Derek Newberry

Is the Microfinance Model Broken?

Provocative, yes, but it has become fashionable to ask this question in other subsections of the financial community – the state of the venture capital industry and more recently, the private equity industry have been heavily and often bitterly debated.

It seems timely to revisit the need for scrutiny in the microfinance industry as it enters the mainstream and to hopefully broaden the debate beyond academic circles and development institutions. CGAP this month published a focus note analyzing the Compartamos IPO, essentially seeking to answer the question of whether the exceptionally high profits Compartamos has earned for its private shareholders can be justified for an organization that is supposed to have the social interests of its clients in mind. CGAP’s answer, while not completely damning, is not a vindication for Compartamos either – they conclude that the NGO could have reasonably charged lower interest rates that would have decreased profits but allowed poor clients to keep more of their earnings.This is an informative case to watch, because it shows that despite all the positive media attention fawning over market-based solutions to social and environmental issues, the ugly reality of trade-offs will eventually become unavoidable. All the feel-good talk in the world praising triple bottom-line initiatives is put in perspective when you realize that as organizations like Compartamos become successful, they have to do the difficult work of stating precisely how they will measure and prioritize social, environmental, and economic returns.

The vision of attracting mainstream investors to the micro-finance or SME finance space is tainted by the fact that there will be a clash of cultures, as TBL values are synthesized with the drivers that move the mainstream financial community. I would praise CGAP for not shying away from this debate and for being willing to bring the ambiguous language of harmonious TBL outcomes down to earth where the profit motives of Compartamos investors (and the much-needed capital that comes along with them) have to be weighed against the social mission of the organization.

I also want to acknowledge the FMO for tackling the deficiencies of microfinance while stepping up and offering a way forward. The Dutch development bank takes a slightly different angle, focusing on the point that in all of the stories about the great benefits of microfinance, we often forget that microentrepreneurs are also subject to many of the same challenges that large companies are facing regarding their environmental and social impact. Environmentally damaging business processes and poor labor practices are by no means limited to the “big bad corporations”.

The solution FMO is proposing is to integrate an environmental and social risk management component into the MFI loan process, similar to but simpler than what is used by many banks when lending to larger clients nowadays. This includes several components such as an activity assessment tool to identify and monitor specific E&S risks for a given micro-entrepreneur, and training sessions to help MFIs utilize these management systems when making new loans. The underlying logic being that just because capital is flowing to underserved clients does not necessarily mean that their environmental impact, for example, will be positive. Still, the answer is not to turn the client away but rather engage them in a constructive manner helping them to improve the TBL aspects of their business model.

This is a win-win proposition that highlights one of the many possible ways to reconcile new TBL solutions like MFI with the values of the mainstream business and financial communities that they hope to become a part of.

So is the MFI model broken? Perhaps not, but if the broad benefits it promises are to become a reality on a large scale, this debate will have to come to the forefront. CGAP and FMO seem to have noted this… any other takers?

UPDATE:? The FMO’s toolkit for micro-finance lenders that I referenced in this post is now available online.