Microfinance is the new subprime

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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.


Ryan Hahn

Operations Officer

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