The Problems With For-Profit Microlending

by: Felix Salmon

After posting about the spat between Muhammad Yunus and Compartamos Wednesday, I found a recent Economist editorial in favor of the Mexican for-profit lender. Since it's one of the more lucid arguments in favor of the for-profit model, it's worth examining it a bit more closely to see where the disagreements are.

The Economist's argument starts off unpromisingly:

Compartamos was born out of the same social concern that inspired Mr Yunus.

This is a dangerous road to go down, because it seems to imply that motivation matters more than incentives. Most observers here agree that there are two ends on the spectrum, with non-profit lenders like Grameen on the left and for-profit loan sharks on the right; the former is Good and the latter is Bad. This is Compartamos's first difficulty: if they're going to convince people that making profits is a good thing, then they have to explain why they're different from the loan sharks, and from only-slightly-more-respectable lenders like Mexico's Banco Azteca. It seems that being "born out of social concern" will make much a difference, especially now it is years after the birth, and there's been a whopping great IPO in the interim. After all, Compartamos is a public company now, with a fiduciary obligation to its shareholders.

The argument continues:

It says its mission has not changed, but it has become convinced that by pursuing profits it will be able to provide financial services to many more poor people far more quickly than it would if it had continued to act as a charity.

I actually buy this. There's no doubt that Compartamos's profits have fueled its growth; it's now by far the biggest of Mexico's microlenders. But then again, why are we comparing Compartamos to other microlenders at all, rather than the arms of much bigger banks which lend to the poor? After all, Banco Azteca is big too, and is living proof that providing financial services to poor people is not in and of itself always a good thing.

The Economist then falls back on an outdated idea of what interest rates are like in developing countries:

By charging an interest rate that generates a profit, the bank can grow fast and provide many more "micro-entrepreneurs" with the finance they need, even at interest rates that by the standards of rich countries seem unacceptably high.

By the standards of rich countries? Mexico is a rich country, a long-standing member of the OECD with an investment-grade credit rating and single-digit interest rates. If a lender in the US were making $450 loans at triple-digit interest rates, it would be declared predatory in the blink of an eye. In Mexico, interest rates are maybe a few points higher than they are in the US: there's no reason why rates of over 100% (the ones used by Compartamos's critics) or 79% (the ones cited by Compartamos itself) are justifiable.

Besides, what about the standards of poor countries? Grameen is based in Bangladesh, which is undeniably a poor country, and has much lower interest rates than Compartamos.

At this point we get the weakest argument of all: that Compartamos has lots of customers, and that "none of these new borrowers was compelled to come to its doors". It's the same argument used by loan sharks and predatory lenders everywhere, and its use by Compartamos and its apologists hints at how weak their case might really be.

The Economist then brings out one of the weirder of Compartamos's arguments. Because Compartamos is so successful, goes the claim, more microlenders are entering the Mexican market. And with the increased competition comes lower interest rates. So big profits are good, because they lead, ultimately to lower profits.

Except one has to wait a very long time: Compartamos itself points to a reduction in interest rates from 115% to 79% over seven years. At this rate, how much longer will we have to wait before rates fall to non-usurious levels? And if your long-term intention is to make less money by offering lower interest rates, why not just do that now? Oh, yes, I forgot: because you're not here to serve borrowers, you're here to serve shareholders.

The Economist also has a very narrow definition of predatory lending:

Profiting from the poor can be wrong, when lending is predatory--when the lender expects that the borrower will be unable to pay the interest or repay the principal.

A poor person comes up to me needing $100 until Friday, when he's getting paid. I give him the $100, in return for his $150 paycheck. Do I expect that the borrower will be unable to pay the loan? No. Am I a predatory lender? Yes.

The Economist does, inadvertently, make one good point about where for-profit entities can play an important role in microfinance:

Since Compartamos started to pursue profit, seven new regulated microfinance providers have begun to compete with it in Mexico, many of them financed by profit-seeking capitalists.

While I'm not a fan of for-profit microlenders like Compartamos, I do think that it's a good idea for microfinance institutions, be they for-profit or non-profit, to fund themselves on the open market. In other words, it's perfectly fine for for-profit banks to lend money on a commercial basis to microfinance institutions, and I have no problem at all with new regulated microfinance providers being financed in this way by profit-seeking capitalists.

Of course, those profit-seeking capitalists will have to provide the money relatively cheaply, since they're themselves competing with any number of development banks and other do-gooders happy to fund microlenders at extremely low rates. Where big banks can be very useful is in providing funding in local currency, rather than in dollars.

The big difference between non-profit and for-profit microlenders is that the non-profit lenders are much more likely to put the interests of their current borrowers first. The for-profit lenders like Compartamos, meanwhile, argue that it's future borrowers who benefit from their model: the people who wouldn't get loans otherwise because growth in the industry would be lower, or the people who will benefit from lower interest rates as competition drives rates down over time.

But using presently non-existent borrowers as an argument for gouging your current customer base seems weak to me. The for-profit microlenders might have turned out to be great institutions, better for their borrowers than the non-profit lenders. But they didn't: they turned out instead, at least in the case of Compartamos, to be mainly fantastic investments for their rich shareholders. Which wasn't really meant to be the point at all.