Striking a Balance between Private and Social Interests: Lessons from Microfinance in Mexico
Wednesday, April 24th, 2013
Microfinance institutions are a promising instrument for alleviating—not eradicating—poverty and expanding the limited availability of financial services for the poorest households, which are often left subserviced by traditional financial institutions.[i] After thirty years of documented practices, the international community has learned much about the challenges of implementation, and what considerations must be made to effectively influence and improve the livelihoods of the populations being serviced. From the standpoint of the microfinance institutions, it is crucial to transcend from the initial stages of implementation—which usually require substantial amounts of capital inflow from large donor organizations to get started—into a more efficient, market-driven model of poverty reduction that can guarantee the company’s sustainability and future viability. This is an important criterion for the success of any microfinance model, since only permanent institutions that achieve complete independence from donor subsidies will be able to assist clients in the end. In this sense, it is inevitable that all microfinance institutions that apply a sustainability approach must eventually evolve into a more traditional business and acquire the profit-maximization goals of the private sector.
This evolution poses a clear threat to the original objective of microfinance, which is to enable poor households to engage in income-generating activities, assets accumulation, and consumption smoothing during times of distress by providing affordable access to financial services. It stems from the simple fact that providing services to low-income populations in marginalized communities poses several implementation challenges to the profitability model, since the disbursement of very small credits implies higher costs for the microfinance institution as the fix-cost component of lending affects smaller loans to a greater proportion than larger loans.[ii] Moreover, the risk of failure in loan repayment is often higher among the very poor, who are more prone to economic shocks. This is perceivably a main reason why traditional commercial banks generally consider the costs of serving low-income populations as prohibitive and opt not to target them with their products. Consequently, achieving financial sustainability in this context implies that the high costs of lending have to be passed on to clients, generally in the form of higher interest rates.[iii]
An ethical issue arises from the necessity to develop internal sources of revenue in order to generate private commercial funds rather than relying on scarce donor funding, because it creates a conflict between the institution’s own social and commercial interests. As mentioned, improving profit margins involves increasing the interest rates charged to borrowers. The increased rates then affect borrower welfare by making the loan harder to repay and by discouraging participation of the poorest members in the system.
This issue is widely present among Mexican microfinance institutions, where very high interest rates are common among for-profit and non-profit providers in the low-end credit market. In many cases, some of the more successful institutions in the country, which have recently opened up to investments from venture capitalists hoping to make a quick profit, have effectively been charging rates above what is needed to clear their costs, causing over-indebtedness and increasing client defaults in some cases.[iv] The creation of a new ethical framework is needed to address this dilemma and put a stop to the rapacity of expanding institutions fueled by private for-profit investors. This framework should then be enforced by the governmental authorities, which are long overdue to intervene in a private sector that has only recently begun to be regulated by the new Ley de Ahorro y Crédito Popular—National Law for Community Savings and Microcredits—in 2009.
A main reason why the greater fraction of the Mexican population does not have access to financial services is due to conditions inherent to poverty characterized by informality, low income, high risk, and lack of collaterals.[v] Additional reasons for financial exclusion may be attributed to lower demographical concentrations in certain regions coupled with geographical barriers that limit access to infrastructure and communication and therefore imply higher operation costs to satisfy the existent demand in these locations.
Because of the lack of fully developed infrastructure, the microfinance sector has become an essential player within the Mexican financial system, as it is the only resource available for some members of the population. Special instruments are tailored within this sector to satisfy the needs and empower their productivity that would otherwise be unmet, excluding this market niche from any kind of alternative services.
A Controversial Example: Compartamos Banco
Of the microfinance institutions currently doing business in Mexico, Compartamos Banco—Let’s share Bank—has been one of the most profitable. Originally created in 1990 by grants from various international development organizations, it was founded as a non-profit organization committed to providing financial services to enterprising people who lived in conditions of disadvantage.
Since its inception, Compartamos has serviced mainly indigenous rural women in some of the poorest regions in Mexico. In recent years, however, the company has evolved and expanded into a commercial bank and completed a landmark initial public offering (IPO) on its stock, which was seven times oversubscribed and considered a huge success by any financial market standard.[vi] Some circles in the microfinance industry have been very critical of the company for what they believe to be an inordinate emphasis on profits over social returns. Other circles have praised their performance in helping “give a significant boost to the credibility of microfinance in commercial capital markets and accelerate the mobilization of private capital for the business of providing financial services to poor and low-income people.”[vii] Nonetheless, Compartamos’ impact on the region is undeniable. It is currently one of the largest microcredit institutions in all of Latin America with more than 616,000 clients, and its rapid growth shows no signs of slowing down.
This successful IPO produced huge profits for the existing private investors of the company. The owners of the bank sold around thirty percent of their shares in the stock exchange market in Mexico and New York, receiving about $450 million for them, which represents more than twelve times the book value of those shares.[viii] This amount reflects a market valuation of the company at over $1.5 billion and an internal rate of return on the selling shareholders’ original investment—about $6 million including grants—of roughly 100 percent a year compounded over eight years.[ix] These vast rewards were only made possible thanks to Compartamos’ track record of high net earnings, which were rooted on charging its female borrowers interest rates that where considerably above what the company needed to cover its costs. For example, “the interest yield for 2005 was 86.3 percent. When the value added tax of about 15 percent is added in, the rate paid by clients is about 100 percent.”[x] According to the MicroBanking Bulletin, this is substantially higher than any other microfinance institution in the world, where the median for reporting institutions is about 30.9 percent.[xi] These rates rank Compartamos as one of the most expensive microfinance lenders in the world, which illustrates the negative impact caused on the welfare of its borrowers.
Interest rates charged by all lenders that reach lower-income markets are in fact already quite high compared to other parts of Latin America and the world. The average interest rate charged in Mexico by microfinance institutions in 2010 was seventy percent, whereas Compartamos is still charging interest rates well above that, which partially explains why it has been such a profitable business.[xii] Still, at such high rates, and lending almost exclusively to customers with little or no credit history, Compartamos has somehow managed to keep past-due loans below one percent of its portfolio, which appears to have been essential for making this business model sustainable and replicable for years.[xiii]
There are several reasons why analysts believe that clients have been able to repay these expensive loans faithfully and continue to flock to the service in large numbers. The first reason is a lack of a larger supply of microloans in rural regions due to underdeveloped infrastructure and generally poorer communities that are a likely risk to lenders. In several of the secluded rural regions where Compartamos operates, it can do so with a monopolist power, because of a lack of competition from other institutions. The wide extension has provided the opportunity for this lending institution to spread out across regions—which may explain why Compartamos only had operations in ten states of the country at the time of the IPO. Therefore, even if the clients do consider the loans very beneficial and more easily accessible than similar products offered by traditional banks in nearby urban areas at lower rates, it seems very likely that they will not have many viable alternative sources to choose from anyway. It would be unlikely for clients to continue applying for loans with such high interest rates if other companies, with more affordable options and similar conditions, further penetrated the market—e.g. no collateral needed. After all, as high as Compartamos’ interest rate is, it is usually still significantly lower than that charged by vendor credits and other informal sources available.
The second explanation as to how the borrowers are able to generate enough returns on invested capital to afford such interest rates is based on the idea that “tiny cash-starved trading and handicraft microenterprises can often generate very high returns on additional capital.”[xiv] Additionally, because the loans are small enough to be manageable with the clients’ income, the probability of repayment is increased. However, this point raised about the “manageability” of the loans still does not account for the fact that a huge portion of the clients’ profits are being spent in repaying the loan itself; therefore, the goal of “improving people’s lives” can be compromised, or at the very least delayed, by the company’s plans to increase revenue. Higher charges to borrowers correlate directly with higher profits captured by investors, including private investors. To that extent, there is a direct and obvious conflict between the welfare of the clients and the welfare of the investors.
Putting a Cap on Capitalism
Learning about Compartamos, one may be inclined to ask, Why would a company that was built as a non-profit to help unemployed low-income women, charge such high interest rates, in clear detriment of their own morals and goals? What kind of values led the evolution of the company from a social enterprise to a multimillion-dollar profit driven business?
Back in 1995, when Mexico was hit by one of the greatest devaluation and inflation periods in recent history, Compartamos—like many other financial institutions in the country—was forced to raise its effective annual interest rate above 100 percent, in order to provide real inflation-adjusted proceeds and keep it from going under during those difficult times. However, Compartamos retained its level of interest rates unaltered after the economy stabilized as they faced little direct competition in the country. Compartamos’ leaders explained this action as a necessary part of the equation for the expansion plans of the company, keeping in mind the ultimate goal of reaching one million women in the country with their services.
The rationale behind this idea was to deny current clients the opportunity of having access to a subsidized loan for the benefit of future clients, who could be reached by the company’s rapid expansion process sooner than what they would have been under different circumstances. By retaining a huge portion of their profits and reinvesting them in the company, they were able to secure a solid internal source of funding for their expansion plans. It is undeniable that in the absence of retaining these high profits, expansion would have been considerably slower. It is also true that a huge amount from the profits of the IPO went directly into the pocket of the company’s original investors. Milford Bateman and Ha-Joon Chang in the World Economic Review suggest this: “Rather than revealing commendable levels of poverty reduction among poor Mexican individuals, the IPO process revealed instead the Wall Street-style levels of private enrichment enjoyed by Compartamos’ senior managers.”[xv] Indeed, most of the sale proceeds from the IPO—$450 million—were reinvested into the company or devoted to other public-purpose institutions. However, close to one third where captured by private individuals.[xvi]
To this extent, why would a company, supposedly devoted to its expansion plans and social benefits of its business model, divert one third of proceeds received from the IPO without reinvestment? It seems that by doing so, the company leaders effectively slowed down their expansive potential and severely tampered with their chances of reaching their main goal on time: providing loans for one million women. Additional consideration to the amount of women that could have been reached and serviced by that additional $150 million dollars would provide a better understanding on the seriousness of the ethical issue raised by this controversial action. While this paper does not delve into that consideration, it should be noted as a topic for further study.
In distinguishing between the existence of profits and the size of profits, there is nothing wrong with the fact that key shareholders made profits out of Compartamos. Indeed, in the majority of the social enterprises undertaken or funded by development agencies there is always the opportunity of providing private profits. Regardless, it is the ethical responsibility of all companies that are founded on social enterprises to temper the amount of acquisitions that their investors can obtain to avoid hindering their overall ability to provide social benefits and reach their ultimate goals. In the case of Compartamos, there is sufficient circumstantial evidence to suggest that the amount of profits withdrawn from the company may have jeopardized or delayed the achievement of their own objectives to a certain extent.
This problem is not an uncommon one in Mexico, and a new ethical framework should be developed to address this problem. Because certain actions are not illegal does not mean that they are not ethically irresponsible; the strength of a particular institution can provide an impact in the communities where it intervenes and, thusly, to the overall reputation of microfinance in general.
For this purpose, it is crucial that a “cap” be placed on the amount of profits that are made on microfinance enterprises, and that investors should not be allowed to profit above a certain level, at least not until the ultimate social goal the institution set is reached. In order for microfinance to be an effective tool for alleviating poverty, the Mexican government should help it play to its strengths, and venture capitalists who invest in the industry hoping to make a quick profit regardless of the consequences are not one of them. Microfinance must be clearly focused towards contributing to the community development.[xvii]
The idea behind these practices is to invigorate the underprivileged parts of Mexico’s economic system and help the spread of capitalism in order to create more entrepreneurs and consumers that can be included in the market economy and help make it grow. This plan will be ultimately beneficial for every enterprise in the economy and especially for those who directly interact with them, such as microfinance institutions. To make this work, Mexico must be as inclusive as possible.
If Compartamos’ expansion plans were executed using all of the resources available to the company, and their profit margins were lowered to a level comparable to other microfinance institutions in the country, the benefits transmitted to their clients would ultimately be returned to them by expanding their client base and the eventual increase in the size of the loans they apply for, making the whole model more sustainable in the long run. However, these social benefits do not seem to be transparent enough at times to be adequately internalized by these companies. The ultimate goal should be working every day to ensure that everybody within the country has all the tools necessary to “play the game”: good health and nutrition, adequate housing, affordable education, access to communication, etc. Therefore, it is not wrong for owners and investors of a microfinance institution to make profits, so long as they have first met their goals in effectively helping reduce the poverty their clients live in and are effectively translating the highest possible amount of consumer surplus in their transactions with them. But if they are making a huge profit without first having accomplished what they set out to do, then I feel there is something very wrong with that.
Mexico has the ideal macroeconomic conditions to foster a healthy development of the microfinance sector, if all players follow a set of best practices. The strong macroeconomic stability of the country guarantees that the ground will be set for the sector to continue growing. Hopefully correcting some of the market failures posed by the near-monopoly situation that has been exploited by the institutions already doing business will allow the ultimate goal of microfinance to be effectively reached: to allow a fair starting point for all players in the country, and promote sound economic development by improving the livelihoods of all Mexicans.
Pablo Antón-Díaz is working towards his Masters of Public Administration in Environmental Science and Policy at Columbia University’s School of International and Public Affairs. Before coming to the United States, Pablo served as a Project Associate for Innovations for Poverty Action in Mexico City, Mexico. Following graduation in May, Pablo will begin work for the Inter-American Development Bank in Washington, DC.