Too Vulnerable for Microfinance?: Risk and Vulnerability as Determinants of Microfinance Selection

Abstract: Microfinance has become a popular part of poverty reduction agendas since its inception roughly 30 years ago. Despite dramatic growth, however, many microfinance institutions face low penetration rates. It turns out many potential borrowers choose not to participate. Current explanations for this phenomenon largely focus on skill, arguing that high skill entrepreneurs generate expected returns above the borrowing rate and select microfinance while low skill entrepreneurs do not and stay away. In this paper I contend these explanations are insufficient because they ignore risk altogether, a fundamental driver of poor household’s behavior. I propose consideration of vulnerability, defined as the inability to smooth consumption across negative income shocks, as an additional factor driving microfinance selection. I outline a model in which the risk level of projects and a household’s ability to manage risk help determine whether or not a household can “afford ” microfinance. Using data from ACP, a large, profit-oriented microfinance institution in Peru, I find positive evidence that vulnerability is significant in determining microfinance participation. These results suggest risk and vulnerability should be incorporated into subsequent analyses of the effectiveness of microfinance as a poverty alleviation tool. 1 I am indebted to Monique Cohen, formerly of the AIMS project and currently of Microfinance Opportunities, for providing me with the data and for putting me in contact with Elizabeth Dunn, the primary researcher for the AIMS project in Peru. I am also indebted to Roger Betancourt for numerous rounds of feedback and good advice, and grateful to John Wallis, Rodrigo Soares