Why Yunus is right about for-profit microfinance
Muhammad Yunus has a heartfelt NYT op-ed railing against for-profit financiers. When he founded Grameen Bank in Bangladesh, he writes, “I never imagined that one day microcredit would give rise to its own breed of loan sharks. But it has.”
Yunus names the obvious names, such as Compartamos in Mexico and SKS in India, which have gone public, providing windfall profits for their founders with little if any benefit for their borrowers.
Yunus calls for stricter government regulation of microfinance entities, saying that their interest rate should be capped at 15 percentage points over their cost of funds. (Grameen manages on a spread of 10 percentage points.)
But Matthew Bishop, on his Philanthrocapitalism blog, pushes back hard against Yunus’s essay, with some rather peculiar arguments. (I’m assuming this is Bishop writing, and not his co-author Michael Green; the posts on the Philanthrocapitalism blog annoyingly don’t have bylines.)
It’s worth taking Bishop’s arguments in order:
For some microfinance providers, like Grameen, the way to keep down the interest rate is to take deposits from clients to fund loans. That is all well and good for Grameen but financial regulations in many countries stop microfinance providers taking deposits and the capital has to come from somewhere else. And, given the limited supply of the sort of philanthropic donations that helped Grameen get started, the only plentiful supply of capital is for-profit investors.
It’s true that it’s much easier to become a lender than to become a fully-fledged deposit-taking bank. If a lender goes bust, only its owners are hurt; if a bank goes bust, either its depositors stand to lose all their money, or else some kind of government insurance scheme takes the hit.
But that’s kinda Yunus’s point: microlenders should be more regulated, and the world of microcredit should not be open to any old loan shark wanting to hide behind a flimsy veil of ostensible social responsibility.
As for those for-profit investors, they come in many forms, and there’s no reason why they need to invest equity. There are lots of people out there willing and able to make relatively low-interest loans to microfinance institutions; those people don’t require an ownership stake or the chance to make millions of dollars when the bank goes public. Microfinance institutions should be owned and run for the benefit of their borrowers and depositors, not by foreign (or even domestic) millionaires.
Banks do need capital as well as loans, but equity isn’t the only form of capital, and philanthrocapitalists looking to support microfinance institutions should be perfectly happy to provide a combination of grants and subordinated debt.
More generally, I’m not at all convinced that for-profit microfinance shops are a consequence of a lack of philanthropic donations: in fact I suspect that it might be the other way around. Given the millions to be made in the microfinance space, entrepreneurs wanting to lend money to the poor are more likely to want investments from the for-profit sector than they are to want grants from philanthropists who will insist that the bank be owned not by its founders but rather by its borrowers. If the world of for-profit microfinance institutions dried up, then maybe all those philanthrocapitalists might be more inclined to simply donate startup capital to non-profit institutions instead.
Of the billion people living in poverty about 150 million currently have access to microfinance, so there is still plenty of unmet pent-up demand. Providers like Compartamos and SKS have grown quickly and therefore helped more people because they have engaged the for-profit capital markets (and as they have grown, they have passed some of the savings from scale efficiencies back to borrowers in lower interest rates). If Mr Yunus has his way, this supply of growth capital will be choked off and hundreds of millions of people will be left waiting for financial inclusion.
This is highly disingenuous, partly for the reasons explained above: we simply don’t know how many people would have access to microfinance in an alternative world where non-profit organizations were the norm.
On top of that, for-profit lenders tend to congregate in dense cities where most of the population already has access to some kind of microfinance institution. In order to provide small loans to the billion people living in poverty, new lenders are going to have to venture out into much more rural areas, where banks can’t easily scale and where the limiting factor is finding qualified loan officers rather than finding sufficient capital. Yes, there’s pent-up demand for small loans. But most of that pent-up demand will not be met by for-profit lenders who can grow much more quickly in banked urban areas.
I’d also like to see some evidence that Compartamos and SKS “have passed some of the savings from scale efficiencies back to borrowers in lower interest rates”. Indeed, according to the CGAP report on Compartamos, the bank grew to its present size partly because of a deliberate decision not to lower interest rates:
When Mexico was hit by heavy devaluation and inflation in 1995, Compartamos, still in a pilot phase of operations, responded by raising its effective annual interest rate above 100 percent, in order to provide real (inflation-adjusted) yields that were sufficient to cover its lending costs. When inflation dropped back to normal levels, the founders and managers deliberated about whether to lower the rates. They had a choice about the matter because they faced little direct competition and were in a near-monopoly position with respect to their clients.
They decided to leave the high charges in place…
Looking at the facts available to us, it is hard to avoid serious questions about whether Compartamos’ interest rate policy and funding decisions gave appropriate weight to its clients’ interests when they conflicted with the financial and other interests of the shareholders.
CGAP’s report makes it clear that Compartamos never reduced its interest rates as a result of scale efficiencies; the only thing which would ever prompt it to lower its rates seems to be competition. Similarly, when SKS reduced its interest rates in October, it was clearly in response to political pressures, rather than a result of any scale efficiencies.
And this, from Bishop’s post, is just plain weird:
Mr Yunus supports the idea that governments should impose caps on the interest rate charged by microlenders. He says this should be no more than 15 percentage points above the cost of raising the funds to lend. In the case of Grameen, he says, that would be an interest rate of 25% – a number that, it would be easy to conclude, is not far off what he thinks would be the right cap on interest rates elsewhere. Yet in countries such as India and Mexico, where interest rates are significantly higher, the consequence of a rate cap of anything close to 25% would be a dramatic decline in the number of poor people able to get access to credit.
The proposal that banks’ lending rate be limited to 15 percentage points over their cost of funds is surely simple enough for the US business editor of the Economist to understand. At no point does Yunus ever say or imply that the lending rate be limited to 15 percentage points over Grameen’s cost of funds. Yet somehow that’s what Bishop contrives to understand him to mean.
And in what bizarro world are interest rates in India and Mexico “significantly higher” than they are in Bangladesh? The benchmark central bank interest rate in India is 6.25%; in Mexico it’s 4.5%. In Bangladesh, by contrast, the interbank rate is 15%. Poor borrowers in India and Mexico pay much more in interest than their counterparts in Bangladesh not because interest rates are higher in those countries, but because microlenders in those countries charge much higher spreads over their cost of funds.
There are good reasons to believe that Yunus’s 15% rule of thumb is overly simplistic: Richard Rosenberg points out that many of Grameen’s own favored microfinance institutions lend at much higher spreads than that. But once an institution becomes huge, like Compartamos or SKS, it’s pretty hard to make a case that it needs to charge vastly higher spreads than Grameen.
Grameen bank showed that the poor could be very good credits, and would repay loans even when they carried an enormous interest rate. Bishop himself concedes that Compartamos has a non-performing loan rate below 2%, which means that it clearly doesn’t need to charge enormous interest rates to cover the credit risk on its loans. And there’s no reason to believe that Grameen is vastly more efficient than Compartamos in the way that it does business, or that its all-in cost of funds is significantly lower. Which means that the excess lending rates charged by Compartamos over Grameen are entirely a function of profiteering, and that Yunus is right to criticize them.
Going forwards, I’m hopeful that a lot of the unbanked in poor countries will be reached by m-banking using mobile phones rather than through traditional microfinance institutions. Which is all the more reason to try to ensure that people lending to the poor do so at reasonable interest rates, rather than dividending monster profits back to international financiers who don’t need the money. I’m definitely on Yunus’s side of this debate: it’s pretty hard to be an apologist for millionaires and billionaires seeking to delude themselves that the best way to help the poor is to extract lots of money from them.
Update: David Roodman has a sophisticated, nuanced, and highly-informed view, which — like all his stuff — is well worth reading.