This article is so good, I wish it wasn’t subscriber-only so that it could get a wider audience! That part about Grameen’s debt collectors telling borrowers to sell their children ought to be on the front page of the New York Times.
I share the modulated outrage of Aneel Karnani (“Microfinance Needs Regulation,” SSIR, Vol. 9, No. 1, p. 48) regarding abuses of certain microfinance practitioners. Outrage is heightened by the dissonance of the pro-poor intentions of microfinance and the very practices associated with exploitation of the poor by the worst moneylenders. However, while laying out a compelling case for government regulation of microfinance to prevent abusive practices, the article does not provide a full picture with proper perspective.
First, Dr. Karnani dismisses the poverty alleviation value of making financial services available to the poor. It is probably accurate that most microfinance clients “do not earn enough to rise out of poverty,” contrary to the rash promises of many advocates. But this “fact” (there has been too little research to date to remove the quotation marks) does not support Dr. Karnani’s contention that microfinance “does not significantly alleviate poverty.” The research results we do have so far indicate that microcredit and microsavings (whether provided by people calling themselves microfinanciers or moneylenders/money guards) significantly help the poor “smooth consumption” day to day and season to season. This hugely alleviates the burden of poverty, often spelling the difference between hunger and malnutrition vs. health and productivity. Microfinanciers typically offer these services at rates substantially less than traditional providers and with greater reliability. And many, even if not most, borrowers are able to invest loans in start-up and growth of micro-businesses, a few even managing to employ even poorer people outside their own families. By itself, microfinance is unlikely to put poverty in the museum envisioned by Muhammad Yunus, but that shortfall does not mean microfinance has no significant value to the poor.
Second, it is misleading to illustrate the “response of the microcredit industry to mounting criticism” by citing the open letter of Carlos and Carlos of Compartamos, which is widely regarded by the “industry” as an inadequate and self-serving self-defense of their company’s IPO. In fact, the strongest and earliest critics of the Compartamos IPO were within the “industry,” including such pillars of the microfinance world as Chuck Waterfield and Rich Rosenberg. For at least a decade, many of us have been issuing repeated warnings about unreservedly embracing profit-maximizing investors as co-owners of microfinance institutions.
Third, the irony is that microfinance regulation is already well under way, thanks to decade-long partnership of CGAP, bilateral and multilateral donors, and national governments. These efforts in most countries have served to incentivize, even coerce microfinance providers to “transform” their social service NGOs into shareholder-owner, for-profit companies. While rightly seeking to protect the interests of the deposit-making public, this rush to regulate has also explicitly encouraged the entry of profit-seekers—without counterbalancing concern for protection of borrowers (despite a movement within the “industry” during the same decade for “consumer protection” and “financial education”). Thus, government regulation itself has created temptations to which a few of us microfinanciers (being as deeply flawed as any other human beings) have succumbed.
Yes, microfinance needs regulation, but of the right kind, built from a deep understanding of both the public interest and microfinance practice and practitioners. Regulation, especially when born of governmental hubris and populist moralizing, is too often a blunt instrument used more to punish than to protect. Good regulation comes from mutually respectful consultation between regulators and the regulated, most of whom welcome third-party help in removing the bad apples before they spoil the whole barrel.
The vast, vast majority of microfinanciers regard abusive collection practices as anathema. We welcome reasonable laws that allow us to bring true abusers to justice.
Lack of transparency in stated interest rates is an embarrassing legacy of the naïveté of the pioneers of microfinanciers. There was little understanding of the difference between nominal and effective interest rates (which Dr. Karnani illustrates well). As sophistication grew, so did the demand from donors to fully cover costs with interest and fee revenues from the poor clients themselves. Caught between the truly high costs of serving the poor and public sensitivity to “usury,” microfinanciers found it just too convenient to maintain the practice of reporting nominal rather than effective costs. As competition arose among microfinanciers, it became unreasonably self-destructive for any one microfinancier to opt independently for “truth in lending.” Chuck Waterfield’s MFTransparency.org initiative has made it possible, country by country, for microfinanciers to step forward together into the brave new world of standardized calculation and publication of their real APRs. Yes, it would be helpful to give Chuck’s efforts the force of law. But competition on a level playing field reinforced by public shaming will do most of the heavy lifting.
My personal experience is at odds with Dr. Karnani’s contention that interest rate caps are in the interest of the poor. Specifically, he asserts that microfinance is a monopolistic industry and that price controls do not reduce supply in a monopolistic industry. The first flaw in this argument is that microfinance is predominantly an urban and peri-urban industry and has become highly competitive—so according to Dr. Karnani, interest rate caps would reduce supply in urban areas. In rural areas, Dr. Karnani is usually correct that one microfinance provider has a monopoly. Given the low margins and higher risks of rural lending, rural microfinanciers are not profit-maximizers. In fact, their social motives for being out there often drive them to self-impose low interest rates that call into question their long-term viability.
I have seen interest rate caps imposed on monopolistic rural microfinanciers—member-owned credit unions in francophone West Africa. After my organization had helped federations of credit unions figure out how to offer credit and savings services to groups of women in very poor, often remote rural communities, the BCEAO (the central bank for most of francophone West Africa) imposed a seemingly reasonable interest rate cap on credit unions. Hardly profit-maximizers, the credit unions could not cover the true costs of service delivery in rural communities and had to withdraw from rural areas or cross-subsidize rural operations with surplus (a.k.a. profit) in urban operations.
The problem with interest rate caps is that they are typically set too low due to political considerations that seldom foresee unintended consequences for the very people they are intended to protect.
Yes, microfinance needs regulation to reduce abusive practice, like any industry. But let’s be careful. There’s a beautiful baby in that bathwater.
Finally, a special plea: Could academics and journalists please stop writing about the notoriously peculiar microfinance industries in Mexico and India as though they are typical of microfinance worldwide!! They are not.
Regulation is sorely needed where microfinance exists as the only financial opportunity. We find many NGOs and even for profit companies relying on microfinance as their primary method to alleviate poverty. We work with companies, mostly western brands, to bring factory jobs to poor rural communities instead of making charitable donations to, and investing in infrastructure for, microfinance. These micro-factories are stable sources of production with a devoted, motivated workforce. Once a micro-factory exists in a poor rural community there is a need for financial infrastructure to deal with payroll, basic employee education in financial management, on-going acceptance of deposits and management of wealth creation opportunities within the community. This is fundamentally more sound economic policy.
Very good article deserves as wide a circulation as possible. My experience of over 250 MFIs in India is that they began with good intentions but very quickly adapted practices that were exploitative - from lack of transparency on their costs and interest rates charged to recovery practices that verge on criminal behaviour. In fact my experience is that the village moneylender (who was much hated) is now charging interest rates lower than MFIs and not insisting on security.
I fear that policy failures by Governments in Developing countries in providing financial inclusion for rural communities or setting the framework in which the market needs to operate has created a vacuum in which exploitative practices have arisen. Regulation is a must but it must have teeth to be effective and secondly it requires citizens that are financially literate - my experiences demonstrate that we remain very far from this objective. As an example our work in rural communities demonstrated that the majority of the villagers were unable to calculate how much kerosene they used per week and what therefore their annual costs were. Leave aside calculating interest rates that confuse the literate. Our work over the last three years is finally creating citizens who feel confident to question and challenge. This is an area that does not attract much investment - Regulation must accompany or be alongside a programme on financial literacy.
I fear that the Deccan Riots moment is arriving for MFIs in India - this will not be in anyones interest.
Professor Karnani wrote an exceptional article in August 2010 “The Case Against Corporate Social Responsibility” in which he argued that “The idea that companies have a responsibility to act in the public interest and will profit from doing so is fundamentally flawed.”
In keeping with that, I am perplexed by his assertion here that “Large commercial banks that are wholesale lenders to MFIs should exercise their social responsibility and press their MFI clients to behave responsibly.”
Whatever shape regulation takes, Yunus inches closer toward his dream of microcredit returning to a completely unscalable endeavor, funded by a hodge-podge of philanthropy that allows for the sanctimony to offer such assertions that microcredit interest rate is more than 15 percent above the cost of funds is too high.
Separately, it is perilous to take at face value Y.S. Rajasekhara Reddy, chief minister of Andhra Pradesh, when he asserts that MFI’s are in any way, shape, or form worse than moneylenders (and what is so bad about the informal sector and a moneylender anyway?) There’s a lot of baggage that comes with a statement like that whole host of Andhra politicians that have themselves been behind stirring up much of the froth, most likely outraged that SKS could wander into their feudal backyards without offering a suitable tithing.
The author often confuses the need for regulation with a need for enforcement of regulation (specifically or those regulations related to consumer protection), a problem that is neither unique to microfinance nor to developing countries. This article focuses on credit horror stories rather a real discussion of steps to prevent horrors in the future.
For example, the author uses the example of the IPO of Banco Compartamos as a key justification of why microfinance needs regulation. He fails to note that Banco=Bank in Spanish, i.e. this is already a highly regulated instition under the CNBV (National Banking Commission of Mexico)subject to the same level of regulation as other banks. For example, in Mexico, there are reasonable consumer protection laws that are being strengthened as knowledge of best practices progresses. However, whether such laws are enforced adequately is largely attributable to whether government budgets provide sufficient resources and manpower to supervise millions of financial transactions, the same problem we face in the United States, where a consumer protection bureau is just now being established, a decade after one was available in Mexico.
Furthermore, a number of countries have microfinance regulation in place, and still others are developing it now. That is the relatively easy part. But there is no discussion of how to improve the ability of government and microfinance officials to detect and prevent the gravest wrongdoings. There are thousands of low-tech microfinance institutions serving poor customers in marginalized areas where commercial banks would never tread. How to effectively supervise and enforce in a cost-effective manner is something this article does not address.
Finally, before advocating price ceilings in such a cavalier fashion, I would suggest the author take a look at the experience of price ceilings in other Latin American countries, such as Ecuador and Venezuela, where they had a chilling effect on the supply of credit. Let’s not subject developing countries to policies that developed countries have long since rejected.
Thanks for the insightful and educated post. Really appreciate Chris Dunford’s push back as well. I’d just like to throw in that speaking in broad terms is needed for discussion and papers like this but it can be damaging to paint a sector with such strokes as there are many responsible organizations doing or trying to do what you are suggesting. Educating clients on financial management, working with them to build businesses, ensuring they are not over indebted, caring for the individual as a person and not a sum of money, etc. I’d love to see the conversation start to use more precision when making statments that can be damaging. Thanks again.
It’s not an issue of whether to regulate, but how much to regulate. We’ve all seen the effects of lack of regulation in the investment community, and now we’re all paying the price for that. Given the opportunity, there will always be people who try to take advantage of a system, to see how far they can push the limits.
We no longer live in a world where people are concerned about doing what is right. Our moral code has eroded significantly. So in lieu of allowing people to use their judgment, regulation to some degree is necessary.
It is indeed a question of whether or not to regulate… or perhaps even a question of which existing regulations in these countries have paved the way for these predatory lenders to become monopolies in their respective markets.
I do not deny that there is a problem, but I do refute the claim that a free market is to blame and that a regulatory solution must be the answer. So, let us evaluate the problem the author has with the free market theory…
Argument 1) “microcredit organizations do not operate in free and competitive markets” - This is a problem that self corrects in a free market, there must be regulation or other coercive government forces at play that have enabled this problem to persist more than a couple of years. Alternatively, the monopolies in question may be using the tactics of organized crime families to maintain their monopolistic hold - which would require the enforcement of existing regulation to correct, not new regulation.
Argument 2) “The second and bigger problem with the free market argument is the assumption that microcredit clients are rational economic actors.” - Irrational behavior has consequences… and, so should deceiptful business practices. What seems most broken in these countries is their inability to educate their citizens, not their inability to prevent predatory lending practices. As for the victims of deceiptful practices, a proper judicial system should rule in their favor nine times out of ten. Considered from a different perspective, how should we govern ourselves in a society and economy where individuals must be assumed to be irrational? The answer is that we will pass law after law which usurp the rights of the individual in favor of the omniscience (and almighty) State. I think most of us would prefer to live in a rational world where rational behavior is rewarded and irrational behavior has consequences.
Argument 3) - Lack of Transparency - “An essential condition for an open and free market is the ability to compare competing products, which requires pricing transparency. Regulation is needed that mandates microcredit organizations to explicitly state the effective interest rate calculated using a standard and prescribed approach, and to describe all the loan terms simply.” - While I certainly agree with the first sentence, the statement of this premise does not logically conclude that regulation is necessary for its achievement. Shouldn’t we expect an individual taking out a loan to ask how much they will have to pay back to cover the loan? And shouldn’t that individual expect to be protected by the legal system if they are deceived regarding the amount they must actually repay? Finally, doesn’t this sound like a wonderful business opportunity for a price-aggregating broker to enter the market?
Argument 4) “Interest rates, profits, and controllable costs are unreasonably high for a significant part of the microcredit industry—and the need to regulate an interest rate cap for microcredit is imperative.” - Again, regulation does not logicially follow, new competition logically follows. I would like to see a scholarly analysis of what is preventing competition from entering these markets, not an well-intended recommendation that would reduce the attractiveness of market entry to would-be competitors.
Argument 5) Abusive Loan Recovery practices. Perhaps the author and I could agree on this point… Intimidation and the threat of force fly in the face of liberty. Individuals suffering from such persecution should be protected by the law. If these laws don’t exist, they should. If they do exist, they should be enforced. If these laws are not capable of being enforced, then the addition of more laws will not help and will most likely only distract government resources from their primary responsibility: the defense of individual liberty.
I look forward to subsequent research on the underlying causes preventing competition in select microfinance marketplaces along with any recommendations for law enforcement and judiciary practices that would better protect lendees who have been deceived or are being intimidated by unethical lenders.
Dr. Karnani has never been a supporter of microfinance, so it’s not surprising that he’s using the current challenges to drum home his points. In fact, in his 2007 piece for SSIR he called for microfinance to be cast aside in favor of support for small and medium enterprises (SMEs). As I noted back then, this is a false choice. And just as microfinance isn’t a silver bullet (and no one said it was), the same can be said of SMEs (there are many examples of SMEs being low-wage job traps for employees who come from disadvantaged groups). Both can simultaneously be used to improve the lives of the working poor.
No one can argue with the need for sensible regulations that set clear guidelines for microfinance institutions (MFIs). Indeed, over the past few years, countries like Peru and Kenya have enacted progressive microfinance regulations, while MFIs in other places have long been asking for “rules of the road.” However, we must strongly resist urges to create laws that are shaped more by political expediency than effectiveness. We must also guard against regulations that could strangle the very institutions they are purporting to help.
The unrest in Andhra Pradesh cannot, and should not, be assumed to be typical of an entire industry that operates in more than 100 countries. Certainly, one aspect of the problems there has been the local government aggressively attacking private microfinance organizations as a way of favoring state-run competitors, and using exaggerated or false claims of abuses to inflame passions in the media and amongst the public. However, there have been real problems in the growth models pursued by some MFIs in India, and I have been critical of those, most recently in my debate with Vikram Akula at the Asia Society (which can be viewed online).
An honest assessment of the shortcomings of certain approaches to microfinance provides a clear opportunity for the microfinance industry to correct its course and return to the basic principles of creating value for poor clients and above all, “doing no harm”. Here are three recommendations for moving forward that Grameen Foundation has been promoting, particularly in response to the India crisis:
•Consumer Protection. Minimum standards for protecting consumers’ rights need to be set by the government, with monitoring and sanctions for non-compliance. A cornerstone of a consumer-protection strategy would be the establishment of a nationwide credit bureau (as has been done for the microfinance sector in Peru), which would provide MFIs and borrowers with insight about total debt and over-indebtedness.
•Improved Transparency and Accountability. Though not all MFIs are “socially motivated,” all should meet minimal standards for ethical behavior. There could also be some taxation and regulatory benefits that are restricted to only those MFIs that meet defined criteria for bringing socio-economic benefits to poor clients. MFIs that are socially motivated – rather than purely motivated by profit maximization – should be required to meet defined standards. These could include using a recognized social-performance monitoring tool (like the Progress out of Poverty Index™) and evaluating executive compensation, as well as dividends and other payouts to already-prosperous investors, against an MFI’s overall financial and social performance on a year-to-year basis. Additionally, MFIs should all be required to state their effective interest rates for all products (loans, savings, insurance, etc), with third-party verification (through MFTransparency or a similar body).
•Regulatory Reform. While mentioned last, this is by no means the least of the elements. One of the challenges in India is the patchwork of regulatory oversight that currently exists for different types of MFIs. MFIs of all types should be regulated by a single regulatory body that would ideally be at the national level and would not have the obvious conflicts of interest that lower-level officials or bodies might have. There should, however, be no arbitrary interest rate caps which would make it difficult for MFIs to cover their operating costs and continue serving poor people, especially those living in remote areas.
Microfinance, when used appropriately, does improve the lives of poor people, as noted in the most recent analysis of studies in Measuring the Impact of Microfinance, Taking Another Look by Prof. Kathleen Odell (commissioned by Grameen Foundation). Our goal should be to ensure that it achieves its full potential – not to tear it down.
I appreciate the light being cast on Microfinance practices by Mr. Aneel Karnani. Having a MFI become the “shylock” does not help the poor. I recently paid off a microcredit loan taken by my family’s driver in Chennai at unacceptably high rates of interest just to help him get his finances back in shape.
What the poor need are “non-profits” that offer microcredit as a sideline not as a core profit making business. After all that is what the local moneylenders do today and at least they keep their profits in the local economy.
The goal of creating institutional microcredit should be to offer lower rates and easier terms to the poor; and the metrics should include portfolio profitability as well as increases in living standards among borrowers. I don’t see why both goals cannot be achieved; it does require sacrificing the profit maximizing goal of purely private enterprises. But utilities in the US owned by private investors have similar objectives of broad public service and profitability. The mechanism for these utilities is the Public Utility Commission (or Public Service Commision) at the state level. . . Maybe this is a place to start the dialogue about microcredit regulation?
COMMENTS
BY Tracy Kaufman
ON December 2, 2010 07:30 AM
This article is so good, I wish it wasn’t subscriber-only so that it could get a wider audience! That part about Grameen’s debt collectors telling borrowers to sell their children ought to be on the front page of the New York Times.
BY Chris Dunford
ON December 13, 2010 11:34 PM
Beware the Rush to Regulate!
I share the modulated outrage of Aneel Karnani (“Microfinance Needs Regulation,” SSIR, Vol. 9, No. 1, p. 48) regarding abuses of certain microfinance practitioners. Outrage is heightened by the dissonance of the pro-poor intentions of microfinance and the very practices associated with exploitation of the poor by the worst moneylenders. However, while laying out a compelling case for government regulation of microfinance to prevent abusive practices, the article does not provide a full picture with proper perspective.
First, Dr. Karnani dismisses the poverty alleviation value of making financial services available to the poor. It is probably accurate that most microfinance clients “do not earn enough to rise out of poverty,” contrary to the rash promises of many advocates. But this “fact” (there has been too little research to date to remove the quotation marks) does not support Dr. Karnani’s contention that microfinance “does not significantly alleviate poverty.” The research results we do have so far indicate that microcredit and microsavings (whether provided by people calling themselves microfinanciers or moneylenders/money guards) significantly help the poor “smooth consumption” day to day and season to season. This hugely alleviates the burden of poverty, often spelling the difference between hunger and malnutrition vs. health and productivity. Microfinanciers typically offer these services at rates substantially less than traditional providers and with greater reliability. And many, even if not most, borrowers are able to invest loans in start-up and growth of micro-businesses, a few even managing to employ even poorer people outside their own families. By itself, microfinance is unlikely to put poverty in the museum envisioned by Muhammad Yunus, but that shortfall does not mean microfinance has no significant value to the poor.
Second, it is misleading to illustrate the “response of the microcredit industry to mounting criticism” by citing the open letter of Carlos and Carlos of Compartamos, which is widely regarded by the “industry” as an inadequate and self-serving self-defense of their company’s IPO. In fact, the strongest and earliest critics of the Compartamos IPO were within the “industry,” including such pillars of the microfinance world as Chuck Waterfield and Rich Rosenberg. For at least a decade, many of us have been issuing repeated warnings about unreservedly embracing profit-maximizing investors as co-owners of microfinance institutions.
Third, the irony is that microfinance regulation is already well under way, thanks to decade-long partnership of CGAP, bilateral and multilateral donors, and national governments. These efforts in most countries have served to incentivize, even coerce microfinance providers to “transform” their social service NGOs into shareholder-owner, for-profit companies. While rightly seeking to protect the interests of the deposit-making public, this rush to regulate has also explicitly encouraged the entry of profit-seekers—without counterbalancing concern for protection of borrowers (despite a movement within the “industry” during the same decade for “consumer protection” and “financial education”). Thus, government regulation itself has created temptations to which a few of us microfinanciers (being as deeply flawed as any other human beings) have succumbed.
Yes, microfinance needs regulation, but of the right kind, built from a deep understanding of both the public interest and microfinance practice and practitioners. Regulation, especially when born of governmental hubris and populist moralizing, is too often a blunt instrument used more to punish than to protect. Good regulation comes from mutually respectful consultation between regulators and the regulated, most of whom welcome third-party help in removing the bad apples before they spoil the whole barrel.
The vast, vast majority of microfinanciers regard abusive collection practices as anathema. We welcome reasonable laws that allow us to bring true abusers to justice.
Lack of transparency in stated interest rates is an embarrassing legacy of the naïveté of the pioneers of microfinanciers. There was little understanding of the difference between nominal and effective interest rates (which Dr. Karnani illustrates well). As sophistication grew, so did the demand from donors to fully cover costs with interest and fee revenues from the poor clients themselves. Caught between the truly high costs of serving the poor and public sensitivity to “usury,” microfinanciers found it just too convenient to maintain the practice of reporting nominal rather than effective costs. As competition arose among microfinanciers, it became unreasonably self-destructive for any one microfinancier to opt independently for “truth in lending.” Chuck Waterfield’s MFTransparency.org initiative has made it possible, country by country, for microfinanciers to step forward together into the brave new world of standardized calculation and publication of their real APRs. Yes, it would be helpful to give Chuck’s efforts the force of law. But competition on a level playing field reinforced by public shaming will do most of the heavy lifting.
My personal experience is at odds with Dr. Karnani’s contention that interest rate caps are in the interest of the poor. Specifically, he asserts that microfinance is a monopolistic industry and that price controls do not reduce supply in a monopolistic industry. The first flaw in this argument is that microfinance is predominantly an urban and peri-urban industry and has become highly competitive—so according to Dr. Karnani, interest rate caps would reduce supply in urban areas. In rural areas, Dr. Karnani is usually correct that one microfinance provider has a monopoly. Given the low margins and higher risks of rural lending, rural microfinanciers are not profit-maximizers. In fact, their social motives for being out there often drive them to self-impose low interest rates that call into question their long-term viability.
I have seen interest rate caps imposed on monopolistic rural microfinanciers—member-owned credit unions in francophone West Africa. After my organization had helped federations of credit unions figure out how to offer credit and savings services to groups of women in very poor, often remote rural communities, the BCEAO (the central bank for most of francophone West Africa) imposed a seemingly reasonable interest rate cap on credit unions. Hardly profit-maximizers, the credit unions could not cover the true costs of service delivery in rural communities and had to withdraw from rural areas or cross-subsidize rural operations with surplus (a.k.a. profit) in urban operations.
The problem with interest rate caps is that they are typically set too low due to political considerations that seldom foresee unintended consequences for the very people they are intended to protect.
Yes, microfinance needs regulation to reduce abusive practice, like any industry. But let’s be careful. There’s a beautiful baby in that bathwater.
Finally, a special plea: Could academics and journalists please stop writing about the notoriously peculiar microfinance industries in Mexico and India as though they are typical of microfinance worldwide!! They are not.
BY Phil Berry
ON January 27, 2011 02:34 PM
Regulation is sorely needed where microfinance exists as the only financial opportunity. We find many NGOs and even for profit companies relying on microfinance as their primary method to alleviate poverty. We work with companies, mostly western brands, to bring factory jobs to poor rural communities instead of making charitable donations to, and investing in infrastructure for, microfinance. These micro-factories are stable sources of production with a devoted, motivated workforce. Once a micro-factory exists in a poor rural community there is a need for financial infrastructure to deal with payroll, basic employee education in financial management, on-going acceptance of deposits and management of wealth creation opportunities within the community. This is fundamentally more sound economic policy.
BY Krishna sarda
ON January 27, 2011 03:30 PM
Very good article deserves as wide a circulation as possible. My experience of over 250 MFIs in India is that they began with good intentions but very quickly adapted practices that were exploitative - from lack of transparency on their costs and interest rates charged to recovery practices that verge on criminal behaviour. In fact my experience is that the village moneylender (who was much hated) is now charging interest rates lower than MFIs and not insisting on security.
I fear that policy failures by Governments in Developing countries in providing financial inclusion for rural communities or setting the framework in which the market needs to operate has created a vacuum in which exploitative practices have arisen. Regulation is a must but it must have teeth to be effective and secondly it requires citizens that are financially literate - my experiences demonstrate that we remain very far from this objective. As an example our work in rural communities demonstrated that the majority of the villagers were unable to calculate how much kerosene they used per week and what therefore their annual costs were. Leave aside calculating interest rates that confuse the literate. Our work over the last three years is finally creating citizens who feel confident to question and challenge. This is an area that does not attract much investment - Regulation must accompany or be alongside a programme on financial literacy.
I fear that the Deccan Riots moment is arriving for MFIs in India - this will not be in anyones interest.
BY Tom Hyland
ON January 27, 2011 03:54 PM
Professor Karnani wrote an exceptional article in August 2010 “The Case Against Corporate Social Responsibility” in which he argued that “The idea that companies have a responsibility to act in the public interest and will profit from doing so is fundamentally flawed.”
In keeping with that, I am perplexed by his assertion here that “Large commercial banks that are wholesale lenders to MFIs should exercise their social responsibility and press their MFI clients to behave responsibly.”
Whatever shape regulation takes, Yunus inches closer toward his dream of microcredit returning to a completely unscalable endeavor, funded by a hodge-podge of philanthropy that allows for the sanctimony to offer such assertions that microcredit interest rate is more than 15 percent above the cost of funds is too high.
Separately, it is perilous to take at face value Y.S. Rajasekhara Reddy, chief minister of Andhra Pradesh, when he asserts that MFI’s are in any way, shape, or form worse than moneylenders (and what is so bad about the informal sector and a moneylender anyway?) There’s a lot of baggage that comes with a statement like that whole host of Andhra politicians that have themselves been behind stirring up much of the froth, most likely outraged that SKS could wander into their feudal backyards without offering a suitable tithing.
BY stan
ON January 27, 2011 04:08 PM
The author often confuses the need for regulation with a need for enforcement of regulation (specifically or those regulations related to consumer protection), a problem that is neither unique to microfinance nor to developing countries. This article focuses on credit horror stories rather a real discussion of steps to prevent horrors in the future.
For example, the author uses the example of the IPO of Banco Compartamos as a key justification of why microfinance needs regulation. He fails to note that Banco=Bank in Spanish, i.e. this is already a highly regulated instition under the CNBV (National Banking Commission of Mexico)subject to the same level of regulation as other banks. For example, in Mexico, there are reasonable consumer protection laws that are being strengthened as knowledge of best practices progresses. However, whether such laws are enforced adequately is largely attributable to whether government budgets provide sufficient resources and manpower to supervise millions of financial transactions, the same problem we face in the United States, where a consumer protection bureau is just now being established, a decade after one was available in Mexico.
Furthermore, a number of countries have microfinance regulation in place, and still others are developing it now. That is the relatively easy part. But there is no discussion of how to improve the ability of government and microfinance officials to detect and prevent the gravest wrongdoings. There are thousands of low-tech microfinance institutions serving poor customers in marginalized areas where commercial banks would never tread. How to effectively supervise and enforce in a cost-effective manner is something this article does not address.
Finally, before advocating price ceilings in such a cavalier fashion, I would suggest the author take a look at the experience of price ceilings in other Latin American countries, such as Ecuador and Venezuela, where they had a chilling effect on the supply of credit. Let’s not subject developing countries to policies that developed countries have long since rejected.
BY Brady Josephson
ON January 27, 2011 04:37 PM
Thanks for the insightful and educated post. Really appreciate Chris Dunford’s push back as well. I’d just like to throw in that speaking in broad terms is needed for discussion and papers like this but it can be damaging to paint a sector with such strokes as there are many responsible organizations doing or trying to do what you are suggesting. Educating clients on financial management, working with them to build businesses, ensuring they are not over indebted, caring for the individual as a person and not a sum of money, etc. I’d love to see the conversation start to use more precision when making statments that can be damaging. Thanks again.
BY kmk
ON January 28, 2011 03:09 AM
It’s not an issue of whether to regulate, but how much to regulate. We’ve all seen the effects of lack of regulation in the investment community, and now we’re all paying the price for that. Given the opportunity, there will always be people who try to take advantage of a system, to see how far they can push the limits.
We no longer live in a world where people are concerned about doing what is right. Our moral code has eroded significantly. So in lieu of allowing people to use their judgment, regulation to some degree is necessary.
BY jared
ON January 29, 2011 09:41 AM
My dear KMK,
It is indeed a question of whether or not to regulate… or perhaps even a question of which existing regulations in these countries have paved the way for these predatory lenders to become monopolies in their respective markets.
I do not deny that there is a problem, but I do refute the claim that a free market is to blame and that a regulatory solution must be the answer. So, let us evaluate the problem the author has with the free market theory…
Argument 1) “microcredit organizations do not operate in free and competitive markets” - This is a problem that self corrects in a free market, there must be regulation or other coercive government forces at play that have enabled this problem to persist more than a couple of years. Alternatively, the monopolies in question may be using the tactics of organized crime families to maintain their monopolistic hold - which would require the enforcement of existing regulation to correct, not new regulation.
Argument 2) “The second and bigger problem with the free market argument is the assumption that microcredit clients are rational economic actors.” - Irrational behavior has consequences… and, so should deceiptful business practices. What seems most broken in these countries is their inability to educate their citizens, not their inability to prevent predatory lending practices. As for the victims of deceiptful practices, a proper judicial system should rule in their favor nine times out of ten. Considered from a different perspective, how should we govern ourselves in a society and economy where individuals must be assumed to be irrational? The answer is that we will pass law after law which usurp the rights of the individual in favor of the omniscience (and almighty) State. I think most of us would prefer to live in a rational world where rational behavior is rewarded and irrational behavior has consequences.
Argument 3) - Lack of Transparency - “An essential condition for an open and free market is the ability to compare competing products, which requires pricing transparency. Regulation is needed that mandates microcredit organizations to explicitly state the effective interest rate calculated using a standard and prescribed approach, and to describe all the loan terms simply.” - While I certainly agree with the first sentence, the statement of this premise does not logically conclude that regulation is necessary for its achievement. Shouldn’t we expect an individual taking out a loan to ask how much they will have to pay back to cover the loan? And shouldn’t that individual expect to be protected by the legal system if they are deceived regarding the amount they must actually repay? Finally, doesn’t this sound like a wonderful business opportunity for a price-aggregating broker to enter the market?
Argument 4) “Interest rates, profits, and controllable costs are unreasonably high for a significant part of the microcredit industry—and the need to regulate an interest rate cap for microcredit is imperative.” - Again, regulation does not logicially follow, new competition logically follows. I would like to see a scholarly analysis of what is preventing competition from entering these markets, not an well-intended recommendation that would reduce the attractiveness of market entry to would-be competitors.
Argument 5) Abusive Loan Recovery practices. Perhaps the author and I could agree on this point… Intimidation and the threat of force fly in the face of liberty. Individuals suffering from such persecution should be protected by the law. If these laws don’t exist, they should. If they do exist, they should be enforced. If these laws are not capable of being enforced, then the addition of more laws will not help and will most likely only distract government resources from their primary responsibility: the defense of individual liberty.
I look forward to subsequent research on the underlying causes preventing competition in select microfinance marketplaces along with any recommendations for law enforcement and judiciary practices that would better protect lendees who have been deceived or are being intimidated by unethical lenders.
In defense of liberty,
Jared
BY Alex Counts
ON January 31, 2011 02:47 PM
Dr. Karnani has never been a supporter of microfinance, so it’s not surprising that he’s using the current challenges to drum home his points. In fact, in his 2007 piece for SSIR he called for microfinance to be cast aside in favor of support for small and medium enterprises (SMEs). As I noted back then, this is a false choice. And just as microfinance isn’t a silver bullet (and no one said it was), the same can be said of SMEs (there are many examples of SMEs being low-wage job traps for employees who come from disadvantaged groups). Both can simultaneously be used to improve the lives of the working poor.
No one can argue with the need for sensible regulations that set clear guidelines for microfinance institutions (MFIs). Indeed, over the past few years, countries like Peru and Kenya have enacted progressive microfinance regulations, while MFIs in other places have long been asking for “rules of the road.” However, we must strongly resist urges to create laws that are shaped more by political expediency than effectiveness. We must also guard against regulations that could strangle the very institutions they are purporting to help.
The unrest in Andhra Pradesh cannot, and should not, be assumed to be typical of an entire industry that operates in more than 100 countries. Certainly, one aspect of the problems there has been the local government aggressively attacking private microfinance organizations as a way of favoring state-run competitors, and using exaggerated or false claims of abuses to inflame passions in the media and amongst the public. However, there have been real problems in the growth models pursued by some MFIs in India, and I have been critical of those, most recently in my debate with Vikram Akula at the Asia Society (which can be viewed online).
An honest assessment of the shortcomings of certain approaches to microfinance provides a clear opportunity for the microfinance industry to correct its course and return to the basic principles of creating value for poor clients and above all, “doing no harm”. Here are three recommendations for moving forward that Grameen Foundation has been promoting, particularly in response to the India crisis:
•Consumer Protection. Minimum standards for protecting consumers’ rights need to be set by the government, with monitoring and sanctions for non-compliance. A cornerstone of a consumer-protection strategy would be the establishment of a nationwide credit bureau (as has been done for the microfinance sector in Peru), which would provide MFIs and borrowers with insight about total debt and over-indebtedness.
•Improved Transparency and Accountability. Though not all MFIs are “socially motivated,” all should meet minimal standards for ethical behavior. There could also be some taxation and regulatory benefits that are restricted to only those MFIs that meet defined criteria for bringing socio-economic benefits to poor clients. MFIs that are socially motivated – rather than purely motivated by profit maximization – should be required to meet defined standards. These could include using a recognized social-performance monitoring tool (like the Progress out of Poverty Index™) and evaluating executive compensation, as well as dividends and other payouts to already-prosperous investors, against an MFI’s overall financial and social performance on a year-to-year basis. Additionally, MFIs should all be required to state their effective interest rates for all products (loans, savings, insurance, etc), with third-party verification (through MFTransparency or a similar body).
•Regulatory Reform. While mentioned last, this is by no means the least of the elements. One of the challenges in India is the patchwork of regulatory oversight that currently exists for different types of MFIs. MFIs of all types should be regulated by a single regulatory body that would ideally be at the national level and would not have the obvious conflicts of interest that lower-level officials or bodies might have. There should, however, be no arbitrary interest rate caps which would make it difficult for MFIs to cover their operating costs and continue serving poor people, especially those living in remote areas.
Microfinance, when used appropriately, does improve the lives of poor people, as noted in the most recent analysis of studies in Measuring the Impact of Microfinance, Taking Another Look by Prof. Kathleen Odell (commissioned by Grameen Foundation). Our goal should be to ensure that it achieves its full potential – not to tear it down.
BY Ananth
ON October 17, 2011 10:26 AM
I appreciate the light being cast on Microfinance practices by Mr. Aneel Karnani. Having a MFI become the “shylock” does not help the poor. I recently paid off a microcredit loan taken by my family’s driver in Chennai at unacceptably high rates of interest just to help him get his finances back in shape.
What the poor need are “non-profits” that offer microcredit as a sideline not as a core profit making business. After all that is what the local moneylenders do today and at least they keep their profits in the local economy.
The goal of creating institutional microcredit should be to offer lower rates and easier terms to the poor; and the metrics should include portfolio profitability as well as increases in living standards among borrowers. I don’t see why both goals cannot be achieved; it does require sacrificing the profit maximizing goal of purely private enterprises. But utilities in the US owned by private investors have similar objectives of broad public service and profitability. The mechanism for these utilities is the Public Utility Commission (or Public Service Commision) at the state level. . . Maybe this is a place to start the dialogue about microcredit regulation?