Microcredit: The Good, the Bad, and the Ugly

For more than twenty years, microcredit has been widely heralded as
the remedy for world poverty. Recent news stories, however, have sullied
microcredit's glowing reputation with reports on scandals, exorbitant
compensation to managers, skyrocketing interest rates, and aggressive
marketing schemes.

Once praised as a universal panacea, microlenders are now being
widely attacked as predatory loan sharks. In December 2010, Sheik Hasina Wazed, the prime minister of Bangladesh and former microcredit advocate, accused microcredit programs of "sucking blood from the poor in the name of poverty alleviation."

What happened?

It turns out there are two very different models of microcredit. As
Muhammad Yunus, winner of the 2006 Nobel Prize, pointed out in his
January 15, 2011 New York Times op-ed,
one type of microcredit program is designed to serve the poor; another
to maximize financial returns to program managers and Wall Street
investors.

The differences raise crucial questions for the future directions of
microfinance. They also help us see where the banking system here in the
United States went off course and how we must restructure it to support prosperous Main Street economies.

Grameen as a Model Community Bank

In 1983 Yunus founded the Grameen Bank, universally cited as the
inspiration and model for the global microcredit movement. His single
purpose was to improve the lives of millions of poor Bangladeshis by
making small loans to poor women to fund income-generating microbusinesses.

The basis for the Grameen Bank's worldwide renown lies in a number of
key characteristics, many of which are not widely understood.

• Grameen staff members facilitate the formation of five-member
  women's credit groups. Each group guarantees the loans taken out by its
  members, allowing the bank to issue the loans without conventional
  collateral.
• Most local branches are self-funded by deposits of their local members in taka, the Bangladesh national currency.
• By serving as a depository for its members, Grameen Bank allows the poor to build their own financial asset base.
• The
  bank extends loans to its members at a maximum interest rate of 20
  percent, a fraction of what many other microlenders charge.
• Operating
  on a cooperative model, profits are redistributed to the Grameen Bank's
  owner-members or are invested in community projects.

These features root the Grameen Bank in the community it serves and
keep money, including interest payments, continuously circulating
locally to facilitate productive local exchange and build real community
wealth.

Microcredit programs seeking to replicate the Grameen model have
spread rapidly across the globe. The feature they most commonly
replicate is lending to poor women organized into groups that guarantee
one another's loans. Few provide their members with depository services
or replicate the Grameen Bank's other defining features, though these
features are central to its commitment to community wealth building.

The Turn to Wall Street

As microlending programs became increasingly focused on repayment
rates and growing the size of their loan portfolios, they looked for new
sources of capital to expand their reach. With encouragement from foreign philanthropists,
many turned to foreign commercial equity investors. Since private
equity conflicts with the nonprofit model, sometime around 2005 many
nonprofit microcredit programs changed their status to for-profit
enterprises and converted their philanthropic nonprofit assets into
private for-profit assets.

One such micro-finance program was Compartamos in Mexico, which in
2007 launched an initial public stock offering. According to a New York Times article,
it charged its borrowers an annual interest rate of near 90 percent,
producing a return on equity of more than 40 percent, nearly three times
the 15 percent average for Mexican commercial banks. This made
Compartamos highly attractive to private equity investors. The public
offering brought in $458 million, of which "private Mexican investors,
including the bank's top executives, pocketed $150 million."

Another example is SKS Microfinance in India, whose initial public
offering in August 2010 raised $358 million from international investors
and yielded its founders stock options worth more than $40 million.

Yunus describes the consequences of such conversions and public sales:

To ensure that the small loans would be profitable for their
shareholders, such banks needed to raise interest rates and engage in
aggressive marketing and loan collection. The kind of empathy that had
once been shown toward borrowers when the lenders were nonprofits
disappeared.

For the groups that turned to Wall Street for financing, the line
between social purpose microcredit and predatory loan sharking began to
disappear, with some programs charging annual interests rates of more
than 100 percent. Programs that had raised philanthropic funding to help
put money into poor communities became vehicles for sucking wealth out
of them to generate financial profits for already wealthy people.

Follow the Money

Apologists argue that so long as the Wall Street-funded microcredit
programs charge interest rates lower than the local money lenders, they
still benefit the poor.

Tara Thiagarajan, Chairperson of Madura Micro Finance, a for-profit
microcredit program in India, followed the money and challenged this
premise in a thoughtful and self-critical blog:

The local moneylender ... may charge a higher interest rate, but being
local will probably spend most of that income in the village supporting
the overall village economy. So potentially, local lending at higher
rates could be more beneficial to the village if the money is in turn
spent in the village, compared to lower rates where the money leaves the
village.

Because foreign private equity investors expect to recover their
investment plus a perpetual flow of profits, the contradictions go even
deeper than what Thiagrarajan outlined.

Say an equity investor in the United States buys shares in a
microcredit program in India. The investor pays for the shares in U.S.
dollars and in turn expects to be paid in U.S. dollars. The microlender,
however, does business in Indian rupees.

The dollars, therefore, are exchanged for rupees in the foreign
exchange market and become part of India's foreign exchange pool, which
funds consumer imports, machinery, foreign scholarships, capital flight,
arms imports, foreign travel, and whatever other uses India may have
for dollars--virtually none of which benefit the poor.

If the microlender meets its profit projections, this creates claims
by the foreign investors on India's foreign exchange reserves
potentially many times the amount of the original investment. To fulfill
this obligation, India must produce goods and service for sale abroad
or sell or mortgage additional assets to foreigners, which creates still
greater claims against future foreign exchange earnings. The community
in which the borrowers reside will be dealing only in rupees, but faces a
similar external drain on its resources to meet the borrowers'
obligations to the lending organization.

Say the microlending supported an increase in village food
production. Rather than improving the diets of the workers who produce
it, however, a portion of their additional production must be sold to
outsiders to generate the rupees to repay their debts.

In return for a short-term inflow of money, both India and the village bind themselves to a long-term outflow of money and real wealth.
It is an insidious dynamic that supports a classic pattern of
colonization and wealth concentration long characteristic of foreign
equity investment and loan funded foreign aid. A small short-term
economic gain can come at a large long-term cost when it is funded with
outside debt or equity.

A Lesson for the Rest of Us

The microcredit experience brings to light a larger principle: the
institutional structure of a financial system determines where money
flows and who benefits. In short, structure determines purpose.

The transformation of microcredit institutions from a model that
serves communities to a model that is "sucking blood from the poor in
the name of poverty alleviation" mirrors a similar transformation of the
U.S. banking system, which occurred through the process of banking
deregulation that began in the United States in 1970s.

Throughout the 1940s, 50s, and 60s the United States had a system of locally owned and strictly regulated community banks,
mutual savings and loans, and credit unions, many of them organized on a
cooperative ownership model much like the Grameen Bank. They were
organized and managed to serve the financial needs of the communities in
which they were located and kept money flowing within the community in
service to community needs.

Banking deregulation over the past 30 years led to a wave of banking
mergers and acquisitions that created too-big-to-fail Wall Street banks
devoted to maximizing financial returns to Wall Street bankers and
financiers. Rather than supporting local wealth creation, the system now
sucks money and real resources out of the community. Both the
microcredit experience and the aftermath of the 2008 Wall Street
financial crash vividly reveal that the values and interests of Wall
Street stand in fundamental opposition to those of Main Street.

Financial institutions can serve communities
in pursuit of a better life for all or they can serve global markets to
maximize financial returns to Wall Street bankers and financiers. They
cannot serve both.

The world does not need more predatory lenders in service to Wall
Street. We all need more local, cooperatively owned community banks on
the model of Grameen.