Travel-Blogue Day 11: Big News

Posted by: Steve Hamm on July 28

In an effort to head off a potential crisis in the fast-expanding micro-finance industry, its leaders are adopting global truth-in-lending standards and creating a system for comparing loan terms offered by competing lenders. To manage the effort, a new self-monitoring organization, MicroFinance Transparency, is being set up as the industry’s policeman. The goal is to prevent companies from taking advantage of poor people with high interest rates and misleading credit offers.

The initiative was announced on July 28 at a micro-credit conference in Bali by Chuck Waterfield, a professor at Columbia University who spearheaded the initiative, and Nobel Peace Prize winner Muhammad Yunus, who launched the micro-credit revolution in Bangladesh 30 years ago with his Grameen Bank. “Micro-finance emerged as a struggle against loan sharks, so we don’t want to see new loan sharks created in the name of micro-credit,” Yunus told me in Dhaka, Bangladesh, a week before the announcement.

A Grameen phone shop

If the industry doesn’t curtail abuses and confusion, it faces the prospect of government crackdowns and donor funds drying up.

Since Yunus pioneered the idea of lending small amounts of money to poor people without demanding collateral, the phenomenon has spread worldwide. These days, thousands of organizations are making loans to tens of millions of borrowers—usually to help them set up or expand small businesses.

But, starting last year with an expose of lending practices in Mexico by BusinessWeek, a steady drumbeat of articles critical of high interest rates charged to poor people have appeared in publications including the New York Times and the Economist. Yunus said he was alarmed by the direction of the industry. “I felt so bad,” he told me. “I made this thing and they came in and abused it. What a way to discredit a whole idea!”

Waterfield, who has been researching and publishing about micro-credit for decades, said he became concerned about the direction of the industry after Mexico’s Compartamos Banco, which had once been a non-profit organization, switched to a profit-seeking enterprise, and then went public early last year. It netted a windfall for its backers and attracting Wall Street money.

There are several sticky issues here. Organizations that seek profits and rich returns for investors have to charge interest rates high enough to produce those yields. Compartamos, for instance, charges more than 100% annually on its typical loans, according to Waterfield’s analysis. In addition, Waterfield says, much of the micro-credit industry markets loans to poorly educated borrowers in ways that are hard to understand and tend to underplay the impact on their family finances. “Organizations that want to make a lot of money can set a very high price that doesn’t look like a high price,” says Waterfield.

Compartamos defends its practices. The bank published a 14-page “Letter to our Peers” in early July explaining why it charges what it does. It argues that it must set high interest rates because its operational costs are high, $152 per client per year on loans that average just $450 dollars. “A plea for lower interest rates is in fact a plea to increase the size of our loans significantly. Doing that can only have two outcomes: the over indebtedness in our clients or moving to a different segment of the market, which amounts to mission drift,” the letter says. The bank argues that it’s better for poor people to have access to credit than not—even if the interest rates are high.

MicroFinance Transparency will collect information from all micro-credit lenders and store it in a database on its Web site (www.mftransparency.org) that’s searchable via the Web by anybody who is interested. All of the loans will be converted into annual percentage rates based on the true cost of the loans. In addition, all of the costs associated with the loan, including any additional fees charged by the lenders, will be rolled into the total. Waterfield says most micro-credit organizations will submit their data, and, for those that don’t, the information will be collected by gathering contracts from their borrowers and crunching the numbers.

These days, most micro-credit organizations market their loans using a monthly interest rate, say 2% to 4%. Sounds reasonable to people used to paying even higher rates to village shylocks, but the lenders don’t spell out to borrowers that these are flat rates—meaning they’re paid on the total loan amount even as the borrower pays down the principle during the year. Yunus’ Grameen Bank operates differently. It charges a 20% annual rate on a declining basis. Each week, when Grameen borrowers make their payments, the principle of their loan and the basis of future interest payments gradually declines. The APR of a Grameen loan is actually about 10% per year.

One of the dangers to the micro-credit industry is that countries may put limits on the amount of interest the organizations can charge borrows. Already, Nicaragua, Ecuador, and South Africa have set ceilings. While that may sound like a reasonable move, if rates are set at unsustainable levels it could smother some legitimate micro-lending activity. There’s truth in what Compartamos says: It’s costly to make and service small loans to poor people. And industry leaders say they need to charge more than a typical bank in a developed nation would charge for a small-business loan. If they can’t charge enough to cover their costs-much less profits, for those that seek them--they won’t be able to stay in business.

By the time the new initiative was announced, more than 15 sizable micro-credit organizations had signed statements endorsing it. The roster included Grameen and BRAC, big Bangladeshi organizations, and SKS Microfinance, a fast-growing outfit in India that’s for-profit. “We’re very supportive of transparent pricing. It’s part of treating your customers fairly,” says Vikram Akula, SKS’ chief executive. SKS already complies with the standards laid out by MicroFinance Transparency. Its rates vary from 24% to 28% on a declining basis, and the APR terms are spelled out on each borrower’s record book. Akula predicts that most microfinance institutions will comply.

Some industry watchers are calling for even more extensive checks and balances. “Transparent pricing should apply to all financial services, not just loans,” says Elizabeth Littlefield, Chief Executive of the Consulting Group to Assist the Poor. “Many poor people are aggressively sold multiple, expensive insurance policies, or are paying excessive fees for remittances.” Still, she says of micro-credit transparency: “We applaud the effort.”

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