Sunday, January 8, 2012

Ethics & MicroFinance - role of excessive commercialization, Compartomos, SKS & the likes

Not so long ago, Microfinance was considered a fascinating and very positive idea in alleviating poverty. The Noble peace prize to Prof Muhammad Yunus in 2006 was recognition that MF is one of the most humane part of international finance system, perhaps the only humane part. Yunus acknowledges that “lack of access to financial services is one of the main reasons why poverty is perpetuated, making massive and long-term poverty one of the greatest threats of peace”. However, much has changed since then, not only in terms of the performance of MF and its affect in removing poverty but mainly on a plain moral & ethical issue. The questionable role of microfinance in poverty alleviation, the exaggerated claims made in this respect by Yunus (?), the tension that exists between moral standards and economic imperatives in setting up and operating MF institutions (MFIs) and the role and merit of “commercial approach to MF” are the issues that need to be looked into in greater detail. By Commercial approach one means a strategy of setting up and running MFIs in a manner that can cover their full cost, including the cost of equity and be permanently independent of subsidies from development institutions. While Yunus is a strong critic of such an approach, there is a general understanding that lack of financial viability can threaten the very existence of an MFI and that MFIs can’t depend on charity and aid for long run sustenance and if to be scaled up on a broader level. However, what’s worrisome is what Schmidt calls “excessive commercialization” (of MF). Development of MFFor long, western development-aid policy is based on the plausible assumption that poor countries lack capital and that having a better financial system would spur economic growth. The concept of a financial system and its improvement overtime has led to the emergence of MF.
In the initial phase in 1950s, development finance consisted of channelling large amount of capital from western countries to government related development banks in the recipient countries. However the ‘trickle down effect’ in terms of ‘a rising tide would lift all boats’ didn’t work and in fact the inequalities increased.
In 1973, Robert McNamara’s speech in Kenya, as World Bank President, marked the second phase of development finance and the emergence of MF. Capital was no longer only provided in larger amounts to large banks and central agencies but also directly in smaller amounts to the newly identified target groups of the poor and of small enterprises. It required finding “delivery channels” . Since Banks had general interest rate restrictions, they were not suitable to reach poor clients. Instead, novel institutions which were not-for-profit institutions and high ethical standards came up for this purpose but they all had very high cost structure and most of them couldn’t survive for more than a year. The second approach to development finance failed with an ethical lesson- “ it is simply not enough to have good intentions”.
Towards 1990s, a conviction emerged that small scale and very small scale enterprises in the developing countries were the ideal targets and the small NGOs , setup and operated by local people were the ideal organizations. A number of international development agencies took up this idea and sponsored several of these new credit-granting NGOs. There were two types of NGOs – first type are the ones which are concerned about limiting costs and increasing revenue. This implies containing cost by concentrating on credit as the sole service provided and increase revenue by charging higher & possibly cost-covering interest rate of loans. The second type consists of MFIs that provide many kinds of services that poor need, charging lower rate of interest on micro loans and being less stringent with respect to repayments. It is a softer approach. In 1992, a study on the “effiency of credit granting NGOs” covering MFIs of these two types, by Inter-American Development Bank, the report of which was published in 1996 concluded that even though softer MFIs were worse, no MFI would be able to survive & would be permanently dependent on subsidies. Given these findings, there were serious attempts to reduce the cost. J. D. Von Pischke, a leading development finance expert, suggested a goal that the sum of administrative and risk costs of a good MFI should not amount to more than 20% of its loan portfolio. Costs of this magnitude would be low enough to be passed on to their customers, thus allowing MFIs to cover their costs and expand the scope of their activity in accordance with their dual goals of sustainability and increasing outreach.
The second half of the 1990s saw dramatic developments in microfinance due to a series of innovations in credit technology and organizational structure of MFIs and of the types of development projects that served to create new microfinance institutions and programs. The best MFIs were able to reduce their costs to a level of about 20% of their loan portfolios. A few even managed to cover their full costs entirely through current revenues.
Two main “approaches” were followed to achieve this. One is the “institution-building approach”, which considers creating viable institutions that can achieve sound performance as the key issue and a prerequisite for financial and developmental success. The main protagonist of this approach was the German consulting firm International Project Consultant (IPC). The other approach was called the “commercial approach”, mainly associated with ACCION, a United States-based microfinance support organization. But the labels do not mean much since there is hardly any contradiction between the two approaches: financially viable MFIs must also be commercially oriented, and if they are to achieve the commercial success necessary to make a lasting impact, they must have a suitable institutional form. Thus, both qualify to be considered as “commercial approach”.
Towards the end of the last century, the commercial approach had clearly won out over the more traditional well-intentioned but inefficient “softer” ways of doing microfinance. However, it would be a mistake to assume that the views shared by IPC and ACCION were universally accepted. The key figures of many MFIs, including Yunus, as well as many experts working in development-aid institutions or academia, had strong reservations vis-à-vis the new approach, in whose view, trying to achieve profit through development projects was morally reprehensible a priori.
By the middle of the 1990s, the economic and regulatory conditions for financing small and very small enterprises had changed. Most importantly, the upper limits for interest rates that banks could charge their clients had been removed in most countries. In view of the serious efficiency problems that most microfinance NGOs had encountered, microfinance experts started to think that it would be more effective and more efficient to have specialized microfinance banks instead of NGOs for providing microfinance services. The most important advantage of banks would be that they are permitted to take deposits. Another advantage is that formal, licensed banks as specialized providers of microfinance services would be regulated as supervised institutions and for this reason alone could be expected to be more efficient. One way of creating the desired kind of banks is a new type of development finance project called “upgrading”. An upgrading project consists of three steps. The first step is identifying a credit-granting NGO whose founders or current leaders would be willing to make their NGO undergo a profound institutional transformation. As the second step, foreign aid is used to strengthen the NGO and turn it into a good credit –granting institution able to cover its full costs or at least well on its way towards full cost-coverage. The final and decisive step consists of changing the legal status of the NGO into that of a corporation, obtaining a banking license and then starting banking operations within the new legal structure.

However, being a strategic shareholder-or simply an owner – of an MFI requires more than merely putting up equity. A qualified owner must feel responsible for the institution and its success in two dimensions – both a financial and a developmental dimension, and act accordingly.
The time between the late 1990s and the middle of the last decade were the golden years of microfinance. What had started as a domain of well-intentioned but hardly competent amateurs became more and more a domain of professionals. In parallel, microfinance also became more and more effective in financial and developmental terms. Many new MFIs were set up and managed in the spirit of the commercial approach, and a considerable number of them became quite successful in purely financial terms and at the same time started to have a sizable impact. The institutions and the networks of MFIs set up by ACCION and IPC/ProCredit served as models, and their “best practice’ was copied by several imitators. The “new world of microfinance”—to quote from the title of a book edited by ACCION—seemed to show that the commercial approach had scored an all-out victory in the battle of finding the best solution for an important problem in social and economic development. It was part of the apparent success of commercial microfinance that commercially oriented investors and their advisors also started to be interested in microfinance as a new and “interesting asset class (!!)”. This interest was welcome because the loan portfolios of the new MFIs were growing fast at that time. There is also the growing tendency of some genuine MFIs to adopt “excessive commercialization”.
Apparent victory can lay the seeds of defeat. Not only those who had for many years worked in microfinance for the purpose of mitigating development problems noticed that commercial microfinance can be profitable.
The new found ‘commercial approach’ over the past few years, have led to five MFIs undertaking IPOs—three of them located in Asia, one in Africa and one in Mexico.
Let’s first discuss the IPO of the Mexican MFI Compartamos, a case that serves to highlight the ethical dimension of excessive commercialization. Surprisingly, this case study has been kept under wraps and not many are aware of genesis of crises in MFI through this route of excessive commercialization has been before the SKS saga.
The IPO of Compartamos in early 2000s was extremely successful in financial terms. The issue price of Compartamos shares was 13 times higher than their book value, which corresponds to an extremely high price-earnings ratio. Assessed at the offering price, Compartamos was worth about US$1.5 billion, although at that time it was still a rather small institution. Despite the high issue price, the issue was oversubscribed by a factor of 13. After the issue, the price rose once again, by about 50%. Over a period of seven years, between 2000 to, and including 2006, the value of investment had doubled each year. The mere fact that shares in an MFI were sold to a broad range of investors or that the IPO was extremely profitable for the investors have the positive effect of increasing the reputation of microfinance “as an investment opportunity”, making it easier for other MFIs to access the capital market and use it as a source of much-needed equity capital. There is cause for concern, however, over the reason why Compartamos shares became so valuable. In this case, it was the extremely high profits earned over the time span since the conversion from an NGO into a corporation.
The past profits of Compartamos were the result neither of low-operating nor of low-funding costs. Rather, it was its pricing policy which consisted of charging an average interest rate of close to 100% on its loans. There had been an outburst of inflation in Mexico in the late 1990s. When inflation shot up to about 100% Compartamos raised the interest rates on its loans accordingly so that the inflation –adjusted interest rates remained positive. However, very soon the inflation rate in Mexico fell back to its normal level. Nevertheless, Compartamos maintained its high interest rates, which suggests that its interest-rate policy may have been chosen with an eye to the planned IPO. This leads to the conclusion that at least until 2007, the commercial orientation of Compartamos was simply excessive and incompatible with the ethical mandate of microfinance—constituting a major ethical problem.There is another issue. Roughly half the shares were sold to hedge funds in the course of the IPO. Hedge funds are not the kind of shareholders likely to show a strong commitment to social and development-related aims. Transferring power to them by issuing ordinary shares with full voting rights amounted to definitively losing power and renouncing the original developmental aspirations.
Interestingly, though, the general public did not really become aware of the Compartamos IPO and its questionable aspects.
India was a latecomer to microfinance and one reason for this was that government-owned banks and government-related programs had dominated the microfinance scene in India for many years. Therefore private MFIs, and especially those with a commercial orientation, had a very slow start. But once it began, microcredit almost exploded in India. Between 2006 and 2010, the number of borrower-clients of commercially oriented MFIs grew from 8 million to 28 million $, and the volume of outstanding loans grew by a factor of 8.
Two events took place in this part of India in 2010 that led to a situation termed by observers a “major crisis” (Wall Street Journal) and even “the death of microfinance” (Global Post, India). One of these was the IPO by SKS, and the other was a series of about 80 suicides that were linked to repayment problems of microfinance borrowers and the pressure that seems to have been applied by MFIs’ debut-collection agents.
Let’s examine the issue of SKS. Over the Years, the ownership of SKS has changed dramatically. It was mainly owned by its clients until 2003. Then before and after the IPO most of the shares were held by American private-equity companies. Measured by the size of its loan portfolio at the time of the IPO, SKS was about twice as large as Compartamos. Shortly before the IPO, Akula (the founding chairman) and other top managers sold their shares, cashing in substantial profits. On 28 August, 2010, 23% of the SKS shares were issued to the general public, including more institutional investors. In financial terms, the IPO was at least as successful as that of Compartamos. On the basis of the issue price, SKS had a total market value of around US$1.5billion, almost exactly the same as Compartamos at the time of its IPO, and the issue was also 13 times oversubscribed.
There is a legal requirement in India that banks must provide a certain fraction of their loans to low-income borrowers. However, they can meet this requirement if they lend money to microfinance institutions; and that is what most Indian banks do. Therefore, for a long time funding was not a problem for the major MFIs in India despite their enormous growth rates. In the case of SKS, the average annual growth rate of the portfolio was more than 160% during the five years preceding the IPO.
Poor borrowers felt encouraged to take out loans from several MFIs. Multiple borrowing was widespread, leading to clients’ inability to repay their loans. With surging repayment problems, debt-collection practices became increasingly ruthless.
However, even though it is premature to diagnose a general microfinance crisis, as some commentators do, the damage is done. Apart from the fact that it means great hardship for the people directly affected, the general effect of the events in South India is that microfinance has lost almost all its former ethical and political appeal. As Chuck Waterfield, an expert in microfinance puts it, ”we run the risk of the world seeing no difference between microfinance and the moneylenders we set out to displace”. Milford Bateman, a British expert, paraphrases Shakespeare by writing “something is rotten in the state of microfinance” and blames “the international-development community’s preferred model of microfinance, the commercial model” for the current situation. As he sees it, “hidden behind the focus upon extending outreach, was the awkward fact that a MFI’s senior managers were quietly turning the institutional gains into private gains taken out in the form of spectacular salaries, bonuses, dividends and, eventually, windfall profits arising from an IPO.”

In both cases of MFI IPOs, people who may once have created MFIs with the noble intention of making a contribution to development, put the MFIs they had created into the hands of “the capital market.” Apparently they thereby lost control over the MFIs and became unable or unwilling to maintain the developmental orientation they may once have had. More precisely, they put their MFIs into the hands of hedge funds and private equity companies – that is, of investors who presumably are only interested in profit and are indifferent to developmental and social effects and aspirations.

We can thus conslude that while MF continues to be socially, morally and economically valuable undertaking, recent developments have caused a moral crises of MF resulting from the excessive commercialization which should and can be avoided.

India has recently come out with a draft bill on MF which among others proposes to cap the upper rate at which loans can be given, method of recovery of loans from the borrorwers, limit on multiple laons by the borrower and bringing a tighter regime of the regulator on the functioning of MFIs. While it may address some of the ills that have plagued and paralysed the sector, the ripple effect of what happened in Andhra Pradesh, the defiant attitude of some of the MFI (thinking that Government in any case will have to bail them out), reluctance of Banks to pump in further funding into the MF and a slight political bias against MFIs (which, while may be justified in terms of excessive commercialization has the danger of drying out entire MF market and forcing people esp women to turn to money lenders yet again)may continue to pose serious obstacles in restoring a MF market which works for the benefit of the borrowers and yet is commecially vaible. The need for MFI has emerged on account of the failure of the Banking sector to be accessable in every nook and corner of the country and thus forcing poor borrowers to pay that extra differntial and the long term solution is "Financial Inclusion" which will ensure that Loans are available to the poor and needy and the Bank determined interest rates.

ps. I was greatly inspired reading "Ethics in Microfinance" by Reinhard H. Schmidt ("Value & Ethincs for the 21st Century, a BBVA publication) and most of these thoughts flow from him.


  1. Dear Arvind,

    This is an excellent review of the history of the financial access movement world-wide and in India. And, to my mind there is no question that there is much work that is ahead of us if the challenges of financial access are to be fully resolved, including those of high interest rates, rigid product designs, limited product suites, and absence of any kind of cogent financial advice combined with comprehensive customer protection legislation.

    However, I wonder if excessive commercialisation is indeed the cause the crisis and if interest rate caps and putting limits on competition and supply of loans per household the way forward to address the issue in a durable fashion. I want to draw your attention to some data / research that points in a different direction:

    1. In over 250 districts outside Andhra Pradesh (AP), week on week, repayment performance of MFIs continues to be near 100%, including that for the larger MFIs. Clearly there must be factors unique to AP that lead to the dramatic drop of collections in AP and could not be a spontaneous reaction on the part of the borrowers.

    2. Research indicates that MFIs are a miniscule part of the households' debt portfolio even in AP and that while multiple borrowing does exist, it is largely from non-MFI sources, and in either case is a very different phenomenon from excessive leverage or over-borrowing. Perhaps limiting the number of loans per household will result in even higher obligations to money lenders and could exacerbate and not ameliorate the problems of excessive leverage.

    3. To the best of my knowledge no research has found a systematic causal linkage between the suicides in AP (either the most recent post MFIs ones or the earlier ones) or in Vidharbha and formal lenders (whether banks of MFIs) -- it is often failure of the crop or other shocks that have produced the loss of income that is the trigger. There is clearly need for high quality loan product design (including perhaps embedding commodity derivatives within loans) here which will help all farmers deal with these shocks but it does not automatically follow that farmers would have been better off if loans had been denied to them entirely and if lower interest rates would have resulted in a different outcome.

    4. Rangarajan Committee, among other things, points out that the operations costs which main-stream commercial banks incur even while giving loans to SHGs are significantly higher than those of MFIs. Banks are compensated for these by exclusive access to lower cost savings accounts, very low cost refinance from NABARD, reimbursement of group formation costs. From the numbers it even appears to me that if the MFIs were given a similar subsidy they could drop their interest rates by as much as 15% with no change in their profitability. It is therefore not clear that excessive cost recovery on the part of the Indian MFIs is universally the case. It is my understanding that RBI already regulates the larger MFIs vigorously since they fall under the definition of being systemically important and has kept a careful eye on the interest rate question for over a decade now.

    I make these assorted observations not in order to conclude that all is well in the world of financial access or with the current design of the microfinance movement but to suggest that we may need to look elsewhere to address these issues -- in my view there are deeper design challenges that need to be grappled with and not an absence of ethics on the part of some of the MFIs.

    Best regards,


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  3. A very thoughtful and crtically analysed paper, Arvind. You have gone very deep on the subject with concept matched with the real experience of an Administrator and now as in charge of the same subject in the Government in senior position. I wish we have many more like you to think deeply and spend time on this kind of exercise.

    This is not a simple subject to study and deal with in the first place. My reaction to the subject of MF is that the concept of better, cheaper and easier financial access to the poor is a socialist thinking, while the translation of the socialist goal into a reality demands a procedure, process that innately upholds capitalist concept of individual profit.

    The operation of the institution at the grass root level replicates the operation of capitalist institution. The good progress in the beginning as had happened in all capitalist growth meets its downfall when it is not sustainable.

    Concept of growth involves freedom of operation but that freedom needs greater regulation if it to be sustained. It implies for greater application of control on the operation and that depends on stricter rules of operation requiring the individual managers's credibility ( Ethics and discipline is the key role here. Just as the bigger institutions failed under lesser supervision and monitoring due to loss of control at the global level, the micro management too failed similarly for the same reason under the capitalist structure.

    To provide better access of finance to the poor in a country like India and developing countries, in my opinion, an indigenous approach need to be invented to suit the local level of administration, culture and ethics. Improving upon the structure that is not sustainable could prove to be more disastrous by lingering on to a system that actually does not fit well.

    Kind Regards,
    Margaret Gangte

    1. Just a shot in the Dark...but, if we really are so inclined to be socialists, why cant the District Magistrate's Office act as a One Source for microfinancing needs? And if we want to embrace capitalism, then it seems odd to apply its principle only on certain areas of the economy, and carry out Socialist policies like Minimum Support Price in parallel.

      Of course, MF cannot be a sustained profitable venture, as long as the crutch of welfare policies is present.

      The interest charged by MFIs, needs to be in equilibrium with the returns that the borrower can himself accrue from his loan use. In my view, only unrestrained capitalism can bring about this.

      PS : Awesome article!

  4. I am reproducing an email received from Prof Reinhard H Schmidt (in 3 parts)

    Part 1

    Dear Arvind,

    searching for something else in the internet a few days ago, I found your blog from April (or so) 2012, in which you presented a nice account of a paper about ethics and microfinance I have published in a volume edited by BBVA. The paper is a piece of work for which BBVA and the editors of that (very nice) book, which you should be able to download from the BBVA homepage, had asked me after having been aware of my original article in an electronic (Berkeley) journal called „Poverty and Public Policy“ which is also easily freely accessible on the internet.

    I liked your account and regard your rendition as a compliment. In your summary of my paper, which of course draws heavily on my text you focus very much on the development of microfinance over the years. This is an interesting topic in itself, however, there is more in the article than what you report, and this refers to two topics which I consider as more innovative. Let me briefly elaborate:

    1. In the article, I have attempted to put the controversy about the commercial approach to microfinance into the broader context of the philosophical debate concerning the question of what constitutes ethically valuable human conduct in general. In this genuinely philosophical debate, there are two positions. One position is what is called „Gesinnungsethik“ in German (in English ethics of conviction). It states that human conduct can only be regarded as ethically valuable if it (aspires to) implement(s) general principles of good conduct. On a slightly – but only slightly – more operational level, one can say that it calls human conduct ethically valuable if, and only if, it is derived from sound general ethical principles and directly aspires to „do the right thing“. Professional philosophers trace this view back to the very well known and highly influential German philosopher Immanuel Kant. In the field of microfinance, I find it reflected in the views and speeches by Muhammad Yunus and, more broadly, implicitly advanced by several of his followers. Examples are Hulme and Mosley or Woller.
    The competing position is that of the equally eminent German sociologist, economist and philosopher Max Weber (who coined the term ethics of conviction for the view that he does not subscribe to), and it is explained in his book „politics as a profession“ from 1918 or 1919. Weber‘s own position is – to use his term – the „ethics of responsibility“ (in the original German: „Verantwortungsethik“). According to Weber, what ultimately counts for an ethical assessment are not guiding principles and possibly noble intentions (as an economist, I tend to say: inputs) but rather the consequences of human conduct (the outputs): Weber calls conduct ethically valuable if and only if a very careful analysis leads tot he prediction of consequences that can themselves be regarded as ethically valuable, for instance because they reduce human suffering.

  5. Part II

    In my article, I exposed the approach to microfinance that focuses above everything else on the aim of alleviating poverty and avoids bothering too much with the financial viability of microfinance institutions, as represented by Yunus, as a manifestation of the Kantian position. In contrast, the advocates of the (moderate, not excessive) commercial approach are, in my interpretation at least implicitly subscribing to the Weberian ethics of responsibility, since, as they argue, the commercial approach helps more people and has a much stronger impact. As an economist by profession and also as someone who has worked quite a bit on and in microfinance, I concur with the Weberian view – at least to some extent. Yes, it is in my view ethically more important what the consequences of different ways of providing microfinance services are than what is aspired and intended. Therefore, over the years I have not been too fond of Yunus‘ speeches in which he regularly put great emphasis on good intentions, valuable principles etc and hardlyx addressed questions of sustainability concerning his bank.
    However, the cases of Compartamos and to some extent also that of SKS made me reconsider my former very one-sided position in favor of Weber and of the commercial approach. As you, Arvind, have rightly reported, in these cases I find that the commercialization is indeed „excessive“. And more precisely, the IPO and its anticipated consequences have deprived microfinance as practiced by Compartamos and SKS of their ethical appeal and thereby greatly tarnished the formerly excellent reputation of microfinance in general. This leads me to my second point

    2. As I have tried to explain, the ethically questionable developments at some MFIs, notably those mentioned before, are, in my view, evidently consequences of the way in which the IPOs of these two organizations were implemented: In the course of the IPOs important decision rights have been given to hedge funds and private equity firms, the types of investors from whom one could NOT expect that they would care about the developmental, social and ethical aspirations that microfinance used to have. Now comes what I find important: It was indeed predictable that these unpleasant developments would take place – extremely high and indeed usurious interest rates in the case of Compartamos and irresponsible lending and overlending/overborrowing in the case of SKS – once power has been transferred to hedge funds and PE-companies.

  6. Part III

    My first question based on this observation is whether an IPO by necessity leads to a „power transfer“ to purely return-driven investors – aka „the capital market“. In my paper I argue that this does not have to be the case. It can be avoided even if a MFI undertakes an IPO. But achieving this is not easy, and it requires a certain precommittment on the part of those people who shape an existing MFI, that wants to go public in order to raise urgently needed equity, and at the same time want to make sure that „their“ MFI remains committed to developmental and social objectives and ethical aspirations. But what leads to this precommittment? The answer is: a clear orientation to ethical principles, good intentions and all of those things, which Muhammad Yunus has always (over-) emphasized in hundreds of public speeches. Thus, even though I still prefer the Weberian position of the ethics of responsibility, I now tend to think that a healthy dose of the ethics of convictions is also needed in doing microfinance ina n ethically sound way.

    You were not the only person who read my paper and liked it, or at leaste liked most of it. Some time ago, I also made a presentation of it at a conference in Paris. At this conference the editor of a reputable French finance journal was present. He encouraged me to write a new and thoroughly updated version for publication in French in his „Revue d’économie financière. With some delay, I now followed up on his invitation. Thus there is now a new complete version, and you or readers of your blog might be interested in it. Therefore, I attach a copy of the manuscript (in English).

    Kind regards

    Prof. Dr. Dr. h.c. Reinhard H. Schmidt

    House of Finance Stiftungsprofessur für Finance and Accounting
    House of Finance | Goethe-Universität Frankfurt | Grüneburgplatz 1

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