The Myths of Microfinance

Examining the dark side of a feel-good industry.

Confessions Of Microfinance Heretic

Don’t criticize microfinance. That’s the first rule of microfinance, says Hugh Sinclair, author of “Confessions of a Microfinance Heretic” (Berrett Koehler), who chose to pursue a career in the microfinance industry — only to discover that it was rife with corruption and doing far less to alleviate poverty than the public realizes. Sinclair’s attempts at exposing malfeasance put him in harm’s way and led to personal retaliation, legal action, and death threats, but that didn’t stop him from lobbying for change. “Confessions of a Microfinance Heretic” — part memoir, part financial detective story, and part exposé — is a devastating indictment of a largely unregulated industry, one that loans money to poor people in Third World countries at interest rates that “would make a European or American cry,” he says.

Exiled from the mainstream microfinance industry, Sinclair lives in a remote corner of South America, where he serves as a part-time consultant for a handful of clients who strive to provide ethical microfinance. While he remains cautiously optimistic that the industry can be changed for the better, he fears the implications of having introduced the poorest of the poor into the financial sector. “We’ve opened a channel and now we’re just going to shovel credit, health insurance, life insurance, DVDs, whatever,” he says — a recipe for over-indebtedness amongst people who can least afford it. No doubt this isn’t what Mohammed Yunus had in mind when he founded Grameen Bank (est. 1983) and subsequently popularized the age-old idea of offering modest, low-cost loans to the poor to help them start businesses and lift themselves out of poverty.

In the following Failure Interview, Sinclair — who publishes a blog on microfinance transparency — discusses how microlenders attempt to justify the eye-popping interest rates they charge, and also explains how 21st century microfinance has come to resemble a Ponzi scheme. Last but certainly not least, he concludes by predicting the next scandal that will befall the sector.

Why did you join the microfinance sector?
I joined with the belief that microfinance was an effective tool to eradicate poverty, so I was just as naïve as most people remain to this day. Gradually I realized that the truth is a little more complicated.

How is microfinance supposed to work?
We’re all familiar with the traditional image of the $500 loan, usually to a woman, who buys a goat or a sewing machine. What happens is that the people in the U.S. and Europe who fund these loans generally go through an intermediary like Kiva, Deutsche Bank, or CitiBank, or a dedicated microfinance fund such as Blue Orchard or Triple Jump. The idea is that these intermediaries invest in your best interests and the best interests of the poor by channelling this money to small banks in developing countries to do effective, ethical microfinance. That’s the theory.

How much money is in the sector?
Microfinance has been overhyped as a miracle cure [for poverty] and has managed to attract money in vast sums. Currently the private microfinance capital invested is about $70 billion. The problem is that when you’ve got a $70 billion sector you’ve also got something on the order of $30 billion a year being paid in interest. This is money that is being taken out of poor communities. People talk about the positive impacts but don’t talk about the negative impacts — the hidden side of microfinance.

Talk about how the commercialization of microfinance has changed the sector.
It has attracted pure-profit motivated investors driven by metrics such as return on equity, profit margins, and accelerated growth rates. It has resulted in high levels of competition between microfinance institutions, which are constantly trying to cut costs (and therefore services), and also trying to increase revenue by charging the highest interest rates possible. It has introduced a new wave of players who are able to deploy spin, PR, and non-transparent operations. This has led to a series of self-regulatory bodies, usually funded by the investment funds themselves, to give the appearance of regulation when none exists in practice. It has also “legitimized” the sector, so that the man-on-the-street believes it is now a formal part of the “established best practice,” and therefore entrusts his money to funds while applying very little scrutiny. And the IPO has become the Holy Grail, where investors can cash out, and profit maximization then becomes the sole aim.

Microfinance started off as a development tool but gradually shifted to a profit motivated tool, and profit has become the driving force behind the sector. Of course, it’s difficult to brand the entire industry with one brush. There are very good institutions out there. So it’s not fair to say that the entire sector has been hijacked — yet.

What about the argument that commercialization leads to competition, which in turn leads to better and cheaper services for the poor?
That argument is flawed. The countries that have demonstrated the apparently positive impacts of commercialization have invariably been tightly regulated and obliged to behave ethically and not charge usurious interest rates. It is regulators who push these improvements, not competition. The argument also assumes that the banks do not form tacit cartels, which is a very bold assumption. It is not in the interests of the banks to compete with one another and drive down margins, nor is it in their interests, or the interests of their investors, to be effectively regulated. Interest rates in Mexico have gone up over the last ten years. The Central Bank of Colombia recently raised the interest rate cap from about 35% to 50%, and all the microfinance banks raised their interest rates accordingly. Where is the competition in this?

The problem is that commercialization, or free-market forces, are presented in a dichotomous way: either total, unregulated, free-market neo-liberal economic capitalism, or stagnant communism and zero enterprise. There is a grey area in-between. I do not think that commercialization is wrong, but it needs to be monitored, regulated, and operate within boundaries. The commercialization practiced in countries such as the U.S. and the U.K. — bastions of free-market ideology — are regulated and monitored, while the commercialization practiced in developing countries is largely not. But we conveniently ignore this as it benefits us, and hurts people thousands of miles away who do not vote in our elections or riot in our streets.

What is a reasonable return for a microfinance fund?
That is an open question, but every 1% more charged to the poor and given to a U.S. or European investor is a 1% transfer of wealth in the wrong direction. To give you an idea, I think interest rates of 30% are fine. Indeed, I am not too fussed even at rates closer to 50%. But above 50% I get seriously worried. Above 100% I panic. Approaching 200% — I cannot understand how these people sleep at night. But rather than ask what the reasonable rate is for a fund to earn, it is easier and fairer to ask: What is a reasonable rate that the poor should be expected to pay and still benefit from the loan?

Wait, interest rates approaching 200%?
Everyone talks about Grameen Bank. They charge interest rates of 20% to 30%, which is actually extremely reasonable in microfinance terms. But that’s the exception. It’s very rare for interest rates to be under 30%. It’s quite rare to be under 50%. If you look at many countries in Africa — when all the costs are considered it’s often well over 100%. I will not work with any institution that charges over 100%, which is hardly a low figure, but this already excludes many banks. The worst case I’ve come across so far — which was detected by David Roodman of the Center for Global Development — is Compartamos [Mexico], which was charging a total cost of 195% [annual effective interest rate, per year, including all fees and taxes]. Obviously when you are paying these sorts of interest rates it is difficult just to pay the interest.

When is an interest rate “extortionate”?
This is a valid question, and one the microfinance sector is not willing to address, as interest rates are one of the prime drivers of profitability. There is a Nigerian bank called Lift Above Poverty Organization (LAPO) that was caught charging interest rates of up to 144%. Recently a bank in Tanzania called Tujijenge was caught charging rates of 150%. People justify these rates using an argument that we now call “The Nigeria Defense.” It was pioneered by Grameen Foundation USA, which defended LAPO’s interest rates because they were cheaper than the [local] moneylender. Many people reject this; just because someone is even more exploitative does not excuse such behavior.

People also defend high interest rates by pointing to “high operating costs,” but they are not so high as to justify these rates. They also cite inflation, which is a fair point, but if inflation is 10% that does not justify an interest rate of 150%.  And they like to quote an example of an individual who happened to make a huge profit from a loan. The 150% interest may have been fine for that individual, but they don’t talk about all the other clients who did not make such amazing returns. This is called the “lottery winner argument.” To see the impact of a lottery you need to look at the people who didn’t win, not just the winners.

We have deviated so far from Mohammed Yunus’s vision of affordable credit used by the poor for productive purposes that some would argue that much of what is practiced today is not microfinance at all, but extortionate consumer lending to vulnerable people.

What are microfinance loans being used for?
This is another aspect of the microfinance myth — that’s we’re funding female entrepreneurs to help them start up their businesses. In practice, it’s not actually clear that the money is being used for any entrepreneurial activity whatsoever. John Hatch, the founder of FINCA, a very large microfinance network, estimated in the Harvard Business Review that 90% of microfinance capital is used for consumption — that is, used for buying a TV or clothes — and that very little gets to any entrepreneurial activity. The head of the Zambian Central Bank came up with the same estimate recently. No one knows exactly, because it is hard to measure the proportion of loans spent on consumption or used to pay off other loans, but what is interesting is that no one wants to discuss this.

An estimated 200 million people are receiving microfinance loans. Do all these poor people actually need credit?
No, but it is very hard to work out who doesn’t. If someone buys a TV in Mexico at an interest rate of over 100% — how do you define “need”? It is a grey area, and another one that the sector does not like to discuss too openly, as the idea of borrowing for consumption or to pay off another loan is not so attractive to the U.S. investor. People like to think the money is used to fund entrepreneurial exercises, hence the photos of women sitting behind sewing machines, which are provided by the funds to maintain this image.

This raises a second question: Is everyone an entrepreneur? No, of course not, in the same way that not everyone in California is an entrepreneur.

Does the benefit to the poor outweigh the amount of interest being extracted from them? Or are they simply dangerously over-indebted?
The first question is hard to answer other than by reference to academic studies. They suggest that en masse no benefit is accruing to the poor, but in isolated cases it does. But they fail to consider the impact on people who are not microfinance clients. When a bank starts lending to some tomato vendors, they may do okay, but to what extent are they driving other vendors out of the market? These others do not appear in any statistics because they are, by definition, not clients. Think of the argument of Wal-Mart arriving in a town and driving the mom-and-pop stores out of business. This negative effect is entirely ignored, but it means that even if — and this is a big if — some clients actually do well, the overall impact may still be zero if this has simply replaced work done by non-clients with work done by clients.

As to the second question: Every year there is a report called the Microfinance Banana Skins report that looks at what is undermining microfinance. This year the number one problem was over-indebtedness, which is chronic, particularly in Colombia, Mexico, and Peru, but also in Ecuador and perhaps Bolivia. It’s not that we don’t have enough microfinance, it’s that the poor are over-indebted.

The sector doesn’t like to discuss the amount of microfinance that is simply used to pay off a loan at another microfinance institution. One woman in Nicaragua who manufactured kites managed to obtain a loan from all 19 banks in the country — simultaneously. Another individual managed to rack up microfinance loans totalling $600,000. What happens is that people take a loan from bank B to pay bank A, and then from C to pay B, and so on. As we saw with Bernie Madoff, as long as the music keeps playing — and the music can keep playing for quite a long time — the banks can say “Everything is fine. Keep giving us your money.” But when the music stops the entire thing collapses. That’s what happened in Nicaragua in 2008, and we’ve also seen crises in Bosnia, Pakistan, Morocco, and Bolivia.

Microfinance-gone-wrong seems dangerously close to a Ponzi scheme. Is that a fair comparison?
Microfinance can resemble a Ponzi scheme in more ways than one. The first is the musical chairs way the loans are recycled from one bank to another until eventually the music stops. As long as the music is playing, each bank can boast growing client numbers, growing portfolios, and low default rates. As long as growth continues, the percentage of loans in default remains low, as few people default [because they obtain loans from bank B to pay bank A], and also because the percentage is the ratio of those in default to the total portfolio. As long as the latter is growing, the ratio stays low. And as long as this continues, investors will keep providing ever more capital — until the entire thing collapses.

A second way is the use of forced savings. A bank will force a client to make a deposit, perhaps 20% of the loan amount, in order to receive their loan. So although the loan is $100, the client only actually receives $80 net, yet pays interest on the full $100, plus a few fees. But the bank can then lend this $20 in savings to the next client — sometimes legally, other times not — and that client also has to make a deposit, and so on. So the bank can make far more loans — and therefore profit — than it would if it only used its own capital, as it is essentially lending the clients’ own money. This is what commercial banks do, and it’s not necessarily a bad idea, but it needs to be tightly regulated and controlled, because it is risky. If all the clients demand their savings back, the bank may not have the money. The microfinance banks reduce this risk by refusing to return savings until the clients have repaid their loans. The problem is that you have unsophisticated village banks engaging in risky, sophisticated financial intermediation, which is a recipe for disaster.

The third analogy relates to the incentives. With a Ponzi, as long as you get in and out before it collapses, you are okay. With the microfinance sector, the people who make the money and control the flow of information are the funds. They take money from their own investors and charge a fee. Then they lend it to some microfinance bank. What that bank does with the money, and how this money benefits the ultimate client, doesn’t really matter to the fund — they get their fee either way. In the case of Nicaragua a lot of funds lost a lot of money when the sector collapsed, but they didn’t mind too much. They simply told their investors: “This is the risk in developing countries,” and moved to the next countries. This is not exactly a Ponzi scheme, but it is certainly a case of ill-aligned interests.

Which countries seemed poised to be home to the next microfinance crisis?
Mexico, which is characterized by huge over-indebtedness, poor use of credit bureaus, extremely high interest rates, major multiple borrowing, high default rates, and incompetent regulation. What is interesting in the cases of Peru and Bolivia is that they have huge microfinance sectors and huge child labor problems. This is attracting increasing attention from academics, and could lead to another scandal in terms of the reputation of the sector.

The problem is that microfinance sits uncomfortably close to child labor. Small enterprises are generally labor intensive and require large numbers of transactions to make any money, particularly to generate sufficient money to pay off the high interest rates. But it is expensive for the owners of small businesses to hire people, so there is a strong temptation for them to use their own children. No one really knows how widespread this is, but a number of academic papers have been published recently showing that children are often removed from school to work in micro-businesses, or micro-sweatshops. So while microfinance may have a positive impact on education — by generating sufficient money to enable parents to send their kids to school, or providing loans specifically for education costs — these two opposing effects don’t cancel out. We need to acknowledge that there are good and bad impacts on education and try to promote the good effects and eliminate the bad. What is happening is that the sector is desperately trying to avoid the topic of child labor, and sweeping this under the rug. I think this is sad, short-sighted, and will come back to haunt us.

If you could do one thing to fix the microfinance sector what would it be?
If I could do one thing it would be to regulate the microfinance funds and lending platforms in developed countries. These are the source of the problem. They provide a false image of microfinance to their own investors, and are exploiting not only the poor, but also the well-meaning investors in the U.S. and Europe who entrust their money with these companies. I would regulate them just like any other part of the financial services sector, which is far from perfect, but certainly better than nothing. The problem is that this is fiercely resisted by the powerful players, including Citibank, Deutsche Bank, and Blue Orchard.

The self-regulatory initiatives the sector has established are a joke. They are financed by the same people who need to be regulated, and are totally ineffective. In fact, the worst offenders in the sector are often members of these initiatives. What we need is an independent regulator who looks after both the interests of the poor and those of the ultimate investors, and has the authority to take firm action against offending companies. Until this happens, these problems will not go away. Expect to see more scandals and crises in the meantime.