Introduction: Muhammad Yunus and the Theory of Microfinance

Microfinance is the concept of extending small, short-term loans to poor individuals and
entrepreneurs that are ordinarily excluded from formal financial/banking institutions. Individuals
who lack credit and access to traditional forms of money-lending are unable to borrow small
amounts of money to start profitable businesses or support existing ventures within their
communities. Small loans can generate income and increase economic growth in an undeveloped
country. Economic growth is defined as an increase in goods and services produced (Gross
Domestic Product) per capita in a given time period in a country. As the microfinance sector
grows, many have questioned whether microcredit is an efficient means of reducing poverty.
Chronic poverty can be defined as extreme poverty which lasts over a lifetime and is transmitted
through generations1.Indicators of poverty include income of population, level of unemployment,
inadequate housing and access to public services, health, education, and level of indebtedness.2
Bangladesh has been the first country to introduce such development programs, and ever
since its establishment, microfinance has evolved into a development approach to benefit lowincome in rural and urban areas.3 From the 1950s onwards, several successive governments in
Bangladesh subsidized large programs to provide the poor with credit below market rates in an
attempt to increase farmers income, so that they might implement more technological advances
in their work, thereby increasing production and efficiency and stimulating economic growth.
Due to lack of specialization and flexibility, such large-scale public attempts to alleviate poverty
were unsuccessful - often resulting in inefficient outcomes and political turmoil.4 Additionally, in
the 1960s and 70s, between 60 and 80% of the rural population of Bangladesh remained living in
poverty. In 1974, shortly after its liberation from Pakistan, Bangladesh experienced a devastating

Sheperd, Andrew, Lucy Scott, Chiara Mariotti, Flora Kessy, Raghav Gaiha, Lucia Da Corta,
Katharina Hanifnia, Nidhi Kaicker, Amanda Lenhardt, Charles Lwanga-Ntale, Binayak Sen,
Bandita Sijapati,, Tim Strawson, Ganesh Thapa, Helen Underhill, and Leni Wild. "Chronic
Poverty." The Chronic Poverty Report 2014-2015: The Road to Zero Extreme Poverty(2015): n.
pag. Chronic Poverty Advisory Network. Web. p.3
2
How is poverty measured?. The European Anti-Poverty Network, n.d Web.09 July 2015
3
The Current Situation of Microfinance in Bangladesh, Yasuhiko Yuge. Center for Emerging
Markets Enterprises. March 2011.
4
Microfinance as a Poverty Alleviation: Have we given it too Much Credit? Allison Rudd.

18
famine.5 At that time, Muhammad Yunus, a young professor of economics, was teaching at the
Bangladesh University next to a poor village where the effects of the famine were painfully
obvious. Disturbed by the absurdity of discussing elegant economic theories in his classroom
while villagers were dying from the real effects of economic policy outside, Yunus began to
examine the village more closely6. He noticed that the villagers lacked formal financial
institutions and other crucial infrastructure for economic growth. He found that individuals
largely depended on cash from local moneylenders to buy stock and supplies, falling victim to a
borrowing-and-repaying trap that did not allow them to acquire wealth. Local moneylenders
demanded 10 to 15 percent interest after 12-hour borrow.7 Thus, many individuals went into
default as they could not pay back their loans in time. (Quote from Allison Rudd about perpetual
debt?) Through this system, Yunus says that it is virtually impossible for an individual to take
herself out of poverty. Unlike previous decades government attempts to reduce poverty on a
large scale, Yunus acted in the private sector, which was immune to the political turmoil of the
time, and so his focus concentrated on specific communities by examining individual needs. He
began lending money to 42 villagers, providing around 27 dollars per week per individual. By
his own accounts, the farmers to whom he had lent money had profitably invested their loans in
small-scale businesses. Villagers were trustworthy, he claimed, as they could pay back interest.
As the first loans were given out of pocket, Yunus realized that in order to start a real
system of moneylending, he needed to create a formal financial institution that could provide
villagers with enough credit to increase growth on a larger scale. In the years that followed the
beginning of his experiment in 1976, Yunus expanded his project, gaining the support and
sponsorship of other banks by 1979. In 1983, in collaboration with the Central Bank of
Bangladesh, he created Grameen Bank, a branch that would specifically lend to poor farmers.
The five main objectives of the Grameen Bank project are: eliminate exploitation of the poor
which occurred during informal savings systems, extend banking institutions to the poor,
promote jobs for unemployed Bangladeshis, enroll women in more important job and leadership
roles and most importantly reverse the cycle of low income, low savings, low capital
5

Muhammad Yunus. 1995. Testimony before the House [Of Representatives of the US].
Committee on Int.Relations, Feb. News Service, June 27
6
Ibid.
7
The Microfinance of Entrepreneurship Geoff Davis, Stanford University. n.d Web. 13 July
2015

18
investments to low income, injection of credit, investment, more income, more savings, more
investment, more income.8
Grameen would become the harbinger of a new generation of microlending.9 Yunus
relied on a phenomenon known as social collateral, an extension of loans to groups of
individuals, predicting that the fear of public shame and a sense of collective responsibility
would discourage loan defaults. Yunus also observed that women were more reliable as
borrowers because they prioritized investment (in their families, businesses, education) over
paying off earlier debts. The results of the Grameen experiment were largely positive, as Yunus
saw that the money lent was profitably spent in small household businesses10. The loan recovery
rate as of 1994 was an astounding 98%.11 An average of 5% of Grameen Bank borrowers had
climbed out of poverty each year.12
Social-Collateral: group microlending:
Social collateral, also known as social capital generally refers to trust, concern for
ones associates, willingness to live the norms of ones community and to punish those who
not13.The theory of a social-collateral is a mechanism within microfinance that lends to
communities and not to specific individuals. By doing so it induces borrowers to select
themselves into groups of same risk level and hold it each other accountable.14 Group-lending
gives incentive for borrowers to pay back the loan on time, to avoid a default. Members within
the community now have more incentive to monitor neighbours and exclude risky-borrowers
who might put them into risky situations15.
Although group-microlending may seem as a successful anti-poverty policy, researchers
from the Green Bank of Caraga performed tests to evaluate the effectiveness of such mechanism
8

Critique of Microcredit as a Development Model, Grace Levin. University of Tennessee.

Microfinance as a Poverty Alleviant Allison Rudd. March 10, 2011.
10
Allison Rudd, Microfinance as a Poverty Alleviant p.3
11
Abu N. M. Wahid, The Grameen Bank and Poverty Alleviation in Bangladesh: Theory,
Evidence, and Limitations. The American Journal of Economics and Sociology 53.1 (1994) : 2.
Print.
12
Microcredit Doesnt End Poverty Despite all the Hype. Roodman, David. The Waashington
Post. March 10, 2012.
13
Bowles and Gintis, 2000.
14
Microfinance as a Poverty Alleviant. Rudd, Allison. p.7
15
The Microfinance Promise. Morduch, Jonathan. Journal of Economic Literature. Vol
XXXVII p1570. December 1999.
9

18
compared to the individual lending of microfinance loans. The results showed no change in the
repayment in loans16.
Pangea Onlus allows women to create Self Help Groups (SHG), formed by a
minimum of 5 up to 20 women that eventually collect their savings as groups to create a social
capital. From the social capital, each woman whom forms part of the SHG receives a loan, and
the interests are paid by all members of the group. Members of SHGs can invest money received
from the loan to create small-scale businesses, to pay their childrens school fees or to pay
medical and health insurance bills. Such mechanism within the concept of microfinance avoids
individuals from not paying back the loan, and eventually being excluded from further loans.

Criticism: David Roodman, Abhijit Banerjee and Esther Duflo

Although microfinance has become popular over the last few years, it has also received a
great deal of criticism. Generally, criticism falls into three categories. 1) Data is unreliable, and it
is difficult to determine how successful microfinance operations are. 2) Taking attention away
from other potentially effective methods. 3) Microcredit can in fact be damaging to vulnerable
populations for various reasons. For instance, borrowers can become overly dependent on loans
while microcredit institutions profit from the poor. Economists such as David Roodman, Abhijit
Banerjee, and Esther Duflo have all become prominent critics of the microfinance phenomenon,
warning of its potential to do more harm than good. It is difficult to compare between nonborrowers and borrowers - mostly because borrowers are self-selecting and MFIs are selective
about the places they choose to operate.
According to Esther Duflo and Abhijit Banerjee one of the main problems of
microfinance is the selectiveness of the borrowers, and the regions where MFI (Microfinance
16

"Group versus Individual Liability for Microfinance Borrowers in the Philippines."

Innovations for Poverty Action. N.p., n.d. Web.

18
Institutions) prefer to operate. In a study called The Miracle of Microfinance? Evidence from a
Randomized Evaluation it was found that there were no significant changes in development
overtime, including education, health and the empowerment of women.
Due to media hype of positive stories involving microcredit loans and hype created by
microfinance organizations themselves, in the eyes of many, microfinance has been viewed as a
life-changing program that can magically relieve poverty in developing countries. According

to

David Roodman, microcredit rarely transforms lives, after a loan some do better than others17.
People use their money in different ways: some invest in profitable businesses, others use the
money to pay back old debt. As a result, banks and creditors are uncertain as to whom to lend the
money. Studies by the Massachusetts Institute of Technology show that over a period of 12-18
months, families whom money was lent, showed no changes in indicators of poverty.
Although microcredit has been described as an effective way to provide capital to poor
borrowers who do not have access to formal financial institutions, some researchers have shown
that this type of aid might do more harm than good. A common problem with microcredit loans
is that while one would expect borrowers to eventually pay off their loans and no longer require
borrowed capital or to eventually gain access to traditional commercial banking institutions, a
great deal of data shows that this is simply not the case: microcredit borrowers tend to rely on
microcredit for as long as such loans are available to them.18 while they may help businesses
grow to a certain point, MFIs are not equipped to help these businesses continue to grow.19
Initially the goal of microcredit institutions was to nourish businesses in developing countries.
As a business grows, it is expected to incur greater capital needs that cannot be provided by
MFIs. Unfortunately, it is often the case that larger banking institutions are not present in the
area. These business dependent on loans, remain clients of MFIs throughout their lifetime.
Individuals who do not qualify for do have access to loans rely on informal savings
systems which demand a lot of interests, that most often cannot be paid back and have very
17

Microcredit doesnt end poverty, despite all the hype The Washington Post. David
Roodman. March 10,2012
18
Peprah, James Atta, and Isaac Koomson. "Addiction to Microcredit: An Obstacle to Social and
Financial Mobility." (n.d.): n. pag. Munich Personal RePEc Archive. University of Cape Coast, 5
Aug. 2014. Web.
19
Addiction to Microcredit:an obstacle to social and financial mobility, University of Cape
Coast, Department of Economics. Koomson and Peprah

18
little security. According to the Microcredit Summit Campaign in 2012, microcredit has grown
very rapidly in the last 10 to 15 years, from 7.6 million clients in 1997 to 137.5 million in 2010.20
Critics of microcredit such as David Roodman believe that microcredit loans do not allow
individuals to escape poverty and that they rarely transform lives.21 Some individuals do better
after receiving loan than others, but very few borrowers are able to move up the socioeconomic
ladder. Some individuals will find efficient and profitable uses for their loans, such as buying
cows and selling milk, but certainly not all borrowers will succeed in their endeavors. An
important study from the Journal of Political Economy in 1998, funded by the Central Bank (of
Bangladesh), reported that microcredit cut poverty in Bangladesh. More specifically it found that
microcredit was more efficient when in the hands of women.

Overall Analysis of Results:

As stated previously the women involved in Project Koppal were initially living in
conditions of extreme poverty, but through the microcredit loans these great number of women
were able to become entrepreneurs themselves, and initiate small-scale businesses within the
community, as well as to become leaders of the cooperatives and/or leaders of the 1007 SelfHelp Groups created since the start of the project. The leaders were able to communicate with
local banks and microfinance institutions in order to demand investments for their businesses.
The women involved are now able to read and write, and successfully manage their
businesses, along with an increased level of social status within the family and local community.
Following the loans, women were able to buy necessary goods such as bicycles, certain types of
food they were not able to buy before, kitchen utensils, livestock, TV, radio and so on.
These 1336 women are now financially independent, and can easily access their bank
accounts to manage their small-scale activities. Along with the financial growth these women
20

The Miracle of Microfinance, Banerjee, Duflo, Kinnan and Glenerster. Massachussets

Institute of Technology. p2
21
Microcredit Doesnt End Poverty Despite all the Hype. Roodman, David. The Washington
Post. March 10, 2012.

18
have received throughout the growth of the project, these women also live in more developed
social situations.

Conclusion
With the insertion of investment, women were seen to able to increase their productivity,
thereby increasing income and consequently increasing savings. The women of Project Koppal
opened safe bank accounts to secure capital and initiated profitable businesses, which
systematically helped them reach out situations of poverty.
Furthermore, the women of project Koppal showed that through the years, as Pangea
Onlus stopped lending money, they were able to continue with their small-scale businesses in
education, livestock, agriculture and many other sectors. The women were able to demand local
banks and microcredit institutions for further loans to continue growing as businesses.
Arising from this study are various unresolved questions linked to the criticism of
microcredit. Roodman argues that data from microcredit organizations such as Pangea Onlus is
often unreliable, and most probably it is difficult to determine the level of success of these
microcredit institutions.

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Works Cited / Bibliography

1. Abu N. M. Wahid, The Grameen Bank and Poverty Alleviation in Bangladesh: Theory,
Evidence, and Limitations. The American Journal of Economics and Sociology 53.1
(1994) : 2. Print.
2. Addiction to Microcredit:an obstacle to social and financial mobility, University of
Cape Coast, Department of Economics. Koomson and Peprah
3. Critique of Microcredit as a Development Model, Grace Levin. University of
Tennessee.
4. Fondazione Pangea Onlus. Quando le donne fanno impresa e diventano una banca.
5. Microfinance as a Poverty Alleviation: Have we given it too Much Credit? Allison
Rudd.
6. How is poverty measured?. The European Anti-Poverty Network, n.d Web.09 July
2015
7. Microfinance as a Poverty Alleviant Allison Rudd. March 10, 2011
8. Muhammad Yunus. 1995. Testimony before the House [Of Representatives of the US].
Committee on Int.Relations, Feb. News Service, June 27
9. Microcredit Doesnt End Poverty Despite all the Hype. Roodman, David. The
Washington Post. March 10, 2012.

18
10. The Current Situation of Microfinance in Bangladesh, Yasuhiko Yuge. Center for
Emerging Markets Enterprises. March 2011.
11. The Microfinance of Entrepreneurship Geoff Davis, Stanford University. n.d Web. 13
July 2015
12. The Microfinance Promise. Morduch, Jonathan. Journal of Economic Literature. Vol
XXXVII. December 1999.
13. The Miracle of Microfinance, Banerjee, Duflo, Kinnan and Glenerster. Massachussets
Institute of Technology.
14. Sheperd, Andrew, Lucy Scott, Chiara Mariotti, Flora Kessy, Raghav Gaiha, Lucia Da
Corta, Katharina Hanifnia, Nidhi Kaicker, Amanda Lenhardt, Charles Lwanga-Ntale,
Binayak Sen, Bandita Sijapati,, Tim Strawson, Ganesh Thapa, Helen Underhill, and Leni
Wild. "Chronic Poverty." The Chronic Poverty Report 2014-2015: The Road to Zero
Extreme Poverty(2015): . Chronic Poverty Advisory Network. Web.