Some_Drawbacks_of_Microfinance

Introduction Microfinance has become the new buzz word in academia as the primary solution to alleviating poverty in the developing world. The term microcredit is the allocation of small loans to impoverished individuals for the means of entrepreneurship ("Definition what is," 1998). Widespread popularity for this form of financial loaning system can traced back to Bangladesh and a professor with a very unique vision. This revolutionary idea started when an economics professor from the Chittagong University took his class on a field visit to a low income town where they interviewed a woman who earned a living by selling bamboo stools ("Biography of dr.," 1998). As he became more familiar with her situation he realized that she was unable to receive loans from formal banking institutions. This was due to the fact that she didn’t have the steady income or collateral to gain access to such a loan to expand her business. Without resolution or access to conventional banking she resorted to private money lenders to get the loan ("Biography of dr.," 1998). Unfortunately, the interest on the loan was at an exploitative rate of ten percent which made it impossible for her to repay and exasperated her financial problems ("Biography of dr.," 1998). Appalled by this story Muhammad Yunus (the economic professor) worked on a solution to not only resolve this individual’s dilemma but to eradicate poverty from the world("Biography of dr.," 1998) . Doctor Yunus dream to eliminate poverty worldwide began to transform into reality through his founding of a company called the Grameen Bank in 1983("A Short history," 1998). This small bank helped to give the most impoverished and unemployed people access to loans. Since 1983 this business helped economically disadvantaged people from all over Bangladesh deal with financial troubles but there is still a long way to go. His efforts were recognized worldwide in 2006 when both the Grameen Bank and Doctor Muhammad Yunus received the Noble Peace Prize ("The Nobel peace," 1998). This historical event has led to further awareness and increased popularity of microfinance. Subsequently, there has been an emergence of multifaceted microfinance’s all over the world. The surfacing of microfinance’s has had a variety of effects on the economic sustainability of small business owners throughout the Third World. Even the remarkable Grameen Bank has faced many obstacles since its creation. This is extremely prevalent after the major flood in 1998 in which left the country in destitute and as a result there was an epidemic of defaulters on the loans that were given out ("Grameen bank ii," 1998). In retaliation to this fragile situation the bank had to undergo dramatic changes in their infrastructure ("Grameen bank ii," 1998). The Grameen foundation isn’t the only microcredit institution that has faced trials and tribulations. As far back as the 18th and 19th centuries variations of microenterprises in England and Ireland have undergone many challenges (Hollis & Sweetman, 1998). Most of the complications that have been encountered have been attributed to administrative issues and confusion with the purpose of the loan (Hollis & Sweetman, 1998). Other microfinance’s during these centuries that did well. One good example of this is the renowned case in Germany. They were successful in their cause because of sound infrastructure, consistency in policy enforcement and cooperation of the local towns in which they coexist (Hollis & Sweetman, 1998). The hundreds of years that microcredit has been around there have been a variety of outcomes in the results of their effectiveness. Due to the inconsistencies arise two main approaches in the proper way that these companies should operate. The two comprise of the institutionist and the welfarist perspective (Woller, Dunford, & Woodworth, 1999). Institutionists debate that self sufficiency is the correct method while welfarists are more concerned with only poverty alleviation (Woller et al., 1999). These approaches and historical documentation of previous microcredit banks gives excellent awareness to the issues regarding microcredit (Woller et al., 1999). Historical experiences of microfinance’s whether successful or a failure can give excellent insight into what these companies in modern society can avoid or imitate in order to accomplish the common goal of poverty alleviation. When looking at microfinance’s in different regions such as parts of Africa exemplifies the failure to properly institute these financial mechanisms. The flaws in African microfinance’s are contributed to institutional issues, corruption, social/cultural factors and moral hazard (Simtowe, Zeller, & Phiri,) . The inherent flawed nature of microcredit cooperatives throughout Africa are working examples that using a universal model for distribution of small loans is less than adequate. Microfinance’s should be organized based upon the unique cultural and social atmosphere of each region in which the microloan foundation is located. Historical Background of Microfinance In order to understand the need for change in microfinance comprehension of the historical background of this unique banking system is fundamental. Microfinance can be dated as far back as the mid 1700's in England (Hollis & Sweetman, 1998). These microcredit companies came in the form of lending charities. Most of the funds were held responsible by the town councils and the trade organizations. The interest rates for such loans were extremely low; ranging from zero to a mere two percent (Hollis & Sweetman, 1998). These loans were given to young aspiring men seeking financial support for their endeavors. As development increased there was a decrease in demand for such lending organizations. One of the more notable of these lending charities was in 1766 by Samuel Wilson (Hollis & Sweetman, 1998). He gave a lump sum of twenty thousand pounds to the Corporation of London to be lent out in the form of small loans. Each loan ranging from one hundred to three hundred pounds and the length of the trade cannot exceed the maximum of five years. The interest rate for these loans was at a one percent for the first year and two percent for every year thereafter (Hollis & Sweetman, 1998). For the first twenty years there was a record of 2,262 pounds lost and most of the repayments that were made were made not by the borrowers but the two cosignatories for each borrower (Hollis & Sweetman, 1998). The reason for this relatively high default rate is due to not only the participant’s lack of compliance but the administrator’s lack of loan monitoring and loan recovery (Hollis & Sweetman, 1998). When a member defaults on their loan legal action and follow up appoint are needed to be taken on the part of the loaning staff. A lot of times those working for Wilson failed to complete these steps due to the inconvenience of the loan recovery process and the expensive legal fees (Hollis & Sweetman, 1998). When the borrowers realize that there aren't any consequences to defaulting creates a multiplier effect. This signifies that there will be an exponential increase on the number of defaults on the loan. As a result this transforms into a flawed system and the inevitability for a failing lending bank. In order to deter from bankrupting there were efforts made to counteract this amount of defaulters. This was done through increasing the mandatory cosignatories for receiving the loan. In 1795 three guarantors were demanded and the in 1821 four were needed to get a loan (Hollis & Sweetman, 1998). This increase in the default rate made it harder for poor or small entrepreneurs to gain access to these charities. Eventually Wilson’s charity became so unstable that the Corporation of London was forced to shut down this entire project (Hollis & Sweetman, 1998). Other contributing factors that led to the demise to Wilsons lending charity are the combination of misappropriation of funds internally by the administrative authorities and the allocation of the loanable funds. For instance, the loans committee charged the charity 33 pounds for 144 bottles of wine. Also, the security's for the loans that the borrowers paid weren't redistributed to the young business men but towards already well established merchants (Hollis & Sweetman, 1998). The original purpose of the loan transformed from helping flourish England economically to aiding the elitist class in their own personal interests. The earliest accounts of microfinance such as the one in England exemplify the inherent problems that arise in this industry. Some of the main issues that Wilson’s lending charity faced were both external and internal. For example, the external issues that were faced were the borrower’s failure to pay back the loan. The failure to pay back the loan can in partial be attributed to an assortment of financial and personal problems. Once there was a repetition in this form of behavior then there was a chain reaction for others to follow in this same path. The ramifications of the high default rate lead to the corporation to go into bankruptcy. Borrowers weren’t the only ones to have poor fiscal management the business is also to blame. The Corporation of London had a variety of internal complications. If the lending company followed stricter protocol then the staff could have discouraged members from defaulting and recovered the lost money (Hollis & Sweetman, 1998). Unfortunately, the administration failed to do so because of corruption and the opportunity cost of legal fees. The employees wouldn’t have misused the funding if there was some sort of an affiliation that monitored expenditures made by those working at the charity (Hollis & Sweetman, 1998). Monitoring is essential but not enough to ensure that the organization is running properly. There needs to be a system of accountability set in place to where if management or the board members are embezzling the members’ money then they will be reprimanded for their alleged actions. Infrastructural changes such as instilling a checks and balances system like in England isn’t enough to insure a sustainable microcredit company. Even though monitoring and accountability is crucial to the livelihood of these small banks having the reputation by the public eye as a legitimate body is highly crucial. One successful case that shows all of these elements working together harmoniously is in the Germany case during the 1840’s to the first part of the 20th century. These organizations were Raiffeisen and Haas Cooperatives (Hollis & Sweetman, 1998). This small banking faction became highly evolved due to targeting small rural communities (Hollis & Sweetman, 1998). In fact their loans ranged from a mere 5 pounds to about 250 pounds and most of these were long term loans (Hollis & Sweetman, 1998). Due to the small scale of the towns worked to the advantage of the cooperative. Since all of the members knew each other there wasn’t any asymmetry of information. This level of intimacy and full information provided incentives for current members to further their investments and to entice others in the community to join (Hollis & Sweetman, 1998). The interconnectedness of the towns was vital to establishing a healthy business environment between staff and their clients. This sense of security combined with the first major auditing system led to the company to decreasing fraud, corruption, default rate and achieving their goal of poverty alleviation. Later the Raiffeisen cooperatives turned into full fledged commercial banks (Hollis & Sweetman, 1998). The Raiffeisen and Haas commercial banks influenced other countries to follow in their same path. Unfortunately, not all imitators had the same results. In fact some microcredit companies tanked. In the case of Ireland from 1894 to 1914 illustrates a failing case that attempted to shadow in the footsteps of an impressive banking system (Woolcock, 1999). The Irish microfinance started in a town called Doneraile as the Plunkett Foundation and their goal was also to target the poor and help them through their financial disposition (Woolcock, 1999). Even though there were a lot of sentiment and high expectations for the same outcome this wasn’t apparent. The differences between the two rely in their original foundation of access to banking and loaning. Ireland already had a well established banks and a government run bank that made it extremely convenient to get a loan (Woolcock, 1999). Germany didn’t have this foundation. The second important aspect of any bank is an effective auditing system (Woolcock, 1999). As stated before Germany had this integrated into their structure but the Plunkett Foundation failed assimilate this into their process (Woolcock, 1999). The third flaw in which they have faced is the lack of monitoring (Woolcock, 1999). As stated earlier monitoring of loans and their members are vital to the sustainability of these financial support systems. Without it members are susceptible to defaulting and misappropriation of funds. The final part that is absent from the Irish micro-lending is the failure to gain confidence and trust by the surrounding group of people (Woolcock, 1999). When people have a general distaste or reluctance towards a bank then they aren’t willing to invest their time and money into that organization. In the Irish scenario there were better substitutes to the Plunkett Foundation and the consumers preferred to go to another financial institution. Competition ended up weeding out the weaker firms such as this one and thus led to Plunkett Foundations demise. When looking at the Ireland’s situation with microfinance’s clearly demonstrates that just because one model works in some countries may or may not work in others. When Ireland attempted to mock Germany’s effective financial organization they assumed that the same results would inevitably follow. Ireland would have had similar outcomes if they would have followed proper procedural guidelines and gained the trust of their potential clients. Since Ireland didn’t do so they didn’t effectively help the rural poor and help them gain access to credit. These are the consequences to a microfinance that assumes that a model will work in all cases and disregards the ingredients that made Raiffeisen and Haas Cooperatives the best of their time. When looking at microcredit cooperatives from a historical standpoint from about the 18th to the early 20th century can give excellent insight into what measures that current microfinance’s can take in order to avoid collapse within the banking company itself. From all of these cases the main lessons to learn are to have a reliable staff, a measure of accountability, sound procedural system that is enforced promptly, proper monitoring and loan recovery, and finally the trust of the community where the microfinance is set up. A reliable staff is vital to make sure that fraud and corruption isn’t prevalent. Having a trustworthy administration will lead to a qualified team that will enforce the monitoring. Measure of accountability is important to hold employees responsible for their actions. If there is such provision set in place then there is a disincentive to commit such fraudulent behavior. Having proper monitoring and loan recovery is essential to decrease a microfinance default rate and to have trustworthy members. In order to have trustworthy clients they have to have trust and faith in the institution that they are investing their livelihoods in. If there isn’t this bond between organization, employees and client then the prevalence of noncompliance to procedure and contract will increase. It is also very imperative that a rising/existing microcredit organization have all of these measures in place at once. Just having one or a couple of these components isn’t a guarantee that the small bank will be sustainable and help the most impoverished gain financial security. Failing Cases of Microfinance’s: The Grameen Account These main components to a successful microcredit have been established early on by both triumphant and failing cooperatives. Today there is still this emerging question on why microfinance isn’t having consistent results and what factors have led to their demise. To better answer these questions looking at the failing cases in the Grameen Bank and the changes that have been made to counteract the negative results of this franchise. The Grameen Bank has been noted for their excellent achievements in helping the rural poor rise out of poverty but this isn’t to say that they have never faced obstacles. This famous bank targets not only the rural poor but mostly to women for two reasons. The first reason is they have higher propensity to pay back the loans than men and second of all is that women are considered the most economically disenfranchised in the developing world. By targeting these high risk groups can pose an issue especially for a lending bank when the entire goal is to be risk averse and not risk loving. Dr. Muhammad Yunus decided to take a chance to aid these people and now there are more than 5.5 million members and about 95 percent of these members are women (Sengupta, & Aubuchon, 2008). When the founder of the Grameen Bank started this independent financial institution he created group lending. This composed of five people in a group; they agree to follow the rules and regulations of the firm and then the first two members receive a loan usually under $100 and have to pay back on a weekly basis until their loan period has expired (Sengupta, & Aubuchon, 2008). This grace period is about a month to six weeks if the loan is successfully paid off the next two get a loan and so forth (Sengupta, & Aubuchon, 2008). If they fail to follow the conditions of their loan they are denied further access to credit and loans. The groups eventually become bigger and extend to eight members if the members are cooperative and work as a team to pay off the loans (Sengupta, & Aubuchon, 2008). Cooperation to pay off loans is sometimes not enough assurance that loans will be paid on time. In the village Ekorchalli in Bangladesh there is a rural settlement in which have many problems keeping afloat. This area has had many environmental disasters because of cyclones and floods leaving the land in turmoil (Woolcock, 1999). These destitute areas despite its setbacks have been opened up to small accessible loans by the Grameen Bank. In spite of all of the branches great efforts there are many problems in which has overwhelmed not only the company but the employees working there. This district has had a record of a 30 percent loan-repayment rate (Woolcock, 1999). The manager, Mokhlesur Rahman Khan not only embodies the role of a manager but he has to solve the personal and financial dilemmas that his clients, potential clients and everyone else in the community is facing (Woolcock, 1999). This chaotic life of conflict management on a daily basis isn’t dealing with petty indiscriminate problems. Most of the issues that are brought up have to deal with school fees, medical fees, paying for sustenance (food, water, shelter, etc) (Woolcock, 1999). If these people aren’t able to pay for these basic needs then it could result in a life and death situation. This type of pressure is placed upon the manager and his staff to rescue these people from their unfortunate circumstances. Adding upon the already volatile situation of the Ekorchalli community is the consequence of defaulting on the loan. The causes of such a high default rate are caused by the external pressures and environmental conditions in which they are living. The effects of this are directly correlated to the meltdown of the cooperative internally (Woolcock, 1999). Relations among all members of the microfinance and the staff are on the verge of a meltdown making group loans extremely difficult to coordinate (Woolcock, 1999). If there is continuous bickering and distrust among the groups then working systematically and calmly isn’t going to be apparent. Then people are more than likely going to default due to the lack of coordinative efforts to achieve their goals and others will be denied access to such funding. Unfortunately, this tension becomes cyclical as more people default leading to market failure. Mr. Khan and his team attempt to bring all the members together in a form of a communal discussion and resolve the ongoing issues in a peaceful and formal fashion (Woolcock, 1999). Public meetings become irrelevant and pointless when the community becomes divided and nothing will get solved. The Grameen Bank is not a miracle solution especially under extreme circumstances. The staff can only do so much to help people but there comes a point when the members have to be willing to collaborate to work out their differences and take the necessary steps to solve the issues at hand. According to Michael Woolcock (1999), “In The Eyes of Grameen Staff, cohesive group and disciplined center meetings are two of the key mechanisms making possible the extension of loans to the poor” (p.27). When this philosophy disintegrates in microfinance’s it develops into a malfunctioning center in which is hard to resolve. In the previous Grameen Branch the combination of natural disaster and impotence to react resulted in its failure. This is not the only way for branches to become obsolete. Center #65, the Bormi Branch for the Grameen Bank had a very different situation. This branch had a record of a 97 percent loan-recovery rate and very successful at adhering to the rules and regulations of the Grameen Bank (Woolcock, 1999). The author, Michael Woolcock recollects his personal account with center 65. He states that when he visited the organization it was in a less than favorable condition with widespread dissatisfaction (p.27-29). Members even with the best of intentions were defaulting on their loans, fleeing the district out of shame because of their inability to adhere to their contract, and blatantly stating that they cannot make a payment due to their personal circumstances (Woolcock, 1999). When faced with this situation the manager of the Bormi Branch explains the importance of putting too much and too little pressure on the group members. If he puts too much pressure than they will result to private loan sharks and if too little pressure will result in members not paying at all (Woolcock, 1999). This tension to apply the right amount of pressure on the clients can be extremely difficult and at times they can become reluctant to abide by their obligations to the firm. Extreme caution needs to be taken on an individual case because of the type of people that gain access to these loans. Most of the members are lower class and may or may not have the job security to guarantee their end of the bargain. Their personal life greatly shifts their economic status. One day everything may be flowing smoothly and the next minute situations such as death and illness can prevent them from paying back the loan. Due to the importance of sound administrative judgment can determine the level of success for the microfinance. Not all members are going to be satisfied and there is going to be some degree of issues due to human error by management and the borrower but the goal is to reduce risk as much as possible. Approaches to Microfinance The Grameen Bank like the other historical accounts mentioned have dealt with many complications in which have led to their demise in extreme cases. Out of the shortcomings of the microfinance community have created a division in beliefs on the appropriate way to handle microfinance’s due to these historical experiences. The polarized views are the institutionist and the welfarist approach (Woller et al., 1999). Those who support the institutionist view point firmly aspire to a financial self-sustaining institution in which poverty alleviation should be addressed on a massive level (Woller et al., 1999). The need to address on a large scale requires large amounts of financial funding (Woller et al., 1999). From their perspective the sources of such financial aid for these programs are subject to political bias, self-interest of the donors and the risk of running out of these resources in the long run (Woller et al., 1999). Requiring that all microfinance’s need to progress to being financially independent so there isn’t this threat or risk of becoming unsustainable. In order to attain this goal of self-sufficiency institutionists’ further emphasize the win-win proposition and “best practices.” The win-win proposition suggests that good banking practices will reduce the most poverty and eventually deter away from subsidies and grow without being financially bound to their donors (Morduch, 2000). Going along with the win-win proposition which is ideologically appealing goes in turn with the idea of “best practices.” “Best practices” are the institutional changes that are made to microfinance’s that operate based upon efficiency and effectiveness (Woller et al., 1999). Examples of such changes are made through management, accounting, marketing, product design and development (Woller et al., 1999). Through these areas can only result in an independent banking company that will generate revenue and directly diminish poverty. Another expected result from taking this approach is that there aren’t any costs to external subsidiaries such as government’s and donors (Morduch, 2000). In fact the view on subsidies and donors is very pessimistic. They view these actors as an inefficient means to gaining financial support. The argument is that funding isn’t guaranteed in the long run and due to donors capability to withdraw aid will leave the microfinance in a vulnerable position subject to market failure (Woller et al., 1999). Donors in this sense are irrational and their actions are motivated by self-interests. The only purpose for this financial support is for positive and negative reinforcement to microfinance’s based upon their performance (Woller et al., 1999). Subsidies are seen as a hindrance on the institution because it eliminates the need to make profit. By eliminating this necessity managers of these small banks are more prone to making mistakes and becoming more lax on operational procedures (Woller et al., 1999). The most prominent organizations that have embodied and pushed this approach are the World Bank and USAID (Woller et al., 1999). This substantial perspective on the institutionist approach endorsed by larger organizations does in fact largely influence the microfinance community. A large portion of microfinance’s has adopted this approach but there are flaws and benefits to this method. There is clear evidence that institutional changes are extremely imperative to the success of microfinance. When reflecting upon the Irish, English and Grameen cases one of the overarching themes mentioned was the necessity of order, accountability, and sound fiscal and administrative practices. Without these components there is a higher probability for the meltdown of these firms. To completely disregard or disassociate the correlation between best practices and the success of this industry isn’t viable. To say that this is the only way that the micro credit industry can effectively eradicate poverty from a macro level is flawed. The problem with applying a large scale model is the tendency to deter from the original purpose of the institution. The original purpose of microfinance is to open up credit and savings opportunities to the poorest individuals so that they may rise out of their financial disposition through entrepreneurial activities. Institutionists’ create a paradox when trying to achieve this and a profit maximizing efficient firm which attempts to rid of poverty on a macro level. When applying this approach there is a tendency to target poverty stricken areas in which have a generalized lower risk of defaulting. These lower risk areas in aggregate are urban cities where small business owners and traders thrive (Morduch, 2000). Overall, these groups of entrepreneurs are more likely to pay back their loan. Unfortunately, this marginalizes those living in the rural areas in which are in the direst need for financial assistance. Most of those living in the country are farmers, and those who make handicrafts (Morduch, 2000). These are higher risk individuals in which are expected to have a higher default rate. Through this weeding out process will gain an efficient micro credit organization but will fail to help the most impoverished areas. Where the institutionists’ fail to achieve is where the welfarists’ attempt to compensate. Welfarists’ main goal is to get to the most impoverished areas such as the rural communities at almost any cost (Woller et al., 1999). Those in support of this approach don’t deny that good banking practices are important to the welfare of the microfinance but they are reluctant in the idea of complete financial independence as the means to meet their goals (Woller et al., 1999). This means that donor funding and subsidies are seen as acceptable avenues as long as they maintain the common goal of eradicating poverty. Donor funding and subsides are not inefficient in the operation of these financial institutions and in fact have proved through live examples such as the Grameen Bank and FINCA as sustainable (Woller et al., 1999). These working examples have proven to not only uphold the welfarists perspective but that the core ideas can be achieved while having external influence locally or internationally. One of the biggest fears that welfarists’ have is the loss of identity of the microfinance industry. They view the institutionist method of profit seeking as a way to deteriorate these values and become more commercialized (Woller et al., 1999). This is again reinforcing the acceptance of donors and subsidiaries as a way to preserve the core values that these companies have modeled. Without these principles then the business will grow farther and farther away from helping the poorest people and once again single out certain groups of people. The last value that separates the welfarists’ from the institutionists’ is through supporting all programs even if they are unsuccessful through their efforts (Woller et al., 1999). The elimination of all supposed bad micro credit banks will stifle innovation and growth. Their argument is that even these less than favorable entities may have new ideas that other microfinance’s haven’t thought of that may help alleviate poverty more effectively. The welfarists perspective is that their approach is the most effective way to alleviate poverty is slightly misconstrued. This approach does have appealing qualities such as the vision to stamp out poverty at all levels. This aspiration coincides with the original purpose of microfinance’s. This may help this industry focus on their clients and create products that try to achieve this goal. Microfinance’s may even focus on mobilization and sensitization of clients that live and work at a greater distance than their own office. This opens up opportunities to a larger array of people to have the chance to help themselves in their financial situation. The benefits to this approach are quite clear but there are some underlying problems. The flaws within this system are the unwillingness to move towards self-sufficiency and the belief that there should be continuous support for failing microfinance’s. The issue is that microfinance’s will never be 100% independent. According to some donors about 5% of these businesses will ever be self-reliant (Morduch, 2000). Also, foreign investment accounts for 15% of the total funding for this industry (Hsu, 2007). This illustrates that donors have the potential to continue investing in a needy market but if they pull out due to future expectations of microfinance’s then this poses a risk for those intending on being completely dependent upon these aid programs. If a microfinance is dependent upon foreign investment the worst case scenario is they won’t have the resources for their programs and will collapse all together. The second flaw that this method has is the continuous support for failing microfinance’s. What this theory fails to elaborate is under what conditions should these failures be supported and the reasons for why they are failing. These should be important determinants for further funding. Just because the microfinance has an innovative idea it doesn’t justify corruption and other human errors that contribute to the demise of such organizations. If the failure is due to resource restraints or a crisis then these microfinance’s are entitled to an evaluation and then be given the correct amount of support on an individual basis. Trying to apply a universal approach to microfinance isn’t an appropriate measure due to how culturally diverse these financial institutions are. There are so many worldwide it is difficult to choose one approach over the other especially when they are so polarized and different in ideologies. When a microfinance is starting to form it should be determined upon the needs of the population, the risks involved, available and potential resources, extent of government help, goals of the bank, regional issues, and any environmental detriments that could affect the overall status of the microfinance. After taking all of these issues into account then determining the allocation of funding domestically or internationally should be studied thoroughly in order to determine the right course of action. Political and international bias should be absent from making these decisions because this can interfere in the best interests of the poor inhabitants where the small lending group is located. Even the approaches to microfinance can lead to ambiguity into the correct adopt when organizing and operating such an industry. This confusion can lead to microfinance’s failure if they are pushed to apply an approach that isn’t suited for them. East African Microfinance: Failures and their implications Historical experiences and the approaches to microfinance’ have been extremely enlightening in the context of the contributions to the failures and shortcomings of this industry. Modern examples of microfinance’s in Africa and their breakdown can give clarity on the predominant issues and if those issues are cyclical. Microfinance in East Africa started in the mid 1960’s to 1970 in the form of SACCOs which stands for Savings and Credit Cooperative Society. These organizations grew out of old farming cooperatives which were for mostly cash crops. Most of these cash crops were controlled by the government but the farmers tilling the land joined to together to form financial services that would accommodate their needs (Beroff et al., 2000). In Kenya there was a progressive movement towards improving this banking system and even after 20 years it is still not even complete today (Beroff et al., 2000). In Tanzania there were mixed results in the formation of the savings and credit cooperatives due to the changes in government and policy (Beroff et al., 2000). Then in the 1980’s the Kenyan banking sector fell and the Tanzanian government nationalized the SACCOs (Beroff et al., 2000). In retaliation to the down turn of the microcredit companies in these two countries led to reform and privatization (Beroff et al., 2000). In Kenya the Cooperative Bank was made in which provides credit and collects the savings from the individual SACCOs in the region (Beroff et al., 2000). Tanzania created a regional body called the Kilimanjaro Cooperative Bank which has similar duties to that of the Kenyan Cooperative Bank. Soon after the creation of these entities small microfinance’s and NGO’s emerged in both countries. Members are usually the male head of the household and usually a cash crop farmer coming from a lower to middle class status (Beroff et al., 2000). Women only account for 15-20% of the members in these SACCOs (Beroff et al., 2000). The majority of the loans that are given out in Kenya are “social” loans which are for emergency and school related purposes (Beroff et al., 2000). Tanzania on the other hand hardly ever gives out loans. The nominal interest rates on the loans in Kenya range from 12-20% and 24-48% in Tanzania which are extremely high (Beroff et al., 2000). With these sketchy demographics from these two countries the performance levels from the microfinance community isn’t optimal. In fact, both of these SACCOs require major changes in order to have an effective financial service industry to the working poor. The problems that have arisen in Kenya are excess demand for SACCOs and a shortage of supply for these services leading to an overwhelmed market that can’t accommodate the needs of the masses (Beroff et al., 2000). Major institutional changes need to be made to compensate for this shortage. Without structure and adaptation to this ever changing environment these businesses will collapse as a result of too much strain on the system. Going along with this overwhelming atmosphere is the lack of a legal or regulatory framework (Beroff et al., 2000). There are cooperative laws but they aren’t functional and don’t have the proper enforcement mechanisms to carry out the law. The combination of the high demand for microfinance’s in Kenya and the mentioned shortcomings have led to less than favorable results in their performance. For example, these companies have a range of 30-40% efficiency rate and 1-7% gains on capital (Beroff et al., 2000). Tanzania faces even worse problems than the Kenyan SACCOs due to the lack of commitment and innovation needed to spur economic growth and development within this country. These programs are seen as unsustainable due in part of the governments control over the policies and structure of this microfinance (Beroff et al., 2000). The governments ever changing policies is a signal that there is confusion on the purpose of microfinance, who it is supposed to target and the effective way to carry out their goals. As time progresses hopefully these problems start to be worked out as the SACCOs and the governments evolve to a more effective and efficient body. Government bodies and the institutional factors aren’t causes of failure in the microfinance. The types of products distributed can give an explanation of why microfinance’s haven’t provided the expected results. One good example that illustrates this is the Joint Liability Lending Programs in Malawi. Simtowe, Zeller and Phiri study lending groups throughout this country. The three types of programs are MRFC seasonal agricultural loans, Mudze seasonal agricultural loan and Mudzi non-farm businesses (Simtowe et al). These group loans are given to those with a specific job. For example, the population consisted of 47% tobacco growers, 28% non-farm business, 17% maize growers and 8% cotton farmers (Simtowe et al). Within the groups it usually consisted of village chiefs and villagers where 66% of the groups consisted of women (Simtowe et al). Village chiefs have significant control over the groups; they can impose themselves in the group or those that they have a close relationship with. (Family and friends) (Simtowe et al). This not only implies that these groups have become riskier due to the lack of screening and appraisal of such members but this can harm the existing good borrowers. As a result of the asymmetry of information and lack of procedural guidelines a higher default rate became more prevalent with an overall 23% default rate (Isotope et al). About 25% of those who defaulted gave the reason that they willfully default which means that the individual has the capacity to pay but refuses (Simtowe et al). The authors identify this unwillingness to pay as ex-post moral hazard. They also noted that 16% have defaulted because of mismanagement (ex-ante moral hazard) (Simtowe et al). A little then less than half of the defaulters were caused by moral hazard. Moral hazard is defined as, “the tendency of people to behave inappropriately when their behavior is imperfectly monitored” (Mankiw, 2009 p. 174-75). The tendency for moral hazard to increase is through the lack of peer monitoring and screening (Simtowe et al). Peer screening and the selection process can decrease the moral hazard issue within these groups but the problem is that group formation isn’t self selected due to cultural and social realms. For instance, the chiefs of the tribe may determine who is in the group and who isn’t without consultation with the other members and this entitlement of status can give an incentive for members to default. Other factors that contribute to the prevalence of moral hazard are whether the groups are homogenous in terms of wealth, social status and kinship (Simtowe et al). The more heterogeneous the groups are usually correlated with a higher default rate (Simtowe et al). Groups that are more alike are less likely to default in fear of harming the others in the group because of the close relationship with one another (Simtowe et al). The biggest problem that the authors suggest is, “the problem with joint liability programs is that the poor are given access to credit without collateral, and in the event of default, they cannot be punished beyond a more denial of future access to credit. This form of limited liability can induce borrowers to take risky actions” (Simtowe et al, p.23). This is the risk that microfinance’s have to endure when starting up group programs. There is always going to be internal and external issues that contribute to a higher default rate. Whether the contributing factors are within the organization of the group, asymmetry of information, the lack of procedure or even the unchanging characteristics of the poor moral hazard cannot be avoided. This is the inherent flaw of the group loaning protocols. As long as the poor are going to be target the micro lending group takes on the chance that the behavior of the client can be mixed. The mixed results that come from African microfinance’s are indicative of the surrounding environment and the soundness in structure of the organization and its members. Through personal experience with microfinance’s in Uganda give insight onto why these programs are failing. The first microfinance that was visited had a 50% default rate and continuous structural problem. Other problems that existed were corruption and the lack of accountability. For instance, there was a woman that came in to withdraw all of her money from her savings and cancel her application for a loan. Her reason for doing so was because of her distrust in the company and she was told by the loans officer that they didn’t have any money to lend out. She thanked him for his honesty on the fragile state of the SACCO but she wanted to look elsewhere for support. The first day that she came in she was told that they didn’t have the money to give to her so come back tomorrow. The next day she came back and the manager told her that she wasn’t allowed to get her money because the chairperson had to be present. The manager promised that the chairperson would be there two days after. The client came back as she was told and the manager once again made excuses. He said the chairperson hasn’t shown up, she won’t answer her calls and for her to come back another day. This troubled woman became understandably irate and demanded for her money. I then asked the manager if he could give her money from the safe and the cash at hand. He said there wasn’t any money in either and that he didn’t have access to the funds at Stanbic bank. The only person that has access to the account is the chairperson and she lives four hours away. This was an irrefutable lie because I had personally gone with him to Stanbic to check on the account and receive a statement. I brought this to his attention and I said that he should show her that money is in the bank in order to reassure her that she could get her money back. In retaliation to this he refused and his explanation was that he didn’t have to. Finally, the chairperson arrived at the end of the week and ended up giving her 200,000 shillings back to her. This money didn’t come from the savings account but it came from the salaries account. These salaries are given by the government. The administration and the faculty squandered the funds to the point where they are unable to give out loans, give back the savings to the clients and maintain the SACCO at a healthy operational level. When it came down to holding the managers and the other administration figures accountable for embezzlement didn’t occur. According to the Microfinance Support Center in Iganga there are cooperative laws set in place but the enforcers are the SACCO board members themselves. According to the director of this government funded agency if there are accounts of fraud noted by them there really isn’t the resources to go after the widespread violators. Without a proper enforcement mechanism gives incentive for criminal activities to occur within these organizations. Other explanations for the juvenile behavior of the Ugandan cooperatives staff besides the lack of rule of law is the free rider issue. The unfortunate experience of this Ugandan SACCO illustrates that management and monitoring management are major issues and if ignored can lead to market failure. Some of the problems with management that can explain the corruption that occurred are through free-riding. When many people are in charge of operating and overseeing the microfinance it increases the incentive for management and other owners to become relaxed in their work and pawn off responsibilities on others (Mersland, 2009). This expectation that the staff’s responsibilities are shared, or aren’t their own can result mistakes. At first these mistakes take in the form of overlooking daily tasks, mismanaging small amounts of funds and then overtime this accumulates to the detriment of the company. This buildup of errors leads to the microfinance failing. Going along with this free rider issue are the given opportunities for SACCO managers and staff to take advantage of the company. Taking advantage of the microcredit organization can come in the form of misusing company funds for personal endeavors. For instance, the employees of the Ugandan cooperative spent SACCO money on airtime to call their friends, ride around frivolously on the company motorcycle, and to pay for meals on a daily basis. At first these small expenses don’t seem to have immediate effects on the financial position of the SACCO but over time those funds start to deplete and the employees have to result elsewhere to carry out their financial escapades. In the extreme case like the one that I experienced they turned to spending all the members’ savings to pay for their needs and wants. Flaws of microfinance’s have been apparent since the beginning of the late 1700’s to present day. These shortcomings in earlier cases like in England have been in the form of lack of enforcement of policies and exuberant expenditure of the administration on luxury items. In the case of Ireland the failure to carry out procedure, competition by better existing firms, lack of participation of members and the lack of confidence by the surrounding community have led to the demise of this microfinance. The two Grameen banks failed due to both external and internal problems. The external problem in the case of the Ekorchalli bank natural disasters created a tense and fragile environment to work under. This tension caused hardships for both the clients and the employees to maintain a rational and calm relationship. Out of these historical experiences arise two main approaches to microfinance’s. The predominant theory supported by large international organizations such as the World Bank is institutionism. This method supports self-sufficiency and the avoidance of donors and subsidies as meaning the main and only source of revenue. The second approach is the Welfarist method. Those who follow this such as the Grameen Bank fully believe that all actions should surround around outreach to the most impoverished individuals worldwide. Being dependent upon subsidies and donors isn’t seen as negative. Instead, as long as the micro credit lending companies are committed and trying to alleviate poverty at all levels then these support systems are worthwhile. Even through these differentiated views of thoughts there are still problems with microfinance’s today. These theories have not solved the problems of a high default rate, internal and external problems of the microfinance. Therefore, a universal approach to microfinance isn’t adequate due to the diversity of the microfinance’s. In each region of the world different cultures, environmental factors, and social factors should be taken into consideration when forming these industries. Microfinance’s shouldn’t be pushed to follow one method or the other because of powerful international lobbyists. When people come together to form a small lending company the goals of the firm, the type of clients they are reaching to, problems that could occur, and the qualifications of the employees should be evaluated thoroughly. Then after much discussion these employees should try to find a product and a method that would best suit the situation. There should be preventative measures set in place to avoid the worst case possible and a system set in place that holds people accountable for their actions. The internal adjustments aren’t enough to ensure a sustainable microfinance. Having confidence and cooperation of the community is necessary. The members needs should be met at all times and have a positive working relationship. There is this element interdependency of the microfinance, the community and all other financial support systems. If one of these elements is not working harmoniously then there is a chain reaction in the other two areas. It is not enough to have adaptations at the business level but in all the other areas. Microfinance’s such as in Africa need to improve this relationship and realize the importance of this relationship between all three areas. The African cooperatives have a long way to go before achieving a workable lending group that will effectively help the poorest individuals rise out of poverty. There is a high demand for these industries and due to media attention these companies have spread all over Africa looking to attain the originating goal of eradicating poverty from the world. Until these shortcomings are fixed African microfinance’s and others across the world will remain in a constant struggle and may or may not fail in their attempts to help at a grassroots level.