Home > Uncategorized > Microfinance is mostly a scam

Microfinance is mostly a scam

October 13, 2015

I might be well behind others on this subject, but I’m trying to catch up. I just finished a book entitled Confessions of a Microfinance Heretic: how microfinance lost its way and betrayed the poor, written by Hugh Sinclair. Published in 2012, it reviews the previous decade or so of microfinance institutions and how there are essentially very few that haven’t become loan sharks for poor people.

The promise of microfinance was this: that poor people are budding entrepreneurs, who simply don’t have access to the capital required to make their dreams come true. Turns out that’s pretty rare in practice, and that 90% of the loans taken out are “consumption loans,” meaning they are used to buy something like a TV or a service, and then some part of the remaining 10% are loans taken out to repay other loans, and so the “investment loans” are down to small single digits.

There’s a success story given in the book of a female Mongolian “head processor,” who takes unused body parts and salvages them, and who borrows money to buy an electric grinder to improve efficiency so she can grind multiple brains per day, and then when that improves her business she buys a freezer so she can buy heads in bulk more cheaply and store them, which improves her business yet again.

It’s a nice story, but of course it means, even in this best case, that the people around her who had previously done what she now does have been pushed out of business. They need to find a new job.

And by the way, the example above happened in Mongolia, which has strict and enforced usury laws, which keeps the loans down to something like 30% annual interest. In other places there are weak laws and little or no enforcement, and the interest rates, if you include fees and tricks, are upwards of 140% (in Nigeria) or even 200% (in Mexico).

Let’s face it, that kind of extortionist interest rate doesn’t anyone. So we come to a basic question: how can that possibly happen under the guise of helping the poor?

The answer is that there’s an inherent conflict of interest between making profitable loans and helping the poor, and greed nearly always wins. Moreover, the feel-good message of helping the poor just seems too good to give up. It’s really sad but also entirely convincing.

The author, Hugh Sinclair, chronicles his efforts to whistle-blow on one particularly egregious microfinance firm in Nigeria, called LAPO, which still seems to exist. He was basically given the job of establishing a better IT system, which means he got to see all the data. I’ve often said, cynically, that companies don’t really want data consultants because those consultants get to see the most embarrassing stuff. Well, in this case the most cynical of readings is true, and Sinclair saw everything and was disgusted by the way LAPO treated its customers, doing stuff like making them put a 20% deposit but charging them on the whole loan, miscalculating their interest rates, using their deposits for further loans, and of course having them sign a form they didn’t understand. Their astronomical interest rates made it impossible for their customers to actually benefit at all.

In fact some of the stuff he uncovered was actually illegal, but it didn’t stop the practices, and even when Sinclair went back to the so-called “microfinance funds” and told them about LAPO, it didn’t stop them from investing, even the one he worked for at the time. Microfinance funds collect money from investors and governments, and their job is due diligence, but they weren’t doing it, nor did they appreciate Sinclair’s attention to that fact, because their investors might get spooked and because the entire house of cards was at risk of falling.

Sinclair also makes a convincing case that regulations and tough regulators are absolutely necessary if we’re going to have widespread loans, and that due diligence is a difficult thing to do from afar but is absolutely required. Not surprisingly, the countries where the most micro-finance occurred are also ones that don’t have such strong regulatory infrastructure (although who does, really?).

The one part of the system that got a lot of credit was, interestingly, the independent credit rating companies, who knew their stuff and refused to be cowed, even through they got paid by their clients, the microfinance funds. That’s nice to hear and is certainly unusual.

At the end of the book Sinclair adds a convincing “Microfinance 101” section that explains how most of the entrepreneurial efforts that the poor are likely to engage in are nothing more than microfinance arms races that do little to help the local economies but do one thing for sure, namely impose a tax on business that is taken out of the local community entirely and distributed back to the rich world in the form of the investors.

Since the book came out, some economists have performed experiments to test microfinance, in the “best case scenario” conditions, i.e. no loan sharking, and they’ve basically found no benefit. Here’s one of them.

My conclusion is that microfinance is a failure in almost all ways, and for almost all people.

Categories: Uncategorized
  1. October 13, 2015 at 7:30 am

    Well, that’s all a bit sad to hear, though the little I’ve read about microfinance in the past did have that ‘pie-in-the-sky,’ too-good-to-be-true feel to it…
    Anyway, thanks for informing me about grinding up brains and unused body parts just as I was about to sit down to my morning coffee and oatmeal. 8-[

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  2. October 13, 2015 at 7:53 am

    Do you include credit unions in “microfinance” ?

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  3. October 13, 2015 at 8:39 am

    Sad but then I suppose not entirely surprising, either. Sigh.

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  4. October 13, 2015 at 9:05 am

    One major problem with microfinance is that your admin costs are really high relative to the loan amounts. So even if your borrowers are a good credit risk (which in practice they’re often not), you’re still going to have to charge a high APR just to break even.

    The reason that microfinance is so popular is that it fits the ideology of neo-liberals who believe that we’re all micro-entrepreneurs who just need a push.

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  5. October 13, 2015 at 9:37 am

    It was a “feel good” story amplified by the media.

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  6. Aaron
    October 13, 2015 at 10:12 am

    Peer reviewed quantitative evidence shows moderate benefits – worth a read for those interested in microfinance’s future direction:

    Banerjee, Abhijit, Dean Karlan, and Jonathan Zinman. 2015. “Six Randomized Evaluations of Microcredit: Introduction and Further Steps.” American Economic Journal: Applied Economics, 7(1): 1-21.

    Abstract

    Causal evidence on microcredit impacts informs theory, practice, and debates about its effectiveness as a development tool. The six randomized evaluations in this volume use a variety of sampling, data collection, experimental design, and econometric strategies to identify causal effects of expanded access to microcredit on borrowers and/or communities. These methods are deployed across an impressive range of locations — six countries on four continents, urban and rural areas — borrower characteristics, loan characteristics, and lender characteristics. Summarizing and interpreting results across studies, we note a consistent pattern of modestly positive, but not transformative, effects. We also discuss directions for future research. (JEL D14, G21, I38, O15, O16, P34, P36)

    The important external validity caveat about partner selection bias for such field experiments is totally reasonable – see this link – but still the above evidence is causal vs anecdotal: http://qje.oxfordjournals.org/content/early/2015/03/17/qje.qjv015.full.pdf

    Site Selection Bias in Program Evaluation
    Hunt Allcott

    “Site selection bias” can occur when the probability that a program is adopted or evaluated is correlated with its impacts. I test for site selection bias in the context of the Opower energy conservation programs, using 111 randomized control trials involving 8.6 million households across the U.S. Predictions based on rich microdata from the first ten replications substantially overstate efficacy in the next 101 sites. Several mechanisms caused this positive selection. For example, utilities in more environmentalist areas are more likely to adopt the program, and their customers are more responsive to the treatment. Also, because utilities initially target treatment at higher-usage consumer subpopulations, efficacy drops as the program is later expanded. The results illustrate how program evaluations can still give systematically biased out-of-sample predictions, even after many replications.

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    • Microblender
      October 13, 2015 at 6:06 pm

      Add universal pre-kindergarten to that list. It would be great if it had a positive return on investment, but it doesn’t. Not to say it shouldn’t be funded but I go ballistic every time I see 3x returns for every tax dollar spent based on studies with no chance of replication…

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  7. mojomogoz
    October 13, 2015 at 12:26 pm

    The criticism are generally fair IMO – microfinance isn’t the wonder thing it was claimed to be. Plus there is always incentive to make extra bucks out of poor people (happens in US and UK too with unwitting institutional support from bad regulatory oversight). Credit often looks bad in isolation however at the broad economy level there is never growth without private debt growth. So debt is good (unless we think that growth is bad). Its probably not so different for poor countries too.

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  8. curmudgeonly troll
    October 14, 2015 at 2:12 pm

    Clearly if ‘head processing’ now uses electrical power and refrigeration, there’s a productivity improvement, less goes to waste, and that’s a development story, no? Seems odd to just write that off.

    Scams should be exposed. Results shouldn’t be overhyped. Seems odd to write the whole thing off as a scam, as opposed to a natural part of development.

    I wonder what history’s verdict is on NY’s Provident Loan Society. Basically a non-profit pawn shop. It was founded to give lower classes access to credit and keep them out of the clutches of loan sharks. Was it a scam, a charity, a successful business, an insignificant footnote? Maybe all of the above. Did it do more harm than good? Really depends on the counterfactual.

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  9. October 14, 2015 at 3:43 pm

    When I was doing my PhD on microfinance in Nicaragua in the late 1990s there was what the writer Jonathan Morduch described as a fight for the soul of microfinance. On one side he reckoned there were the Welfarists, who saw a role for lending to the not-so-poor poor but only as one amongst a holistic range of tools revolving around the idea of social welfare, and at realistic interest rates given virtually all MF institutions were receiving subsidised funds.

    On the other side Morduch proposed that there were what he called Institutionalists, those of a free market bent who saw microfinance as lending to micro-entrepreneurs who were deprived of credit, who saw the main aim of microfinance institutions as becoming self-sustaining as quickly as possible (charging high interests to do so even though their own funds came from Apex funds at subsidised interest rates) and who wanted nothing to do with any social welfare ideas.

    Microfinance was still rare in Nicaragua when I was there but already the practices described above were becoming widespread – eye-wateringly high interest rates so that small informal businesses were only just keeping afloat to make money for the MF institutions, loans overwhelmingly for consumer goods such as TVs which would be seized back illegally if repayments were late, cherry-picking the not-so-poor poor and claiming miraculously high repayment rates; some of you may remember that the ultimate end of this process was a nationwide repayment strike across Nicaragua in which vast numbers of MF clients refused to make their payments.

    MF clients had developed a wide ranger of defensive tactics; taking out loans with numbers of MF institutions to cross-fertlize loans until default (or renegotiation) became inevitable; dropping out in large numbers once one loan was completed and moving around institutions to leverage the best deal – bearing in mind that what was most important to the majority of MF institutions was to be able to maintain that fantastically high repayment rate to keep the donor funds pouring in.

    Oh, and did I say? The Institutionalists won…

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  10. Duncan
    October 16, 2015 at 4:32 pm

    Perhaps the problem isn’t necessarily that providing “access to the capital required to make their dreams come true” is in itself a failure, but that capitalizing them via debt-finance is futile and prone to exploitation. Technically speaking, aren’t there alternative ways of “democratizing capital,” as it were?

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  11. Alina
    October 17, 2015 at 8:07 pm

    Reblogged this on Alina's Blog.

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  1. October 14, 2015 at 8:00 am
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