Smart subsidies for microfinance

In a recent column, Nicolas Kristof of the New York Times advocated donating to BRAC, one of Bangladesh’s oldest microfinance organizations. But at a recent U.S. Committee on House Financial Services hearing, Damian von Stauffenberg, chairman of MicroRateargued against putting donor money into the microfinance sector, saying that donations dilute the MFI’s entrepreneurial drive, lead to inefficiency and lower the quality of operations.

Von Stauffenberg’s fears aren’t unreasonable. Much of the excitement around microfinance stems from the possibility of achieving massive scale through highly efficient operations. And as microfinance moves toward a model of increasing commercialization and focus on sustainability, profitability has become one benchmark by which to measure institutions. But there is a time and a place for donor money, provided it comes in the form of “smart subsidies.

The idea behind a smart subsidy is that subsidies are neither inherently useful nor inherently flawed. Rather, their effectiveness depends on how they are designed and deployed. There are several concrete ways in which subsidies can help increase the scale of microfinance, and open access to commercial funds and outreach.

First, they can help multiply scale by “crowding in” additional capital through enabling leverage, enabling deposit taking, and helping to demonstrate the concept, capacity, and impact in ways that attract additional funds and allow ideas to be adapted elsewhere.

Second, subsides can help by demonstrating and testing innovations. Research and development is challenging for non-profits to self-fund: the benefits of R&D are enjoyed widely while the costs are borne by the innovator alone (in economic jargon, investment in innovation has a strong positive externality). This externality weakens any one institution’s incentives to invest in research and new product development, which leads to inefficiently low levels of R&D. External subsidies provide important support that allows organizations to experiment with new models and products that can later be scaled up.

Finally, subsidies can help by allocating resources with an eye to generating net impacts. Whether or not a rigorous impact evaluation takes place, the central idea behind evaluations remains critical. This is that the ultimate goal of any program is to have a positive net impact by making a positive difference in people’s lives. Smart subsidies can support institutions in reaching costlier, harder-to-reach customers.

Microfinance experts like von Stauffenberg worry that badly designed subsidies will undermine the financial performance of micro lenders and the social impacts by limiting scale and the quality of services. These fears are not unjustified, but they shouldn’t get in the way of seeing the positive impact that well-designed subsidies can have.