Preying on the Poor or Filling a Niche? Lessons from Payday Lending on Profits in Microfinance

The international microfinance movement - cheered and arguably hyped for its ability to alleviate poverty through access to microcredit - originated based on a social mission to provide financial services such as small loans to the poor and underserved. However, the recent explosion of profit-seeking providers (in some instances, non-profit MFIs going public, such as the now-infamous Compartamos IPO, in other cases, a surge in predatory micro-lenders) has been met with a mix of applause, skepticism and in some cases, disgust. Now, some microfinance leaders are speaking out about the risks industry faces if it loses sight of its social mission, fearing the likelihood of an influx of profit-seeking actors offering credit products that are actually more welfare-harming than welfare-enhancing. My question is: Has anyone else noticed some eerie similarities between these debates over profits from microcredit and the debates within the US over payday lenders?

First, the crux of the current debate in microfinance is over what we could call "ethical" interest rates and hence profits for micro-credit institutions. Mohammad Yunus, winner of the Nobel Peace Prize for his poverty alleviating microcredit model, has "blasted" Mexican MFI Compartamos for charging effective interest rates over 100%. And in a recent Economist article, Poor People, Rich Returns, microfinance expert Chuck Waterfield argues that these rates "little different than what illegal loan sharks demand, and it is deliberately making it difficult for poor borrowers to understand how much they are paying for their loans." Sound familiar? Opponents of payday lending in the United States have argued for years that those who take out such loans typically do not understand them, will unlikely repay within the typical two week repayment deadline, and end up in a debt-trap that pulls them deeper into financial despair and poverty. And to be sure, in the US annual interest rates on some loans (such as those recently "banned" in Ohio) have reached beyond 300% (three times the arguably unjust rates charged by Compartamos). One difference though is that so far the vast majority of the microfinance industry operates under a system that incentives instead of discourages high repayment rates on loans.

Also, there is the common fear of uncontrollable industry growth rates. Today there are thousands more payday lenders and check cashers than there are McDonald's in the US. Similarly we've seen growth in microfinance institutions within just a handful of years from just a few hundred to close to four thousand, according to the microcredit summit report. Some say the increase in predatory "loan sharking" in the US is a product of a breakdown of Federal Usury laws since the 1970s. In microfinance, leaders argue not a breakdown of laws but an explosion of practice where such regulations and protections simply don't yet exist.

Then there are even similarities on the flip-side of this debate. Some argue that clients of both U.S. payday lenders and MFIs are consciously and willingly entering into these arrangements. They counter that the high interest rates are more a reflection of limited supply meeting great demand. Indeed, Compartamos is reaching vast, unmet demand for microcredit in Mexico (60 thousands to 900,000 loans in eight years), and US payday lenders operate where historically banks couldn't be bothered to. This is a valid argument, but does not take into account the information asymmetries, lack of disclosure or understanding of such products that might lead some to make "less rational" decisions than they otherwise might. Finally, both in the US and abroad, it's argued that if you take away the very limited financing options available to these individuals (an unregulated MFI in a remote area or a check casher in an impoverished neighborhood, let's say), then these clients will turn to even more risky and potentially dangerous options.

Finally, there are also similarities in efforts to expose and address such. Groups like Self-Help (and the subsequent, policy-focused Center for Responsible Lending) have been working to expose and eliminate welfare-harming lending practices in the US for over a decade. They have argued for interest rate caps, increased transparency and more and better financial services options for targeted communities. While such efforts are relatively new within microfinance, recently leaders within the microfinance movement have addressed concerns over lack of transparency, indebtedness of clients and extraordinary profits of micro-lenders "in advance of adequate competition" that seem to mirror those expressed by CRL and others. See the Poncantico Declaration signed just one month ago by a high level group of MF leaders. One difference is the call from the Declaration for a code of conduct and ethics to guide microfinance practices around the world, though this is a reflection of the fact that microcredit abroad was born out of a social mission. On the other hand, payday lending in the US was born solely out of a desire to fill an extremely lucrative market niche within disadvantaged and underserved areas.

To be clear, I'm not anti-profit and I do believe in the power of creative capitalism. However, I also believe that the trends in microfinance and their similarities to pay day lenders in the US possibly foreshadow the very real problems that will arise if creative capitalism to help the poor escape poverty succumbs to creative capitalism to maximize profits above all else.