Debating the profit motive in microfinance

2 November 2010 at 08:26 13 comments

Microfinance has been featured extensively in the media recently – even making it on to an episode of The Simpsons, where a cartoon version of Muhammad Yunus, founder of Grameen Bank, provides financial advice to Lisa.  The real live version of Mr. Yunus also made headlines in an exchange at the Clinton Global Initiative with Vikram Akula, CEO of SKS, an Indian microfinance bank that raised over $350 million through an initial public offering (IPO) this past July.   The IPO fueled a debate within the microfinance community on governance structures, and whether microfinance organizations should pursue profit and/or be publicly traded.

Despite the ideological debate over the profit motive, it is my view that success will be determined by who borrowers choose to do business with, and how an organization chooses to balance their social mission with the profit motive.

In order to examine the profit motive in microfinance, let’s take a closer look at two of the key participants in our potential microfinance transaction:  Borrowers and Microfinance Institutions (MFIs).

Borrowers

The borrowers I have met here in Tajikistan each made a conscious choice to enter into a loan agreement with their Microfinance Institution.  Given available options, they determined that their best economic opportunity was to take out a loan for their business; agreeing to pay the principal and interest as defined in the contract.  In deciding which MFI to borrow from, my impression was they were less concerned with the governance structure of the organization or its stated social mission, and more concerned with finding a loan with a low interest rate, from an MFI who provided good customer service and convenient banking options.  The transactions illustrated the economist Milton Friedman’s central principle of free markets that “no exchange takes place unless both parties benefit.”

Microfinance Institutions

From the lending perspective, let’s take a look at the MFI I’ve been working at for the last 3 months, Humo and Partners.  Humo was started through funds from an international aid organization in 2004.  The grant allowed them to focus on lending to very poor clients in war torn areas of the country, at rates that were below the commercial cost of funds.  However, without the guarantee of future donations, it became clear that in order for Humo to survive and continue serving their target market, they would need to become financially self-sufficient, requiring a raise in interest rates.  Since they are an organization legally prevented from taking deposits, their primary source of funding is international creditors such as Oikocredit, Blue Orchard, and Kiva.  Right now Humo prefers this debt financing because it is comparatively cheaper than what they would expect to pay on dividends from equity, and they are free to control the strategic direction of the organization without having to answer to shareholders who could demand profits.  However, they conceded that in order to continue expanding, they would eventually need to attract equity investors.

So as a for-profit organization, what is to prevent Humo from excessively profiting off of the poor?  In my time at the MFI, I have observed two compelling reasons:  1) a well-defined social mission, and 2) (socially responsible) self interest. 

First, Humo has a social mission that drives them to target rural areas, serving a population that often would not otherwise have access to financial services, and meeting the seasonal borrowing needs of farmers who are often excluded from conventional loans.  A crucial element to ensuring loans are mutually beneficial is that both sides are fully aware of the terms of the agreement.  To help encourage informed decisions, Humo has client protection principles and a code of ethics that ensure cost transparency to clients and incentivize staff to avoid irresponsible lending.  This year Kiva began an initiative to understand and encourage the social performance of its Field Partners (two informative blogs on the topic were written by Kiva Fellows, Betsy McCormick and James Allman-Gulino).

Second, as the MFI goes about its operations, market forces have also driven them to socially responsible outcomes.  Acting in the interest of the organization resulted in benefits to clients.  For example, during the recent economic crisis, Humo was struggling with client over-indebtedness, as many clients had taken out loans from multiple organizations.  The delinquency on repayments was jeopardizing the financial health of the organization.  As a result of this challenge, Humo initiated a credit exchange with other MFIs and banks to compare client lists.  If a client has an open loan at one organization, other organizations will refuse to issue additional loans.  A second example is the lowering of interest rates based on competition.  As the economy is emerging from the financial crisis, some MFIs have begun to decrease their interest rates.  The competition among MFIs provides a constant pressure to improve efficiencies, and lower rates.

Enabling the choice

Based on my observation there is no one operating model that will fit each unique local situation and regulatory environment.  I believe actors within the industry should be free to evolve, selecting the governance structures and operating models that best meet their needs; including the option to tap into greater investment capital as a publicly traded company.  Fueled by competition, organizations that provide high-quality financial services to clients, at an attractive price will be rewarded with sustainable business – and in doing so will contribute to people’s access to financial services and economic development.  For my own personal investments, I would like to support organizations that find ways to share profits with the poor – I believe Kiva’s initiative to analyze the social performance of its Field Partners will help identify and promote these organizations.  But I also believe that the increased potential for capital and transparency resulting from MFIs being publicly-traded can expand the reach of the industry.  As the economist Adam Smith said, “it is not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than would otherwise be so, that the most judicious operations of banking can increase the industry of the country.”

Having shared my thoughts on the profit motive in microfinance, I’d be very interested to hear yours.  What do you think?

Donald Hart is a Kiva Fellow in Tajikistan

Entry filed under: KF12 (Kiva Fellows 12th Class), Tajikistan. Tags: , , , , , , , .

Today is an exciting day! Presenting Manuela Ramos, a Kiva Field Partner

13 Comments

  • […] Donald Hart, Anna’s brother, who served as a Kiva Fellow in Tajikistan, about his experience. http://fellowsblog.kiva.org/2010/11/02/debating-the-profit-motive-in-microfinance/ […]

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  • 4. Will Stanley  |  18 November 2010 at 11:49

    I quit reading the article upon noticing that the author has misspelled “principal”. This given me very little confidence.

    • 5. Todd  |  18 November 2010 at 12:09

      I quit reading Will Stanley’s comment upon noticing that the author has misspelled “gives.” This gives me very little confidence.

    • 6. donaldhart  |  21 November 2010 at 20:44

      Thanks for the spell check Will — principle is now principal.

  • 7. Rajan Alexander  |  3 November 2010 at 09:52

    @ Howard

    “Having an informed entrepreneur make the final choice of which source to select as the loan provider is a postive answer to the basic question of fairness. Like most of us, he/she will probably choose what he/she thinks is the best option available. If he/she chooses correctly he/she will probably repeat the experience, if not appropriate changes will likely be made for the next loan.”

    a. Are the poor in India informed? Having worked in the NGO sector for 30 years, my opinion is in the negative. You must keep in mind that most are illiterate and not exposed to mass communication.

    b. You assumed entrepreneurs are being funded. Unfortunately, not all of us are cut out to be entrepreneurs. This is what central agency NABARD Director was quoted by the Economic Times:

    “In a static village economy, there is little scope to have too many petty traders. Two-thirds of the villagers directly live on non-cash-crop agriculture, and another 20% are small-time artisans. The cycle of economic activities for these people range from about six months to one year. None of them generate income to meet weekly repayments, and none of these activities generate a rate of return to afford interest rates of 20-40%.

    And if they borrow — and many are compelled to borrow at such interest rates because banks have failed to provide them with credit that they deserve at affordable interest rates — they would never be able to rise from their levels of poverty, and very often just go back a few years in their economic status.””

    What’s wrong with Micro-finance Institutions? Practically everything as the case of SKS illustrates.
    http://devconsultgroup.blogspot.com/2010/10/whats-wrong-with-micro-finance.html

    • 8. donaldhart  |  4 November 2010 at 00:44

      @ Rajan

      In contrast to your comment, my experience has been that borrowers have been well informed of the loan agreement — including a full loan repayment schedule and cash flow analysis of of their business.

      As for literacy, to take Tajikistan as an example, literacy is greater than 95%, so I would not be inclined to call these entrepreneurs illiterate or uninformed.

      As for being actual entrepreneurs, there are a wide range of income-generating businesses that the MFI supports, including loan products that are specifically tailored to agriculture, where the majority of the loan principle is repaid at the end of the loan term, allowing borrowers the opportunity to raise crops or livestock.

      I would be interested to understand, what is your proposed alternative? Is it self-sustaining, or dependent on donor funding?

  • 9. Rajan Alexander  |  2 November 2010 at 11:40

    Interest rates: The Poisonous Fangs of MFIs

    MFIs were touted to provide the poor access to affordable credit, reduce poor people’s need to use moneylenders and indebtedness. In short, provide a much kinder, cheaper alternative to the village loan shark. Instead, they evolved as the new class of institutionalized loan sharks which neo-liberals gave respectability to. MFIs did improve access to micro loans but failed in their touted mission to provide affordable and gentler credit and above all, one that lifted people from the clutches of poverty. Objects of institutional financial sustainability exhort them to charge interest rates and fees high enough to cover the costs of their lending and other services.

    MFIs argue that they need a spread apart from all costs to provide for contingencies and growth. Fine but the moot question is how much should be this spread.

    MFIs argue that economies of scale and competition will drive interest rates down. This remains only a theoretical argument. “Mexican micro-finance institutions charge such high rates simply because they can get away with it”, said Emmanuelle Javoy, the managing director of Planet Rating, an independent Paris-based firm that evaluates micro lenders!!

    If at all, the average Indian MFI interests rates appear more benign than in Latin America or Nigeria, then it simply because other than factors internal to the MFI industry, the sector faces strong competition from governmental and NGO SHG micro-saving programmes in the absence of which, these MFIs would have formed a cartel. Past angry public and government reactions that resulted in a backlash against them, which included the arrests of MFI top leaders, like Uday Kumar of Share Microfinance Ltd as in 2007, keeps their profiteering impulses under check.

    The sooner MFIs are seen as profit enterprises, the better. The longer they pretend they are pro-poor, the longer they discredit the NGO sector that gave birth to a Frankenstein. By 2014, they target to reach 110 million borrowers. Remarkably, despite two decades of operations, if statistics are to be believed, these MFIs only reach just 20 million people in the country, a good proportionate of them, multiple counted. Yet, they succeed in gaining an attention, so disproportionate to this minuscule reach. Act now to prevent they becoming an epidemic in the country. Act now, when they are most vulnerable.

    And how do know they are vulnerable? Because Vijay Mahajan, the father of MFIs in India tells us so:

    “We are facing collapse. Unless something changes on the ground, the industry as we know it is basically gone. ”

    Mahajan, we have news for you. The day when the likes of you are gone, that will be the turning point for the fight against poverty!

    What’s wrong with Micro-finance Institutions? Practically everything as the case of SKS illustrates.

    Read More: http://devconsultgroup.blogspot.com/2010/10/whats-wrong-with-micro-finance.html

  • 10. Aaron  |  2 November 2010 at 11:40

    I like your point about the social mission. Not-for-profits don’t have shareholders, but they face similar decisions; do we use excess cash flow to provide new services, cut prices for the indigent population, or give our employees a raise? No matter what the legal form of business, management must commit to running the business in a way that benefits the customers.

  • 11. howard zugman  |  2 November 2010 at 09:05

    Hi Donald,

    Wonderful post. Having an informed entrepreneur make the final choice of which source to select as the loan provider is a postive answer to the basic question of fairness. Like most of us, he/she will probably choose what he/she thinks is the best option available. If he/she chooses correctly he/she will probably repeat the experience, if not appropriate changes will likely be made for the next loan.

    For profit sources can then compete on an equal footing in the open market with not-for-profits.

  • 12. Todd  |  2 November 2010 at 08:55

    It seems to me that the question becomes as follows: Does an organization profiting from their loans ultimately help borrowers (by keeping the loan organization around and interested in continuing their work in micro finance), or hurt borrowers (because the profits taken in by the company could hypothetically be used to fund other loans)?

  • […] Check out my post added today on the Kiva Fellows Blog — debating the profit motive in microfinance. […]


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