“Microfinance is not simply banking, it is a development tool”, defined the World Bank 25 years ago. Microfinance activities involve small loans, informal appraisal of borrowers and investment collateral substitutes with group guarantees or compulsory savings, micro-savings and, sometimes, micro-insurance services generally to the populace unbanked by the so-called mainstream financial services and commercial banking.

There was an era when the microfinance model of development finance was hailed as a panacea to almost every socioeconomic problem. It was portrayed as a tool to reduce poverty, increase financial access and inclusion, provide formal financial services to the unbanked population, promote gender equality and empower women, support income generation and self-employment schemes, proliferate small and micro enterprises and so on. The United Nations designated 2005 as the International Year of Microcredit. The “Grameen” model of rural finance pioneered in the early 1980s by Bangladeshi economist (and later Nobel Laurette) Mohammad Yunus was replicated in about a hundred developing and a few developed countries. Ironic, though, that he received a Nobel Peace Prize (2006), not in economics.

But by now, all the hoopla has sublimated, and microfinance as a development finance instrument is, in totality, considered a failed model. A study by the University of California, Berkley, concludes, “Microfinance is not the cure-all for worldwide poverty that international organizations, financial institutions, and countries have claimed it to be. Microfinance is not designed to end the cycle of poverty”. Rather, microfinancing, with the high cost of borrowing, further perpetuates poverty. “Many microloan and credit recipients are not likely to be able to pay off the loan in a timely manner, so they find themselves in an even worse place when their interest accumulates.” A report with a few different findings has also been published in the Stanford Social Innovation Review.

Promoting businesses has also proved to be a big farce globally. In some countries, such as South Africa, 94 percent of micro-borrowers were found using the funds for social and family functions. Simply, these microcredit clients are neither likely to have the “next big idea” to expand their businesses nor are they likely to find larger investors to upscale their business operations substantially.

Often exaggerated benefits, mostly non-economical ones, of microfinance have always shadowed the exorbitantly higher interest rates thrust upon poor borrowers. In some countries like Mexico, the total cost of funds is calculated up to 200 percent; in countries like Cambodia and Nepal, it ranges between 20 to 30 percent. Apparently, the rate of return on investment must at least be 100 percent for a borrower to pay the interest, sustain the business and support the family as a self-employed individual, which is beyond economic logic.

Case in point: Nepal

Nepal started the microfinance nature of development financing nearly six decades ago, in 1967, with the establishment of the Agricultural Department Bank. Its aim was to help finance the farmers to modernise their farming practices and commercialise agricultural products. Several other experiments followed, like the Small Farmer Development Scheme in the 1970s, to replicate the Grameen model by establishing five rural development banks in each of the then-five development regions in the early 1990s. These banks were promoted by Nepal Rastra Bank (NRB), the central bank of Nepal, with its direct investment. With the advent of the liberal economic era, several private investors and financial non-governmental organisations (FINGOs) entered the market. The Rural Banks were later privatised.

By 2017, the number of central bank-regulated institutions providing microcredits, including microfinance institutions (MFIs), FINGOs and saving and credit cooperatives (before mushrooming) reached 103. At present, according to NRB data, there are 55 microfinance institutions with 6 million members and 2.66 million borrowers with a portfolio of Rs400 billion.

The evolution and now looming crisis in Nepal's microfinance industry are not different from the general global scenario. Initially, MFIs were portrayed as tools to increase formal financial access to the unbanked, poor and marginalised population. They were also expected to increase the farm productivity of small farmers, promote micro-enterprises, and, of course, reduce poverty and help accelerate economic growth.

These tall tasks were never achieved. There has not been any systematic and comprehensive research on actual benevolent outcomes of microfinance activities on poverty reduction, enterprise development, etc. But lately, the over-indebted “victims” of the MFIs are continuously protesting against exploitation and coercion to pauperise them.

The findings of a study by the NRB only reinforced the general belief that MFIs have failed to achieve any articulated objectives except expanding some level of banking literacy in the rural hinterland. Nearly 30 percent of the borrowers’ ticket sizes were less than Rs50,000. Any actual economic activity can hardly be expected of them. Only 18 percent of the deceitful borrowers syphoned 38 percent of disbursed loans by indulging in multiple banking and perceivably circumventing the weak regulatory framework.

A long series of misguided policies and authorities' unwillingness to correct them have only aggravated the problem. First, the actual cost of borrowing was never brought into policy discussion. Until the previous year, when the NRB put a 16.5-percent cap, it was often reported that the cost of borrowing from MFIs frequently crossed a 30 percent mark. Resource mobilisation methods of these MFIs as the second-tier intermediaries—borrowing from commercial banks and lending to customers—were essentially faulty. Perhaps the biggest mistake on the part of regulators is to allow these MFIs to list in the stock market, the scribes of which have become soft spots for market manipulators and insider traders. Due to this, despite the poor financial performance of many of these institutions, their share price is constantly on the rise. The stock market index is thus becoming increasingly spurious.

Worst of all, even after all the anomalies and shortcomings have come to the fore, the government and regulatory authorities are unwilling to take decisive corrective actions. As the following monetary policy is just around the corner, the monetary authority must gather the courage to salvage the financial system from the menace of microfinance, which has only proven to be a burden to the economy. The only excuse given is that the size of the people involved is not enough to allow a massive market distortion in banking as well as the capital markets.