Judging For-Profit Microfinance

One of the most controversial discussions that emerged from the recent Microcredit Summit Campaign conference in Bali was Mohammed Yunus’s scathing condemnation of for-profit microfinance company Banco Compartamos, which to much fanfare recently held an IPO that raised almost $500 million. Compartamos started as a typical nonprofit MFI, but switched over to a for-profit model in 2000, and has now become one of the world’s first publicly traded for-profit microfinance companies.

Most criticisms of Compartamos revolve around the relatively high interest rates that they charge clients – typically 70-100% APR. Although rates have been decreasing steadily over the past seven years, they are still much higher than rates offered by traditional non-profit MFIs, which typically range from 20-40% APR. The disparity was apparently severe enough to draw considerable ire from more socially-minded microfinance practicioners when Compartamos announced their IPO. The notion of wealthy executives becoming rich at what is generally (but not necessarily accurately) presumed to be the expense of the poor clients is obviously a difficult notion for many to stomach. Yunus himself stated "Microcredit was created to fight the money lender, not to become the money lender."

But how does one distinguish microfinanciers from moneylenders? Making any such distinction is an more of an art than a science, and therefore involves drawing a line in the sand. Interest rates alone are an insufficient gauge as they provide almost no information on actual outcomes of loan recipients. It is distinctly possible for high-interest microloans to ultimately benefit poor clients when initial returns to capital are high (research indicates that they often are), which suggests that attempting to distinguish “good” and “bad” microcredit on the basis of interest rates alone is rather misguided. A recent paper by McKenzie and Woodruff estimated real returns to capital in microenterprises to be approximately 95% annually, which suggests that accepting seemingly exorbitant interest rates may still be in the best interests of the poor, especially the entrepreneurial poor. Taking high-interest loans may well be the first step small entrepreneurs need to take to accumulate enough capital to operate at an optimal scale.

The strange confluence of high initial returns to capital, extremely low default rates, and high market interest rates suggests severe credit market failure among the poor in Mexico. Conventional economic wisdom suggests that competition for clients between for-profit MFIs should lower interest rates, so one would expect increased investment to drive interest rates down. The inherent endogeneity of MFI density makes it rather difficult to rigorously evaluate the impact of increased MFI competition on interest rates (and outcomes among the poor), so it is quite difficult to offer any rigorous empirical support for this notion. However, the fact that Compartamos’ average interest rate has decreased from 115% to 79% over the past seven years, which was paralleled by the emergence of several competing MFI, might suggest that the markets are slowly starting to adjust.

So how does one distinguish between the microfinancier and the moneylender? Also relevant is the issue of information. For lending to be considered “fair” a basic presumption is that clients actually understand the products they are signing up for. As long as the clients make an informed and conscious choice to take a loan, and the MFI issues loans with the genuine presumption that the client will be capable of repayment, I would be hesitant to condemn any MFI as “predatory.” Of course, these terms grow even more hazy in light of varying levels of financial literacy among poor clients. High interest rates, although a matter of concern, appear to me to be more of an indictment of inefficient and underdeveloped credit markets than of the MFIs themselves that profit from them. There are also very well-documented cases of non-profit MFIs collecting relatively high interest rates in order to finance expansion, and in some cases compensate for inefficient operating practices. In light of all this, it seems that profit motive alone is also not a particularly useful criteria for distinguishing between “good” and “bad” microfinance practitioners. MFIs should be judged in terms of overall impact on client outcomes rather than hazy notions of intent.

To their credit, Compartamos has been more than willing to admit that they are not a socially conscious organization. Danel, the CEO stated "A lot of people have suggested that financial inclusion can be a poverty alleviation tool," he says. "We're not out to prove that. We're out to provide financial services as opportunities to these clients, realizing that some people might make better use of them than others." In light of the remarkable successes of more socially-minded MFIs such as Grameen, Bandhan, etc, it is hard to deny that Compartamos could probably be doing more to benefit their client base than they are in their current mode of existence. But at the same time, what they are doing is still probably better than doing nothing. And there is no denying that their IPO has increased interest in microfinance among “mainstream” financial service providers, which may trigger increased investment and drive interest rates towards their (presumably lower) equilibrium levels. For all of these reasons, I think that outright condemnation of for-profit MFIs might be somewhat misplaced. A more useful debate might focus on understanding the factors that have led to such pervasive failure of credit markets to meet demand among the world’s poor, and what corrective measures offer the best remedy.