Lies, Hype, and Profit: The Truth About Microfinance

Modern microfinance began in Bangladesh, where economist Muhammad Yunus discovered that a stool-maker from a poor village was effectively enslaved because she did not have the 22 cents that would let her to bypass usurious middlemen. Yunus made an interest-free $27 loan to her and other villagers the next day.

And so, microcredit was born. Until recently, it was a darling of international development. By making small loans between $50 and $500 to low-income individuals and small businesses, microfinance was believed by many to offer a ladder out of poverty. Though accurate numbers are hard to come by, estimates suggest that worldwide, there are now over 600 million microcredit clients with combined loans of over $100 billion outstanding. The United Nations declared 2005 to be the Year of Microcredit, and in 2006, Yunus was awarded the Nobel Peace Prize.

Five years later, microcredit has descended into controversy. Critics question whether it is truly helping the poor or driving them further into poverty with aggressive client recruiting and high-interest lending. Bangladesh has launched an investigation of Yunus' Grameen Bank. The Indian state of Andhra Pradesh cracked down on microloans, citing a scourge of suicides by over-indebted borrowers. Even Yunus himself took to the New York Times to blast "megaprofits" made by some microcredit banks.

The backlash against microcredit questions the myth that the poor can easily climb out of poverty with some credit; or that microcredit can be financially self-sustaining. Microcredit is supposed to be a lifeline for borrowers, a winner for investors, and a self-funding route out of poverty for the world.

The reality is far more complex.

To understand the backlash, let's go back to August 2010. SKS Microfinance, the country's most rapidly successful microcredit organization, held a public IPO that made millions for its founder, ex-McKinsey-consultant Vikram Akula. Many hailed the achievement as proof that microcredit could be financially self-sustaining. Local politicians saw it as Robin Hood inverted - a plot to steal from the poor and give to the rich. They persuaded borrowers to stop paying back their loans.

Another controversy occurred in Mexico in 2007. Banco Compartamos, a non-profit organization turned for-profit bank, raised nearly half a billion dollars in its IPO. Compartamos makes loans at an APR in the range of 75-100%. Yunus blasted Compartamos, saying, "Microcredit was created to fight the money lender, not to become the money lender." Most microfinance institutions justify their high rates by arguing that they need to absorb costs of administration. Compartamos further adds that it if it were to drop rates any lower, it would shut out its competitors, who charge even higher interest rates. I recently spoke with Alvaro Rodriguez, chairman of Compartamos, who claims, "We need to encourage an ecosystem of microcredit. We can't serve everyone who needs loans on our own."

There's posturing and skepticism, highlighting the difficulty of making generalized statements such as "microcredit is good" or "microcredit is bad." There is no pat answer. Microcredit can fall prey to three forces: overhyped rhetoric, imprudent lending, and the profit-focused nature of capitalism.

First, pretending that credit is sufficient to help poor people is misleading. Yunus himself advocates his cause by pooh-poohing other obstacles: "The poor are poor not because they are untrained or illiterate but because they cannot retain the returns of their labor." His views have softened with time, but public oversimplification and the neverending mantra of "the poor only need credit" remains, leading to a global movement that promotes itself indiscriminately.

The developed world needs no reminders on the pros and cons of lending. Certainly not the United States. In the housing bust, the U.S. saw the effect of too many bad loans. In the recession, it saw the ravaging effects of too few loans. It's pointless to say, "lending is good" or "lending is bad" overall - what matters is that each loan is granted by a careful weighing of benefits.

As to capitalism, microcredit would like to benefit from its efficient, meritocratic, and growth-focused qualities. Proponents argue that microcredit needs formal investors to extend the benefits of microcredit further. But, capitalist institutions have their dark side, too. Accepting such investments puts microcredit banks in the hands of shareholders whose primary goal is profit. There is no denying the cash flow that takes money out of poor clients in the form of interest and puts it into the coffers of already rich investors. Good or bad? Again, a well-considered balance is key.

Thus, microcredit requires a delicate and ongoing balancing act between undesirable extremes. It's no wonder then that accusations fly when balance is lost.

Photo credit: Wikimedia Commons

In a future article, I'll debunk the myths of microcredit.