THE CRITICAL TRIANGLE OF INTEREST FREE MICROFINANCE: A RESEARCH GAP ANALYSIS

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1 Volume 3, Issue 6 (June, 2014) Online ISSN Published by: Abhinav Publication Abhinav National Monthly Refereed Journal of Research in THE CRITICAL TRIANGLE OF INTEREST FREE MICROFINANCE: A RESEARCH GAP ANALYSIS Ameer P.A. Research Scholar, School of Management Studies, CUSAT, Kochi, Kerala, India ameer.pazhamayil@gmail.com ABSTRACT Once hailed as the most important solution to poverty, microfinance lenders are now criticized for profiting from exploitative usury. The success of microfinance has been contradicted by intense criticism in the current literature, particularly regarding loan repayment, high interest rates, exploitation of women borrowers, ineffective microfinance provision to target groups etc. It was in this context many scholars proposed interest free microfinance system as an alternative way for micro financing and recognize the urgency of attending the needs of the chronic poor than those of the poor or moderately poor or the not-so-poor. Based on the rigorous literature survey conducted with the objective of identifying a research gap in current literature, the researcher discovered that no comprehensive research has been carried to find out the sustainability of interest free microfinance in the long run. The impact of such programmes on its poor beneficiaries also remains unknown. In addition, the study found that the outreach performances of interest free microfinance in terms of various dimensions such as depth, length, etc is still minimal or lacking and enough research has not been done on the overall performance of interest free microfinance in poverty lending. Keywords: Interest Free Microfinance Institutions (IFMFIs); Microfinance; Outreach; Poverty Lending; Sustainability; Triangle of Microfinance; Welfare Impact INTRODUCTION Microfinance has been considered as a powerful instrument to fight poverty and create income opportunities for the low-income population, particularly in developing countries. There are several studies which show that microfinance can lead to an increase in income, more employment opportunities, better nutrition for families, greater high school attendance, empowerment of women, and subsequently alleviating the spiral of poverty (Borbora and Mahanta, 1995; Gaonkar, 2001; Mishra & Hossain, 2001; Dunn & Arbuckle, 2001; World Bank, 1999; Puhazhendhi and Satyasai,2000; Manimekalai, 2001; Dunn & Arbuckle, 2001; Mishra et al, 2001; Hossain, 1988; Todd, 2001; Chen and Donald, 2001; Barnes, 2001; Pronyk PM, et al., 2006). But on the contrary, there are some studies which raise doubts on the effectiveness of microfinance in reaching the core poor, the reality behind the immediate and high repayment rates and the high indebtedness of beneficiaries as a result of cross borrowing etc. The success of microfinance has been contradicted by intense criticism in the current literature, particularly regarding loan repayment, high interest rates, exploitation of women borrowers, ineffective microfinance provision to target groups (Holt, 1994; Dignard and Havet, 1995; Ditcher, 1996; Hulme and Mosley, 1996; Christen, 1997; Rahman, 1999; Mallik, 2002; Assaduzzaman, 2002; Amin et al, 2003; Baru and Woller, 2004; Coleman, 2004 Deheija, 2005; ). Hence, to avoid the above mentioned evils of traditional (interest based) MFIs, a handful of interest free microfinance programmes have come forward in recent years to provide interest free financial Available online on 53

2 services. A few countries including USA and UK have introduced interest free banks and micro finance institutions. In the mean time, Habib Ahmed (2002) found that interest free microfinance is more successful in poverty alleviation and reaching the poorest of the poor than interest based microfinance. The attention towards IFMFIs further increased when the ADB report (2006) mentioned the special characteristics of interest free finance and its capability to provide alternative means to reach underserved groups in small rural areas and agriculture producers. In India, the attention towards IFMFIs was started and further boosted when Reghuram Rajan (2008), stated the role which IFMFIs can play to reduce the vulnerable effect of financial exclusion, which is believed to be the main reason for extreme poverty in the country. It is surprising that only a few studies have attempted to investigate the performance of interest free microfinance in terms of sustainability, outreach and impact (popularly known as the triangle of microfinance) in a systematic manner while these concepts triggered a lot of debate and discussion in the field of microfinance. Apart from that, the evidence presented in the available literature is mixed and many times anecdotal. With the aims of closing this gap and thus expanding the body of existing empirical works, the present study calls for an in-depth analysis on how IFMFIs attain financial sustainability and outreach while giving more preference to serve the needs of the extreme poor. OBJECTIVES OF THE STUDY 1. To study the importance of interest free microfinance in the current context of criticising conventional microfinance in terms of, high interest rates, exploitation of women borrowers, ineffective microfinance provision to target groups. 2. To identify research gaps in the current literature on interest free microfinance and propose an in-depth research to bridge the gap. Interest Free Microfinance (IFMFIs) Interest free microfinance is one of the fastest emerging areas of microfinance industry that aims to maximize social benefit as opposed to profit maximization. It can be defined as the investment of capital (in cash or kind) based on interest free modes of finance to poor entrepreneurs in order to help them to start or maintain their business (Smolo 2007). It has been a part of interest free banking system from the 1970s. According to The Banker interest free finance industry is rapidly evolving from niche to mainstream, with a growth rate of 15% to 20% a year. In the meantime, many countries, especially western countries like the USA and UK have amended their banking laws in favour of interest free banks. Today, there are more than 500 financial institutions; including 292 banks with a total capital size of more than 1400 billion dollars have been operating in more than 75 countries across the world. But The 2008 CGAP survey revealed that global Interest free microfinance supply is very limited and concentrated in only a few countries (80% of the 380,000 clients of Interest free microfinance worldwide are in Bangladesh, Indonesia, and Afghanistan). Moreover, it is also found that Interest free microfinance does not exceed more than 0.5% of total microfinance outreach. Though the literature on the performance of Interest free microfinance in poverty reduction is very few, there are some authors like Ahmed (2002) argued that interest free microfinance is more successful in poverty alleviation and reaching the poorest of the poor than interest based microfinance. In addition, Asian Development bank report (2006) pointed out that the special characteristics of interest free finance can provide an alternative means to reach underserved groups in small rural areas and agriculture producers. Moreover, there are studies, mostly from Bangladesh, India, Pakistan, Iran, UAE, KSA and Australia provide theoretical framework on the structure and functioning of IFMFIs and also argued that interest free finance could be a viable alternative to socio-economic crisis derived out of interest based economic system (A Haran, 1996; Habeeb Ahmed, 2002; A.J.M. Farooque, 2004; Choudary, 2007; Osmani, 2007; Ubaidulla, 2006; Bhuyan, 2006; Khatoon, 2007; ReghuramRajan, 2008; Jannat Ara Parven, 2009; Deasy Aseanty and Abul Hassan, 2013). However, there is a lack of VOL. 3, ISSUE 6 (June 2014) 54

3 literature on financial sustainability, outreach performance and welfare impact of IFMFIs on its beneficiaries. The Triangle Theory of Microfinance There are different arguments and opinions concerning how to evaluate the performance of microfinance institutions. Zeller and Mayer (2002), proposed a very popular method called "Critical Micro-finance Triangle or Triangle Theory of Microfinance" to evaluate the performance of microfinance institutions in a more systematic manner. The proposed research decided to evaluate the performance of interest free microfinance institutions (IFMFIs) in Kerala by adapting the concept of critical triangle of microfinance". According to Zeller and Mayer (2002) the need for any MFI to manage simultaneously the problems of outreach (reaching the poor, both in terms of numbers and depth of poverty), financial sustainability (meeting operating and financial costs over the long term), and impact (having a discernible effect upon clients quality of life) is of utmost important. It is also believed that the successful MFIs shall be expanding all sides of that triangle. The triangle can be depicted as (Mayer, 2002): Source: Zeller & Meyer, 2002 Here, the corners of the triangle represent outreach to the poor, financial sustainability and welfare impact. According to Mayer (2002) Performance criteria are required for each objective and all three must be measured thoroughly to evaluate micro-finance performance, the inner circle in the figure represents MFI innovations in technology, policies, organization, and management that affects how well each objective is met. The outer circle represents the environment within which micro finance operates that also affects performance. This environment broadly includes the human and social capital possessed by the poor, the economic policies of the country, and the quality of the financial infrastructure that supports financial transactions. Improvements in the environment make it easier for MFIs to reach the three objectives." (Meyer, 2002). The Critical Triangle of Interest Free Microfinance: Identifying Research Gap As understood from the above section, the need for any MFI to manage simultaneously the problems of outreach (reaching the poor, both in terms of numbers and depth of poverty), financial sustainability (meeting operating and financial costs over the long term), and impact (having a discernible effect upon clients quality of life) is of utmost important. The rest of the paper will elaborate the research gap in the current literature on performance of interest free microfinance in poverty alleviation and the urgency of bridging that gap. Sustainability of Microfinance Sustainability in general means the ability of a program to continuously carry out activities and services in pursuit of its statutory objectives. For an ideal MFI this would mean the ability to continue VOL. 3, ISSUE 6 (June 2014) 55

4 operating as a development financial institution for the rural poor (Khandker and Khalily, 1995). There are two different approaches pertaining to the concept of sustainability: Institutionalist approach and Welfarist approach. Research shows that microfinance Industry is significantly characterized by the instituionalist approach to sustainability. Institutionalist Approach Most research on MFIs of developing countries, during late 1990 s, has adopted the Institutionalize approach to analyze the sustainability situation of these institutions (Rhyne,1998). The following table summarizes the variables, most frequently used by eminent researchers, to measure the sustainability of MFBs under the institutionalize paradigm. Table 1. Sustainability indicators according to intuitionalist paradigm Sustainability Indicator Variables References Return on Assets ROA Conning (1999); Meyer and Zeller (2002); Hulme and Mosley (1996);Schreiner and Woller (2003) Operational Self Meyer and Zeller (2002); Schreiner and Woller OSS Sufficiency (2003); Khandker (1998); Hulme and Mosley (1996) Return on Equity ROE Conning (1999); Morduch (1999); Andogo and Stork (2005) Debt to Equity Ratio DE Quyyum and Ahmad (2007) Meyer and Zeller (2002); Morduch (1999); Shreiner (1997) Number of Active Breadth Hulme and Mosley (1996); Conning (1999) Quyyum and Borrowers Ahmad (2007) Transaction Cost per Borrower COST Meyer and Zeller (2002); Hulme and Mosley (1996) Source: Zaigham & Asghar, 2011 Welfarist Approach In contrast to institutionalize paradigm, the Welfare approach argues that attaining financial sustainability is not a pre-requisite for becoming a sustainable MFI (Woller et al, 1999a). According to welfare, funds and grants are a type of equity, which is donated by social investors. By social investors it implies that they are distinguished from private investors as they are willing to sacrifice financial returns (or earn minimal financial returns) by investing in an institution (MFI) that utilizes funds for social uplift. Therefore, welfare emphasizes on measurement of variables that determine the level of social impact. The following table summarizes sustainability indicators most frequently used by researchers under the welfare approach. Table 2. Sustainability indicators according to welfarist paradigm Sustainability Indicator Variables Depth of Outreach Proportion of Women borrowers Borrowers below Poverty Line DEPTH WOB BBPL Source: Zaigham & Asghar, 2011 References Navajos et al (2000), Meyer and Zeller (2002); Morduch (1999); Coleman (2004); Conning (1999) Schreiner (1997, 2003); Hulme and Mosley (1996) Quyyum and Ahmad (2007); Andogo and Stork (2005) Meyer and Zeller (2002); Amin et al (2003); Pitt et al 2003 Gertler et al (2003); Khandker (1998:2003) Most research carried out during late 1990 s and early 2000 s indicates that researchers do not evaluate sustainability by restricting to just one of the two approaches mentioned above. It is observed that, in VOL. 3, ISSUE 6 (June 2014) 56

5 fact, they have adopted a multi-dimensional approach to determine sustainability of MFIs. This is evident by the fact that researchers have analyzed sustainability by combining relevant variables under the welfarist and instituionalist approach. Even though, there is many methods and methodologies invented and developed to measure the sustainability performance of microfinance. The empirical evidence, however, is inconclusive. Moreover, no systematic research on the performance of interest free microfinance in financial sustainability has so far been carried out. Outreach of Microfinance Outreach at glance means the number of clients served. But, Meyer (2002) noted that outreach is a multidimensional concept. In order to measure outreach, we need to look into different dimensions. Navajas et al. (2000), indicated that there are six aspects of measuring outreach: depth, worth of users, cost to users, breadth, length and scope. Where, depth of outreach refers to "the value the society attaches to the net gain from the use of the micro credit by a given borrower," (Navajas et al. 2000). This measure is to identify the poor clients. Because, the poor are the one who fail to get access to get credit from formal financial institutions since they fail to signal that they can repay their loan (Conning, 1997). And, worth of outreach to users refers to "how much a borrower is willing to pay for a loan,"(navajas et al. 2000). Similarly, cost of outreach to user refers to "cost of a loan to a borrower," (Navajas et al. 2000). These costs to users might consists of prices like interest rates and various payments that they have to pay, which could be revenue to the lender, and other loan related transaction costs like expenses of documents, transportation, food, taxes, etc. (Navajas et al. 2000). Finally, "breadth of outreach is the number of users, length of outreach is the time frame in which a microfinance organization produces loans," and "Scope of outreach is the number of types of financial contracts offered by a microfinance organization," (Navajas et al. 2000). It is argued that the length of a loan matter, because if the microfinance institutions support the poor only in the short run it will hamper the social welfare of the society in the long run. In the case that when the client of the microfinance institution knows that he/she will not receive additional loan in the future they would have no incentive to borrowers to repay their loan (Navajas et al., 2000.). However, when we come to the empirical investigation, it is found that the outreach performances of interest free microfinance in terms of various dimensions such as depth, length etc is still minimal or lacking. Impact of Microfinance From a doubtful experiment in Bangladesh 40 years ago, microfinance has become a worldwide movement as a development activity, a way of helping poor people out of poverty (Ditcher, 2006). According to Dr. Muhammad Yunus, among poverty eradication mechanisms microcredit is the best suitable option which will enable the poor to overcome their poverty. Several literatures reveal and confirm the nexus between microfinance and poverty alleviation. In their view, it has all the potential to eradicate poverty from this world by providing financial as well as social services to unbanked poor people who have creative potential to improve their quality of life if they get the right opportunity in right time. There are several experimental and quasi-experimental studies which confirmed this claim by providing adequate empirical evidences. The best among them is An Asian Development Bank study conducted by Khandker (2001) in Bangladesh shows that microfinance clients do better than nonclients in both 1991/92 and 1998/99 in per capita income and per capita expenditure. The incidence of poverty among participating households is lower in 1998/99 than in 1991/92 and lower than among non- participating households in both periods. Plenty of empirical studies such as Borbora and Mahanta (1995), Gaonkar (2001), Mishra & Hossain (2001), Dunn & Arbuckle (2001), etc. have revealed that the microfinance programme is a vital input for increasing employment, alleviation of poverty and empowerment of rural poor, especially women. Meyer (2002) reached a similar conclusion. Surveying the available evidence from Asian countries, he concluded that while access to microcredit seems to have an overall positive effect on income and education, results differ substantially across countries and programs both in magnitude and statistical VOL. 3, ISSUE 6 (June 2014) 57

6 significance and robustness. In addition, Hashemi and Morshed (1997) observed that the Grameen Bank is not only reducing the poverty it also improves the standard of living of the borrower of the bank and increase the ability to smooth their income over a period of time. Similarly Kamal (1996) reported that per capita income of the borrowers is higher as compared to non-borrowers. Chowdhury et al. (1991) observed that the participants of the Bangladesh Rural Advancement Committee (BRAC) have more income, owned more assets and earned more, as compared to the non-participants. Like Chowdhury et al. (1991), Mayoux (2001) observed that the credit is playing a crucial role in the increase in income of the clients, to live comfortably, including female clients and enables them to handle the external shocks and contingencies. The famous impact studies by different prominent authors such as Puhazhendhi and Satyasai (2000), Manimekalai (2001), Dunn & Arbuckle (2001), and Mishra et al. (2001) also showcase the similar results of an increase in income of the programme clients in the post-shg situation as compared to their income in the pre-shg situation. The studies by Hossain (1988), Todd (2001) and Chen and Donald (2001) have also proved that the incomes of programme clients are significantly higher than the incomes of non-clients. Regarding the impact on household asset, Hulme and Mosley (1996) found that there was a significant increase in assets, savings as compared to non-participants of the program and they earned more profits from their micro businesses. Similarly, Barnes (2001); Pronyk PM, Hargreaves JR, Kim JC, et al. (2006) observed in South Africa that there is increase in household assets after 2 years of participation in microfinance program. Pitt and Khandker (1996, 1998) suggested that there is a positive relationship between micro credit and human development and their tangible assets. Mosely and Hulme (1998) observed that the income of the borrower improves the position of assets owned. In contrast to these earlier mentioned studies, Coleman (1999) found no significant impact of access to microcredit on improving household wealth using a sample of households from north-eastern Thailand. However, when the sample was broken down into general beneficiaries and committee members, Coleman (2006) found that the insignificance was limited to general beneficiaries and that a positive impact was found among the committee members who received access to financing. Montgomery (2005) supported the findings of Coleman by using data from Pakistan and found a mild significant impact on per capita food expenditure in the months after the beneficiary first borrowed. However, access to microcredit did not have a significant impact on non food expenditure. Similar to Coleman (1999), there are studies which highlight and propagate the severe effect of microfinance on their poor clients who became more vulnerable after entering into this programme. According to Sadegh (2006), The equation between microfinance and poverty alleviation is not straightforward, because poverty is a complex phenomenon and many constraints that the poor in general have to cope with. The triumph of microfinance has been contradicted by deep criticism in the recent literature, vis-à-vis loan repayment, high interest rates charged, exploitation of women clients, ineffective microfinance provision to target groups (Holt, 1994; Dignard and Havet, 1995; Christen, 1997; Mallik, 2002; Baru and Woller, 2004). It is clear that the previous studies on the impact assessment of microcredit programmes have been narrow in their focus and show mixed results. Some studies show a significant, positive impact on beneficiaries while others show no significant impact. However, all of these studies simply assessed the impact of interest-based microcredit programme which did not consider the impact of interest free microfinance on poverty alleviation. Unlike other microcredit programmes, this scheme has incorporated ethical and moral development activities in its microcredit programme. Therefore, the present study understood the need for conducting a rigorous research to assess the impact of interest free micro financing on poverty alleviation. CONCLUSION From the literature review, it is understood that Interest free microfinance can offer an alternative paradigm for millions of poor people who are currently not served by conventional microfinance. But VOL. 3, ISSUE 6 (June 2014) 58

7 there is no rigorous research work has been conducted on how interest free microfinance is attaining financial self- sufficiency and wide outreach while considering the needs of the chronic poor than those of the poor or moderately poor or the not-so-poor. With the aims of closing this gap and thus expanding the body of existing empirical works, the present study calls for an in-depth analysis on how IFMFIs attain financial sustainability and outreach while giving more preference to serve the needs of the extreme poor.. The study would be looking into the welfare impact of interest free microfinance on its clients by adapting recalculated cross-sectional analysis, which was introduced in 2007 by Gwendolyn Alexander-Tedeschi. A mixed method research design expected to be more useful for analyzing both quantitative and qualitative data to be collected from survey, case study and FGD methods. REFERENCES 1. Ahmad, H. (2007). Waqf Based Microfinance: Realising the Social Role of islamic Finance. (nternational Seminar on )ntegrating Awqaf in the )slamic Financial Sector. Singapore. 2. Amin, S., Rai, A., & Topa, G. (2003). Does Microcredit Reach the Poor and Vulnerable? Evidence from Northen Bangladesh. Journal of Development Economics 70 (1). 3. Chowdhury, & Bhuiya. (2001). Programmes reduce inequity in health: Lessons from. (D. Leon and G. Walt ed). UK. 4. Chowdhury, M., Alam, J., Ghosh, D., & Wright, R. E. (2005). The Impact of Micro-credit on Poverty: Evidence from Bangladesh. Progress in Development Studies Vol. 5, No Christen, R. P. (2001). Commercialization and mission drift: The transformation of microfinance in Latin America. Occational paper No: 5 Washington DC: CGAP. 6. Coleman, B. (2006). Microfinance in Northeast Thailand: Who Benefits and How Much? World Development 34(9), Conning, J. (1999). Outreach, sustainability and leverage in monitered and peer monitered lending. Journal of Development Economics. 8. Fernado, N. A. (2004). Microfinance Outreach to the Poorest: A Realistic Objective? ADB Finance for the Poor. 9. Hossain, M. (1988). Credit for Alleviation of Rural Poverty: The Grameen Bank in Bangladesh. IFPRI Research Report, No Hulme, D., & P, M. (1996). Finance against poverty. Routledge, Lendon. 11. Karlan, D. (2001). Microfinance Impact Assessments: The Perils of Using New Members as Control Group. Journal of Microfinance, Khandker, S. (1998). Fighting Poverty Microcredit. In S. Khandker, Fighting Poverty Microcredit. Dhaka, Bangladesh: University Press Ltd. 13. Khandker, S. (2005). Microfinance and Poverty: Evidence Using Panel data from Bangladesh. World Bank Economic Review. 14. Khatoon, A. (2007). Islamic Banking - More Compatible with Micro-Financing,. Management Accountant, Institute of Cost and management Accountant of Pakistan, Vol Meyer, R. (2002). Track Record of Financial Institutions in Assisting the Poor in Asia. ADB Institute Research Paper No Montogomery, H., & J, W. (2005). Great Expectations: Microfinance and poverty reduction in Asia and LatinAmerica. ADB Research Institute paper series No 63. Manila: ADB. 17. Morduch, J. (2005). Smart subsidies for sustainable microfinance. Finance for the poor: ADB Quarterly Newsletter of the Focal Point for Microfinance,6, 1-7. VOL. 3, ISSUE 6 (June 2014) 59

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