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.