All over the world, poor people are regularly excluded from formal financial systems. The degree of this exclusion ranges from partial exclusion in developed countries to full or nearly full exclusion in developing countries. In response to these needs, a new branch of financial services has emerged called microfinance.

Microfinance is the provision of financial services to micro-entrepreneurs and small businesses which have traditionally lacked access to financial services such as insurance, credit, savings and methods for transferring funds. Its aim is to reduce poverty by providing loans to impoverished individuals and groups with the goal of helping them increase their earning potential through entrepreneurial ventures.

The poor are often unable to provide collateral for loans in the traditional form of cash or valuable property, and are therefore ineligible for credit through formal lending services. As a result, poor people often turn to moneylenders, individuals or groups who offer small loans at exorbitant interest rates. Microfinance attempts to offer loans at significantly lower interest rates as a means of combating poverty.

In light of the inherent promise of microfinance as a means of promoting economic equality and reducing poverty, microfinance institutions (MFIs) have historically struggled to offer microfinance services while remaining financially sustainable and self-sufficient. Recent advancements in psychometric testing may be able to solve this problem, allowing MFIs to be both effective and self-sustaining.

Although these proposed applications of psychometric testing are quite modern and revolutionary, the field dates back to the late nineteenth century. Sir Francis Galton, a relative of the more well-known Charles Darwin, created some of the first psychometric tests and analytical procedures to measure individual differences in aptitude and personality. The tests sought to quantify the degrees of various human behaviors by presenting questions of a somewhat ambiguous variety, offering answers that related to a person’s underlying characteristics and personality traits.

There are no right or wrong answers, and the test forces participants to make difficult decisions that align with their personal characteristics and beliefs. For example, prospective microfinance borrowers may be asked questions pertaining to whether they would repay a loan given a difficult family or economic situation; the response would allow those personality traits that correspond to the borrower’s likelihood to repay the loan to be measured, therefore allowing the lender to minimize the risk of default.

Today, these tests can be used to asses a variety of skills and characteristics, including cognitive, sensory, perceptual and motor functions. Prospective employers have come to embrace these forms of testing in order to gain a more accurate insight into a prospective employee’s characteristics and abilities than can be gleaned from a resume.

The Inter-American Development Bank (IDB), a multilateral institution financing development efforts in Latin America, released an article earlier this year arguing that psychometric testing can be used by financial institutions to reduce defaults on loans by 20 to 45 percent and increase profits by 15 to 30 percent.

These numbers are based on a study of a form of psychometric testing developed by the Entrepreneurial Finance Lab Research Initiative, a program developed at Harvard University that is, according to its website, dedicated to evaluating “the impact of psychometric screening tools and alternative financial contracts on access to finance and entrepreneurial growth” in developing countries.

The test consists of 150 questions measuring potential borrowers’ business savvy, ethics, general intelligence, beliefs and other personal traits. This information is used to generate a score that is meant to indicate potential borrowers’ willingness and ability to repay a loan. According to the IDB article, the testing “costs little, and has already been implemented by financial institutions in 11 countries in Africa and two in Latin America.”

Various pilot projects implementing psychometric testing have compared the scores of tested borrowers and their actual business performance and repayment rates. According to IDB, these projects have found that the tests are accurate and efficient predictors of creditworthiness.

The promise of psychometric testing is simple: certain financially self-sustainable MFIs have the potential to fundamentally alter the way we approach economic development and poverty reduction. The MFIs’ traditional lending models enable them to maximize their economic and social impact. It’s a win-win for all parties involved, and is sure to fundamentally alter the way the microfinance industry operates.

Makai McClintock is a Collegian columnist and can be reached at [email protected].