The Impact of Commercialization on Microfinancing

By Erin Casey
Note: This policy paper is addressed to the finance departments in countries who participate in microlending. It is meant to draw attention to the changing industry of microfinancing and propose a useful solution.

INTRODUCTION
Microfinancing has recently been hailed as one of the most promising ways to reduce world poverty and make real progress towards the Millennium Development Goals. Indeed, the International Microcredit Summit has been graced by heads of state, the UN declared 2005 the Year of Microcredit and the microfinance authority that was awarded the 2006 Nobel Peace Prize added even more attention to the movement. And, in the face of a worldwide economic downturn and global budget cuts, investment in the microfinancing industry has steadily grown. Once solely a nonprofit endeavor, more and more for-profit entities and commercial banks have begun entering the realm of microfinancing. However, this growth is not without cost. As Arnab Mukherji, a researcher at the Indian Institute of Management, says weve seen a major mission drift in microfinance, from being a social agency first, to being primarily a lending agency that wants to maximize its profits. The shift of the entire industry towards commercialization is a potentially dangerous development that requires our immediate attention. Authorities of finance in countries around the world must realize that reform is necessary in the microfinancing industry. If measures are not taken quickly to protect them, the poorest members of our societies will be taken advantage of and profited from. Specifically, fully transparent data and strong supervision by a global regulatory body is needed to salvage the initial promise of microfinancing. This paper will begin by outlining the historical shift in microfinancing from nonprofit to for-profit institutions. I will then explain my reasons for my recommendation by citing several ways that commercial microfinance institutions (MFIs) take advantage of the poor. Then, I will examine India as an example of the destruction that for-profit

MFIs can cause. Finally, I will propose what changes I think are necessary to protect the poor and monitor the changing industry.

CHAPTER 1
Background

The modern microfinancing began in the 1970s when Muhammad Yunus founded the Grameen Bank during a famine in Bangladesh. Today, there are an estimated 13,000 microfinance institutions (MFIs) worldwide and over 300 countries participating. MFIs have always been in various legal forms including credit unions, cooperatives and NGOs, but recently, the number of for-profit or commercial MFIs has exploded. The growth is due to the success of early non-profit organizations like Grameen Bank. Traditionally, the poor had been viewed by commercial banks as a credit risk. Most were unable to obtain any credit because of their inability to provide collateral funds and the belief that they would default on their loans. However, Yunus bank proved these views wrong as evidence continued to show extremely high rates of repayment among microborrowers. Commercial banks began to notice these statistics and the success of institutions like the Grameen Bank. They began entering the microlending industry to earn profits. Suddenly, a tool that had been used for three decades as a way to promote nonprofit economic development became harnessed by for-profit entities as a new way to earn profits. Commercial microlending organizations began to spread and grow around the world, purporting to have the same mission and goals as nonprofits to improve social welfare. But instead of focusing on improving the standard of living of the poor and developing

stable communities, these new organizations main goal is to reap profits for their shareholders. Now, by taking advantage of the high rates of repayment and subsequently high rates of interest paid on microloans, commercial banks have been able to reap huge profits from the poor around the world. One example of a wildly profitable MFI is Banco Compartamos of Mexico which grew from 60,000 customers to over 800,000 between 2000 and 2007. In 2007, the bank went public and, soon after, was worth $1.6 billion. (Cull, Kunt and Morduch) Today, the entire microfinance industry has over $60 billion in assets the majority of the money is increasingly concentrated in the hands of for-profit institutions. Elisabeth Rhyne, who runs the Center for Financial inclusion, testified in Congress this year that banks and finance firms serve 60 percent of all clients, while nongovernmental organizations (NGOs) serve 35 percent and local credit unions serve 5 percent.

CHAPTER TWO Evidence

Irresponsible lending leading to multiple loans without due diligence, unproductive loans for consumption and consumer durables, lack of transparency in operations, usurious interest rates, coercive recovery practices, have all resulted in hyper-profits to microfinance institutions and impoverishment of the poor" R. Subrahmanyam

Commercial banks charge extremely high rates of interest on microloans, significantly higher than the rates that most non-profits charge. Annual interest rates range from 50% to 120% among commercial banks engaged in microlending, compared to the worldwide average of 31% among nonprofit microlending institutions. At the time of Banco Compartamoss hugely profitable IPO, their customers were paying an average rate of 94 percent. (Kull) Exorbitantly high interest rates defeat the purpose of microfinancing itself, which was intended to replace the poors reliance on local moneylenders that were charging rates of 100 percent on loans. When microlenders charge the same rates that usury moneylenders do, then there is no point to the movement. By profiting from charging high interest rates, commercial banks are essentially taking money from the poorest members of our society. On top of high interest rates, for-profit organizations engage in reckless and aggressive lending practices to maximize profits. The poor are convinced to borrow huge amounts of money, without anyone checking their credit history or ability to repay, and then buried in interest charges. Microloans, originally intended to help generate income for microenterprises and expand small-businesses, are now being used for a variety of things since there is no inquiry about the use of the money. Commercial banks claim to have stopped these loan utilization checks because they are too costly. A particularly alarming development is the rise of multiple borrowings. The poor are increasingly being

caught up in a debt spiral as they borrow from one MFI just to repay another. ( Rajshekhar) Commercial banks have no incentive to prevent this, as their goal is only to keep making more and more loans. Many commercial banks also use their clients lack of education and literacy to their advantage by not fully disclosing the information in their contracts. Often, the poor are sign documents locking them into financial commitments that they cannot possibly meet, simply because they do not understand the terms of the loan. In addition, abusive and coercive collection methods are used to force repayment. In India, reports of unbearable harassment from MFIs have even been linked to suicides.

CHAPTER THREE An Example

One very recent example exemplifying the dangers of the new commercial microfinance model is in India. The rapid expansion of microfinance, from 8 million to 25 million borrowers between 2007 and 2010, was mostly due to the arrival of a number of aggressive for-profit MFIs (see table below). As the number of commercial entities lending increased, the market for microfinance began to become saturated, with 17 percent of the population possessing a microloan. This over-saturation led to increased competition among MFIs, which in turn caused banks to carelessly lend to individuals who had no ability to repay. The goal of these institutions was simply to recruit the most clients and lend the most money possible. Soon, the number of multiple loans was over 80 percent, meaning that of the people that had microloans, four-fifths had more then one.

Many of these customers had taken out new loans simply to repay older microloans, not to invest in productive business enterprises. Table and Graph Showing Massive Short-Term Growth in India's Commercial MFIs
Source: Mixmarket.com

This mounting indebtedness in the poorest communities (largely due to the ease in obtaining multiple loans) combined with growing anger towards the spectacular levels of profiteering by MFIs, reached a peak in late 2010, when almost all borrowers in the Indian state of Andhra Pradesh abruptly stopped repaying their loans. At the same time, reports emerged of growing numbers of suicides that apparently directly followed from commercial MFIs aggressive loan recovery techniques. Even as legislation was passed to restrict lending and collecting practices, payment on over $2 billion in loans virtually ceased. Now, Indias once thriving microfinancing industry is facing collapse because of the largely ideologically-driven move to commercialize microfinance. (Milford Bateman) The growth at any cost strategy employed by so many for-profit MFIs has now endangered the non-profits that had successfully operated for years in India. India provides an early example of the possible consequences of the shift from nonprofit to forprofit institutions. CHAPTER FOUR Proposal for Progress

Despite the warning that India provides, the trend of commercialization in microfinancing is likely to continue growing and more for-profit institutions are expected to participate in microlending. Commercial MFIs are here to stay, and, instead of attacking their principles or arguing against their morals, we must focus on effectively regulating the industry to ensure the protection of borrowers. Vaga Reddy has said that the idea that MFIs should be treated like banks but given soft regulations is dangerous. To remedy this danger, we must implement several changes: the formation of regulatory institutions, the formalization of all MFIs, full transparency and information sharing, and

consumer protection measures. Yunnus asserts that every country where microloans are made needs a microcredit regulatory authority. In addition to these national authorities, we must also establish an international organization that will oversee all of them and monitor the industry as a whole. All banks currently participating in microfinancing and any banks wanting to enter the industry in the future will be formally certified. This certification will require them to submit to the authority of their countrys regulatory agency, as well as the international body. They will need to adhere to a set of generally accepted microfinancing principles and abide by the international organizations limits on interest rates and profit margins. Any banks found practicing microlending without certification must be held accountable and reprimanded by the international organization. In addition, all banks certified and practicing microfinancing must agree to be completely transparent and, if summoned, provide any available data on their interest rates, yearly revenues and other relevant financial information. Any complaints from consumers will be investigated by their countrys national authority and a report will be sent to the international body to file on record.

CONCLUSION

Microfinancing is a growing and evolving industry with the potential to help many people around the world. Its intended design, to help the impoverished create and grow their businesses to escape poverty, is a good one in theory. However, with more forprofit MFIs entering the field of microfinancing, regulation and transparency is absolutely essential to protect the economic development goals of the original founders.

Because of their use of high interest rates, irresponsible lending practices and coercive loan recovery tactics, commercial banks have proven that they cannot be trusted to govern themselves and protect their poor clients. India provides a perfect example of the dangers that this new shift presents, and, should be viewed as a warning to finance departments around the world. A formal, international body is needed, as well as national organizations to help enforce regulations and monitor all parties involved in microfinancing. This is the only way that we can ensure the protection of the poorest members of society from profiteering banks that do not have their interests as a priority.

Works Citied
http://www.smartcampaign.org/about-the-campaign http://www.businessweek.com/bwdaily/dnflash/content/jul2008/db20080728_875314.ht m Setting Standards for Microfinance http://www.nytimes.com/2011/01/15/opinion/15yunus.html Sacrificing Microcredit for Megaprofit Larry Reed Commercialization: Overcoming the Obstacles to Accessing Commercial Funds while maintaining a commitment to reaching the poorest. http://www.microcreditsummit.org/papers/Plenaries/ExecSummReed.pdf 2007 Microcredit Summit Report http://www.ruralfinance.org/fileadmin/templates/rflc/documents/1253177264086_SOCR 2009_English.pdf Banks Making big profits from tiny loans NYT http://www.nytimes.com/2010/04/14/world/14microfinance.html? scp=6&sq=microfinancing&st=cse Microfinance meets the Market Cull Kunt and Morduch http://financialaccess.org/sites/default/files/G4_Microfinance_Meets_Market_0.pdf Microfinance struggles to restore its reputation http://www.philly.com/philly/business/20110309_Microfinance_struggles_to_restore_its_ reputation.html Help microfinance, dont kill it http://www.indianexpress.com/news/help-microfinancedont-kill-it/716105/0 Milford Bateman on the Andhra Pradesh Microfinance Crisis in South India http://indiamicrofinance.com/milford-bateman-andhra-microfinance-crisis273203821.html