Don’t invest in microfinance

By Felix Salmon
August 13, 2009
taking a skeptical look at the excesses of PE-funded microfinance institutions, even if the newspaper still feels the need to put the word "microfinance" in scare quotes in its headlines.


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It’s good that the WSJ is taking a skeptical look at the excesses of PE-funded microfinance institutions, even if the newspaper still feels the need to put the word “microfinance” in scare quotes in its headlines.

I’m a fan of genuinely local, bottom-up microfinance. But what the WSJ is talking about — which is where the real growth is — is top-down microfinance, driven by external funds from the developed world. Ethical funds, in particular, love these investments, partly because they have very little correlation with any other asset class, and partly because everybody loves to think they’re investing in the next Grameen. The problem is that Grameen never took foreign money, for a very good reason.

At heart, a lot of these investments are a gussied-up carry trade. Developing-country financial institutions borrow dollars, and invest them in the local markets, with little if any currency hedging. A few organizations are beginning to offer hedging services to microfinance institutions, but such services are unlikely to prove particularly popular, because it’s that implicit FX risk which accounts for a huge proportion of these institutions’ profits. Much better that microfinance organizations grow a little more slowly, and much more organically, either by getting grants rather than loans, or by funding themselves locally.

It’s undoubtedly true that microfinance could be a lot bigger than it is now. But the way to get there from here isn’t to throw for-profit private-equity dollars at it. The real constraint is finding and training good local women who can underwrite well and who know their customers on a personal level. There’s a reason that these PE-backed microfinance dollars are concentrated in cities right now: it’s the only way to scale up quickly. But speed is the enemy of quality, as the WSJ’s Ketaki Gokhale demonstrates, and in Ramanagaram it has resulted in the local mosque successfully urging its congregation to default on all their loans, with stubborn uncooperativeness on both sides:

The mosque leaders are also demanding that lenders give them an accounting of their finances. The lenders say they’re not about to comply with that.

Any microfinance institution which so easily angers and refuses to cooperate with local religious institutions is walking on very dangerous ground. If western do-gooders want to support microfinance lenders, they should simply donate their money to grassroots organizations in the developing world. If they want to make a profit, they should stick to more conventional investments.

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Comments
25 comments so far

“everybody loves to think they’re investing in the next Grameen”

for values of “everybody” not including anybody who wants to get their money back?

Posted by dsquared | Report as abusive

Felix, many of the chief institutional investors in microfinance are well aware of the problem and take steps to deal with it. Note the “donors and investors” section in the list of signatories to the Campaign for Consumer Protection in Microfinance at the link below.
http://www.centerforfinancialinclusion.o rg/Page.aspx?pid=1621. See also pp 6-7 on overindebtedness in the Client Protection Questionnaire for MFIs
http://www.centerforfinancialinclusion.o rg/Document.Doc?id=606

Felix, great post – thanks for explaining this. I’ve been looking at microfinance for a while as a potential do-well-by-doing-good investment opportunity, and am glad to have such a cogent explanation of why I should rather simply do good without expecting to do well.

At the same time, I’m more worried now about the exploitive motives of top-down microfinanciers.

Perhaps the Fed should also be made responsible for this, since they’ve done such a great job of protecting the US consumer from the securitized mortgage bubble…

Posted by Eric Dewey | Report as abusive

Felix, many of the principal institutional investors in microfinance are well aware of the problem. See the “donors and investors” section of the list of signatories to the Campaign for Consumer Protection in Microfinance at http://www.centerforfinancialinclusion.o rg/Page.aspx?pid=1621 See also pp 6-7 on overindebtedness in the Campaign\’s Client Protection Questionnaire at http://www.centerforfinancialinclusion.o rg/Document.Doc?id=606

Why do you jump straight from loans to grants instead of equity?

Felix–

How do you feel about a non-profit microlender like Kiva? I’ve been giving interest-free loans through them for a while, they give me regular updates on the borrowers, and it feels good. Is there a dark side to this I was unaware of?

Posted by Sam Browning | Report as abusive

Sam, I’d just urge you to look at the FX risk your borrowers are taking. If they’re in USD countries, not a problem. But what happens if their currency devalues sharply?

Posted by Felix Salmon | Report as abusive

Matt, equity is even worse than loans, because it dividends even more money out of the poor country.

Posted by Felix Salmon | Report as abusive

Apologies for bad link in comment about the Campaign for Client Protection in Microfinance above. The Campaign’s Client Protection Questionnaire, a self-assessment tool for microfinance orgs, requires signup, here. http://www.centerforfinancialinclusion.o rg/Page.aspx?pid=1714
The questionnaire includes ten criteria for preventing client overindebtedness. A sampling:

o Management is aware of the potential for over-lending, regularly obtains information on client over indebtedness, and is responding appropriately to risks.
o Management regularly monitors product performance, lending sales practices, approval procedures, and incentive programs to reduce the risk of over-selling and mis-selling and adjusts operations and training programs accordingly.
o The loan approval process requires borrower repayment capacity and loan affordability to be assessed. The loan approval process does not rely solely on guarantees (whether peer guarantees, co-signers or collateral) as a substitute for sound risk management.
o Credit approval policies give decision makers explicit guidance regarding borrower debt thresholds and acceptable levels of debt from other sources
o The credit decision making procedure and supervision function promote sales force or loan officer accountability for the quality of the loan.

Felix,

That’s an excellent point about an operation like Kiva with which I keep a few hundred dollars in circulation.

I’m not concerned about losing any money via Kiva but your comment has sparked a concern Kiva should address.

I think I would prefer to have the money I loan converted into the local currency at the time of the loan so that if I lend $25 US and that converts at the time of the loan to 100 Grouchos that Kiva lenders understand that the recipient of the loan will repay 100 Grouchos. If that only converts back to $20 US at the finish of the loan that would be my burden (such as it is).

Posted by HeavyG | Report as abusive

Yes, the WSJ story is just the tip of an iceberg. The whole sector is trembling and in 3 months RBI will have a big crisis to handle. Ironically, 10 years after fly-by-night operators who collected deposits and vanished, we have here the poor people who have learnt the trick to collectively default on their payments, instead of committing suicides individually like farmers. Fine, let them also get a chance! Never in the human history did the poor get to have the cake and eat it too. At least this time it may come true. Risky investments should have the buffer to withstand or vanish.

Posted by Narsing | Report as abusive

I did a little more research into Kiva, and it seems the currency risk is borne by the field partners (not the borrowers)in each country, and the field partners can limit their exposure through a stop-loss option. I found this in the Kiva field partner info:

Foreign Exchange Hedging Cost
This cost varies from country to country – all Kiva’s loans are in U.S. dollars. However, Kiva offers its MFI partners the ability to “stop-loss” their foreign currency risk. If an MFI chooses to enable currency exchange loss, it will not have to suffer the full impact of a revaluation of the $USD above a certain threshold. If the feature is chosen by the MFI, its foreign exchange loss is limited to a 20% revaluation of the $USD relative to the local currency. This means that the MFI partner would not have to repay more than an extra 20% in local currency relative to the amount disbursed, regardless of how severely the $USD revalues relative to the local currency. Any foreign exchange losses above the “stop-loss” threshold would be borne by Kiva lenders.

This would be similar to HeavyG’s proposal where the lenders would bear the currency risk (although not all of it). I wonder how many of the MFIs choose the stop-loss option. If they don’t, I would rather just donate to the MFIs directly.

Posted by Sam Browning | Report as abusive

Note that Kiva doesn’t say how much the stop-loss option costs, and pockets all the proceeds from selling those options for itself.

Posted by Felix Salmon | Report as abusive

Kiva responds on twitter -
@Kiva : @jyandziak He’s wrong. The stop-loss option is free for partners – no proceeds to pocket. Losses above 20% are passed to lenders.

Everyone is responsible for the crisis. Govts. and regulators’ incompetencies continue to create and perpetuate poverty. Banks are making a ton of money lending to MFIs, but are not doing any real assessment, control or coordination of the way their funds are applied, often by multiple MFIs in the same market. Equity investors are in it for the growth story. There are few real social investors – after all, social investing means that you trade in financial returns for social returns, but most of the so-called social investors are still looking for commercial returns. MFIs are in it for the bucks – they think their balance sheets will be stronger, and of course its money in their pockets.

But where to invest all this excess cash? A socially motivated MFI, looking to benefit the poor, will be more concerned to address underserved, tough to reach markets. But there is a high correlation between eagerness to get commercial capital and lessened emphasis on social mission – under the gun to deliver ‘performance’, these are the folks who address the easiest markets, which is urban, or rural cannibalization where someone else already has a presence, since that makes service introduction easier.

And that leads to multiple lending.

Posted by Bala K | Report as abusive

Hi Felix et al,

Appreciate the article and the thread.
Felix, one question – how do you propose to satisfy the need i.e. Assuming we accept CGAP’s estimate that the need for credit is c. $300bn and this is only c.15% satisfied, then we’re a few bucks short … how do you propose to fill the gap? It’s not going to come from savings or charity – well at least not within the next generation or two … any ideas? other than the e.g. Oikocredit “blended value” investment model?

Posted by paul | Report as abusive

You asshole this is a very misleading title. The problem lies with the investor only. When a grassroot MFI asks for funds these PE’s say they want only commercial MFI’s since governence and operationaly these MFI’s are not sustainable. Then how are you going to help grassroot MFI’s grow. How many investors are there who will invest in these kind of MFI’s. The socialy motivated Funders are too less in numbers and the funds they have also is very less when you compare the demand.

Posted by Jack | Report as abusive

Could someone please explain how lending at usurious rates to the pooresof the poor is “doing good”.

This isn’t charity, it’s business and we should stop treating MF as if it’s anything else…

Posted by nic | Report as abusive

This is where I give as an alternative to going the microfinance route. Though it only operates in the U.S. at this time, this orgs entirely different approach makes sense to me: http://www.modestneeds.org

Posted by Jeff | Report as abusive

Here’s a link to the extensive blog post that Kiva did addressing this:
http://kivanews.blogspot.com/2009/06/new -kiva-feature-currency-risk.html

Here’s what they decided to do:

1 – Kiva Field Partners will now have the choice to “opt-in” to this feature; they can choose to manage all Foreign Exchange Risk themselves, or – by opting into the Feature – pass on the risk of currency devaluation over 20% to Kiva Lenders.

2 – You can see which loans have opted into the Foreign Exchange feature on the business page on the right side of the page under “About the Loan” in a section called “Currency Risk,” which has three statuses:

* Covered – If the Field Partner has not opted-into currency risk sharing
* Possible – If the Field Partner has opted-into currency risk sharing
* N/A – If the Field Partner does not disburse funds in a local currency (if they disburse U.S. dollars).

3 – Once a Field Partner has opted into this feature, the Foreign Currency Risk will only be shared with Kiva Lenders for new loans. All loans which have already been added to the Kiva site – whether they have already been funded, whether they are still being funded or whether they are yet to receive funding – will not expose you to the risk of losing funds via currency losses. So, you always have the choice to lend to businesses that have a possibility of foreign currency devaluation over and above 20%.

Felix, as someone in the microfinance field, I think this article is pretty misleading since you are oversimplifying several issues and the arguments seem circular.

(1) Foreign exchange risk is rarely borne by borrowers. And even in the instances where borrowers do take loans in USD (primarily in a handful of dollarized Latin American countries), if their country currency devalues there is generally upheaval in the domestic economy that is going to make it impossible to repay the loan, so borrowers will default and investors will lose their investment. This is generally fear since US investors can generally diversify their currency risk.

If this seems worrying, you should *want* microfinance banks to hedge currency exposure (which many do) with the help of orgs like Kiva. It is counterintuitive that you criticize such efforts.

Posted by Nicole | Report as abusive

There has also been much criticism of the high interest rates charged to borrowers. The real average portfolio yield cited by the a sample of 704 microfinance institutions that voluntarily submitted reports to the MicroBanking Bulletin in 2006 was 22.3% annually. However, annual rates charged to clients are higher, as they also include local inflation and the bad debt expenses of the microfinance institution. Microfinance institutions that charge more than 15% above their long-term operating costs should face penalties.

A very interesting blog entry, Felix. I’m in São Paulo at the moment researching my dissertation about the Microcredit industry here in Brazil. As you’ll no doubt be aware, the microcredit industry here, for a number of reasons, is massively underdeveloped despite a huge demand for funds from its sprawling informal sector. Microfinance loans are served mainly by public banks but everything I have read has, until now, convinced me that Brazilians’ demand for credit will only be satisfied with the assistance of the private sector. This will only happen, however, if the government reduces its participation substantially. What are your thoughts on this? There’s clearly not enough money in the public coffers to fulfill the demand for credit, so what is your solution if you believe private investment likely to cause a bubble?

Any ideas on avenues for Brazil-specific research much appreciated from anyone at all. My e-mail address is edward_dot_moore_at_gmail_dot_com.

Posted by Edward Moore | Report as abusive

Felix, interesting blog. I work in microfinance and agree with you that too much growth too fast is a risk with a number of MFIs. Nonetheless, there are many cases where external support, including loans and equity, are the only option for MFIs to work at all.
Grameen didn’t borrow from abroad because it isn’t allowed to; Bengladeshi law does not allow it. It was however permitted to collect savings locally, something which is not permitted in many coutnries. And since microfinance can be quite risky, in many cases I prefer to see the funds of international lenders be put to risk, rather than the savings of local people who have nothing to spare and no way of protecting themselves.

Posted by Jessie | Report as abusive

Investment of PE in MFIs is a must. Otherwise micro-finance industry would never be able to serve 4 billion people at BOP globally. There are number of instances where MFIs became sustainable in a reasonable time frame and started generating profit.

Now at the early days there might be some hick up. But does not justify the urge like “don’t make investment in MFI”.

Posted by AsifurRahman | Report as abusive
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