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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.