The Myths of Microfinance

Examining the dark side of a feel-good industry.

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.

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