Dark Skies After All

In my last post, I posited a bright future for microfinance —a future I’m still hopeful will emerge. But since I wrote that post, a couple of troubling developments have left me a bit deflated.

One is the release of the Malegam commission report in India. The Malegam commission was set up by the Reserve Bank of India to review microfinance regulations and propose any needed changes. The positive intent of many of the Malegam recommendations are clear. But the likely, though unintended, consequences of many of these recommendations is deeply concerning.

There are a number of excellent detailed reviews (with varying opinions) of the Malegam commission so I’ll skip over the details while encouraging you to read David Roodman’s , IFMR’s and Rajan Alexander’s take. My concern is that the net effect of many of these recommendations will be to calcify the microfinance industry in India. That’s a huge concern because, as I noted in my last post, we are finally learning not just that the traditional microcredit product has little net impact (positive or negative) but how that traditional product might be tweaked to maximize benefits. The report recommends banning individual liability in favor of group lending. That’s a problem because there is little evidence that group liability benefits anyone while it drives up costs and limits the attractiveness and usefulness of the product to most borrowers. Borrowers clearly only tolerate group liability because they have few alternatives. A bright future for microfinance is dependent on serving client needs, not on retreating to misinformed dogma.

Another set of concerning recommendations of the committee are hard caps on both the total debt per household and the spread between the cost of funds and loan rates. The former is problematic because there is no proposed mechanism for accurately measuring household indebtedness—and as Portfolios of the Poor shows us, most households borrow from many informal sources. The hard cap on indebtedness is likely to have two effects: 1) cause MFIs to turn a blind eye to the informal financial services clients are using (because its too expensive to examine and will put too many clients off limits) thereby missing an opportunity to learn about and serve client needs better, and 2) push clients to even greater reliance on expensive, risky and inconvenient informal financial services. The latter cap is a problem because it will be a major limit to expansion and innovation. The explosive growth of microfinance has primarily been in urban and semi-urban areas with dense populations where each loan officer can serve more clients. Serving rural areas where the poor need financial services every bit as much as urbanites is more expensive and always will be—the hard cap is a strong incentive for MFIs to cancel rural expansion. But the hard cap is also a strong disincentive to innovation—offering more flexible products that might better meet client needs but are more risky for banks to offer. If MFIs can’t charge appropriately to risk then those innovative and risky, but highly beneficial, products simply won’t be offered.

Limiting innovation in microfinance in India is a global concern. Indian MFIs have historically been on the leading edge of the evolution of the microfinance industry. If Malegam closes the door on innovation in India, will others step up? Where else are there MFIs of sufficient capitalization and scale to fund major innovations? Innovation remains a particular concern in microfinance because of the strong conservative streak in the industry—embodied by Mohammed Yunus’ recent Op-Ed in the New York Times where he essentially said that any MFI that doesn’t slavishly follow his model is a creature of darkness. It’s taken 30 years for microfinance to begin to get beyond Yunus’s limited and limiting vision. The last thing the industry needs now is to get dragged back there.

Another area where I’m newly concerned is the hints of government intervention in Grameen Bank of Bangladesh. Again, there are excellent reviews of the details elsewhere (see Kristof, Bishop/Green, and Roodman). The concern here is the continuation of a trend of political manipulation of microfinance. While there are causes other than politics of the crisis in Andhra Pradesh, politics certainly played a role. Politics was also a major player in the “I Won’t Pay” movement in Nicaragua in 2009 that led to the insolvency of one of the major MFIs there. Finance for the poor has always been a favorite tool of false populists and political opportunists. But until recently microfinance had largely been able to steer clear of overt political manipulation. That no longer seems to be the case—indeed political risk should probably rise to the top of the agenda of any funder of microfinance whether for-profit or non-profit. If this trend continues, and microfinance becomes just another tool of power politics, the future for the industry will be much darker.

Troubling signs on many fronts indeed. I still believe there are sunny days ahead from microfinance, but I’m far more sanguine than I was just a few months ago.

Read more stories by Timothy Ogden.