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Monday, June 09, 2008

Microloan Sharks

Source: Stanford Social Innovation Review

Banco Compartamos, the largest microfinance institution in Mexico, is the acknowledged poster child for commercial microfinance institutions (MFIs). From its inception in 1990 until 2000, Compartamos operated as a not-for-profit nongovernmental organization (NGO), receiving $4.3 million from international development agencies and private Mexican donors. In 2000, the organization was reaching 60,000 borrowers? mainly poor women in rural areas. To tap commercial funds for even faster growth, the NGO and other investors converted it to a for-profit business. By the end of 2006, the corporation was serving some 616,000 borrowers?a tenfold increase.

The corporation went public in 2007. For its initial public offering (IPO), Compartamos? owners sold about 30 percent of their shares to new investors, raising a total of $450 million for the original investors?not bad for an initial total investment of $6 million. Following the IPO, the corporation was valued at more than $1.5 billion. That comes out to an internal rate of return to investors of roughly 100 percent a year, compounded over eight years, reports the Consultative Group to Assist the Poor (CGAP).1

Many observers hailed the Compartamos IPO as an unalloyed success. ?The financial markets have shown the true value created by high-performance, double bottom line?oriented microfinance institutions. We hope that this is the first of many [IPOs],? concluded ACCION, a U.S.-based microfinance network, in a document on its Web site.

Yet the realization of Compartamos? commercial bottom line has come at the expense of its social mission. Compartamos? borrowers routinely pay annual percentage rates (APR) of more than 100 percent. In contrast, microlending institutions worldwide average an APR of 31 percent, according to a Dec. 13, 2007, BusinessWeek article. Even Americans with bad credit histories get better terms on their credit card debt, receiving APRs that range from 22 percent to 29 percent, according to the same article.2

Virtually every MFI argues that it must charge high interest rates because servicing very small loans in rural areas to people with no credit history is an expensive business. Commercial MFIs add that they must charge high APRs to generate profits and attract private investment capital, which in turn will allow them to scale up their ventures and reach even more impoverished people.

Yet the Compartamos IPO generated such high returns that many are now asking whether microfinance should be about poverty alleviation or profit generation. Can it be about both? Can microfinance serve two masters?

The field of microfinance is still too young for observers to know the answers to these questions. But the Compartamos IPO raises a red flag: There is something decidedly unseemly about profit-maximizing investors backing an MFI that charges 100 percent interest, compounded annually, to the world?s poorest people. And it?s all the more unseemly when new studies?such as one by Women?s World Banking?find that commercial MFIs are helping fewer of the very people whom they were designed to help: poor women.3

In all the talk about market solutions to poverty, investors seem to be forgetting that microfinance markets do not operate like typical markets. Indeed, many places in which MFIs operate have no markets and few, if any, banks that serve the poor. Moreover, some MFIs like Compartamos do not yet face market pressures or legal requirements to disclose the information that both investors and impoverished borrowers need in order to make the best choices.

Microfinance lending?like all financial and budget decisions? is a reflection of values. The time has come for the microfinance establishment to recommit itself to alleviating poverty.

The industry?s thought leaders should reexamine the ideology that appears to embrace many kinds of MFI behavior on the grounds that eventually the marketplace will correct itself. Instead of adopting a big-tent, everything-goes attitude, microfinance funders and practitioners should decry an MFI?s interest rate pricing if it exploits the poor, just as they decry money lenders who prey on vulnerable people and commercial bankers who ignore them.

Microfinance funders?including foundations, microfinance investment vehicles, government agencies, and microfinance technical assistance providers?should disassociate themselves from profiteering MFIs. Microfinance investment vehicles should as a matter of policy not fund MFIs that abuse the marketplace. For instance, MicroCredit Enterprises (MCE), which I chair, recently rejected a loan application from an MFI that charges high interest rates.

Collectively, the industry needs a code of conduct to which every funder subscribes. Social investors, foundations, and government aid agencies should adopt a unified set of standards and criteria that define expectations and set the bar for acceptable lending policies.

As the Alliance for Fair Microfinance has noted: ?In microfinance today, growing numbers of practitioners are relying on practices that would be considered illegal or unethical in mature financial markets?untrue information, unlawful repossession, and usurious interest rates in particular. Lack of adequate customer protection in emerging markets thus easily opens the door to exploitation of poor people.?

Indeed, the Microfinance Network?an international association of 37 MFIs from 31 countries?and its individual members, including Compartamos, sign a fair-pricing pledge that states that members will price their services at fair rates. They agree that their rates will not generate excessive profits, but will be sufficient to ensure that the MFI can survive and grow to reach more people. But as the Compartamos IPO exposes, enforcement is voluntary, and the definition of ?excessive profits? is left to the imagination.

We in microfinance can do better. Investors in microfinance should accept responsibility for conducting more aggressive due diligence. Money is power. Microfinance investment funds need to reveal how they are using investment capital, and the marketplace needs to hold them accountable. Every microfinance fund reports to investors on the MFIs in which it invests, describing their geographic balance, average loan size, poverty indicators, and sustainability metrics. But they rarely? in fact, I have never seen an exception?report on MFIs? interest rates or other consumer protection policies.

Finally, the microfinance industry should anticipate governmental regulation and become proactive. Microloan borrowers operate their businesses in the informal economy, free from governmental regulation and protection. No enforceable usury laws, no consumer rights lawyers, no small claims courts, and no Better Business Bureau promotes or monitors ethical lending. As government officialdom learns of Compartamos- like abuses, regulations to redress these abuses will follow. Smart, mature, and successful industries have learned that outrageous marketplace behavior by the few invites governmental oversight of the many.

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