What should we charge the poor? Ethics in microfinance.

By: Preeti Dhillon

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Microfinance is a popular poverty alleviation tool

The following examines the ethics of a very popular poverty alleviation tool: microfinance. Specifically, it focuses on one area of this umbrella instrument, microcredit, that is, providing small loans ranging from $50-$1000 USD to those who typically cannot access them from other institutions.[i] Microfinance has become a very popular policy tool, especially within the mainstream agenda. The UN declared 2005 the ‘International Year of Microcredit’ and with the 2006 Nobel Peace Prize going to Professor Muhammad Yunus and his brainchild, Grameen Bank, the popularity of microcredit was sealed. Microfinance also is a controversial policy tool, with the quantitative evidence for its efficacy being inconclusive at best, and negative impacts being reported at worst.

Despite the controversy, microcredit continues to prosper. As of December 2010, over two hundred million people were receiving microcredit. Between 1990-2010, microcredit is purported to have helped at least forty-five million people in India rise above the $1.25 a day threshold. The microfinance market grew by nearly 20% in 2012 and is forecast to grow by 15-20% in 2013. Given the high interest rates and over-indebtedness of many clients, it is imperative to change the way microfinance is practiced and conceptualized to avoid a crisis similar to the sub-prime mortgage crisis, but this time affecting the very poor.

There has also been a lot of controversy regarding the increasing commercialization of microfinance institutions (MFIs). The following looks at how not-for-profit microfinance has been practiced and its mixed record of success, before turning to the ethics of this new turn in the practice of microcredit. It then takes one step back and looks at the ethics in theory and practice of not-for-profit microcredit, before exploring other, potentially more ethical, options.  The discussion about the ethics of commercialization, whilst necessary, is also distracting from the wider conversation about ethics in microfinance in general.

What is ‘microfinance’?

The overarching aim of microfinance since its inception in the 1980s is to provide access to credit and other tools, such as insurance and savings, to those who are currently excluded from financial instruments. This generally means the very poor and poor, as defined by the World Bank’s thresholds of living on $1-2 USD per day respectively. A study of thirteen developing countries shows that only 6% of funds usually borrowed by the poor comes from formal sources, with the majority being from informal sources such as friends, merchants and moneylenders. Through microfinance, it is hoped to raise the income and consumption level, specifically of the very poor, in both the short and long terms.

Is microfinance necessary?

The idea came about in a reality of many developing countries having poor credit and savings systems in place. Due to the high fixed costs of administering savings accounts, many banks charge high fees, which then deters the poorest in society from opening accounts due to the lack of return on their small investment. As there is a lack of savings, there also is less capital to provide in loans. The loans administered have high interest rates, sometimes up to 5% a day, which are thus inaccessible to the very poor. One prominently discussed reason for this rate is the cost of contract enforcement and the cost of defaults. This justification has been disputed, since repayment on microcredit has proven to be around 97%. The result is a system of price discrimination regarding interest, with the wealthier being able to borrow cheaply, whilst the poorest are excluded due to having comparatively high interest rates. Microfinance aims to increase equality of access to this tool.

How does microfinance work?

Microcredit is believed to work through a few different channels. Firstly, by providing access to cheap credit, people will invest in expanding or starting their own business. Secondly, by focusing the credit on women, it is likely the welfare of the whole household will increase, as women purportedly spend more of their income on household consumption than men. In addition, lending to women enables their empowerment against the widespread lack of decision-making power. Lastly, there are potential long-term benefits from increased spending on human capital such as health and education, mostly through channeling funds to females.

To mitigate risks of default considering there is little to no collateral involved in microcredit schemes, the tradition has been to engage in joint liability schemes, such that money is lent to a group of individuals and they are all liable for ensuring repayment. This is meant to reduce the moral hazard aspect of repayment, as peer monitoring and the risk of public shaming are thought to be effective in reducing the risk of default. However, these schemes are not being practiced as widely anymore due to doubts of their efficacy and impact on repayment. The new trend is to provide individual liability but encourage groups to form as moral and informational support. Grameen Bank does not practice joint liability, but lends to individuals and requires that they are part of a five-member group to ‘oversee that everyone behaves in a responsible way and none gets into repayment problems’.[ii]

Has microcredit been successful?

A mixed record of success

The most common measurement of success is if the real income/consumption level of  clients has risen. Other measurements include the impact on non-economic indicators such as female empowerment and education and health levels.

Overall, a lot of the evidence suggests that microcredit does help people live a bit better, but it cannot get them out of poverty. In fact, many of the recipients are those who are not even the ‘very poor’ but live just above the poverty threshold. In many cases, microcredit helps to expand businesses where they currently exist but it does not always increase the number of new ones. For instance, in rural Morocco a study by Crépon et al. found that access to credit had no impact on the number of new ventures, but it did significantly increase the expansion rate of existing businesses, though this was restricted to agricultural enterprises. Another study by Karlan and Zinman in the Philippines shows the impact on creating new enterprises to be negligible. There is very convincing evidence that microcredit is failing in its original task of helping individuals to set up businesses, and that the majority of funds are not used for this. It has been estimated that even up to 90% of microloans are used for non-business purposes.

When businesses are formed, the failure rate is very high. Bateman cites research that in Bosnia, after one year the failure rate was close to half. In Tamil Nadu province in India, on average only around 1% of microenterprises were still operating three years after they were established. This failure rate has ramifications such as causing a cycle of indebtedness as clients borrow more in order to try again or to try to salvage their fledgling businesses. In some extreme cases, it has even been linked to increased suicide rates.

Regarding non-economic factors, the record also is unclear. The goal of female empowerment may not be fulfilled, as there are cases where men are often violent as they feel emasculated by not being the main breadwinners anymore. Where there are not tensions this is often because women give up to 90% of their earnings to their husbands to manage. The record on education and health indicators is also mixed.

The mixed record of success is due to a number of factors. One is simply a measurement problem, of quantitative versus qualitative analysis, with the latter providing more success stories than the former. It is also hard to establish how much of an increase in business turnover is due to microfinance, though the increased use of randomized controlled testing is somewhat solving this issue. The failures are also due to market saturation, assumptions of entrepreneurship and low levels of investment. These will not be explored further here, but it is sufficient to say that microfinance has not been the silver bullet for poverty and female oppression that it is regularly advertised to be.

What has changed and why?

Increasing commercialization of microfinance

Since 1992 onwards, there has been an increasing commercialization of microfinance, with many for-profit institutions like Swayam Krishi Sangam (SKS) in India and Banco Compartamos in Mexico popping up. This commercialization has occurred in two main ways: mainstream banks, such as Deutsche Bank and HSBC, have branched into providing microfinance; and not-for-profit microfinance institutions have turned themselves into banks, such as Bolivian BancoSol from PRODEM, and Kenyan NGO K-Rep into K-Rep Bank.  They work in four main ways: they lend directly to clients; they lend to MFIs; create MFI subsidiaries which then do the above two forms of lending (such as SFC in Peru a subsidiary created by Banco de Credito); and securitise funds. Between 1992 and 2003 there were 39 not-for-profit MFIs in 15 countries that became commercial. The move from not-for-profit to for-profit was largely motivated by the desire to increase the capital base by getting injections of funds from private foundations and social investors, thereby being able to help more people by having more funds. The early MFIs were funded by donors and heavily subsidized, and they have since expanded to become more sustainable and less dependent, but a reliance on repayments of loans and small savings accounts leaves little room for expansion to reach more people.

Is this commercialization ethical?

Usurious rates and a lack of commutative justice

There has been much uproar over the for-profit MFIs. Banco Compartamos in Mexico illustrates the issues. Compartamos was set up in 1990 in Mexico, as an NGO turned group money creditor. In 2000, it decided to be for-profit, leading to the bank’s formation in 2006, Banco Compartamos. It is Mexico’s most successful bank, making profits through its high interest rates. In 2005 they were charging 86% per annum, but they have been known to charge over 100%. The average interest rate in Mexico is around 30%. Meanwhile, the bank’s representatives earn bonuses of up to 120% of their salary and most of them are multimillionaires. 9 out of 10 of their clients seek a new loan when they have settled payment on their old one, which they take as a sign of success. Banco Compartamos has come under fire for its high interest rates and the over-indebtedness in which it leaves its clients. Father of microfinance, Muhammad Yunus, has even stated ‘when you discuss microfinance, don’t bring Compartamos into it. Microcredit was created to fight the moneylender, not to become the moneylender’.[iii]

The main arguments against this commercialization are: the high interest rates; the lack of access for those most in need; and the destruction to social capital. Whilst MFIs have always charged relatively high interest rates, those on par with Compartamos are unjustifiable. Even given the fact that investments made by the very poor have a higher rate of return than any other income bracket, the interest rates are not based on the costs of administration and transaction costs, but 23% of the 86% interest that Compartamos charges is pure profit. Secondly, due to the need to appease stakeholders, the commercial MFIs ultimately chase the big returns. Therefore, the areas most in need of access to credit do not necessarily get it, as they are perhaps too high risk and would only provide returns in the long-term. The ‘new wave’ of MFIs also has a negative impact on social capital, that is, the value from relations between people. By abandoning communities and with their preference for the high-return individual lending rather than group lending, they break down the solidarity and trust built up in the communities, both internally and between the community and the MFI, which makes it much harder for new, not-for-profit MFIs to work in those areas.

If we are to assess the ethics of commercialization of microfinance in the same way as not-for-profit microcredit, then the main question is: does it help alleviate poverty? The biggest microfinance provider in India, SKS, serves around 25% of the total microcredit recipients in the country, which was 5.3 million clients in 2009. Their interest rate is 24.55% per annum, which they reduced from 36% when they had their initial public offering. Preliminary research into the short-term impact of their Ultra Poor Program shows they did indeed ‘shift participants away from subsistence livelihoods’[iv]. However, a study of Compartamos’s activities showed that after twenty-six months ‘economic impacts were modest, with increases in business activity but not in profits or household income’[v]. Like not-for-profit microfinance, for-profit MFIs face the same issues of evaluating impact of their work. If the commercial MFIs could be seen to be having a large impact on poverty reduction then would it still be ethically undesirable? Yes.

Whilst the outcome may be ethical, the process itself is not. There is a commutative justice issue, in that the treatment of the individuals or groups in the situation is an unethical situation, there is not a free and fair exchange. Commutative justice occurs where there can be said to be justice in a transaction between two agents, where there is a level of equality and neither party has been unfairly harmed or exploited in any way. Aristotle called this ‘rectificatory justice’, as he was concerned with rectifying the situation, believing the appropriate solution would be compensation to the harmed party. As Argandoña explains, in an uncompetitive microfinance industry the borrowers have little bargaining power, whilst the lenders have a lot, and can thus impose high interest rates and not use the profit for other welfare increasing activities or to provide lower interest loans to some. Moreover, there are often aggressive loan collection practices and issues of over-indebtedness, such that commutative justice is violated. Microfinance is based on a consequentialist approach, that the outcome justifies the means. Unlike the cooperative style of lending, there is not usually an emphasis on autonomy or ownership, but a dependency relationship is created between the lender and borrower. This is a problem not just of for-profit microfinance but microfinance as a whole.

Is not-for-profit microfinance ethical?

Free market ideology permeates microfinance assumptions

The way that most microfinance is practiced is consequentialist in its approach. There are some notable exceptions, such as the Grameen Bank being 75% owned by its clients, but for the most part there is little client ownership. Moreover, as of 2005-6 the average MFI interest rate for both profit and non-profit was 35%, with a range of 17-80%. This average is higher than the SKS bank rate, somewhat undermining the argument of extortionate interest rates from commercial operations. There is evidence from Conroy and Downey that there is actually very little difference between for-profit and not-for-profit MFIs in terms of loan sizes, amounts and interest rates. In fact, they show that not-for-profits appear to have higher financial profitability than for-profits. As we have seen above, not-for-profit MFIs also have a mixed record when it comes to reducing poverty. Lastly, there is a problem of over-indebtedness not just with for-profit microlending but also with not-for-profit, as seen in crises in Bolivia in 1999 and Bosnia and Herzegovina and Morocco in 2008. Given this, why is there uproar over commercial lending practices but not necessarily microfinance as a concept? This is due to the complementarity of microfinance to the given rational-choice capitalist doctrine.

Microfinance emerged at a time when the free market philosophy was beginning to reign, in the late 1970s-early 1980s. By providing a market based solution with little to no government intervention necessary, microfinance was quickly welcomed as a strategy for poverty reduction. The widespread belief in trickle-down economics led policymakers to believe that eventually the poorest will benefit from economic growth, and microfinance seemed to be a useful bottom-up approach to begin to integrate the poor into this growth. There is a widespread assumption that microfinance is ideology free, but it is in line with the mainstream neoliberal doctrine. With its focus on individual entrepreneurship, microfinance puts the onus of development on the poorest individuals themselves, essentially absolving governments of responsibility for any interventions. There is also an underlying assumption that everyone has an entrepreneurial spirit that just needs capital to be unleashed. With these links to the mainstream agenda, and with its main aim essentially being to create more consumers, is it possible for microfinance to be ethical at all?

Fair interest rates

Perhaps the most ethical system would be to have no usury for the poor.

The biggest question in microfinance is thus: what is a fair interest rate to charge the very poor? Yunus suggests it is no more than fifteen percentage points above what it costs to raise the funds to lend, with ten percentage points being even better. However, it is unclear where the justification for this comes from, especially since Yunus also states that credit should be a human right. If his proposition is the case, then perhaps the most ethical system would be to have no usury for the poor. In Judaism and Islam it is already forbidden, with the former then giving free loans to the poor and the latter preferring charity. In Islam, what is known as riba’ is forbidden as it is exploitative of the borrower and it prevents the lender getting involved in other worldly occupations if they have a guaranteed source of income from interest payments. Christian organisations, particularly those with Catholic origins, are also known to have low interest rates and yet still operate fairly efficiently for clients and have high repayment rates. Thus, the justification for high interest rates, or interest rates at all perhaps, does not seem to stand up under further scrutiny.

Fair future

As well as the need for access to credit in the short-term, there also are concerns over sustainability, hence one of the reasons for the move to commercialization in the first place. For this, interest rates would seem to be necessary, or finding alternative sources of funds rather than relying on savings of clients, especially since it is prohibited by law in most countries for MFIs to collect deposits. Perhaps the Kiva model could be useful to rectify the sustainability problem. If we accept that reaching more people with microfinance is a desirable option, then perhaps models like that of organisation Kiva could be a step in the right direction. Kiva allows people worldwide to lend as little as $25 USD to an entrepreneur of their choice. They have a 98.96% repayment rate, and operate on a no-interest basis. Whilst this may go some way to tackle the availability of credit issue, which has led to commercialization, it does not do much for principles such as dignity, with candidates having to market themselves with moving pictures and stories in order to attract attention, reminiscent of child sponsorship organisations. In fact, Kiva does not actually even wait for the donation target to be reached before lending but the MFIs it is connected to give the loans first and then receive money from Kiva later, so it is merely a post-hoc gimmick and potentially a waste of resources to be an intermediary. Moreover, it may not be very sustainable either considering it relies on the goodwill of the public, which can fluctuate depending on local economic circumstances and a myriad of other factors.

Fair ownership

The Grameen model of client ownership could be a way to tackle the commutative justice issues and ensure the recipients are also the decision-makers. The clients own equity and are on the board. This has not only helped in bringing interest rates down (though being able to collect deposits is a large part of this) but also has ensured that it exercises ethics from the means to the ends. However, this then runs the risk of becoming somewhat indistinguishable from the cooperative system of ownership, which calls into question the added value of microfinance in the first place.

Fair rules

The most likely way that microfinance can regain its ethical credentials is to be regulated more closely. This could ensure there is a cap on interest rates, ensure transparency, and protect the clients. This could then satisfy the consequentialist and the intrinsic ethical arguments. For something to be intrinsically ethical means that there is recognition of something having value in itself. In this case, intrinsic ethics would ensure that the clients are protected and that their interests are put ahead of profit making. Kant believed that human beings have an intrinsic worth, namely dignity, due to their ability to reason, and as such are valuable in themselves. There are a number of self-regulation codes of conduct already out there, such as the Consultative Group to Assist the Poor’s guiding principles, and the SMART campaign’s certification and the SEEP initiatives. Maybe more external regulation is needed. Whilst government regulation somewhat goes against the ethos of microfinance, there needs to be some level of enforcement outside of reputational shaming to ensure the myriad of microfinance institutions comply. Just as the consumption smoothing ‘payday loans’ in the UK are being investigated by the Office for Fair Trading, there needs to be some external regulation, as has been starting in Ghana, for microfinance.

Conclusion

Reduce or abolish interest rates, collect deposits, have collective ownership, regulate

Microfinance has a consequentialist rationale, and, especially since its success record is mixed at best, it can be deemed unethical in practice. In theory, if it had the impact it intended to have, then the lack of autonomy and decision-making power of the clients could perhaps be forgiven. Commercialization of microfinance is arguably perhaps the next logical step for an initiative that supplements free-market capitalism, and whilst it too is unethical, it is not that distant from not-for-profit microfinance, which also charges high interest rates and can cause over-indebtedness and dependency. Any discussion of ethics in microfinance needs to look at the concept as a whole rather than just the explicit commercial aspects.

Given that the intended consequence of poverty reduction is an ethical objective, and access to credit is an issue for at least two billion people, then how can microfinance be made more ethical? Interest rates need to be reduced, or even abolished, given the lack of empirical evidence for their justification. Given that sustainability is also an issue however, perhaps the legal restrictions on MFIs collecting deposits could be lifted, which could provide a stable source of funds, according to CGAP. To be ethical intrinsically, ownership of the MFIs could include the client base more, similar to the Grameen Bank. In the meantime, to create some sort of industry standards that are enforced externally rather than relying on self-regulation would be helpful to start a dialogue around the ethics that drive microfinance and prevent a potential sub-prime crisis among the poor.

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