Q&A with a Microfinance Heretic– Hugh Sinclair

Hugh details several scandals and describes what makes some microfinance organisations more effective at addressing poverty than others. Without fundamental reforms, Hugh argues that microfinance will fail to live up to its promise. Here Hugh talks openly about his book and his views on an actuary’s role in microfinance with Qinnie Wang.

QW: What prompted you to write the book “Confessions of a Microfinance Heretic: How Microlending Lost Its Way and Betrayed the Poor”?

HS: I had worked in the microfinance sector for some years, initially as an advocate of the model. Gradually, I saw a disturbing level of fraud and deception in many institutions that I worked for. It dawned on me that the entire sector is built largely, not entirely, on a deception. We had created an industry, and this industry required a continual flow of capital, and countless companies sprung up to tap this flow. However, what was actually happening on the ground was rarely discussed outside of the sector.

We made lofty claims, which deep down we knew were largely untrue, but such claims paid our salaries. We developed a ‘standard rhetoric’– the proverbial woman with a goat who took a loan for $50 and all her problems vanished, and her children lived happily ever after. Perhaps some of us even believed it. Then Yunus won the Nobel Prize, which somehow legitimised the otherwise fringe activity. And then Compartamos Banco did their ludicrously profitable IPO, personally enriching many individuals and institutions, albeit on the back of high interest rates charged to the poor.

Many of us were concerned with this trend. Poverty eradication was replaced with return on equity and PE multiples. People in smart suits replaced the casual attire at conferences. The atmosphere changed. I decided to confront my employer having discovered some gross negligence, if not outright fraud (depending on your definition), and eventually won a case against them, but nothing really changed.

The poor were increasingly being used as hapless vehicles in a money-making scam. Well-meaning, if not slightly naive donors were equally being deceived, and this seemed not only unethical, but a cruel irony: to exploit the poor in the name of poverty alleviation.

But how to shift such a large beast? So I started speaking to journalists and trying to get media coverage, and eventually the NYT picked up on a terrible case I had been involved in, in Nigeria. This created a moment of panic in the sector, and while it was short- lived, I saw a small opportunity to get people thinking laterally about microfinance. Around this time the Andhra Pradesh scandal struck, when 54 women in India committed suicide due to chronic over- indebtedness, and the WSJ broke the story.

At the same time, I began to discover other people in the sector, journalists, academics etc. who were also questioning the wisdom of endlessly indebting poor people, which was empowering. But ultimately it was the simple disillusionment that I was doing anything constructive to actually help the poor that prompted me to take the gamble, and when I speculatively contacted a publisher, as an unpublished heretic, they immediately loved the idea and offered me a contract. At that point I couldn’t say no.

QW: What do you think has changed since the book was published in July 2012?

HS: Many things have changed, some for the better, others for the worse, and I would not like to take undue credit for my actions. Confronting microfinance has been a collective effort. I think my book was more accessible to the layman than many more academic texts challenging the sector, and also pointed out to the academics the fundamental role the investment community played in causing many of these problems.

Since 2012, the criticism of microfinance has certainly increased, and such criticism has reached the mass media. I think many investment funds are nervous of being associated with another scandal, and are acting more prudently. A lot of people have quit the sector entirely, and there have been tentative steps towards increased regulation.

The ongoing crises in the sector have perhaps driven away some of the more philanthropic investors and donors, but these have largely been replaced with hard-nosed investors seeking a decent return. The sector seems to be slowly splitting into two distinct segments which were previously merged. A genuinely social branch, that take the welfare of the poor as their primary focus, and a more commercial arm, who believe fanatically that the provision of financial services is development, and that there is simply no need to focus on poverty, because the invisible hand of capitalism will solve their problems, and thus these investors believe they can act with impunity and earn the returns without much regard for the poor.

I am exaggerating the two extremes here to make the point, but institutions that genuinely straddle both sides of the gulf are becoming increasingly rare. To the extent that this takes place in a regulated environment it is not necessarily a bad thing: MF was invented precisely because the traditional banks refused to lend to the poor. Now such banks increasingly are lending to the poor, and traditional MF institutions are converting to banks. But we risk forgetting a key difference: our clients are often vulnerable, often borrowing for emergencies, often they run small businesses that do not lend themselves to leverage, and they face other challenges in their lives that can radically upset an otherwise reasonable business, but made all the more catastrophic in the presence of debt. We cannot push an essentially ‘western’ model into these countries without also pushing the regulatory environment, financial literacy and client protection that we take for granted in the ‘west’.

QW: What opportunities are there for actuaries who are interested in microfinance?

HS: As the sector grows and becomes more competitive, markets become increasingly saturated and regulation (slowly) creates a more level playing field. It is increasingly hard for an institution to gain a competitive edge. It simply becomes a race to scale. However, with the expansion of decent computing power, software and skills within the institutions, and the ability to cross reference internal data with external data (such as from a credit bureau), there is a largely untapped field of analytics that is yet to be harnessed.

Banks are sitting on terabytes of data, but unaware how to use it for any purpose other than to see who owes them money this week. What any actuary is aware of is that with large samples of data over extended periods, patterns begin to appear. Which clients are not paying? Which clients are progressing particularly well? Which loan products are suitable in various circumstances? Do certain combinations of products or services have a particularly good or bad effect while in isolation there are different tendencies? How do factors such as age, gender, number of children, marital status, etc. impact different aspects of the business? Such questions were not so important previously, when margins were high, defaults were low and competition was negligible. But the sector has changed, and still very few people are asking these questions. Client desertion is becoming a serious problem in the sector, and yet we can barely agree how to even define it, let alone look at the causal relationships behind it. Such analyses may sound simple, but in the messy day-to-day reality of MF it requires a certain mindset to filter through the data and uncover answers, and these are precisely the sorts of skills that actuaries possess.

To give one example, from an un-named bank. This bank displayed the famous characteristic within the sector of higher repayment rates from women. But when we looked at the repayment rate of new clients, male and female repayment rates were almost identical. When we looked at those clients renewing their loan, likewise. And those renewing a second, third, fourth time – there was no significant difference between male and female default rates, and yet overall female default rates were lower. This initially appeared a mystery. What we observed is that at each successive cycle the default rate generally declines (for a variety of reasons which are not so relevant in this example), but for men and women equally. However, female clients generally stayed at the institution longer, they were more likely to renew their loans and reach the later cycles. A man in the fifth cycle was just as likely to repay his loan as a women in her fifth cycle, only less likely to get there. Thus retention seemed to be the key, and the institution began to focus on this. Obviously there are a host of cause-effect paradoxes to resolve here, but this gives an insight into the type of complexity that an apparently simple observation can hide.

QW: What are the unique challenges that set microfinance apart from other financial services? In your opinion, are these challenges being addressed effectively?

HS: Unique challenges: poor data quality, high volume but small amounts, unstable samples, constant rotation of clients and staff, problems objectively capturing data, elevated levels of fraud, difficult working conditions (poor infrastructure, lack of basic services such as reliable internet and electricity, physical insecurity, long distances on bad roads in unreliable vehicles to reach a client etc.), little regulatory oversight in most cases, substantial deviations from best practice, unusual accounting practices, politicised working environments where talent does not always correspond with seniority, problems hiring specialised staff, nepotism,… the list goes on.

The key skill is patience.

Moving from mainstream finance to microfinance can be a shock, and there are no short-cuts, and no substitute for being in the field. But don’t expect to learn it overnight. In terms of the application of microfinance compared to ‘regular’ finance, the main problems include the relative vulnerability of the clients; lack of financial literacy; the inability for the client to separate personal expenses from work expenses (it is ‘one pot’); a lack of data on the underlying business; hidden borrowings from other sources; difficulty in enforcing a contract; questionable title over fixed assets; political interference; serious over-indebtedness; credit bureaus of varying degrees of reliability (a partially reliable credit bureau can be more dangerous than no credit bureau!); in some countries it is challenging to uniquely identify a client; again, the list goes on.

Are these being addressed? To a great extent, not. Sometimes I feel like we are trying to run before we can walk. The financial sectors of the ‘west’ took hundreds of years to develop, and while leap- frogging such delays is a great thing, we need to identify where the problems may lie. For example, financial literacy needs to correspond with the sophistication of the loan and savings products. A line of credit is fundamentally different to a fixed- term loan, but if the client views both as ‘debt’, without fully understanding the difference, this will eventually lead to trouble.

Sometimes we seem to focus too much on the innovation, such as mobile banking, without thinking of the more core question – when should a client borrow and when not? And the sector remains too focused on loans and insufficiently on savings and other financial products such as insurance. We can create the most sophisticated financial inclusion opportunities in a country, but if that results in millions of over-indebted clients with insufficient savings, is that a worthy outcome, even if we did it using the latest i-Pad?

My most serious concern relates to client protection and informality. We pay no more than lip-service to this currently. By promoting microfinance, are we encouraging an ever-expanding informal economy? Are we considering the protection of vulnerable people within the community? Are children being denied an education in order to stack the shelves of a micro- enterprise which might, on paper, appear to be growing and repaying loans, but is causing an intra-generational problem? Are we siphoning scarce capital away from the small and medium enterprises and lending it instead to an army of basket-weavers fiercely competing with one another? Does society benefit from having such a large and potentially growing share of its resources involved in enterprises that do not employ many people, do not obey local employment law, do not pay tax, do not obey basic health and safety laws, etc.? We call this ‘job-creation’, but is it really? Are we simply reducing the pressure on governments to develop sensible industrial policies to create competitive industries, in favour of an informality that traps a country in a never-ending stagnation of low-skilled employment? And where is the training, the financial education, the advice on not becoming over-indebted, the basic business skills required to run and grow a business?

These are mostly problems that the mainstream financial sector does not have to consider in such detail, but microfinance faces them daily. The problem is that we focus too much on the industry, the institutions, the growth rates, etc., and forget about the people receiving these services and the society they form part of.

QW: Do you believe that microfinance can be an effective tool in poverty alleviation?

HS: Financial inclusion, in the full breadth of the meaning, is a useful function in a society. Financial exclusion is a curse. But finance is a tool, and can be used wisely or poorly. Financial inclusion is not the end goal. It needs to form part of a bigger picture, of macroeconomic growth, of skills development, of education and financial literacy, etc.

I liken it to a medicine – it is very useful, but the goal is not to simply produce as much medicine as possible and dump it across an entire country. It needs to be used carefully, with regulations governing its use, with contingency plans for when it is used poorly, directed at those that need it and restricted from those that do not, or who seek to abuse it.

In terms of savings and insurance, as long as these are fairly priced and offer transparent services and meet certain regulatory control, it is hard to think when these should not be promoted. But they are generally the most ignored aspects of financial inclusion. The focus is principally on the most dangerous financial tool – microcredit. This has led to catastrophic crises (Andhra Pradesh, Bosnia, Pakistan, Bolivia, Morocco, Nicaragua, etc.), and yet is the most profitable and thus most promoted branch of microfinance.

It is useful in carefully controlled doses, at fair prices, to a certain sub-set of the poor who are actively involved in a genuine business activity which can grow with leverage without causing excessive harm to those around him/her i.e. it does not lend itself to massification.

Perhaps not surprisingly, when microcredit is offered to anyone with an ID card and capable of signing their name regardless of the loan purpose or level of indebtedness and costs 80% per year, this ends in tears. And yet this is precisely what we see, over and over again. Again, to use a medical analogy, is morphine a good drug? In some circumstances it is marvellous, but handing it out at street corners is not a good idea! The problem, at least in the short run, is that doing so is good for morphine producers (i.e. microfinance banks and their shareholders).

If we returned to the basis of what debt is, and when it should and shouldn’t be used, instead of becoming over-excited about delivering debt over a mobile phone or whatever the latest fashion is, then we might have a better chance of creating a healthy financial inclusion sector. But currently this is lacking, which is a great pity, as the few banks out there that are practising wise lending are tarnished with the same brush as the sector at large. And if a bank does a stellar job at nurturing good clients and helping them grow, but another bank offers the same client unlimited credit with a signature, the danger is that the client gives into the temptation and the implications eventually fall on both banks – good and bad, and the client.

Finance is a useful tool only in a regulated environment, and regulated well.

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