The cracks in this system have been visible for years. As far back as 2015, a collection of six independent studies published in the American Economic Journal found that microloans did not improve the economic situation of their recipients, failed to produce any positive social changes, and even found that some families who received such loans were taking children out of school and putting them to work.

Perhaps the impracticality of the idea should have been evident when Yunus told his Norwegian audience in his Nobel acceptance speech that “in a poverty-free world, the only place you would be able to see poverty is in the poverty museums.” Leaving aside the utopian vision of ending poverty once and for all, there were good reasons to doubt that this approach would bring about transformative changes.

Offering loans to individuals or businesses at below-market rates seems like a generous and rational approach for those who do not qualify for bank credit, but it has a spotty record. When credit is passed out too easily, without real lending standards, then borrowers will have difficulties in repaying loans, and many will be forced into default or bankruptcy. That is a common pattern in loan programs that lack solid credit standards. We have seen this happen in credit crises in the past, including in our own subprime mortgage crisis of 2008.

For any such system to work, loans must be made to businesses that will generate income streams out of which the loans can be repaid, then made available to future borrowers. Yet microfinance was always linked with philanthropic or political impulses — for example, in the emphasis on female entrepreneurs or in the practice of offering loans at below-market rates without due regard for risks of failure. It was conceived, in other words, as a means of helping poor people, not always as an instrument for business development.

The Grameen Bank was subsidized by governments and not-for-profit institutions, which is true of other microfinance banks as well. In the early years, the government of Bangladesh provided operating capital to the bank. Later, when the bank raised capital through bond sales, the same government guaranteed those loans, making it possible to offer them at low rates of interest. Other governments and foundations also provided subsidies, including the World Bank; the International Fund for Agricultural Development; the governments of Norway, Sweden, and the Netherlands; the U.S. Agency for International Development; and the Ford Foundation. Those institutions did not insist upon repayment in the manner of for-profit investors. The Grameen Bank evolved into more of a philanthropic outfit than a bank operating on the basis of real lending standards.

That was true of other microfinance banks as well, though certainly not all of them, because inside contacts and a degree of political celebrity are often required to gain entry into subsidizing institutions. Yunus was able to capitalize on both in raising capital from government agencies and foundations. To this end, he created a nonprofit organization, Grameen America, to raise funds in the U.S. Through that nonprofit organization, he made a donation to the Clinton Foundation, after meeting with Clinton, probably for the purpose of raising capital from the U.S. government. In short order, USAID announced that it was partnering with the bank to extend microfinance operations abroad.

The Grameen Bank and others like it experience difficulties earning profits from their loan portfolios. The loans were expensive to make: They required staff and research time. The loans, even when repaid, generated small returns. Rather than using loans to launch or run businesses, many recipients used the funds to pay medical expenses or to cover other costs. Naturally, those loans were not repaid. Those factors meant that the expenses of the banks had to be covered by subsidies of one kind or another, instead of by investment capital looking for returns.

Spurred on by the reputed success of the Grameen Bank and by the popularity of the microfinance concept, private banks and investors piled into the market, purchasing stakes in microfinance lenders or purchasing securitized microfinance debt. As in the U.S. mortgage crisis, the people or institutions approving the loans were not always the same people who put up the capital. The amounts of capital ballooned, as did the number of borrowers. According to the Wall Street Journal, microfinance lenders around the world had outstanding loans of $220 billion, with more than 140 million borrowers. Not surprisingly, default rates on these loans are increasing. An OECD report in 2021 estimated that 30% of microfinance loans in sub-Saharan Africa were in default, though default rates in other countries are substantially lower. Nevertheless, high default rates are a real problem for microfinance.

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This does not mean that microfinance is a flawed concept or will never work, but that it should operate on the basis of proven models and ought not to be viewed through philanthropic or political lenses. To make the system work, lenders must extend loans to real businesses that can generate streams of income to cover expenses, profits, and repayment.

It will always be difficult to run this system on below-market interest rates, because the loans are expensive and time-consuming to supervise. For these reasons, microfinance will inevitably depend upon subsidies of one kind or another from governments or charitable foundations. But once the subsidies come in, then the political and philanthropic considerations enter into the picture, turning microfinance from a banking model into something much less helpful.

James Piereson is a senior fellow at the Manhattan Institute. Naomi Schaefer Riley is a senior fellow at the American Enterprise Institute.