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Microfinance Goes Bad in India

by Peter Renton on January 26, 2011

The microfinance movement began in south Asia when Muhammad Yunus started Grameen Bank in Bangladesh in the 1970′s. He was awarded a Nobel Prize for his efforts in helping bring women out of poverty in that country. It has been a successful experiment in social lending extolled by the likes of Bill Clinton, Kofi Annan and many other world leaders.

These days, however, microfinance is starting to lose its luster. In the last month there have been several news stories on the dark side of microfinace. There was this story on NPRthe New York Times and and many others. The basic problem is this. The interest rates charged by lenders in these countries are exorbitant and they are given to poor people who typically have little or no business experience. It has become a huge business, particularly in India, run by large corporations focused on short term financial results. Sounds like a recipe for disaster and that is what is happening. All this negative news prompted this response from Yunus in the New York Times last week.

In the Indian state of Andhra Pradesh, home to 75% of the microfinance companies in India, the state legislature has passed a new law that will likely send most microfinance companies out of business. Of course, like any industry there are many reputable companies that have been caught in the crossfire, and there have certainly been many success stories. But with many women being driven to suicide because of their mounting debts something had to be done.

The problems stem from the predatory lending practices in place at many of these microfinance companies. While the average interest rates are not exorbitant, in the 24-30% range, some lenders are charging 70% or more. What is worse, though, is that uneducated women are encouraged to take out more loans than they could possibly afford to pay. The money is often used to pay for health care or groceries (or other loans) rather than as seed money to start or expand a business.

Where is Kiva?

I keep expecting to see an article on Kiva’s blog addressing these issues, but no such article has been forthcoming. I know they don’t have operations in India so maybe they think it is not that relevant to them. But with all the negative press about microfinance I don’t see how they can continue to ignore it. I would have to think it is impacting the amount of new lenders coming on board with them.

One great part about Kiva is that they do try to be transparent about their field partners. These are the companies that are basically getting free money from the lenders on Kiva and then lending it out and charging interest. You can go to Kiva’s Field Partners page and see the success rate of different companies. Some have very impressive records while others are only average. I have been a Kiva lender for several years and I only fund loans that will be administered by successful field partners.

Lessons for P2P Lending

Let me be clear about one thing, microfinance is not peer to peer (p2p) lending, and microcredit in India has very little in common with p2p lending in this country. Rob Garcia of Lending Club wrote this excellent article a few months ago explaining the differences between microfinance, p2p lending, and crowdfunding. Despite all this, I fear that the general public doesn’t make that distinction. Many people don’t understand these differences, they may see the problems in India and think I better steer clear of these microlenders like Kiva, Prosper and Lending Club (even though the latter two are not microlenders).

There are so many differences even between Kiva and the leading p2p lenders. The average loan size on Kiva is $382, on Lending Club it is $10,078 (2010 average) and on Prosper it is $4,916 (2010 average). Peer to peer lending is about lending money between individuals. Most microfinance is run by companies lending money to people, and even though the seed money for these loans may come from individuals through not-for-profit organizations like Kiva, many of the microfinance companies doing the actual lending are for-profit institutions.

A Loan Should be a Win-Win Deal

Like all business dealings, lending money, whether it be a couple of hundred dollars or several thousand dollars, should be a win-win for both sides. If we start to focus on one side of the equation, then the long term viability of the business becomes questionable. This is what has happened in India. The lenders were not interested in a win-win loan, they just wanted to make the loan and collect their commission.

Peer to peer lending is different. While there will always be some people looking to game the system, the vast majority of people involved are looking for a win-win situation. Borrowers want a loan with a lower interest rate than they would pay for a credit card loan (since most banks aren’t doing personal loans these days) and lenders want a better investment return on their money. The p2p lending facilitators (Lending Club and Prosper) need both the borrowers and lenders to be successful so they can continue to grow and take their small slice of the pie. In most cases these days all parties are getting what they want.

I hope that the micr0finance industry in south Asia can get their act together and create a sustainable win-win industry. But I think it behooves the p2p lending industry to not ignore this crisis. In marketing, perception is everything, and p2p lending wants to continue to be perceived as an industry benefiting all parties.

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Rob G January 26, 2011 at 2:55 pm

Good thoughts here Peter.

The reality is that every business must find ways to cover their expenses. Reaching out to the poorest does carry a cost. The problem is when the MFIs extend themselves too much and pretend to pass their cost to the people they are supposed to be helping.

It’ll be interesting to see how Microfinance will evolve after this negative attention it’s getting.

Dan B January 26, 2011 at 4:30 pm

Microfinance as well as p2p companies do walk a fine line. As a lender I don’t have a problem with high rates.
However if I were a neutral observer, I could easily build a case that interest rates on the high risk end such as Prosper’s 31.99% harm borrowers……… Are we delusional enough to believe that they are actually consolidating other debt that charges more than 32%? How much imagination does it take to come up with what is really being done with this money? How is this not new debt, & new debt at a rather high rate no less? So can p2p loans at this rate possibly be of benefit the borrower??

Peter Renton January 26, 2011 at 9:06 pm

@Rob, It will be interesting to see how the dust settles after this crisis. I think there will be a great deal more regulation and poor people will likely find it harder to obtain loans. It is a shame, because done right microfinance can be a very useful tool but put in the hands of the greedy and it becomes damaging to all.

@Dan, You make a good point. Personally, I don’t like the super high rates Prosper charges for the high risk loans and I can’t imagine being willing to pay a 32% interest rate. But when I look at some of these loans they often have no delinquencies or public records and half-decent credit (scores over 700), so I don’t know. We may be helping them dig themselves into a deeper hole. But then you have to look at the payday lending industry that has rates many times that and is a multi-billion dollar industry. I realize that a pay day loan is super short term, so likely serves a different purpose, but maybe some of these people are regular customers there. To them a 32% loan certainly sounds better than a 600% loan.

Dan B January 27, 2011 at 12:35 am

I feel that the sooner p2p grows up out of this adolescent “lets help people, feel good stage”………..the better. That way it won’t have to defend itself on all these different fronts & it’ll stand or fall like every other investment option. And as for interest rates, I don’t think there should be artificial caps on interest charged period. If interest rates are too high for your needs, don’t borrow. And if yo have to borrow then beggars can’t be choosers. It may not be “feel good” but that’s the real world we live in.

Lewis Zwick January 27, 2011 at 8:48 am

Am I missing something? A business model that is based on borrowing money at 0% and lending it out at 25%. Sounds like the microlenders are acting just like our banks. The only difference I see between US banks and micolenders is that the banks have certain bk protections built into the system.

Peter Renton January 27, 2011 at 12:02 pm

@Dan, There will always be some people who get into p2p lending because it has a more personal feel than dealing with the TBTF banks. So, it may never completely “grow up” out of the let’s help people phase and I don’t think that is a bad thing. Having said that, for p2p lending to be mainstream it does need to succeed or fail as an investment vehicle by simply comparing the numbers with any other investment.

Microfinance, the focus of this post, from its very beginning has been targeting poverty relief and such has been reliant on people for feel good about helping other people. This mission has been lost in many parts of South Asia but it remains the focus of sites like Kiva.

@Lewis, It does sound a bit like the US banking system, doesn’t it. Here is Kiva’s explanation of the interest charged to borrowers. Keep in mind here that the original mission of microfinance was poverty relief, but for that mission to be truly sustainable the people on the ground need to be making a fair profit.

jes June 2, 2011 at 4:08 am

I hear that a new P2P website is being launched with significant political and financial backing called, finally something that meets the market demands.

Moe June 16, 2011 at 2:53 am

Just saw that Indian website and this whole Social Lending name totaly sounds bad to me, it makes it sound like some kind of charity. And by the way when I see a borrower writing “please help me out” or “need help” I skip them right away, it just gives me a bad feeling.

Peter Renton June 16, 2011 at 10:13 am

@Moe, I agree that in India and other impoverished nations social lending and micro finance have got a bad name and in many cases that is justified.

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