Microfinance: Making a profit from loans to poor carries risks

In August 2010, SKS Microfinance, a Hyderabad-based enterprise making tiny loans to poor women, raised $350m in an initial public offering that valued the firm at $1.5bn. The stunning market debut seemed to affirm that microfinance – lending money to those too poor and without sufficient collateral, to access normal bank loans – could be made profitable and attractive enough to attract investors.

Other fast-growing Indian microlenders were expected to follow SKS’s profitable path to market. But instead, the IPO – only the second listing of any microlender after Mexico’s Compartamos went public in 2007 – precipitated an unexpected crisis.

Officials in Andhra Pradesh state, where Indian microlenders had concentrated much of their portfolios, accused firms of seeking “hyper profits” and using “coercive” collection tactics, and banned all outstanding microdebts collection and new lending.

The edict, which continues to paralyse microlenders’ operations in the state, sent shockwaves through the global microfinance community, including lenders, investors and microfinance advocates.

It also served as a powerful warning about the political risks confronting commercial microfinance companies if they are too aggressive in pursuing growth to satisfy profit-seeking shareholders at the expense of their impoverished borrowers.

“We must not create, in the case of credit, unfettered access to financial services that carry harmful potential, else we risk the next subprime-type crisis,” Tilman Ehrbeck, chief executive of the Consultative Group to Assist the Poor, recently told Microfinance Voices in the wake of the crisis.

“It would be distressing if we helped expand access to formal financial services, but those services were no fairer or safer than the informal alternatives they were meant to replace,” Mr Ehrbeck said. “We need to offer something better, or we will have failed in our mission.”

The business of microfinance is providing small loans to poor women, so they can reduce their reliance on usurious informal local moneylenders and start microenterprises to lift their families out of poverty.

Initially, microfinance programmes were mainly undertaken by social organisations and charities, funded by Western development aid, and sometimes also mobilising the savings of the poor themselves. But microfinance has undergone a dramatic transformation, as private companies, backed by private, profit-seeking capital, began to be involved.

Supporters of commercial microfinance argue that business models generating profits and returns to shareholders can overcome the reliance on scarce donor money, long a constraint to making microloans more widely available to a greater number of poor people.

However, critic Milford Bateman, author of the book Why Doesn’t Microfinance Work? says the Indian crisis is “the almost inevitable outgrowth” of commercial microfinance, whose benefits mainly accrue to lenders’ highly paid executives and shareholders, through “spectacular salaries, bonuses, dividends, and eventually the windfall profits arising from an IPO ... As microfinance was increasingly commercialised from the mid-1990s onwards, ‘best practice’ for a MFI was simply to pump out as much microcredit as possible, in order to grow fast, grab market share, hike up profits, and so grow even faster,” Mr Bateman wrote recently.

Advocates of commercial microfinance acknowledge that many Indian lenders had lost sight of microfinance’s social mission of poverty alleviation.

“People went for speed, numbers and efficiency, and what got dropped out were the close relationship with clients and other things,” says Sam Daley-Harris, director of the Micro-credit Summit Campaign, which lobbies for greater funding for microcredit programs.

Yet he and other advocates insist that commercialised microfinance is not inherently incompatible with poverty alleviation, as long as social goals are given sufficient priority in a company’s structure. Within the microfinance community, there is now intense debate on just how lenders can retain their social orientation, while still generating sufficient profits so as to be financially sustainable.

The Microcredit Summit Campaign is advocating a new “seal of excellence” system, recognising microlenders based on how well they deliver on the “transformational dimension in the lives of clients and their families”, by lifting people out of poverty.

The highest endorsement would be awarded to microlenders with third-party certification of clients moving out of poverty. Lenders that adopt social protection principles, or move beyond provision of pure credit to support for health or education would also be recognised.

“The bottom line is that the field and the public and the investors are desperately in need of clarity of what constitutes top-quality microfinance,” says Mr Daley-Harris. “You’ve got to manage for social performance, not just measure it.”

Elisabeth Rhyne, of the Centre for Financial Inclusion, argues commercial microlenders also require more robust client protection systems than once operated in social organisations or charities.

One of the centre’s campaigns is urging microlenders to adopt six key client protection principles: taking reasonable steps to avoid over-indebtedness; transparent pricing; ensuring appropriate, non-abusive collections practices; ensuring ethical staff behaviour; creating well-functioning grievance mechanisms; and protecting privacy of customer data.

“When we first started talking to microlenders about consumer protection, they said, ‘what are you talking about? We are a socially motivated organisation’,” she says. “People have never focused on this particular set of issues – overindebtedness, collections practices, what to do when clients have problems.

“When they were small, they could handle client problems on a case-by-case basis. But when it’s big, they need systems to do it.”

Indian lenders, already grappling with their frozen Andhra Pradesh portfolios and a sharp slowdown in bank lending, are confronting these issues. They now face new central bank rules, including caps on interest rates and margins, as well as consumer protection requirements for the sector.

Vishal Mehta, co-founder and managing director of specialised private equity firm Lok Capital, says firms are still struggling to adapt. “I don’t think they have a good sense of what operational changes they still need to make to their business models to comply with the changes in their regulations,” he says. “That is something still to be seen.”

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