6 Ethical Concerns in Microfinance: Not as Simple as it Looks

This post was written by Fehmeen Khan, a guest blogger from Microfinance Hub, a website that aims to educate people about the various nuances of microfinance.

Microfinance is a unique credit model that allows capitalism to work in a social context, by creating an optimal mix of profit motivation and social entrepreneurship. This merging of two traditionally-divergent philosophies makes microfinance a delicate balancing act, which increases its vulnerability to criticism on ethical grounds. Here are six ethical questions in microfinance, along with their censures and relevant explanations, that help clarify the intentions of practitioners.

Credit pollution

This occurs when multiple microloans are advanced to individual clients without much consideration of their credit ratings or repayment capacities, because microfinance institutes (MFIs) simply wish to widen their customer base. This behavior is typically driven by intensifying competition in the sector, since a failure to expand or maintain clients will spell failure for the firm. As a result, clients become over-indebted and many defaulters may simply visit the next MFI for a new loan, carrying their debt with them. In the long run, the market may face a repayment crisis, as in Bolivia.

Profit Motivation

Many critics say it is not ‘fair’ to profit from the poor but they fail to realize that interest rates need to be charged to ensure financial sustainability, on account of the less-than-perfect repayment rate (usually 95-98%), overheads, and the high transaction cost of manually extending a large number of small loans to individuals in remote areas. Nevertheless, it is difficult to know the difference between greed and sustainability, as highlighted below.

High Interest Rates

Many MFIs use the above-mentioned justifications  to charge excessive interest on loans, but proponents of the free market economy believe higher rates will attract competition and improve the flow of funds to the poor. Indeed, in the long run, competition will help lower interest rates. However, interest-based income often leads to fat bonuses and paychecks for managers of microfinance providers, and cases like those of Bank Compartamos highlight the severe danger of mismatched financial and social objectives.

Merging business and charity

At the other end of the spectrum lie MFIs that aim to succeed purely as a social business. They employ poor credit control, and as Professor Yunus puts it, ‘credit without discipline is charity’. These firms may forget that being too compassionate will prevent financial sustainability owing to an increasing number of loan delinquencies. Microfinance providers must partner with their client and ensure mutual success, and when borrowers default, their loans should be rescheduled instead of forgiven, or their credit histories should be reset if new loans are sought.

Transparency in pricing

The lack of transparency in pricing is a direct result of high interest rates on micro loans because microfinance providers wish to target as many borrowers are possible, yet profit maximization remains an objective. Hidden transaction fees and sales taxes, complex interest rate representations, and compulsory deposits mean the rate paid by the client is a lot higher than the rate advertised.

Group Lending

In an effort to lower the risk associated with collateral-free microlending, many MFIs practice group lending, which acts as a form of social collateral. This delivers immense advantages in terms of lower costs and cooperation, as a result of which microfinance providers boast high repayment rates, especially among women. This became a moral issue when it was revealed that group borrowing leads to immense peer-pressures that women cannot bear. In other words, the high repayment rates may be a result of the inability of women to bear opposition and disapproval of their group members, and not because they are inherently good entrepreneurs.

Microfinance, like any other social enterprise, has to tackle many gray areas. This context helps us understand the dilemma faced by MFIs on a regular basis, and appreciate the effort put into managing the delicate balance between social good and financial independence.

Microfinance: Neither Miracle Nor Menace

There has been a fair bit of buzz around microfinance and it’s ability to lift individuals and their associated communities out of poverty.  In a nutshell, microfinance is a more recent form of loan with a much smaller line of credit that is extended to individuals or small groups of people in countries where credit is not as easily obtained and/or the borrowers have little in the way of collateral.  Since the idea was pioneered by Mohammad Yunus in Bangladesh, and later developed into the Grameen Bank, it has caught on widely as a form of social business that has potential to empower citizens within poorer nations.

As one of the figurehead leaders in microfinance, Kiva has been instrumental in bringing the concept of microfinance to a wider audience and in helping a number of microfinance institutions (MFIs) to flourish.  Indeed, Mohammad Yunus, through receiving the 2006 Nobel Peace Prize, and Kiva, through influential endorsements, including Bill Clinton and Oprah, have made microfinance the most widely recognized form of social enterprise in use today.

Because of its great success in Bangladesh in empowering women (the primary borrowers) and reducing poverty, microfinance gained a reputation for being a cure-all solution that could lift the world out of poverty.  Since such complicated problems are rarely solved by one simple answer, it was inevitable that all the hype would lead some to become disillusioned, or even to disparage microfinance as an ineffective/exploitative method.   Some recent studies that show marginal improvements in the lives of microfinance recipients lend some fuel to this argument, while other studies seem to show that microfinance can be effective to a certain degree in some environments.

For those of us who can find all of this a little confusing, I find that a new statement released by Kiva, as well as a recent New York Times article, strike about the right tone of neutrality, pointing out that microfinance can never live up to quite the hype that was attributed to it, but remaining firm on the matter that the method is effective in some contexts – and that MFIs are forging important pathways and networks in previously uncharted territory.