Microcredit as loan sharking?

Microfinance - the design and delivery of specialist financial services to poor consumers - doesn't often make it onto the front pages of the global media. So it was no surprise that the front page story about microcredit on the International Herald Tribune (and the New York Times) today ended up focusing on some of the industry's more unsavoury elements. Prime among these are the sky high interest rates that some microcredit organizations charge their low income customers - in Mexico, for instance, the average rate is currently some 70%, although the global average is around 37% (which is still considerably higher than rates for "normal" lending). Neil MacFarquhar, the NYT reporter lays the blame squarely on the takeover of microcredit by "a raft of banks and financial institutions", which he claims has got microfinance advocates "wringing their hands over the direction it has taken" and created a "fracas over preserving the field's saintly aura"

Such debates about the direction and financing of microcredit are hardly hot off the press. In fact, in our recently published Business Ethics textbook, we've written a case on Microfinance ("Targeting the poor with microfinance: hype or hope for poverty reduction?") that deals with exactly these concerns. Now we like to claim the book is cutting edge, but we don't expect to break the news ahead of the New York Times. Still, MacFarquhar's critique is timely in some respects in that it does at least put an important debate around microfinance in the mainstream at last. And it helps put to rest a little of the unabashed enthusiasm that tends to accompany a lot of discussion about microfinance. But in other respects, the article is rather uneven in its criticism and probably rather misses the point with its castigation of banks.

There are in fact three quite distinct issues at stake here. The first concerns what a fair price for poor consumers to pay might be in terms of interest rates. Microcredit consumers almost by definition represent a higher cost to serivce for financial institutions because they are difficult to reach and do not fit the existing banking infrastructure. As we say in our case, "providing financial services to the poor may not be as risky as once thought, but it remains expensive because of the large numbers of small transactions that need to be processed and the considerable resources that need to go into developing education and outreach services." This is why much microcredit began as a nonprofit exercise funded by donations. But when it comes to for profit providers, are lenders bound by a "fair price principle" that may not be in evidence in other markets? Isn't the fair price what consumers are willing to pay? Well, not exactly. Fair prices are those that are transparent, understandable, and where customers have an opportunity to switch. These are conditions that are not always met in microcredit markets, suggesting that some kind of addition protections may indeed be necessary to prevent exploitation.

The second issue is about what it takes for microfinance to really take off and go mainstream. First we derided banks for ignoring poor people. Now that microcredit organizations have shown that it can be profitable (and relatively low risk) to target them, we still deride the banks for greedily entering the market. But in reality, few large banks have yet to take up microcredit with much enthusiasm. And even those that have, typically only have a small percentage of their business accounted for with microloans. Despite what MacFarquhar hints at, microfinance is still not a big bank phenomenon and much of the microfinance world is still looking to further its inroads into the commercial sector to prove that its not just charity but actually good business as well.

And firnally, the third major issue is whether microfinance actually has any major effect on poverty reduction. This "fierce debate" as MacFarquhar terms it, is a crucial one for the long term complexion of microfinance, because without substantial impacts on poverty, microfinance has far less attraction to the development world (though it will stay in vogue for the finance industry whilst it maintains it sheen of profitability mixed with principles). And the truth is, the definitive answer to that one is still not apparent. In our case, we put it like this:

"The evidence on the impact of microfinance on poverty alleviation is limited. In part, this is simply due to the relative youth of the industry, as well as the very real problem of providing any definitive correlations given the range of variables involved in determining poverty levels. Despite numerous case studies of successful initiatives, hard empirical evidence is lacking.At best, the existing evidence seems to suggest that, on average, microfinance reduces vulnerability and dependence among client groups, even if it doesn’t necessarily make them richer."

Critics therefore suggest that efforts should be targeted at other approaches to poverty reduction whilst advocates, even in the absence of hard evidence, still endorse the more organic, inclusive and bottom-up approach to develoment represented by microfinance. This argument isn't likely to go away any time soon, but the need is clearly there to develop more sophisticated impact assessment tools to gauge its effectiveness.

So the upshot is, the picture is probably rather more messy than the New York Times presents it, but also somewhat more nuanced. Microcredit is not about big banks versus nonprofit providers battling for the heart and soul of a "saintly" practice, but about a form of lending that can and will be practiced in a variety of ways to serve a variety of ends.