I rarely describe an article or PPT as obligatory reading. If you have any interest in the state of the microfinance sector, and wish to actually get to the heart of the matter rather than dance around the periphery, watch this:

http://www.mftransparency.org/resources/growth-profit-compensation-in-microfinance-how-much-is-too-much/

It is by Chuck Waterfield, an esteemed microfinance veteran. Chuck has been campaigning for a fair deal of the poor ever since the Compartamos IPO in 2007. He is not a “radical”, he does not suggest all microfinance should be run as an unsustainable, subsidy-fuelled charity, nor does he buy the mantra of the wonder of unbridled free-market neo-liberal capitalism. He is one of the few people to actually have the intellect and courage to attempt to define the point of equilibrium between these two extremes and present it in such an accessible manner. Frankly, I am hard-pressed to think of anyone remotely involved in this sector who should not be strapped down and forced to watch this PPT, enlightened with a lively and personal commentary by Chuck, in his wonderful rhetorical style that keeps you listening to every word, and occasionally chuckling at his laconic style. It is simple, concise, and describes exactly the issue at stake. The microfinance sector apparently oscillates between the extremes of sluggish NGOs and loan-sharking vultures, if the media coverage is anything to go by. The truth is more complex, and Chuck hits the nail on the head. It’s useful to a variety of people:

Microfinance funds managers: you are critical gatekeepers of both money and information between “the field” and your ultimate investors and often abuse this power. You should watch this to understand how your quest for returns can harm the poor and deceive your investors.

Microfinance investors: this will help you find that middle ground between making a reasonable return and avoiding either the pure subsidy model, or outright client exploitation. It may also guide you in how you select a microfinance investment fund.

Users of peer-to-peer lending platforms: don’t focus on the interest rates you charge, but those that the poor pay. If your P2P cannot even tell you the interest rate paid by the poor, ask yourself if this is an effective platform.

Regulators (especially in Mexico): wake up, you have a number of tools at your disposal, but if you don’t understand the core dynamics in the market you risk either ineptitude resulting in crisis, or over-regulation resulting in an exodus of microfinance from your country.

MFI managers: strive for efficiency, strive for improved service, but be aware of the perils of striving for profit-maximization. You need to pick your investors as carefully as you pick your clients.

I think the situation is perhaps a little bleaker than that presented by Chuck, although I suspect this is prompted by data limitations. Return on Equity can always be massaged downwards by paying massive salaries to senior management (an expense). The use of portfolio yield as a proxy for APRs is flawed, as I blogged here, but Chuck is well aware of this given the work of MFTransparency – it is just to stress that the portfolio yields are under-estimates of the actual cost of capital to the poor, so the data presented may in fact present an optimistic picture of the situation in Mexico. Counteracting this effect to an extent, the returns are nominal rather than real, so taking inflation into account would reduce the effect of accumulating returns. A minor point. Also, the cost to the poor is not necessarily the income of the MFI: the effect of VAT (IVA in Mexico) is an additional cost to the poor which is not income to the MFI. An expense of $120 to the client may represent an income of only $100 to the MFI. To stress, this is not to criticise Chuck’s work, which is ultimately limited by data constraints (Mexico is not a country he has analysed in his excellent country reviews) and the requirement to explain this simply in 40 minutes. I merely suggest that the situation may be worse than that presented.

This is a sobering but enlightening PPT. It lends serious weight to the fact that regulators could do so much more than they currently are. It demonstrates how woefully inadequate our due diligences of MFIs are in practice, and the paramount importance of transparency. It highlights the importance of aligning the interests of the poor with those of the ultimate investors, and those of the intermediaries used to channel funds. It acts as a guide to where we have messed up the microfinance sector, but equally to guide us how we can improve. We have procrastinated on these issues, as Chuck euphemistically suggests. I would suggest we have turned a deliberate blind eye bordering on outright deceit and negligence, but Chuck is often more tactful than I.

I directly asked Larry Reed of the MicroCredit Summit Campaign about defining the point at which interest rates become exploitative. For a sector that seeks to replace the evil moneylenders and loan sharks it is remarkable how we have failed to define extortion and loan sharking. Chuck’s framework provides us with a firm guideline as to how the sector could in fact take concerted action to put this monster on the table. His traffic-light system of ROE is excellent, although I might suggest a lower threshold than 25%, but it’s a good start. His interest rate pricing curves demonstrate how we need to consider loan size rather than a blanket interest-rate cap. This is the way ahead. The question is simply “What are we going to do about it?”.

a) do nothing, continue making a ton of money from the poor, extracting wealth from the bottom of the pyramid for the few lucky folk at the top, exploiting yet more poor women, causing yet more crises and adverse press coverage, until eventually we are all branded as scum akin to the loan-sharks we so merrily criticise but have in fact become.

b) wake up, take concerted action and some tough decisions, start using carrots and sticks to actually regulate this sector within reasonable boundaries, and act responsibly for a change.

Chuck suggests the sector may be at a turning point. I suspect we’ll see another collapse (my money is on Mexico, as it appears Chuck’s is also) before people wake up. But I share his optimism. The pressure and backlash against microfinance is in full-swing, and the temperature will continue rising until we do something. Scandals are emerging almost daily, how long do these jokers wish to continue along the current trajectory?

Thank you Chuck.