The Crisis in Microfinance—Posner

On October 29, 2006, shortly after the award of the Nobel Peace Prize to Muhammad Yunus and his Grameen Bank of Bangladesh, Becker and I blogged about microfinance, which Yunus and his bank had pioneered. The term “microfinance” (or “microlending”) refers to the making of tiny loans to small farmers, shopkeepers, artisans, and other minute commercial enterprises in underdeveloped countries such as India and Bangladesh at high interest rates—sometimes as high as 20 percent a day. In my blog posting, I called microfinance a worthy experiment,  superior to philanthropy because the high interest rates that the microfinanciers charge should induce self-selection by the borrowers: a borrower has to have confidence in the project for which he is seeking microcredit in order to be willing to assume the burden of servicing his debt. But I sounded a skeptical note. I said that the “success [of microfinance] has yet to be demonstrated despite glowing appraisals by Kofi Annan and others. It may simply be the latest development fad…The evidence for the efficacy of microfinance in stimulating production and alleviating poverty is so far anecdotal rather than systematic. The idea of borrowing one's way out of poverty is passing strange. And I am unaware of any historical examples of nations that climbed out of poverty on the backs of small entrepreneurs financed by credit.” I noted that the Grameen Bank had a surprisingly low default rate and pointed out that it “does not have written loan agreements and does not sue defaulters or invoke other legal remedies against them. The natural inference to draw is that the bank is extremely selective in its choice of persons to whom it is willing to lend, and such selectivity, if imitated by other microfinanciers, must greatly limit the scope and impact of microfinance.” I concluded by “suggest[ing], albeit tentatively, that there may be a good deal less to microfinance than its boosters claim.” 

Microfinance has continued to expand since 2006. The number of microloans made in India rose from 10 million in March 2007 to 26.7 million in March 2010. By the end of 2009 total microloans stood at $70 billion, half of them in India and Bangladesh. But a series of suicides by microborrowers in the fall of 2010 in the Indian state of Andhra Pradesh, the site of more than 25 percent of Indian microlending, led to charges that the microlenders, which are commercial rather than eleemosynary enterprises (though, as we’ll see, the Grameen Bank seems to straddle the two types of enteprise), were charging exorbitant interest rates and coercing people into taking out loans they could not afford to repay. Politicians urged borrowers not to repay their microloans; and repayment rates, previously as high as 98 percent, plummeted to 10 to 20 percent. The government of Andhra Pradesh has imposed strict limitations on microlending, and the Reserve Bank of India (India’s central bank) has proposed that similar controls be established throughout India—controls including a ceiling on interest rates and loan amounts and limiting eligibility to borrowers having an income above a specified level. In December 2010 the prime minister of Bangladesh declared that microlenders were “sucking blood from the poor in the name of poverty alleviation” and ordered an investigation of Grameen Bank. Similar reactions to microlending have taken place in Nicaragua, another country that had embraced microlending with enthusiasm. 

And then just a week ago, in a short article in the New York Times entitled “Sacrificing Microcredit for Megaprofits,” www.nytimes.com/2011/01/15/opinion/15yunus.html?_r=2&scp=2&sq=microfinance&st=cse,Yunus himself wrote: “when I began working…on what would eventually be called ‘microcredit,’ one of my goals was to eliminate the presence of loan sharks who grow rich by preying on the poor. In 1983, I founded Grameen Bank to provide small loans that people, especially poor women, could use to bring themselves out of poverty. At that time, I never imagined that one day microcredit would give rise to its own breed of loan sharks. But it has.” He writes that the problem “began around 2005, when many lenders started looking for ways to make a profit on the loans by shifting from their status as nonprofit organizations to commercial enterprises. In 2007, Compartamos, a Mexican bank, became Latin America’s first microcredit bank to go public. And this past August [2010], SKS Microfinance, the largest bank of its kind in India, raised $358 million in an initial public offering.”

It seems rather an odd point for Yunus to make, because the Grameen Bank is itself a stock corporation, not a nonprofit. See www.grameen-info.org/index.php?option=com_content&task=view&id=179&Itemid=145. Yunus says in the Times article that all the bank’s profits are returned to the borrowers in the form of dividends, but if so I don’t understand how the bank attracts equity capital. He contends that his is the best model for microlending, explaining that “commercialization has been a terrible wrong turn for microfinance, and it indicates a worrying ‘mission drift’ in the motivation of those lending to the poor. Poverty should be eradicated, not seen as a money-making opportunity… Instead of creating wholesale funds dedicated to lending money to microfinance institutions, as Bangladesh has done, these commercial organizations raise larger sums in volatile international financial markets, and then transmit financial risks to the poor…Some advocates of commercialization say it’s the only way to attract the money that’s needed to expand the availability of microcredit and to ‘liberate’ the system from dependence on foundations and other charitable donors. But it is possible to harness investment in microcredit—and even make a profit—without working through either charities or global financial markets.” The phrase I’ve italicized is strange, because Yunus claims that his bank does not make a profit, but instead distributes any surplus of income over expenses to the borrowers, and urges that as the model for the microfinance industry.

The recent uproar in microlending puts one in mind of our own controversies over payday lending, title lending (borrowing at high interest rates with one’s car as security), credit-card lending, and subprime mortgage lending—all examples of loans at very high interest rates, made largely to unsophisticated consumers. There is an inconclusive literature on the net social benefits of these forms of credit (sometimes lumped together in the term “fringe banking”). The basic difference between our fringe banking and microfinance is that fringe banking is primarily consumer rather than commercial lending, but the small farmers and shopkeepers who take out microloans probably are even less sophisticated on average than the American customers for fringe banking. Moreover, although what critics of fringe banking call “predatory lending” is not highly regulated in the United States and as a result fraud and other exploitive conduct may well abound, regulatory protections are undoubtedly far weaker in countries like India and Bangladesh. 

Yunus’s mysterious nonprofit-profit model of microfinance cannot attract substantial capital, but commercialized microfinance seems increasingly unlikely to have substantial social benefits—and this with or without regulatory controls designed to protect unsophisticated borrowers. Without the controls, there will undoubtedly be a good deal of fraud, and improvident borrowing without fraud. With the controls, the amount of lending will be curtailed. But with or without controls, the amount of lending will be limited by the very high default rates that can be anticipated unless there is very careful screening of would-be borrowers. Interest rates will remain very high and will strangle many of the businesses that rely on microfinance. Microfinance may turn out to be a niche service, with little overall impact.

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