“You’re unhappy. I’m unhappy too. Have you heard of Henry Clay? He was the Great Compromiser. A good compromise is when both parties are dissatisfied, and I think that’s what we have here.” – Larry David
Within the international development community, a debate for the heart of the movement came to the fore two years ago with the IPO of Compartamos, the largest microfinance institution in Mexico. Divisive and controversial, Compartamos’ decision to sell shares and publicly list on an exchange is perhaps the clearest manifestation of where the two sides diverge. One side, led by Muhammad Yunus, founder of the Grameen Bank and winner of the Nobel Peace Prize in 2005, contends that, at its core, the sole fundamental mission of microfinance is poverty alleviation. The other side argues that the goal must be maximizing profit and, more specifically, ROE (return on equity) – extending services to a previously unbanked population and expanding via revenue growth. Just about everyone has an opinion on the decision and, at the very least, it allows for a great philosophical and economic debate about the most effective way to assist the billions of people who live below the poverty line.
First, a brief background on microfinance for the unitiated. Without going into too many specifics, microfinance describes the provision of financial services to individuals below the poverty line with no material collateral. Microcredit, specifically, refers to the disbursal of small loans – generally between $50 and $1,000, depending on the sophistication of the institution and the industry in general (average loan with Compartamos is $623) – to individuals that cannot access credit via the traditional banking system. Given their small size, the cost of servicing these loans, as a percentage of the total, is high. Remember: it costs the same amount to service a $10,000 loan as it does a $100 loan (salaries, office materials, etc.), and these microfinance institutions often have to track down the borrowers on a weekly basis to collect the interest and principle. In other words, interest on microfinance loans are higher than one might think appropriate. In the United States, 50% for a loan may seem exorbitant. But, when you look at it relative to the alternatives (up to 800% from loan sharks) and the fact that these loans are expensive to service, high interest rates are a necessity. But at what level are interest rates exorbitant, even for an MFI? This is the question at the heart of the Compartamos debate.
Interest rates have an inverse relationship with loan size.
For an MFI to be financially sustainable (in other words, rely on profits, rather than donations or grants), it needs to generate sufficient revenue from its loan portfolio to pay for its overhead. For it to grow, it must make substantially more than that. Muhammad Yunus would argue that all profits be reinvested in organization and put toward subsidizing interest rates, focusing on the singular mission of poverty alleviation. Yunus’ organization, Grameen Bank, is actually owned by the borrowers, so profits that are not reinvested are distributed as dividends. Compartamos, which has institutional and private investors, takes a different approach. In 2005, Compartamos had an average interest rate of over 88% – an exorbitant rate, even within the world of microfinance. Yet, at the end of the day, Compartamos has been a model of success in the microfinance world. It generated annual returns on equity of 53% between 2000 and 2006, attracted investment capital from around the world, and, in the process, expanded access to credit and financial services for millions of people without previous access. So why is it controversial?
At its core, microfinance embodies the idea of the double bottom line – a dual commitment to financial profit and social responsibility. By nature, the management of a publicly-traded entity is responsible to its shareholders, above all else. Unless there is an agreement among shareholders to sacrifice profit for social impact, the tenets of publicly-traded organization are at odds with the concept of the double bottom line. An MFI like Compartamos will target clients higher on poverty chain in an effort to reduce default rates, ceasing to serve the poorest – those most in need of microcredit. So is this an acceptable model? Muhammad Yunus would argue that the answer is simple: a microfinance organization cannot be a publicly-traded entity, because its goals are inconsistent with the mission. Here Mr. Yunus vents his frustrations:
Yunus, 67, says he fears that his innovation has been twisted to benefit investors, rather than the poor. But he has particularly unforgiving words for microlender Compartamos. At one point during a conversation, Yunus objected to the mention of Compartamos and microfinance in the same sentence. “When you discuss microcredit, don’t bring Compartamos into it,” he instructed. “Microcredit was created to fight the money lender, not to become the money lender.”
Oh snap! Yunus’ opponents and Compartamos supporters would argue that, without generating profits for investors, MFIs will never attract the capital necessary to achieve poverty alleviation on a scale large enough to reach all those that need microfinance services. After all, in the eyes of potential investors, money that could be making more money is actually losing money. But a highly profitable MFI, like Compartamos, will attract a lot of money, which, in turn, can be put to work by potential entrepreneurs in the developing world. In response to M. Yunus’ scathing review, Compartamos released an 11-page statement defending itself:
We generate social value by providing access to financial services for as many people as we can in the least amount of time. We create economic value by building a profitable and strong company where private capital can participate, making this industry attractive for others to compete in providing better financial services for low income people. We also generate human value by believing in people, by giving credit to their word and their willingness to succeed and realize their capacities, and by encouraging them to be better persons. Not only do we believe these are not contradictory goals, but we are convinced the three reinforce each other.
Touche, Compartamos. So, the other side would argue, Compartamos and profit-generating MFIs not only remain true to the fundamental mission of poverty alleviation, they actually serve to expand it well beyond the scale it could achieve in a more socially-oriented framework.
A myriad of other factors are critical to an informed discussion of this debate. For example, how can Compartamos serve the poorest individuals with a higher risk of default when it is responsible for generating returns for its shareholders? (The answer is that it doesn’t, nor does it claim to.) Without that function, how then is it any different from the traditional banking system it was designed to circumvent? These are questions for another post. I’ll try my best to posit a solution, or at least a compromise that might satisfy both camps.
Microfinance can operate across the pyramid
It seems to me that these two models of microfinance – non-profit or borrower-owned vs. public for-profit – can coexist, serving different populations within the spectrum of poverty. Currently, the microfinance industry serves ~10% of the estimated $250 billion of global demand. Microfinance institutions, in theory, offer a broad suite of services to individuals with no access to the traditional banking system, yet the unbanked population (~4 billion people) is dramatically stratified. At the very bottom are the destitute, those living in extreme poverty (less than $1 per day). Here, microfinance is ineffective, and aid, in the form of food and healthcare, are necessary. For the ~3 billion people that could benefit from these services, both the non-profit Yunus model and the public Compartamos model could each serve a valuable role. For the vulnerable non-poor and those just below the poverty line (just above the poverty line) that are more reliable, Compartamos could offer high interest rates and still generate a positive return on equity, attracting large investments from institutional investors, rather than donor capital. Compartamos is serving businesses with high inventory turnover (i.e. buy a dozen eggs for 100 pesos in the morning, and sell them for 120 pesos in the afternoon, for a 20% daily return). Therefore, 88% annual interest is actually not as burdensome as it seems. Also, success breeds replication, which helps serve the poor even more. Compartamos has perhaps been a victim of its own success, as new competition by others replicating its model has driven interest rates down from ~88% in 2005 to 71% in 2008.
The MFIs in the Grameen camp, on the other hand, can still focus on those below this level with reasonable interest rates, remaining sustainable, but still functioning as non-profits. The interest rates will continue to make these organizations appealing to clients, as will the provision of other non-financial services, like micro-insurance, energy programs, entrepreneurship training, and others. These institutions could mandate specific thresholds for potential clients in order guarantee the social mission (The Progress out of Poverty Index comes to mind). These socially-focused MFIs will continue to receive grant funding from international development organizations, like the World Bank and the IFC, and philanthropy groups, like the Gates Foundation and the Clinton Global Initiative. Investors can make decisions based on their own motivations. Online P2P lending organizations like Kiva have proven that people are willing to accept 0% rates of return, provided funds are directed to borrowers of a specific profile. In addition, institutional investors are crawling over themselves to give money to successful organizations with a social mission. For them, the 10-12% returns on investment are satisfactory.
At the end of the day, the success of microfinance and microcredit depends on scalability and adherence to mission. The Compartamos IPO highlights the divide among the development community. I reject the premise that the two models are mutually exclusive. I’d go so far as to argue that they are complementary. Pursuit of profit is a good thing – it is what drives the capitalist engine, and microfinance is fundamentally a capitalist approach to development. And, though the idea is controversial, I believe that it is OK not to have an committed social mission if an institution is still serving the unbanked, as this is a social mission in itself. Again, Compartamos explicitly defines their role in microfinance:
Everybody agrees that MFIs are going through a period of deep and important change. There is no question that the debate will continue. This letter is merely a contribution to better understand our point of view in the debate. In the end, the ability to expand the market and include large numbers of excluded low income people into the financial sector, will give us all a better perspective on the benefits of the commercialization of microfinance.
Let Compartamos target a lower risk, less impoverished clientele, and focus the Grameen segment on the still-unbanked poorer individuals. True, this is a drastic oversimplification of a complex and nuanced topic, but at the end of the day, a large percentage of this market remains untapped. It is premature to be arguing about which of these two proven models are best going forward. After all, there is more than enough business for everyone.
Note: This is a modified and updated version of an article I wrote for a public policy journal, found here