Profits & Perverse Incentives: The New Face of Microfinance


Microfinance has lost its first love and lost its way. A focus on investor incentives over borrower incentives led to 6 shifts in in the practice of microfinance that changed its face and left it looking more like a for-profit bank and less like a pro-poor innovation.

SKS Microfinance, one of the world’s largest microfinance institutions (MFI) just raised an estimated $350 million in a stock offering which closed yesterday. The very successful IPO was oversubscribed by nearly 14 times. The founder, Vikram Akula, who has already sold shares worth $13 million, holds shares that after today will be worth an estimated $55 million. Perhaps its time for the old adage of social enterprise “doing well by doing good” to be updated. With these numbers, “getting filthy rich by doing good” seems more fitting. But one has to wonder if the “doing good” part still fits.

In 1999, I designed and led a microfinance program with World Concern in rural Bolivia. I had written my undergraduate IPE thesis at UPS on microlending in 1996 and used that research as the basis for the design. The key at the time was understanding the incentives of the borrowers – how do you get very poor borrowers who have neither a credit history nor collateral to offer to borrow and repay in good faith so that you can recover your capital and re-lend to other poor? (And how do you cover your lending costs on interest from tiny loans ranging from $20-100?) The answer was a relatively new banking model, developed originally in Bangladesh by Muhammad Yunus, an economics professor who received the Nobel Peace price in 2006 for his work. Dr. Yunus had solved the incentives problems that kept the banking industry from being able to lend to the poor. The new model worked very well and the poor demonstrated an ability to repay loans at rates that often beat highly-collateralized commercial borrowers in the formal sector. Long story short, the previosly unbankable poor were finally granted access to reasonably priced credit and the flow of capital to poor entrepreneurs helped launch and grow millions of small businesses.

The early success of microfinance led to a massive scale-up and everybody from NGOs to banks to foundations to private investors began launching MFIs in every corner of the globe. The problem then became how to finance this scale-up and so the key shifted from understanding the incentives of the borrowers to understanding the incentives of investors. At some point, a good part of the microfinance movement got hooked on the hubristic notion that we had to provide credit access to every poor person on earth and in order to do this we’d have to access the formal capital markets, which were driven solely by financial incentives. And so, without hardly a look ahead at what it would mean, profitability became the leading indicator of success. Instead of talking about how many people had been helped to move out of poverty, MFIs began bragging about low rates of portfolio at risk and high rates of ROI. Healthy assets were prized over healthy borrowers.

The new focus on investor incentives over borrower incentives has led to a number of dramatic changes in the industry. Here are six shifts in the face of microfinance that make it almost unrecognizable to someone like me.

1. shift from poorest of poor to the moderately poor

There are two fundamental problems with lending to the poorest of the poor when you are concerned more about profit than poverty alleviation. One is that they are very vulnerable to external shocks. A late rain, a death in the family, a run-over pig – these are economic catastrophes for the poorest of the poor. They have a very limited ability to rely on savings (stored grain, fattened pig) or other sources of credit (equally poor relatives and neighbors) to smooth out these frequent bumps. When faced with a choice of surviving or repaying their loan, these will survive. Second is they don’t have a huge appetite for credit. They generally want really small loans. They are incredibly risk-averse (see point one) and don’t want to become highly indebted. Even if you charge 3% a month on a loan, when that loan is $40, you need both really low operating costs and lots and lots of borrowers to make any money. The solution was to abandon the very poor and begin lending the moderately poor – a safer and more profitable lot. We lost our first love.

2. shift from rural to urban

To lower the operating costs many MFIs began operating exclusively in places with a higher population density – i.e. cities. This limited the time and cost required for a loan officer to service his caseload. It also changed the nature of the loans from agriculture to commerce. Agriculture loans are slow to turn-around as the capital is tied up for some fixed amount of time in something like corn stalks or goat kids. And these investments don’t generate any cash until the very end (i.e. harvest or slaughter). Most agriculture borrowers only pay interest until the very end when all the principle can be returned. Commerce loans on the other hand have a fast turn-around and generate principle payments throughout the cycle since the new business asset or inventory begins generating new income immediately. This keeps capital cycling quickly through the loan portfolio which generates more cash for the lender. But it also means that the rural poor, who already had the least amount of access to financial services, were further abandoned.

3. shift from starting businesses to growing businesses

To decrease risk and increase repayment rates, MFIs began shifting away from start-ups and toward business growth. When they worked with the poorest of the poor, they were providing seed capital that gave the poor entrance to income generating activities. But, most new businesses fail, especially when led by inexperienced entrepreneurs, whereas established businesses have a better shot at profiting from an influx of additional capital. So, those who already had some capital and income generation were given access to more, while those who had none lost the opportunity.

4. shift from peer lending to individual collateralized lending

A few months ago I was in Nicaragua visiting a branch office of a local non-profit MFI. The offices were stuffed with a crazy assortment of household appliances. Loan officers’ desks were wedged between refrigerators and stacks of radios and microwave ovens. It turned out this was all the stuff the “pro-poor non-profit” organization had taken from the homes of the poor. They had collected their collateral on at-risk or defaulted loans. I thought, “What business is this NGO in?How in the world do they measure success as they sit in the middle of all this capital they’ve collected from the poor?”

The anonymity and mobility of city dwellers coupled with the difficulty of getting established business owners to risk their capital by co-signing on loans with mobile strangers made this shift almost necessary. It turns out that it is also a lot less time consuming to work with a bunch of individual lenders than it is to manage the complexity of peer lending groups or community banks. So this had the additional benefits of permitting an increase in the caseload of each loan officer. This has been the saddest shift for me. Peer-lending was the key to solving the incentives puzzle in the first place. It was a practical way to value the relationships people had in their own communities as an asset you could bank on. In many ways, this was the final capitulation to becoming a niche in the banking market rather than an anti-poverty social movement.

5. shift away from auxiliary services

As the focus shifted toward making profitable loans and away from alleviated poverty, the ability to justify expenses to investors that were unrelated diminished. Quasi-related services like literacy and health training were the first to go. These may empower someone and increase their well-being, but they don’t directly help them repay a loan. And as loans became increasingly collateralized and borrowers increasingly business experienced, the cost of providing even the most related auxiliary services like small business and financial management training soon outweighed the benefits (in terms of loan repayment rates.) It was cheaper to threaten to seize collateral than provide business training. This helped further drive down operating costs and increased the caseload capacity of loan officers, which is a critical driver of profitability. It also discontinued some really good anti-poverty activities, many of which had nice synergy with the peer lending model.

6. shift from the poor as the primary beneficiary to the investor

And now we see the end game. Microfinance is becoming at once more complex as MFIs develop new products like microinsurance and remittance mechanisms, and more simple as many have become more comfortable and unabashed about their profit motives. While more and more impact studies conclude without rejecting the null hypothesis on the new breed of microfinance programs, their investors and founders are raking in huge profits.

While investors pat themselves on the back, stuff their pockets with cash, and cynically declare that they’re just “doing well by doing good”, I wonder how their clients feel. Afterall, it is the interest charged to the poor that generate profits in the first place. It would be one thing if this new kind of MFI could prove they are helping the poor, but there are almost no studies these days that provide such evidence. So it is on the backs of the poor that these MFIs derive their profit. The industry has done more than lose its first love, it has turned on them and devoured them.

Perhaps this is why Dr. Yunus had this to say about the recent spate of MFI IPOs:

“This is pushing microfinance in the loansharking direction. It’s not mission drift. It’s endangering the whole mission.”

“By offering an IPO, you are sending a message to the people buying the IPO there is an exciting chance of making money out of poor people. This is an idea that is repulsive to me. Microfinance is in the direction of helping the poor retain their money rather than redirecting it in the direction of rich people.”

I couldn’t have said it better.

_____________________________

Here’s some links to other views on all this:

A Guide to the SKS/Unitus Story” by Tim Odgen at Philanthropy Action

“Ironies in Yunus Attack on SKS IPO” by David Roodman at the Center for Global Development.

Interview with Dr. Yunus at Microfinance Focus

“How to provide for sustainable development AND a Social Mission” by Jerome Peloquin at Microfinance Focus.

“What is a Socially Responsible Investor?” by Jerome Peloquin at Microfinance Focus

“SKS IPO: Bringing Wall Steet to the Slums of India by Katherine Chasmar at Ashoka US

A repost of July 16 Wall Street Journal article with comment at Wokai Blog

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23 Comments on “Profits & Perverse Incentives: The New Face of Microfinance”

  1. Clare Scott
    August 3, 2010 at 8:08 pm #

    Aaron, given the direction things appear to be going, what role does a set-up like Kiva play in encouraging people away from the “microfinance is a good investment” way of thinking and keeping the semi-philanthropic nature of a loan which, in the worst case scenario, you just don’t get back, and even in the best case, you’re not actually going to make money on.

  2. August 4, 2010 at 2:21 am #

    I second Clare’s question, how does Kiva fit in with your view of the current microfinance environment? FWIW, I think Kiva, Vittana, and similar p2p financing models are pushing MFIs back toward social impact; Kiva lender/donors expect to hear stories of impact, it’s part of the Kiva model. If MFIs want funding from Kiva, they have to deliver social impact.

    • August 4, 2010 at 11:24 am #

      Clare and Dan,

      Thanks for the question. I was actually going to talk about Kiva and others like it (Wokai for example). I had even tagged the post with Kiva, but I just ran out of room. I was expecting the post to be much shorter, but I got carried away. :-) So, here’s what I wanted to say about Kiva in short. I think it is a good model. I hope that they continue to focus more on smaller non-profit MFIs with strong social indicators. I would prefer that had a stronger screening mechanism for social performance and a better way to validate it. They currently only “prefer” that partners have profile with Mix Market, which collects and analyzes both financial and social performance data, but doesn’t do much to validate the information they receive from the MFIs. What I really like about the model, however, is that it is getting capital from true social investors (people for whom ROI is in terms of social, not financial return) into the hands of poor entrepreneurs. As Kiva grows and other copy the model, I hope that it is able to move significant resources through organizations that have so far resisted making the too many of the shifts I catalogued in this post. I think Kiva is a good way to demonstrate that sustainability does not necessarily mean that an MFI generates enough profit to cover operational and growth costs, but rather that they can generate enough cash through a mix of profit, grants, and investor loans to sustain operations and growth. So long as social investors and foundations see the social impact of their work, small non-profit MFIs can be sustainable without having to cut serves to their clients or charge interest interest rates sufficient to generate investor grade ROI.

      • August 5, 2010 at 2:13 am #

        Thanks for your reply, and I would agree with you in general on the importance of social performance of microfinance, and I’m glad Kiva and others are supporting this.
        That said, I do think there is some self-defeating purist logic going on with those who want to keep microfinance off the stock market. From a broad social perspective, I think getting larger financial institutions to offer more financial services to the poor and underserved will boost financial literacy and lower their cost of capital. Take for example loan sharks charging 300% interest, vs. 30% from consumer credit. Yes, both are ‘bad’ but when a person needs cash, access to formal credit is better than the loan sharks, correct? My view here would be in support of ‘baby steps’, with the current microfinance trends pushing larger financial institutions to lend at all to the poor in a viable/profitable way based on the best practices of SKS and others (where they used to ignore the poor), and over time drive down credit costs through technology (m-pesa mobile money transfers for example).

  3. Jonathan
    August 5, 2010 at 1:45 am #

    Thanks for this post. I think it is important and thought provoking. As I was reading it, I found myself wondering where the line is drawn between serving the poor and becoming a bank. For example, let us say MFI legitimately targets the poorest of the poor for a first time loan, and the recipient starts a successful business. It seems reasonable for the MFI to continue to partner with the entrepreneur in expanding that business by providing another loan (if desired). However, I’ve seen this cycle continue to the point that the MFI is now dealing with a legitimate small business that could receive loans from commercial banks. So, where is the line drawn? Should the MFI cap the number of repeat loans, or the size of the loan offer? (I think the latter makes some sense).
    It seems that the fundamental issue is that of mission focus not profit focus. Is it inappropriate for a MFI to continue to serve larger more profitable clients IF the MFI stays on mission seeking out and serving the poorest of the poor? One could argue that the stability and profitability of loans to growing businesses could make microfinance services to the poorest of the poor more sustainable.

    That said, this is a long way from taking an MFI public. I definitely agree the the return in ROI should be social and not economic.

    • August 6, 2010 at 10:12 pm #

      Jonathon,

      You ask some good questions. It’s no secret that repeat borrowers with larger loan amounts end up subsidizing the operating costs of making loans to new borrowers. This is not necessarily a bad thing, but the temptation is to improve the health of your portfolio by stacking it with more experienced borrowers and higher average loan amounts. So, I think MFIs that wish to stay focused on helping the very poor need some kind of graduation policy as you suggest. For what its worth, I used a loan amount cap in my MFI in Bolivia.

  4. August 14, 2010 at 3:00 pm #

    Everyone talks about Grameen Bank surviving on funds generated from clients (savings) but in a recent blog post by David Roodman, we learn Grameen Bank has an equity that is precariously low from the risk management point of view. In that context, where will the money come from? There is only so much money that can be donated. I’m not all for IPOs either, but I’m not against profit making either. The fine line lies between sustainability and profit maximization, and unfortunately, that’s a very fine line. I recently read about BRACs entry into the capital markets, and analysts praise this MFI for sticking to it’s mission.

    However, that’s only one example that comes to mind (all others are appalling).

    P.S. I came across your blog through the Develop Economies Blog, and I’ve subscribed. I look forward to reading your material in the future.

    • August 14, 2010 at 11:35 pm #

      Fehmeen,

      I appreciate your comment and largely agree. I’m not against profit either, just when it replaces your focus and leads to an inexcusable mission shift. But sustainability is not necessarily defined either by operational self-financing. Consider most large development NGOs. Consider World Vision. This is a giant NGO that’s been operating for 60 years now. It has an annual budget of nearly $4 billion. Are they sustainable? Sure seems like it. How many of their programs are self-financing? Zero. You can grow an organization based on social performance – microfinance institutions included. The fact that they can also generate profits doesn’t mean that they have to generate profits to the extent that they no longer require outside financing to grow, much less to the extent that investors in the regular capital markets want a piece of the action.

      I’m glad to hear about BRAC – I hope its true. I hope there are many exceptions to the pattern I’ve described, but when it comes to getting into the capital markets, I honestly expect to see more stories like SKS and fewer like BRAC.

    • August 14, 2010 at 11:40 pm #

      BTW,

      Could you send a link to the blog you referred to? I’m not sure I’m familiar with it.

      Also, are you sure you subscribed? – I don’t see your email on the subscription list.

  5. August 16, 2010 at 12:07 pm #

    Yes, I subscribed. Through RSS, not e-mail. It takes a day or two to show up in ur feedburner stats. Here’s the post that referred me to you: http://developeconomies.com/?p=1708

    I agree MFIs don’t all have to generate profits just because they can, even though most of them do. I know someone who works in the local MF sector and that’s the inside scoop – it’s generates impressive returns and that’s all the shareholders care about.

    As for sustainability, again, I agree it doesn’t mean self-financing, but these large NGOs took years to get here and they get noticed by donors easily now. New MFIs/charities have to try harder to get noticed because the sector is saturated. Growth driven by social performance is ideal, but is it practical in all cases?

  6. Dave
    November 11, 2010 at 6:14 am #

    While I agree in principal with many of the risks associated with the commercialization of microfinance I wonder where the growth (and therefore increased outreach) would come from if not from for-profit investors? Even the most socially minded MFIs are funding the majority of their loan portfolios with debt, often from purely profit minded lenders.

    I think that without the additional capital from outside of the usual philanthropic channels growth in the industry would have plateaued. Also the use of commercial vehicles, like bond offerings, open up investments in MFIs to everyday people. I think the Calvert Foundation is a pretty good example of this.

    The risk of mission drift is real however and added transparency to social reporting might help to correct this in much the same way that people pulled out of investment when they found out they where investing in companies that operated in countries like Somalia.

    • December 7, 2010 at 11:45 pm #

      Dave,

      Sorry it has taken so long to respond to your comment. As you may have seen, I took a little hiatus from blogging for a bit. Let me make a couple of points.

      1. If there is a trade-off between quality and quantity in microfinance, I’ll vote for quality every time. Microfinance done poorly not only fails to deliver financial results for the poor (increased income, increased wealth, increased assets), it can bring real harm (increased violence against women, increased suicide, worsened ratios of debt to capital). So, I’m just not that concerned about growth in outreach. If you provide a quality development intervention with proven social impact, growth will take care of itself. When you look at, say, World Vision or any of the largest non-profit development organizations, there is no question that these organizations have ridden a sustainable path of growth based on making good on promises of social impact. None of their programs (save those that do microfinance) generate cash from the poor, much less enough of it to fully fund the programs. Donors come up with billions of dollars every year to fund “non-self-sustaining” development programs because they believe they do good and the social ROI is enough for them to reach deep into their pockets year after year after year.

      2. I think part of the withdrawal or plateau of donor generosity has to do with the fact that microfinance isn’t the new kid on the block any more. Its lost a bit of its shine. But I also think, a good part of the problem is that MFIs aren’t doing enough to make their case for social impact. The more they go on and on about what a good financial investment microfinance is, the less appealing it is to the kinds of social investors and philanthropists that underwrite the multi-billion dollar development and aid field. Microfinance has failed to communicate convincingly what difference it makes in the lives of the poor, and people are taking their funds elsewhere.

      3. I think development organizations need to reclaim microfinance from the private sector. Yes, banks and for-profit companies can make a killing doing microfinance, but to what end? Are they transforming lives? Not according to most academic studies in the field these days. Are they helping the poor out of poverty? Are they empowering women? Are they providing auxiliary services that help families and communities improve their holistic well-being? No, no, and no. So, I say, “so what that you can generate profit doing microfinance?” Is that our business? Let’s all sit down and re-read our mission statements and then ask ourselves, “Does the way we approach microfinance really align with and contribute to our mission, or have we gotten confused about what our business really is?” If we aren’t demonstrating, convincingly, that our MFI work is producing meaningful social change for those that have been marginalized by the formal financial sector, then why are we doing it at all? If its all and only about making profitable loans to a poor market segment, then let the financial sector do it, they are infinitely better positioned and equipped for that work. But if its about something else, well, then let’s make sure we stay focused on that something else.

  7. December 6, 2010 at 4:12 pm #

    Hi Aaron! I found this post because it’s cited in this article: http://microfinancehub.com/2010/08/23/debate-commercialization-of-microfinance-part-i-arguments-for-and-against-it/

    (Cited in paragraph 4). Very nice. The author said that your view is representative of WV – do you agree?

    • December 7, 2010 at 12:08 pm #

      Clare,

      Thanks for raising this question. Short answer: No I do not. I do not pretend to speak for any employer past or present. My views are my own. I read Femeen’s article some time ago. If you scroll down to the comments section, you’ll note that I clarify this with hiim in the fifth comment dated August 24. I also refer him to the Vision Fund home page.

  8. December 18, 2010 at 5:08 pm #

    Hi Aaron,

    Stumbled across your blog. Been a number of years since the class in New Hampshire. Can’t find your email address anywhere here, but mine is recorded here. Would enjoy catching up with you.

    If you don’t know about MFTransparency, do visit our website. I think you’d find it interesting!

    Chuck Waterfield
    CEO
    MFTransparency

  9. October 3, 2012 at 8:01 pm #

    “making money out of poor people..”

    This strikes me as an emotionally attractive perspective but dangerous to the extent that it confuses cause and effect.

    It seems to me that net total return to the borrower is the only meaningful measure of success.

    This would immediately eliminate what I consider inexcusable. Namely, micro borrowing for consumption. The net return of borrowing for consumption is negative — the cost of all fees plus interest.

    Among poor populations without access to credit — capital starved groups — one would expect that the initial returns would be high.

    It seems to me that a lot of the problem that was addressed really boils down to more traditional financial activity borrowing (stealing) both the name “microfinance” as well as some of its technical innovation.

    Larger, more traditional, profit oriented lending should simply call themselves banks. If they can profitable service segments of the population that was underserved or misserved triditional banks, then that seems to be a positive development.

    Lending to poor, capital starved groups — expecially those that may have strong percentage but truly micro sized returns — are truly microfinance. And there is a good argument to subsidize the expenses that can’t be recovered when dealing with these groups.

    If the returns (minus potentially subsidized expenses) are very low — (and always in caes of consumption) — it would be simpler to forget about loans and directly transfer income to the poor.

    The distinction between consumption and investment is not always easy. The US financial crisis was partially driven by failure to make this distinction. Namely, owner owned residential real estate is *not* an investment, but rather consumption. (it is financially equivalent to borrowing to finance future personal housing expenses — like borrowing to prepay rent — and as such, is simply speculation on future price and interest trends).

    This opinion is based on my personal experiences with traditional finance and very limited experience with micro lending. As such, it may be totally off the mark. At least I hope it is interesting.

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    July 23, 2013 at 4:55 am #

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Trackbacks/Pingbacks

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    [...] Grameen Bank, one of the largest MFIs in the world, grew purely based on its social performance – grants, donations, voluntary savings from borrowers and deposits from the general public are major sources of funds (see 2009 Balance Sheet for details). World of Vision, another giant NGO, falls in the same category because its ideas of sustainability are far from commercial. [...]

  2. Debate: Commercialization of Microfinance Part I – Arguments For and Against It - The Microfinance Blog and Information Hub - Microfinance Hub - October 13, 2010

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