." (Bajaj, 2011a).

CONCLUSIONS

Micro lending has had a very positive impact in reducing destitution and improving the lives of very poor families in many nations. However, in other countries the impact and possible benefit of micro-finance is less clear. While the total set of outcomes apparently has both positive and negative aspects, the basic financial model and the resulting micro-finance programs have the potential to constitute a major step in reducing poverty and advancing democracy and human rights, as cited by the Nobel Peace Prize Committee at the beginning of this article.

This article has surveyed the strengths and weaknesses of the current state of micro-finance. It offers some suggestions to the lending institutions, to governments, to small business owners, and to those who assist them to improve both micro-lending and micro-borrowing, and it provides a research agenda which might lead to a better understanding of the various models and forms of micro-finance and the policies and actions needed to further the role of micro-finance in reducing world-wide poverty.

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Matthew C. Sonfield

Matthew.Sonfield@Hofstra.edu

Hofstra University
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