Guest post: Growth in microfinance field spurs debate

Written by ACCION USA Microfinance Council on May 11, 2010 - 9:11pm

Microfinance has officially arrived, as evidenced by recent debate about its core purpose.  For example, the industry has been portrayed in a New York Times article as seeking to indebt the poor and the vulnerable for personal profit.  The recent controversy around microfinance has demonstrated a fundamental misunderstanding of the industry among intelligent commentators.  However, the positive outcome is that it has revealed the growing role that microfinance plays in the global economy to bring financial services to underserved populations.

Both in the U.S. and worldwide, microfinance has successfully become a tool for financial inclusion.  Its popularity is demonstrated by its average annual asset growth of 39% between 2004 and 2008. Commercial banks and investors are increasingly interested in investments in microfinance institutions (MFI), which some in the industry celebrate because it represents scale and ability to reach hundreds of millions.  Others in the industry raise questions about the entrance of these investors—highlighted by the New York Times—as well as in other forums about whether investors are attempting to take advantage of “the poor” by seeking high profits.

The expansive growth of the industry, however, should not be considered a departure from its charitable roots—microfinance continues to give unbanked entrepreneurs access to financial services they would not otherwise receive.  The increased amount of money flowing in from capital markets presents opportunities and challenges which should indeed be debated and addressed.  However, neither the corporate form of an MFI, nor the composition of its investors, should in itself indicate that the industry has drifted from its original mission.  CEOs and Boards with integrity and a commitment to poverty alleviation can turn the profits made in this sector into opportunities not only for investors, but for borrowers too.  Furthermore, institutional investors and organized investment funds can use their best practices models from more traditional markets to push for corporate governance and transparency in MFIs.  According to a report by the Consultative Group for the Poor (CGAP) at the World Bank, there is an increasing number of investment funds whose investment and due diligence guidelines include environmental, social and governance criteria.

Fraud and abuse may have begun to seep in to the microfinance industry, but this does not mean that microfinance necessarily scams the poor. Rather, it indicates that the field has grown to such capacity and strength that it is ripe for regulation, either by the industry itself or the government.  Industry groups are already pushing for greater transparency and consumer protections.  For example, the Center for Financial Inclusion has recently begun a new client protection initiative that publishes Client Protection Principles used by investment funds in assessing MFIs.  In addition, MFTransparency is an organization that was launched in 2008 to raise awareness of best practices in pricing transparency in financial products offered by MFIs.  Central banks and governments in certain countries worldwide also now regulate MFIs as depository institutions.  In fact, the Bank for International Settlements recently issued a best practices document to instruct regulators on how to examine MFIs given their unique structures and needs.  These initiatives will increase the availability of information, accountability and integrity, thus pushing the industry towards a more competitive, market-oriented approach.

The popular debate about microfinance ignores the most important ideological challenge confronting the industry: how to balance the tradeoff between interest rates and sustainability.  The cost of providing microfinance products is extremely high.  Large banks benefit from scale and from borrowers’ strong credit histories and collateral in case of default; a MFI generally has none of these advantages, making it more difficult and costly to determine whether the loan will be repaid.

The focus of the debate should instead be on how to balance the tradeoff between interest rates and sustainability—should a MFI seek to provide subsidized loans to low income individuals, which limits the number of individuals they can provide credit to, or should the MFI lend at a rate that covers all underwriting and operational costs?  The latter requires a higher interest rate, which from an outside perspective may appear excessive. Yet, without access to relatively high interest rate loans, what other access to capital does an aspiring business owner have?  In the absence of microcredit, is the business owner compelled to borrow at an even higher interest rate from a loan shark in the informal sector?  What are the consequences to the borrower if the informal sector loan is not paid?  Does access to informal sector lending even exist, and if not, is the aspiring business owner forced to give up their entrepreneurial dream?  These are the debates within MFIs as they contemplate the development of the nascent industry, and should be stimulated in the popular press as well.  These issues need to be empirically studied to determine the range of rates that would be both affordable to MFI borrowers and sustainable to MFI lenders.

These ideological challenges the microfinance industry currently confronts are ultimately beneficial.  However, we must all take care to accurately frame this debate and understand the arguments on both sides. How this balance between interest rates and the sustainability of MFIs is accomplished will define how microfinance grows over the next decade.  We hope that improvements in underwriting efficiency and technology narrow the gap between these choices—and as more professionals study the industry, we are confident that this will materialize.

The views in this article written by a guest author do not necessarily represent the views of Woodstock Institute or its Board of Directors.