Lima Reconnaissance Trip in May

In May 2007 I hitched a ride with Tom Sanderson, Director of Five Talents UK (FT UK), Craig Cole, Executive Director of Five Talents International (FTI), Helga Buck and Kelli Ross of FTI and David Fletcher, board member of FT UK, to Lima. For them it was an opportunity to visit the project they are funding in one of the southern poor districts of Lima called San Juan de Miraflores. For me it was an opportunity to meet the people I was, at that stage potentially, to work with come July. During the trip David filmed our encounters with clients as well as an interview with the Executive Director of ECLOF Peru, Carlos Venturo, one of the most upstanding citizens of the world you are liable to meet. This is the fruit of those labours.

The Word of the Day: Opportunity

It's impressive how much introspection, if not outright criticism, is going on in microfinance. Not long before I left London, and well after I'd submitted my resignation to Goldman Sachs, I went along to a meeting of the Microfinance Club UK held at the Barclays building in Canary Wharf. The talk was entitled "What's Wrong With Microfinance?" If I was in need of a reality check for my off-to-save-the-world ambitions, here it was in flashing neon lights.

Two gentlemen, who had coincidentally just published a book with the same title, stood forth and pontificated on their views that microfinance is really microcredit, with loans being dispensed but with few other financial services being offered. It promotes debt and often excludes the poorest whom microfinance nominally seeks to help the most. Microfinance isn't the basis for a sound economy. Women (to whom the majority of microloans go) don't create businesses, they work for themselves. [This one drew bemused laughter from the assembled.] Self-employment is just a euphemism for survival. There's too much cash pouring into the arena chasing too few real opportunities for investment. A large section of the population being unbanked doesn't mean there's unmet demand. And so it went. A GS colleague who had similarly just left our esteemed employer to join Five Talents, she on a full time basis, was sitting next to me at the meeting. Was it too late to change our minds, we joked?

So is there any foundation to the accusations? Well three months of exposure to a small corner of microfinance in just one country does not an expert make. However having spoken to quite a few of ECLOF's clients and having perused much of the learned writing of microfinance insiders, both pro and anti, the answer, as ever, lies somewhere in the middle.

Richard Posner exclaims (on the excellent Becker-Posner Blog) that "the idea of borrowing one's way out of poverty is passing strange". Furthermore, he states, "I am unaware of any historical examples of nations that climbed out of poverty on the backs of small entrepreneurs financed by credit". He has a point, but it's unfortunate that he chose to express it so starkly without considering the whole picture. Microfinance is, and should be, the provision of financial services to the poor. That is to say that as well as loans, savings and insurance products should be offered. Many institutions in the field focus on the debt and this is what is drawing much of the criticism. And it is valid. Consumer debt cannot solve the problem on its own.

The crucial goal is to provide opportunities. The poor are not just poor of cash, but generally poor of opportunity, mainly because of the view that providing opportunities to the poor is a money-losing (or at best profit-neutral) proposition. Which for some players it is bound to be mainly because they're not set up for this kind of high-cost, low-margin customer interaction (e.g. my former employer). However this is a profitable (but please, not too profitable) business if done right. Though the providers need to be constantly mindful that the goal is not simply to load up the poor with debt. Microfinance needs to be a means of assisting the poor with all of their financial needs. At times and for certain people the need will be to give them a place to keep their money other than under their mattresses. At different times and for other people the need will be for leverage to enable them to exploit a niche they see in the market. And for all of them the need should be to hold inexpensive insurance such that they aren't starting from scratch if an earthquake fells their home.

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

To profit or not to profit (part I)

After two months here, it's about time I got around to explaining what this microfinance stuff is all about. This is going to require several entries, so bear with me. There are a plethora of models around in the microfinance world so in the interests of ease, here's a stab at classifying them. Perhaps the most contentious division and that which splits the microfinance world in two (not in terms of 50% of assets fall into each camp, more in terms of two very different points of view), is the for-profit vs non-profit model. Each model has its proponents with varying justifications as to why their world view is better. Each model also has a range of incarnations with varying service levels and product offerings. But let's make one aspect clear at the outset: they all charge interest, and they all expect the loan capital to be paid back. Helping the poor microfinance may be, but charity it ain't.

Let's start with the non-profit version. ECLOF Peru, whose offices I work in, are of the non-profit mould. Thus interest is charged on loans, but there is no profit taking out of this interest. All proceeds are used to pay operating costs and whatever is left over is capitalised and used to make further loans. ECLOF International in Geneva is the head office of the ECLOF empire. It is an organisation that was set up after the Second World War to help in the reconstruction of churches bombed by various parties. In 1971, after its primary mission had been completed, it transformed itself into a development organisation. In part due to ECLOF's roots in the Christian faith its view of how to implement microfinance in practice is grounded in values of support, justice and humanity. This means that whilst charging what almost anyone in the developed world would consider at first glance a seriously steep interest rate, when viewed in context the reality is that ECLOF Peru's clients are actually getting a decent bang for their buck.

When people from the impoverished parts of Peru with few assets and no home ownership walk into a Peruvian retail bank (Interbank, Scotiabank, Banco Continental, Banco de Credito) and ask for a loan, they'll politely be told that their financial situation disqualifies them. End of conversation. So the next place to turn to might be a loan shark in the street, happy to lend money to all and sundry at his attractive interest rate of 100% p.a. or higher. Step in the microfinance institutions (MFIs). Even the for-profit types charge far better rates than this. These might range up to 60%. Still high, but more manageable. ECLOF Peru's policy is to charge 2.5% per month. Annual equivalent rate 34.49%.

The story does not end there however. Even in the non-profit space, the range of services provided by the MFIs varies from the warm and cuddly to the cold and distant. A characteristic of the microfinance client base which I had failed to appreciate prior to arriving here is a lack of what in the developed world we take for granted: an understanding of the most basic financial instruments. Many of the people who want to borrow money have never encountered the fine print of a loan agreement. Overdrafts and credit cards, means by which most of us become acquainted with the pleasant minutiae of compound interest are non existent in this segment of Peruvian society, where even holding a bank account is a rare thing indeed.

Thus ECLOF Peru provides financial and business training to all of its loan clients. This takes the form of workshops run by ECLOF Peru's analysts attended by anywhere from five to twenty new clients. This service is free, or the price is included in the interest rate charged on the loan, however you want to view it. On top of this there's a significant amount of hand-holding, particularly with clients taking out their first loan. Reminders are hand delivered a week in advance of a repayment date and analysts are available on the end of a phone or in the office to resolve any problems. No six option automated phone lines here. On the other hand, some of the non-profits simply hand over the cash and say "let's have that back in six months please with 40% annualised interest" and on to the next client. The ECLOF Peru approach of hands-on service yields one very positive financial benefit: default rates across the portfolio of less than 2%. By contrast the biggest microfinance player in Peru (one of the two beasts of the market with a loan pool of $345 million at the end of 2006 versus ECLOF Peru's $2.2 million), Banco del Trabajo, has a write off ratio above 10%.

The effect a default has on a client's borrowing potential at this end of the income spectrum can be devastating. Even an organisation like ECLOF Peru which seeks to help the least enfranchised at the "base of the pyramid" (on oft-used phrase in development circles) has to keep its financial risk wits about it. Lending to individuals with no assets to use as collateral, nor much in the way of income, with a previous black mark, or several, against their name is not going to prove a solid foundation to building a sustainable lending business.

Meeting good people

The organisation I'm working for here in Lima is called ECLOF (Ecumenical Church Loan Fund) Peru. I've been seconded to them by the organisation that hired me in London, Five Talents. ECLOF's set up here includes a central office, where I'll be spending most of my time and three regional offices, one in the northern suburb of Lima, one in the southern and one outside of Lima down near Lake Titicaca (the highest commercially navigable lake in the world, so they tell me). In each of the regional offices, between one and five credit analysts meet clients, provide business training and moral support and of course cash.

I've been spending this week in the two suburbs of Lima, following the credit analysts around as they visit clients. It's been a humbling experience to witness both the work the credit analysts perform day in, day out in uncomfortable conditions, as well as witnessing the habitats of our clients. These run the gamut from those who have the basic necessities of a decent amount of space, four walls with a solid roof, running water and waste disposal services to those who live in shacks to which a stiff wind would pose a problem, to which water has to be brought by tanker (not by the government but by enterprising private individuals) and whose toilets are communal outhouses.

At the end of each day this week, I've been able to come home to my brand new apartment in a quiet area of the swankiest part of town. Those clients are still in their little abodes in the hills around Lima probably somewhat cold as the evenings close in. And the credit analysts also live out in the burbs in (obviously) much better conditions than most of our clients, but probably still in areas that many of us would find difficult to cope with. I've met a few people over the years I've thought were doing virtuous work. These credit analysts rank with the best of them. A lesson in humility.