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Microfinance is the new subprime

Ryan Hahn's picture

UntitledI don't usually look to Time Magazine for insightful reporting on development issues, so I was a bit surprised when I ran across this recent article on microfinance. Titled "The Big Trouble in Small Loans," the article takes a look at the increasing commercialization of the microfinance industry. According to the article:

Microfinance, once a relative cottage industry championed by antipoverty activists and development wonks, is on the verge of a revoluation, with billions of dollars from big banks, private-equity shops and pension funds pouring in, driving growth of 30% to 40% a year. Financiers are convinced that there's huge money to be made in microfinance.

If a topic makes it into Time Magazine, you know it must be part of the mainstream, no longer a "cottage industry." The article gives examples of commercialization in practice, and then ends on a rather somber note: "Recent history says that when a financial trend gets popular, it gets riskier too. Think subprime mortgages. That may or may not be the case with big banks and microfinance. What is clear is that this pair won't be parting ways anytime soon." What are we to make of this claim that microfinance could be the new subprime?

Time Magazine isn't the only one reporting on this trend. CGAP and the Citi Foundation sponsored a survey of participants in the microfinance industry that was published in March of this year (the cover of this report is pictured). And what risk had grown the most according to the respondents since the last survey was conducted? Competition. Practitioners were particularly concerned about this, although investors seemed more bullish.

I have to say that I share the concerns of the practitioners (and consequently of Time Magazine!) In most markets, greater competition leads to cheaper services and greater differentiation of products. These serve to improve the welfare of poor consumers.

In the case of microfinance, however, it seems to me the problem of limited liability is rearing its ugly head. Poor borrowers generally have little or no collateral, so they usually have little reason to avoid a strategic default. One large exception is when a microfinance institution has a monopoly—this provides a bit of deterrence against default, since the borrower will be denied access to a loan in the future. Once competition ramps up, this form of deterrence loses its force. According to respondents to the CGAP/Citi survey:

[B]orrowers were getting the message about lower standards and had become more delinquent, running up debts to several banks at once. Group guarantees, traditionally the underpinning of individual creditworthiness, were also weakening. Philip Biswas, executive director of the Rural Reconstruction Foundation in Bangladesh, said “the main risk we are currently facing - and it'll be critical in future - is the duplication of different MFIs in the same area with the same borrowers.”

Am I being alarmist, like Time Magazine, or is this a serious problem? What can be done to overcome problems of limited liability? My first thought is credit information sharing facilities between microcredit institutions. Any other thoughts out there in the blogosphere?

Update: I came aross a presentation by CGAP that discusses some of the similarities between the subprime crisis and microfinance.   

Update II: The microfinance=subprime meme seems to be picking up speed. See this article on microfinance in India.

Comments

I think there is a cause for concern regarding the likelihood of micro-borrowers to default. When only borrowing small sums of money there is little incentive to not default if you get strapped for cash and can't make the payments. Even after defaulting the borrower is likely to obtain credit again, albeit for a higher risk premium. I am reminded of payday loan providers in the U.S. The exorbitant interest rates allow them to endure a greater rate of default. The borrowers who do repay the loans are essentially paying for the losses incurred on loans in default, so the lender keeps lending to those with very high risk (borrowers that have defaulted before). This happens even when there are credit reporting agencies.

Submitted by BILL CLARK on
In dealing with a wide number of MFI's (Micro Finance Institutions), we have noted a "c" change in the model. Heretofore, the borrowing was for the purpose of purchasing equipment that would facilitate the making of money and increasing their economic status. Now it is merely the financing of some product that has nothing to do with helping the individual increase their earning power and therefore use the system to finance purchases of consumables and luxuries.

Submitted by Tanvir Uddin on
This is not surprising at all. Call me cynical, but when the World Bank jumped at the idea and the whole world went crazy about microcredit I knew that they were mostly interested in making money out of it. If they were doing it for humanitarian reasons, then they would have created ongoing support programs and pressured to change the political and social contexts of the poor in developing countries. You can't just give a small loan and expect the situation to change over night. In countries like Bangladesh and some African countries, the price of food is rising, there is street violence, unstable governments. How can microcredit facilitate total development under these conditions? I think as with just giving aid - it's not the parting of money that is the difficult thing - it's about approaching developing holistically. And unfortunately, most institutions are not interested in that. Microfinance and microcredit seem like new heart-warming rhetoric.

Submitted by Janice Takyi-Appiah on
Microfinance certainly has an element of subprime credit facility. I have had the personal experience of working in the microfinance sector, and most of the clientele were small scale exporters who were not able to access credit from the traditional commercial banks, mainly because they were not creditworthy having previously defaulted and did not have access to collateral. These facilities were approved but with very high interest rates and with no collateral or collateral that barely covered the facility. The loan duration periods were mostly between 90 days to 6 months and almost always after the customer had displayed a semblance of a good track record for the initial facility, then subsequently they default and since it is not well secured and barely recoverable it is sent to SPV for recovery. From my experience, the nature of these microfinance loans and the clientele involved fell within the subprime loan classification.

Hi Ryan, I just ran across your post and am pleased to see that PSD is thinking about observations and potential lessons from the US subprime crisis on microfinance. You may be interested in the following related commentary from the Global Assets Project at the New America Foundation. Back in April and May, when the CGAP report was released and after a BBL on the topic, I epxressed similar concerns via our blog, The Ladder: http://www.newamerica.net/blog/asset-building/2008/preying-poor-or-filling-niche-lessons-payday-lending-profits-microfinance-4181#comments and http://www.newamerica.net/blog/asset-building/2008/sub-sub-sub-subprime-borrowers-100-million-strong-worldwide-and-growing-3202.

Submitted by Edward Rouse on
Microfinance was seen as an exciting, new and revolutionary approach to aleviating poverty. The high moral sentiments attached to the initiatives obscured the potential outcomes. Indeed in India, for instance, where day to day pressure in the 'untouchables' caste leaves people without the finance to what we would see as essentials, children's school fees and medical bills are often what people turn to microfinance to fund. The assumption that these initiatives are in anyway entrepenuerial is far from always the case people in dire need of funds for survival take this money and when they cannot repay it enter a self destructive cycle. This is apparent in the suicide rates attachted to these loans which is by any estimates in the hundreds of thousands.

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Microfinance is the new subprime | Private Sector Development

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