To profit or not to profit (part II)

Imagine if you will, Mother Teresa finding out that Donald Trump was going to take over her hospice and, although promising to continue catering to the dying, things were going to be run a little differently from now on. This gives you some idea of the shockwave that spread through the microfinance world in April of this year when Banco Compartamos of Mexico, a microfinance lender of 17 years' standing, completed its IPO (initial public offering). The IPO was 13 times oversubscribed and reportedly made US dollar millionaires of some board members and senior officers. Accusations of making money off the backs of hard-working poor people flew.

In the entry from 2nd October I gave a short explanation of the non-profit model of microfinance. The for-profit version involves the same mechanics. Short-term, small-sized loans aimed at poor businesspeople with (comparatively high) interest rates applied. Both the for-profit and non-profit models cover administrative and capital costs (staff salaries, cost of funds, infrastructure) out of interest charged so we'll leave that out of the picture. However there are some very fundamental differences. At first glance, running a microfinance institution (MFI in development parlance) as a for-profit means simply that some of the cash generated from interest on loans is taken out of the cycle as profit, instead of being plowed back into further loans, as all of it is in the non-profit version. Is this making money off the backs of poor people?

Consider two MFIs charging the same level of interest to clients, say the roughly 35% per annum that my firm ECLOF Peru charges. The first, the non-profit uses 30% to cover costs and the remaining 5% goes into enlarging the loan pool. The second, the for-profit uses 30% to cover costs and the remaining 5% goes to infrastructure improvements, staff bonuses and shareholder dividends. From the point of view of an individual borrower there's nothing to separate the two institutions. Whichever she pitches up at, they're charging 35% interest.

One might then argue that the earned interest that doesn't go into increasing liquidity at the for-profit has an opportunity cost which is the reduction in possibilities for an incremental few borrowers to finance their businesses. This is true, but then not providing an opportunity to borrow doesn't count as profiteering from the poor. So in principle a for-profit structure in this field may not necessarily be morally wrong. For-profits bring many advantages which non-profits lack, not least of which is much easier access to funds. Even social investors are more likely to place their available dollars where a financial, as well as social, return of some kind is likely. However, there are also some serious disadvantages to the for-profit model. Not least of which is the profit motive itself.

The returns available in the informal economy are considerable. Which is why MFI loan clients are able to pay such hefty levels of interest. Large institutions are prevented from piling in with large sums of money to take advantage of these returns because the barriers to entry are high and scaling up would be logistically problematic to say the least. In addition to which the margins may be significant relative to the investment (i.e. in percentage terms) but in absolute terms we're still talking about small dollar amounts. An interesting example of this is demonstrated by our recycling clients. There's big demand from large manufacturers for scrap metal, which is abundant in the poor areas around Lima. The same goes for used plastic, cardboard, cans and so on. However there's no systematised collection mechanism. The manufacturers will pay a decent rate for this material, enough to incentivise locals to start businesses and make good money by paying local residents for their scrap and selling it back to the manufacturers. However those manufacturers could never do this for themselves. Having to take on employees, pay benefits, taxes, etc. would likely make them run this part of their business at a loss.

The heads of for-profit MFIs are well aware of this return potential. If the loan clients can therefore absorb higher interest rates, why not charge them? There's clearly a tension between social and commercial objectives here. And even the best-intentioned for-profit MFI head might be at pains to argue the case in the face of agitating shareholders. The current housing situation in several developed countries demonstrates the point. The difference is that intense competition in that arena means that interest rates are set by the market so it's the size of the loans which are being jacked up, with evident consequences. In the microfinance space there's only so much the size of the loans can increase (for now), so the interest rate is the flexible variable.

Banco Compartamos has been skewered on this point from various quarters. Their website is not exactly forthcoming but a report by the Consultative Group to Assist the Poor (CGAP), a kind of industry think-tank, estimates that Compartamos has been charging its clients 100% interest, a quarter of which being profit. Rates are generally higher in the Mexican market for various reasons, however on Compartamos' 2006 reported gross loan portfolio of $271 million, the estimated profit would be around $64 million. Is this profiteering from the poor? Is this the way to fix global poverty?

Further reading / Sources:
CGAP Report on the Compartamos IPO (PDF format)
Commentary on the Compartamos IPO by Jonathan Lewis, CEO Microcredit Enterprises (PDF format)
General discussion on the Compartamos IPO
PBS mini documentary on Compartamos (20 mins)
Banco Compartamos