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Thursday, May 22, 2008

Microfinance and the Rule of Law: From the Coffeehouse to the Credit Bureau

By David Lehr

MicrofinanceLehrA recent Forbes publication, "Microfinance Fights Growing Pains," examined the rapid growth and associated challenges of the microfinance field.

As noted in the article (and thanks to Vital Wave Consulting for highlighting this), the explosion of new entrants and the overall rapid growth of microfinance may be creating an environment ripe for inefficiency or fraud. For example, with little communication between lending agencies, some loan recipients have borrowed multiple times against the same collateral. The Forbes article called for credit bureaus to be established so that lenders can communicate (formally and informally) with each other in order to avoid double or triple lending to dishonest borrowers.

Credit evaluating mechanisms exist throughout the developed world - credit bureaus for loans, better business bureaus for businesses, and even seller ratings for those trading on eBay. These institutions create trust, critical to a well functioning economy, and where the rules and behaviors of doing business are either not codified or not enforced, the economic impact can be severe. In fact, the worst case scenario - which was in full force during a recent work-related trip to Aceh, Indonesia - can bring business to a crawl.Unable to rely on contract laws and enforcement to support their deal-making, entrepreneurs in Aceh instead rely solely on relationships. They deal only with people they know, cutting off future business with anyone that cheats them and relying on reputation (or lack thereof) as the outcome for good or bad behavior. Those in the same line of business must meet almost daily in coffee and tea houses to share breaking news and exchange information on who can be trusted, and on who can't.

Though most of us enjoy a good cup of coffee, the limitation on being able to do business with only those that you know takes time and effort, reduces transparency, and ultimately decreases overall commerce and earnings. This same phenomena of a world without clear rules and laws may also go a long way towards explaining why certain diaspora members have done so well in business no matter where they go.

All food for thought on the challenges microfinance faces as it continues to grow - and a reason to move information exchange on potential clients from the coffeehouse to the credit bureau.

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