What Price Microfinance?

Martin Luther King Day seems like a good day to write about microfinance.

A couple years ago I heard Vikram Akula speak at a top graduate business school about his for-profit micro-finance firm in India, SKS. The talk was held in a large lecture hall, probably seating at least 250. The talk was held after the Lehman collapse. One of the remarkable things I remember about the talk was that it was standing room only and many, many future MBAs were standing to hear it. Another remarkable thing I remember was that Akula asserted during his talk that his managers and workers were paid something on the order of 20% less than they could make in more traditional finance firms. I remember him saying that the rationale for this was that he wanted people who were interested in doing good, not just in making money. At least, this is how I remember it.

But the most remarkable thing I remember about his talk was that when it was done, he fielded question after question from different members of the audience, all on a theme of "how do I come work for SKS?" Even at only 80 cents on the MBA starting salary dollar, a lot of the audience wanted to come work for SKS.

I suppose they might have been asking that last question because at the time and for a multitude of reasons traditional finance wasn't looking like an attractive career option. But I think not. Most of the future MBAs phrased their questions in ways that suggested that the draw was putting their skills and talents to work doing some good in the world. And they were willing to work for less to do this.

This is not news. Economist Robert Frank provided evidence some years ago that people are willing to work for less when they believe they are doing some good in the world. (As an aside, I will point out that this phenomenon is entirely consistent with utility maximization, but not with maximization of indirect indicators of utility, such as income).

A couple weeks ago, my friends and readers began sending me links to articles about "beneficiaries" of micro-finance in India resorting to suicide when their indebtedness became overwhelming. More recently, Muhammad Yunus, micro-finance originator and Nobel Peace Prize winner, weighed in with this condemnation of for-profit micro-finance. This was followed by a fairly predictable response from the Philanthrocapitalism blog making the usual arguments in support of for-profit micro-finance and this more nuanced and thoughtful response by Felix Salmon.

Salmon does an outstanding job of critiquing the Philanthrocapitalism blog, so I'm not going to re-cover that territory. But I have a couple of observations.

The first is that, personally, I like the idea of micro credit. Availability of credit at a reasonable interest rate seems to be the main difference between me and a lot of less well-off people. Something unexpected happens that makes a temporary hole in my income, I have resources. I can borrow to fill it. It requires me to give up some future income to repay it, but that's a lot better than having to sell everything and start over again. The fact that micro credit often is used to increase economic self-sufficiency by funding entrepreneurship is an even stronger argument in favor of it. If it lifts people out of poverty in a sustainable way, it's hard to find fault.

Unless the people it is lifting are not those in poverty, but those who already own plenty of capital and want to own more (at the expense of those they purport to be lifting). And there's the rub.

Look, I'm only going to repeat this a few more times: the higher the returns, the higher the risk.

If micro-financiers have to charge higher interest rates, it's because they're making riskier loans to people who probably should not be receiving them. I'm sorry. I know it's harsh, but that's the reality. There are probably some people who should not receive loans, especially if one desires to make a profit. Those people should receive gifts. Yes, gifts. Not loans, gifts. Subsidies, transfers, job training, education. Gifts.

Or, if micro-financiers have to charge higher interest rates, they're employing people who want to make money rather than people (willing to work for 20% less) to do good. There are probably some people who should not be in micro-finance either as investors or as employees. Those for whom only money matters.

So. If you're in the micro-finance business to make money, you should probably resign yourself (like those MBA students I described above) to making less money. You will have entered into a business where it is not OK to shift risk to those least able to bear it. You will have entered a business with dual objectives and one of them imposes an ethical contraint on your returns.

You get to charge higher interest rates because your clientele are high-risk, but you don't get to lend to just anyone regardless of their ability to pay and then claim that you're doing good by making credit available to more people. Nor do you get to charge any old interest rate you feel like charging. Yunus is right. It should be tied to your underlying fund costs. Anything in excess of the 15 percentage point spread between fund costs and interest charged that he describes can only be justified by increased risk, which neither lenders nor borrowers should be taking on. Especially already impoverished borrowers.

Spreads in excess of Yunus' 15 percentage points for for-profit micro-financiers can only signal either too much risk or too much profit. Either way, it's too much when the dual objective is profits and lifting people sustainably out of poverty.

Failure to recognize the above and to structure micro-finance responsibly to achieve the twin goals would put micro-financiers in the same ignominious company as sub-prime lenders, liar and interest-only loans, and all the wonderful, creative, entrepreneurial guys who gave us our current economic recession.

Leading indicators that risk and/or profits are too high would include increasing reports of suicide among your "clientele." It's a sure sign that investors have rigged the game too much in their own favor. It would be a Good Thing to find another, less final leading indicator and provide pre-emptive remedy before people start dying. I'm willing to bet that the borrowers most likely to kill themselves are also the ones most likely to want to pay back their loans. Not a selection effect an investor should want to encourage.

The price of the moral high ground isn't high, but neither are the profits associated with it. Those who occupy it are willing to work for less. Those who invest in it should be willing to accept lower returns on their capital, knowing that the rewards are more than monetary and the risks, for both lender and borrower, are less variable and more sustainable. That makes borrowers, lenders, investors, and the rest of us, all, better off.

Comments

[Brad Fallon]

I am aware of this micro finance type of lending loans. This is particularly applicable to third world countries like India. Before these micro lenders approves the loans, these clients undergo credit investigations and background investigations. Micro finance loans are actually character loans that are aimed at those clients that want their business or income to grow. If these are handled by the lenders well, it is actually a very helpful venture..

[Peter T]

I like your argument - very well put, and very right.

[Peter Kurze]

Maxine,

I don't know all of the backstory with the controversy over Yunus's comments so I may be missing your point entirely, but it sounded to me as though it was a controversy between groups that were primarily focused on alleviating poverty and were charging enough intrest to stay useful, and those that were trying to do some good while they were turning a profit, and whether that extra burden of profit taking is justified given that challenges faced by their clients.

Microfinance has also attracted players with purely predatory motives. You may be interested in this link:

http://www.businessweek.com/magazine/content/07_52/b4064038915009.htm

The other question I have about this is the question of the scalability of the solution, which is something that I have been thinking a lot about recently in many different contexts. I love what I know of what Yunus has done, but I wonder if the success of the small scale entrepeneurship might tend to rapidly raise entry barriers, and if the small-scale of the enterprises started might in some way be self-limiting in their ability to raise a poor population as a whole in a world dominated by more highly developed enterprises.