The Dark Side of Microfinance: An Industry Where the Poor Play ‘Cameo Roles’

Hugh Sinclair is the author of a new book titled, Confessions of a Microfinance Heretic: How Microlending Lost Its Way and Betrayed the Poor, in which he debunks the image of microfinance as a do-good industry committed to helping poor people create sustainable businesses. Instead, he documents rampant corruption, extortionist interest rates, cover-ups and a lack of transparency that he says characterize much of the microfinance industry today. Sinclair, who has worked in the field with global organizations, banks and funds for more than a decade and holds degrees from the University of Durham and IESE Business School, spoke with Knowledge@Wharton about his book, the problems microfinance continues to face, and some solutions for moving forward.

Below is an edited transcript of the conversation.

Knowledge@Wharton: Hugh, thanks for joining us.

Hugh Sinclair: Thank you.

Knowledge@Wharton: I’d like to start out asking you why you wrote this book.

Sinclair: I wrote this book because there is a lot of misinformation and misunderstanding about what really is going on in microfinance. On the one hand, we hear of rumors of exploitation of the poor. But on the other hand, good, well-meaning Americans and Europeans are donating and investing their money in this sector without really knowing what’s happening. I’ve been in the sector for so long and have seen so many things that were going wrong that could be done so much better, that eventually I just decided I have to come clean and explain what’s happening.

Knowledge@Wharton: Reading this book it, seems that the problems of microfinance are so entrenched by now that they can’t be fixed, especially the corruption that seems so pervasive. Are the problems indeed intractable?

Sinclair: I don’t think so. There are a number of good institutions out there — [although] I would say [they are] certainly in the minority — and good peer-to-peer lending platforms. There are even, possibly, some good microfinance investment funds [although] they are rare. I don’t think the problems are intractable, but I think that we have to begin by acknowledging [the need] to do something about the appalling, woefully low level of transparency in the sector. We need to regulate it much more tightly, both in developing countries and in developed countries where a lot of the money is sourced. And I think we need to refocus our efforts on the poor. This is about the poor, not profit.

Knowledge@Wharton: You quote someone from the microfinance community in your book as saying that nine out of 10 microfinance loans are for consumption rather than to start or grow an enterprise or even to buy food or clothing. Doesn’t that undermine the whole basis, the whole theoretical underpinning, of microfinance?

Sinclair: It does totally. And it was [said] by a noted expert, John Hatch from FINCA, one of the biggest networks in the world, in the Harvard Business Review. Yes, it does totally undermine it.

No one really knows [the numbers] because there is no good data on how much is used for consumption and investment. But very rarely do you have anyone saying [spending on consumption] is under 50%. John Hatch suggests it’s 90%. I have no idea where it is within that range, but yes, large amounts of money are used for nothing other than to buy a new TV or to some new clothes. in addition to that, you have to take into account the amount of money that is used simply to repay off other loans.

Knowledge@Wharton: Right. Poor people borrow from one bank, at a high interest rate, and then borrow from another bank to pay off the first bank, and then they get into serious debt. You also talk about mission drift, the idea that microfinance has forgotten its mission to serve the poor and really exists to make a profit for the officials running the programs. Is this common?

Sinclair: Yes it is, and increasingly so. What happened at the end of the 1990s and this century was the era of so called commercialization, when large banks and profit-motivated specialist investment funds piled into the microfinance sector, aware of potentially vast profits at the bottom of the pyramid. We saw the first big $100 million, $200 million IPOs with massive payouts to individual people.

Mission drift is a very, very serious problem, and it has been so since the beginning of the microfinance movement. But it’s really accelerated in the last few years. There are people who are very well aware of it, and institutions that actively manage mission drift. It’s something that has to be actively managed. You have to constantly be aware of it and fight it every day to stop yourself drifting. But yes, it is pervasive.

Knowledge@Wharton: That gets to the whole question of the role of big banks and investment funds in all of this. It sounds like the banks, the investors, the ratings agencies, the MFIs themselves are almost in a conspiracy to enrich themselves and hide what’s really going on, at least with some of the programs that you cite. Or is this too harsh?

Sinclair: I think that’s too harsh, particularly with the ratings agencies. Actually I think the specialized ratings agencies for the microfinance sector are, if anything, something that other ratings agencies could learn from because they have demonstrated on a number of occasions that their [information] … is extremely accurate, often more accurate than the information that the microfinance investment funds themselves [have].

But it is true, [especially] when you think of the financial crisis that has happened in Europe and the United States recently involving large, supposedly regulated Wall Street banks and these sorts of profit-motivated institutions, and you look at the mess that they have caused in the developed world. Is it really much of a surprise that if you take these same players and you place them into a totally unregulated market with much more vulnerable clients who lack the protection of a regulator acting in the best interest of its citizens, is it really much of a surprise that things have gone wrong?

Knowledge@Wharton: Right. But why are people so reluctant to speak out against what’s going on in the industry?

Sinclair: Well, we seem to forget that currently microfinance is estimated [to be] about a $70 billion industry. If you think of the typical interest rates that the poor are paying, which on average may be around 50%, maybe a little bit lower, you’re looking at $30 billion a year being paid in interest. So this is a vast sum of money, and it has now attracted the big players who have valuable investments to protect. They have valuable interests. We have so far reached 200 million clients. The mantra of the day is, “Let’s go for the next billion.” So there is a huge amount of money to be made there, and people are very reluctant to admit even the slightest problems in the sector. This is one of the key problems that I see: It’s not, “How do we start fixing it:” It’s, “We can’t even really acknowledge that there’s a problem.”

Knowledge@Wharton: Yes, throughout your book, you offer several examples of corrupt microfinance institutions (MFIs) and also examples of good ones. But a particularly corrupt one is the Lift Above Poverty Organization — LAPO — in Nigeria, which you describe as, and I’m quoting here, “Totally dysfunctional, uncontrolled, unmanaged chaos run by people with limited understanding of the absolute basics of finance and charging the poor astonishingly high interest rates”– in fact, interest rates in excess of 100%. But you also offer examples of good ones in such places as Mongolia, a country that you say has one of the best microfinance programs you’ve seen. So how big is this gap between a good MFI and a bad one, and what is the relation between the two of them?

Sinclair: The difference is as extreme as what Muhammad Yunus said when he won the Nobel Prize. He wanted to set up a good, affordable, microfinance institution that would enable the poor to work their way out of poverty with fair price credit. That is great. He said that he wished to replace the evil money lenders. What has happened and what he subsequently said is, “I could never believe that the microfinance institutions have become the very same evil money lenders that we attempted to replace.”

Knowledge@Wharton: The sharks, right?

Sinclair: This is the problem: You have a huge variety [of MFIs] going from very ethical, good institutions, all the way up to the loan sharks. And the average person in the United States and Europe has no real way of distinguishing between the two. Not only that, but there are warped incentives in the investment community. Because the money lender operations are actually a lot more profitable, there is an incentive, a strong temptation to be attracted to these institutions which are obviously growing much faster, have much higher profitability, much higher return on equity. If you can buy shares in them, then you can have serious returns on your investments.

This temptation, this lure, is attracting a lot of the capital toward the money lender operations, the more loan-shark type operations. But the average man on the street has no way of knowing about this. That is one of the problems. There is a complete lack of transparency.

Knowledge@Wharton: You mentioned Muhammad Yunus. In your book, you take on some of the most revered names in the field like Yunus, like Grameen Foundation, Kiva, the Calvert Foundation. What are their roles in this?

Sinclair: In the case of Kiva and Calvert, they were both investors in LAPO [in Nigeria]. Kiva provided $5 million before it eventually pulled out of LAPO. Calvert had invested in LAPO somewhat, I suspect, by mistake on the basis of incomplete information provided to it by its own advisors. But then we’ve also got Deutsche Bank, Citibank, Standard Chartered. And then in Europe, the big institutions such as Blue Orchard Responsibility, Triple Jump, ASN Bank. The reason why I zoom in on these is because what’s interesting is that they had all invested in this specific institution, Grameen Foundation included. Now Muhammad Yunus doesn’t make direct investments himself, and he is generally an advocate for fair price, ethical microfinance. The unfortunate problem with Muhammad Yunus is that while he lectures extensively on the evils of high interest rates, the Grameen Foundation — on whose board he sits — was, in fact, one of the investors in LAPO, one of the earliest investors and guarantor to the loans from Citibank and Standard Chartered. So there’s something of a paradox there.

Then, when all the scandals about LAPO emerged, particularly when they reached the front page of The New York Times, shortly after that, the Schwab Foundation actually gave LAPO an award for the entrepreneur of the year or something in Africa. Muhammad Yunus sits on the board of the Schwab Foundation and is really the only person who has a good knowledge of microfinance. So there’s a sort of ambiguity as to exactly what his role is in all this. While in general, he aspires toward a very good, ethical form of microfinance, there are still a few questions to ask about his role, particularly with regards to LAPO.

Knowledge@Wharton: But overall, in terms of his reputation, he is one of the good guys. Is that fair to say?

Sinclair: Yes. I think he set out with extremely good intentions. There was a documentary released by the Danish journalist Tom Heinemann which questioned that and created a bit of an uproar. Then it inspired the backlash of PR companies such as Burson Marsteller to do a smear campaign on Mr. Heinemann’s documentary. There are a couple of question marks about certain transactions that took place between the Norwegian government and Grameen back in the 1990s which were revealed in the documentary. But in general, Yunus is one of the good guys. The way I portray him in the book is the good shepherd who lost control of his flock. I think that actually he’s probably extremely disappointed with a lot of the microfinance that he sees going on around him, but is powerless really to do much about it.

Knowledge@Wharton: Some people might accuse you of trying to capitalize on the many problems that microfinance faces by writing this book, and suggest that maybe you have become part of the problem. I’m going to infer that you don’t see it that way?

Sinclair: No, I don’t see it that way. I see [the situation] as a case of huge injustice, because on the one hand, you’ve got poor people who are very seriously suffering at the hands of these banks and, in the worst cases, are committing suicide. I’ve spent the last decade in microfinance. I’ve spent seven of those years working in developing countries. So I [have observed] this first hand, and it really irks me when I see these people desperately trying to work their way out of poverty. Sometimes I just think, why bother? I mean, do you honestly think you’re going to be able to repay that loan at those interest rates and get out of poverty?

On the other hand, there is this hype, this myth, this kind of aura around the sector that leads well-meaning Americans and Europeans to donate their own money or to invest their own money, often at very subsidized interest rates, to support what they see as a meaningful cause. They themselves are also being abused.

No one was speaking out about it. It drove me up the wall to the point where I just said, “You know, I can’t go on like this. We have to get this information [out], not to the elite, practitioners and the academics, but to the men on the street so that they can vote with their wallets and say, “You know what? If I’m going to give you money for your microfinance institution, I want to know the following things. How are you [selecting] your clients? What interest rates are you charging? What regulatory protections do you afford your clients?” Empower the people who are ultimately providing the fuel for this fire, empower them to know how to make sure that their money is being used wisely and for the benefit of the poor. It’s what the ultimate investors want to do, and it’s what the poor want to benefit from. The problem is, is we’ve got people in the middle who have a different set of incentives.

Knowledge@Wharton: Your book is not just a diatribe; you do offer a number of solutions to the problems you analyze. So how can they be fixed? If you had to pick maybe the three single biggest problems this industry faces, what would you do about them?

Sinclair: First of all, acknowledge the problem. Secondly, put the poor back into the center of the equation. It’s ridiculous that we’ve allowed profit to be the mantra of the entire sector. The poor play a cameo role in microfinance now. I think that the two best things that we can do is really focus on improving the transparency of the sector. So what actually is happening in the field? What information can we find out about the microfinance investment funds? They need to publish more information about what they’re doing so that people can make an informed decision.

But ultimately, I think what we need to do is regulate. We know that regulation hasn’t worked entirely smoothly, but is the alternative zero regulation? I think this, to a great extent, explains the atrocities that we’ve seen in countries such as India, Nicaragua and others. If you just allow unbridled, profit-motivated, totally unregulated economic capital flows when the poor clients are vulnerable and not financially literate, it’s going to end in tears, and it has ended in tears. But we keep on doing it…. It has to stop.

Knowledge@Wharton: You have said in your book that in 2012, which is now, you would probably be working with some of the ethical funds and their decent MFIs. Are you?

Sinclair: Yes. I’m working with a small group of funds, two funds in one bank. And I have to say that the list every year gets shorter and shorter and shorter. But these institutions do exist, and my sincere hope is that, as a result of improved awareness of what’s going on in the sector, we can build on the good institutions and help them to grow and to actually take a more central role. [At the same time, I hope we can] limit and regulate some of these bad institutions.

The trouble is that the profit-motivated capital tends to be much more attracted to the less ethical institutions because they are much more profitable. So unless we change it from the top down, the problem with the good institutions is that they [will continue to] struggle to raise capital. They struggle to grow because they are not as attractive to a Wall Street investor as someone who [offers] a return on equity of 40%. The problem is, we know where that return on equity comes from: There’s one source — the poor.

Knowledge@Wharton: Do you feel that you’re going to be excluded from the microfinance sector? I understand that you’re working now, but do you think that your future lies in this industry? Or have you become a pariah? At one point in the book you say that the microfinance community often resembles a religious cult and that criticism is considered heresy and isn’t tolerated. And in fact, that is reflected in the title of your book, Confessions of a Microfinance Heretic. So what do you think is going to be the response from people who consider you a heretic?

Sinclair: I’ve already been excluded from about 90% of the sector. I’m never invited to conferences anymore. There’s no point bidding on projects because I’ll be rejected at the outset. And what’s more worrying is that I know other people…. I’m not the only person who has spoken out about microfinance. [The result] is the standard operating procedure — a smear campaign, you don’t get invited to speak, you can’t present papers, you don’t win bids, you do get excluded. But the alternative is, “What do you do? Do you just play the game?” I’ve been playing the game for 10 years and at a certain point I just said, “You know, I can’t keep on doing this with a clear conscience….  I’m no longer prepared to keep quiet.”

What I’m seeing now, which fills me with hope, is that — often from some surprising places — I am actually getting quite a bit of support. More people are coming out and saying, “Yes, there are some good points in this book,” all [based on] their own independent research. Academics are now having the courage to come out and say, “What about child labor in microfinance? What about these extortionist interest rates?” So I think we’re seeing something of a rediscovery of the sector, but it’s going to be a battle, and we are still the small minority. But I’m optimistic. I think that maybe we’re at the dawn of a new era. Who knows?

Knowledge@Wharton: So you don’t regret having written the book?

Sinclair: Not so far. There have been some sleepless nights, I have to say, when you get a threatening phone call at 3 a.m. from an anonymous person. At some point I have thought, was this the wisest decision? But no, I’m happy that I’ve done it and I just hope that people will read it and understand it and take action on the basis of it. If we can get the message to the people who are voting with their wallets, then I think that we can really have a huge impact because, potentially, [microfinance] can be a powerful tool for poverty eradication. Unfortunately, it’s been hijacked. We just need to take it over again.

Knowledge@Wharton: Hugh, thanks for talking with us.

Sinclair: Thank you.

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