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Thou Shalt Not Criticize Microfinance

"I'm a dodgy moneylender, exploiting the poor with useless, overpriced loans, ideally obliging their children into forced labor in the process.

This did not go down well. I had been introduced to yet another gathering of bright-eyed microfinance experts at yet another microfinance conference, and I had incorrectly assumed that irony and sarcasm were within their grasp. They were not. I attempted to redeem myself.

"Guys, I'm joking . . . it was a joke. I'm a microfinance consultant, we're all cool . . . sorry.

I had broken the golden rule of microfinance, the unwritten code that bonds its practitioners together. I had criticized microfinance and, perhaps worse, I had implicitly challenged the developmental claims the sector proclaims so vehemently. This is unacceptable from an insider. But none of the experts offered a defense or rebuked my confession. Such comments cut a little too close to the nerve to warrant further conversation. It is usually better to discuss the weather or the palatial dĩcor of the conference rooms instead.

Lack of tact had once again led me into an awkward situation, but it could have been worse. Twice I have narrowly avoided being punched in conferences for daring to suggest that microfinance was in fact falling a little short of miraculous.

There is actually surprisingly little evidence supporting microfinance as a practical tool of poverty reduction, but this rather critical detail is ignored within the microfinance sector for one simple reason. Microfinance does not apparently require evidence to prove it works—since, on the face of it, it seems to work. It works because the poor repay loans, and this is all the proof the sector requires. Some 200 million people now receive microfinance loans,¹ most of whom repay the loans. Therefore they miraculously became better off in the process. So the argument goes.

The majority of credit card holders in the U.S. and Europe pay their bills eventually, so therefore they too are becoming wealthier by the day thanks to Visa, MasterCard, and American Express. The argument is no more complex than this. The fact that a large proportion of these micro-loans are used for consumption, or to repay other loans, or to pay off the evil village moneylender, is irrelevant.

The fact that crippling poverty persists in countries like Bangladesh, India, Nicaragua, Nigeria, and Bolivia is seen as an irrelevant detail. The persistence of poverty means that we need more microfinance. When Indian women started poisoning themselves under the burden and shame of chronic overindebtedness, or when the citizens of an entire country refused to repay their microfinance loans claiming unfair treatment, those who provided the loans remained silent or claimed that it all had nothing to do with them.

Many people do rather well out of microfinance, and celebrities from Bono to the Clintons, President Fox of Mexico, and the Queen of Spain have jumped on the bandwagon. The sector is of course extremely proud of its Nobel Peace Prize–winning godfather, Muhammad Yunus.* Yunus had embarked on a courageous mission to rid the world of poverty using fairly priced microloans to entrepreneurs. Alas, those charged with achieving this globally had a slightly different vision. Even Yunus himself has criticized the microfinance sector for the extortionate interest rates some microfinance institutions (MFIs) charged, accusing such institutions of becoming precisely the loan sharks that microfinance had initially sought to replace. Yunus's flagship institution, Grameen Bank, with whom he shared the Nobel Peace Prize, charges interest rates of about 20 percent²—enough to make any mortgage-holder in the developed world weep, but actually very reasonable in the microfinance world. The fact that Grameen Foundation USA had inadvertently supported and invested in at least one bank that charged rates six or seven times higher has been largely ignored.³

Microfinance is a $70 billion industry, employing tens of thousands of people, predominantly managed by a closed group of funds based in the U.S. and Europe acting as gatekeepers of the private capital available, and increasingly some of the public funding as well. The industry is largely unregulated, opaque, and hard to investigate in practice. A tireless PR machine recruits spokespeople, advertises on television, and holds endless promotional events. An almost cultlike aura surrounds the sector. Insiders are expected to toe the party line. It's to all of our advantage to belong to such an epistemic community with a common set of broadly held beliefs.

The cracks started appearing when Compartamos, a Mexican MFI, did the first big stock market flotation of a supposedly "social bank, netting a tidy $410 million for a handful of lucky investors, financed in large part by ridiculously high interest rates that the poor seemed bizarrely happy to pay. A few maverick academics had been trying to sound the alarm for some years, and some insiders began to question the fundamentals of pumping credit into mostly ineffective "businesses at suspiciously high prices. But as with all nascent bubbles, promoters perpetuated the hype. Compartamos had woken people up to the fact that it was not merely a fringe of the poor who would reliably pay interest rates of 100 percent or more for a loan of $200, but hundreds of millions of them—the profit potential was massive. Forget sub-prime—sub-sub-sub-prime was way better, and what's more, there were few pesky regulators to keep an eye on such inconveniences as consumer protection. A new gold rush began.

The Department for International Development (DFID, the UK equivalent of USAID), a traditional supporter and investor in microfinance, funded a major study of the research surrounding microfinance and concluded that the entire exercise had been mostly ineffective:

[I]t might have been more beneficial to explore alternative interventions that could have better benefitted poor people and/or empowered women. Microfinance activities and finance have absorbed a significant proportion of development resources, both in terms of finances and people. Microfinance activities are highly attractive, not only to the development industry but also to mainstream financial and business interests with little interest in poverty reduction or empowerment of women. . . . There are many other candidate sectors for development activity which may have been relatively disadvantaged by ill-founded enthusiasm for microfinance.

However, it remains unclear under what circumstances, and for whom, microfinance has been and could be of real, rather than imagined, benefit to poor people. . . Indeed there may be something to be said for the idea that this current enthusiasm is built on similar foundations of sand to those on which we suggest the microfinance phenomenon has been based.⁴

While I do not refute the findings of this important report, I equally cannot refute the evidence I have seen with my own eyes: that some microfinance is very beneficial to the poor. I hope to explain how this dichotomy of opinions arises within the microfinance sector.

I stumbled into the microfinance sector in 2002. Initially I shared the naƒ¯ve belief that microfinance was "the next big thing and could genuinely assist the poor. The initial signs looked promising to an untrained eye, and I joined the club in promoting the panacea of microfinance.

The underlying concept of microfinance sounds so seductive. Ask a microfinance expert what microfinance is and they will recount a heartwarming tale of a woman living in a hut in some poor country who gets a minuscule loan to buy a productive asset, often a sewing machine or a goat,⁵ and by working hard she builds up a small business that receives successively larger loans until she is eventually catapulted out of poverty. Depending on the creative flair of the storyteller, the loans may also lead to amazing benefits to her children and community, and phrases like "female empowerment, "human dignity, and "harnessing entrepreneurial flair will be slipped in periodically.

This concept appeals to people in the "developed world, many of whom are increasingly skeptical of simply handing money to traditional charities after apparently so few results of decades of this practice. Helping people to help themselves appears more compatible with the ethos of developed countries: hard work and ambition, competition, and developing new markets. The heroes of the NASDAQ are the pioneers who take a simple idea and propel it to become a huge multinational business—why not in developing countries also, on a smaller scale?

Microfinance touches on the core values of entrepreneurial vision, of teaching a man how to fish rather than handing him a fish on a plate. It appears to be such an excellent idea. Capital is loaned, invested wisely, recycled to the next wave of poor people, investors in Geneva and Washington make a reasonable return in the process, and soon poverty vanishes altogether. It appeals to the positive aspects of capitalism and economic development, and it leverages the positive desire to work hard and provide for one's family. Everyone's a winner. So how dare anyone ever criticize it?

The problems with these crass descriptions of microfinance blurted out at dinner parties by zealous microfinance experts are numerous. Insiders are conditioned to reel them off automatically, but many privately agree they are mostly fantasies. But the fantasy is more palatable than to admit to having negligible impact while charging high interest rates to the poor. We promote an end to poverty if only the poor would take out a never-ending series of overpriced loans.

To cite a selection of the flaws of the romanticized image of the female microfinance client living in the hut with the sewing machine:

1. Such cases are surprisingly hard to find in practice. Men often send their wives to get loans because they know they are more likely to be approved.

2. Loans are almost invariably not spent on the productive sewing machine or goat, but on a TV, repaying another loan to a very similar bank, paying other bills, or general consumption. The benefits of the loan quickly disappear, but the debt remains, accumulating interest at an alarming rate, often encouraging the client to obtain another loan elsewhere to meet the repayments, often from the very moneylenders the microfinance community claims to replace.

3. Interest rates on loans, when all the various hidden charges are considered, are substantially higher than those stated. Interest rates under 30 percent a year are disappointingly rare, and rates of 100 percent or higher are common. One celebrated MFI in Mexico charges up to 195 percent per year.⁶

4. The small business is rarely able to generate sufficiently massive returns over prolonged periods to cover these interest payments. And even if the loan does result in some genuine improvement to the life of the individual entrepreneur, it is quite possible that this is at the expense of other people in the marketplace. When Walmart opens in a town in America, many smaller shops are driven out of business. According to the microfinance sector this phenomenon does not occur in developing countries. We ignore the businesses that fail.

5. The number of people catapulted out of poverty is minimal, and no widespread measurable reduction in overall poverty has been detected. At best, a few individuals see their situations improve, and these lucky few provide the examples for MFI marketing materials. The real debate about actual poverty reduction fluctuates between it being marginal or negative. Serious belief in Muhammad Yunus's suggestion that poverty will be eradicated from the planet and become a historical curiosity in "poverty museums within a generation or two is hard to find in practice.

6. It is assumed that every poor person is a budding Bill Gates. A quick glance at the overwhelming majority of businesses that receive microloans hardly suggests cutting-edge innovation—most market traders sell precisely the same products as everyone else in the marketplace. Not everyone in Europe or the USA is a budding entrepreneur, so why would we expect anything different in developing countries?

7. The use of child labor is a carefully avoided question. The reality is that many families involved in labor-intensive micro-enterprises employ their own children, and no one knows the impact of such labor in the long term. As universal education becomes a reality in more and more countries each year, particularly in Latin America, it is likely that some of these children are stacking shelves or selling cellphone cards at the expense of getting an education. Conveniently, few microfinance banks and only one microfinance fund have policies on child labor.⁷ The self-regulatory watchdogs carefully avoid discussion of child labor in their "Client Protection Principles.

8. Most microfinance clients are not part of the "extreme poor. In fact, quite a few are perhaps best described as lower middle class, and while it is a pity that commercial banks will not lend them money on reasonable terms, it does not follow that an MFI offering them a loan at 60 percent interest per year to buy a TV is necessarily contributing to development.

9. The clients of most MFIs are not generally covered by the regulatory protection afforded to people in more developed countries.

10. When joining groups of borrowers who guarantee one another, one rather unpleasant downside is overlooked for the defaulting client—not only do they incur the wrath of the MFI, which can be quite oppressive, but they also lose their friends, who are obliged to step in and meet the shortfall.

This list of valid questions to challenge the stereotypical microfinance loan is far from exhaustive. In response, the sector is slowly acknowledging that it overhyped microfinance, and that expectations of the imminent eradication of poverty were perhaps optimistic. But the machine has been set in motion. Large commercial banks have entered the sector, lured by the whiff of profit and the appearance of social responsibility. Universities now offer courses in microfinance. There are microfinance MBAs. There are even microfinance T-shirts. (See the appendix, "Microfinance Economics 101, for a quick review, and a critique, of the fundamentals of microfinance theory.)

My concerns about microfinance took a decade to develop and involved extensive travel across the globe, working with many of the key players and seeing microfinance in action (for better or worse) from a variety of perspectives. I drifted into the sector after prematurely finding myself unemployed two weeks after joining the ill-fated Enron. Disillusioned with mainstream finance, microfinance seemed to be an interesting, and perhaps more constructive, way to deploy a finance background. I thus packed my bags and headed to Mexico full of optimism. As cracks began to appear in the overall microfinance model, I initially assumed that they were exceptions, teething problems, or temporary blips. But the cracks did not vanish, and as the sector matured (if that is the right word), the propaganda machine worked overtime to disguise rather than repair them.

There do exist cases where microfinance is genuinely benefitting the poor, but in my experience these are few and far between. Accepted wisdom has come to believe that access to microfinance is a necessary step in the direction of development. We have managed to create a buzz around the very word microfinance that attracts volunteers, the media, and celebrities. Muhammad Yunus goes as far as to suggest that access to microfinance is a human right.

According to the generally accepted belief, the recent financial crisis was caused by reckless bankers designing esoteric and complex financial products, and providing loans to people who perhaps should not have bought a $1 million home in the first place. Entire European nations racked up debts of astronomical proportions. People began defaulting on their loans, governments could no longer service their debts, and the house of cards began to collapse, necessitating the mother of all bailouts that generations to come will have to repay. Meanwhile, MFIs across the developing countries continued to hand out ever more over-priced loans to the poor, and many of the investors in these MFIs managed to get a tax credit for such behavior since these were considered ethical investments.

A few hiccups along the way were covered up, but dissenting voices began to raise concerns. Some simply quit the sector entirely. A few funds closed the doors to further microfinance investments. The first country to spectacularly and publicly collapse was Nicaragua (previous collapses had been less public, such as Bolivia in 1999/2000). This raised some concerns, and cost the microfinance funds in Europe and the USA some painful losses. Never mind—it wasn't their money in the first place, and the collapse was blamed largely on "the populist government. Critical documentaries and books began to emerge, and then scandals involving the darling of the sector, Grameen Bank, finally hit the mainstream press.

With the benefit of hindsight most calamities can be avoided, but to understand the crisis in microfinance, we must look beyond the propaganda. Histories of the microfinance sector do exist, and they are generally pretty dry texts. The public impression that microfinance was invented by Muhammad Yunus in some Bangladeshi village in the 1970s is probably the industry's foundational myth.

During the colonization of Indonesia in the early nineteenth century the Dutch developed a system of financial services across the sprawling colony that bore a striking resemblance to the current microfinance sector. Bank Rakyat Indonesia (BRI) was formally founded in 1895, and to this day BRI is one of the world's largest, if not the largest, microfinance banks.⁸

Wilhelm Raiffeisen founded a credit union in 1864 specifically to provide affordable credit to farmers who otherwise relied on exploitative moneylenders for credit. In Quebec, Alphonse and DorimĬne Desjardins founded a credit union in 1900, a forerunner to the North American credit unions, again in response to high interest rates. Desjardins Group remains active in microfinance to this day. Although many current microfinance operators have limited pedigree, Accion was founded in 1961 and began microfinance operations in Brazil in 1973. ShoreBank International was launched in 1988. It largely depends on how we define microfinance, but it is likely that some form of small lending activities predated even the Raiffeisen model.

Yunus was certainly a pivotal pioneer in the sector. He provided the sector with an iconic figurehead from a poor and downtrodden country. By the end of the twentieth century, microfinance was sandwiched awkwardly between the traditional development sector and the formal financial sector. It was the unwanted child of each. Many development specialists were skeptical of a practice so overtly commercial and capitalistic in nature. Bankers were skeptical of a practice that focused exclusively on poor people without collateral.

Early applications of microfinance beginning in the 1970s had yielded some positive results, and practitioners began to dream of it becoming a key tool in the eradication of poverty. There was certainly some profit to be made from microfinance for those who provided the original capital if the banks could reach a sufficient scale. It would require public acceptance to propel microfinance from the fringes of development and finance to the forefront of the battle against poverty. The microfinance strategy also fit well with a general disillusionment with traditional aid sectors. Unleashing entrepreneurial flair was a more attractive proposal than handing out free food. Bono summarized this succinctly: "Give a man a fish, he'll eat for a day. Give a woman microcredit, she, her husband, her children and her extended family will eat for a lifetime.⁹ The general public was ready for a new approach to development.

Thus after extensive campaigning, the UN declared 2005 as the year of microcredit, and the following year it gained its ambassador. Muhammad Yunus received the Nobel Peace Prize, and microfinance stepped onto the main stage. It was now firmly acknowledged as a principal tool for development. Accelerated growth began, hugely profitable stock market flotations were launched, and microfinance became a household name. Presidents and rock stars opened conferences; specialist investment funds began sprouting up like mushrooms; universities began offering courses in microfinance; and the television messages of the "new cure for poverty were beamed into living rooms across the planet. But by 2011 Muhammad Yunus had been unfairly fired from Grameen Bank under political pressure, the sector was facing widespread criticism in the media, microfinance clients in India were committing suicide by the dozen under the pressure of massive accumulated debt, and the sector was attempting to reinvent itself.

Was Muhammad Yunus's original dream flawed, or had the sector morphed into an entirely different beast that now faced a serious challenge? When did the crisis start?

I realized the magnitude of the crisis permeating the sector in 2009 when I received a call from the managing director of Deutsche Bank asking me to cease my criticisms of microfinance. I had been raising some awkward questions about a particularly questionable microfinance bank in Africa that appeared to be making incredible profits by exploiting the poor with extremely high interest rates. It had attracted some of the largest investors in the entire sector, including Deutsche Bank, many of whom claimed to be ignorant of the MFI's underlying activities.

Senior people in the sector had invested in the African MFI in question, and they were now appealing to me to keep quiet. I had visited this bank extensively, and I had seen the poor women struggling to repay loans costing them over 100 percent per year. It angered me and saddened me that the sector had morphed into little more than yet another means for the rich to exploit the poor. I declined the offer to back down. Some months later the incident landed on the front page of the New York Times, explicitly naming Deutsche Bank, Calvert Foundation, and the darling of the public face of microfinance—Kiva. The article caused a major stir in the sector, yet another blow to the ludicrous hype that had been perpetuated for a decade about the miracle cure for poverty. I played a significant role in getting this article into the New York Times, and I knew that in fact this example was only the tip of the iceberg.

A subtle shift had occurred in the microfinance sector that Mohammad Yunus himself pinpointed perfectly: "I never imagined that one day microcredit would give rise to its own breed of loan sharks.

A key problem in the sector is the distance, not simply physical, between the poor recipients of microloans and those sitting in air-conditioned offices in Europe and the USA running the sector. The words loans and clients are used interchangeably. Most of those directing the capital that drives the microfinance sector have spent limited time actually with the poor. Photos and stories are meager substitutes for meeting and knowing the poor. In our case, and wife and I have spent eight of the last ten years living in developing countries. The staff and clients of MFIs were not mere curiosities to visit on a two-day trip to assess a potential investment in an MFI—they were our neighbors and friends. We attended their weddings, and they ours. We bought stuff from their shops and ate with them. We found that their situations are complex and challenging and not easily resolved with a $100 loan.

I enjoy visiting their small businesses and chatting with them about how their markets operate, the competition they face, their future plans. But I often leave wondering if credit is what they actually need. Some modest training, some advice on managing inventory, or strategic help on how to turn their plans into reality—these may be far more helpful than a $100 loan at 60 percent interest a year, but this kind of assistance is generally not available. Some MFIs offer such support, which I applaud. But I believe that in the sector's quest for relentless growth we have lost sight of the human element at stake: the poor are people. They may deserve access to credit, but they certainly deserve respect and fair treatment.

During my decade in microfinance I worked with countless individual MFIs, the rating agencies, and other transparency initiatives and service providers, including consulting boutiques and IT providers to the microfinance sector. I worked with microfinance funds and peer-to-peer lending platforms that channel money from investors to the MFIs. I worked with large microfinance networks with global operations, spoke in various conferences, and had some modest interaction with public multilateral investors such as the Inter-American Development Bank. I was fortunate to witness the rise and fall from grace of microfinance over this period, from a variety of perspectives.

This period may be best described as the commercialization of microfinance sector, when big banks and political ideology infiltrated microfinance to the highest levels. What began as a good idea was gradually hijacked by large investors and a new wave of dot-coms, muddled with media hype. Poverty reduction has been marginal. Some clients have found microfinance more a curse than a blessing, at times driving them to suicide. Most investment funds, acting as the principal intermediaries between those with capital and the MFIs pumping out the loans to the poor, have little idea about microfinance in practice, and are motivated by a perverse set of incentives that benefit neither their own investors nor the poor.

Each time a scandal erupts the microfinance funds are placed in an awkward position. If they admit they knew of the practices but did not challenge them, they seem to have betrayed their very raison d'Ļtre. If they claim they had no idea, they admit that their due diligence is sloppy. They are damned either way. Best to avoid the question altogether.

The average person on the street has been spoon-fed a deliberately naƒ¯ve view of microfinance. Most individuals who have invested in microfinance have little idea how their funds are deployed in reality, and many would be disturbed to find out the truth. They cannot board a flight to Burkina Faso to check whether their $25 investment is being used wisely, so they entrust their money to a fund or a website that offers assurances of incredible impact. They read the website and magazines produced by their chosen intermediary and assume the claims to be true. Little do they know that these institutions are largely unregulated in practice and have a rather different view of microfinance from that presented in their magazines, stuffed full of photos of poor women in action poses, bouncing out of poverty every second of the day thanks to $25 loans.

Meanwhile the poor largely remain poor, even as billions of dollars in interest payments are extracted from their pockets justified by a few isolated but celebrated cases of successful tomato vendors splashed across the promotional materials of the companies leading the sector. An article in Time World summarized it succinctly: "On current evidence, the best estimate of the average impact of microcredit on the poverty of clients is zero.

To highlight the unusual range of opinions, contrast this with the conclusion drawn by two-time Pulitzer-winning New York Times columnist Nicholas Kristof: "Microcredit is undoubtedly the most visible innovation in anti-poverty policy in the last half century.

In my opinion the truth is likely closer to the former than the latter. While the poor are being deceived about the impact an over-priced loan will have on their actual situation, so are many of the well-meaning investors who believe their money is being put to good use. Microfinance can and does work if applied correctly. In practice it largely does not. This is a pity, and a missed opportunity. It was not always like this, and need not be like this. The sector morphed gradually over the last decade into its current state of crisis. I saw this happen from the inside, and this is my story.