Lessons for Microfinance

Lately the microfinance industry has come under a lot of scrutiny, but media coverage doesn't reveal the full picture. A recent New York Times article painted microfinance an industry overrun by big banks that charge eye-popping interest rates.

First, a couple of misperceptions have to be cleared up. Yes, interest rates on microloans are higher than on conventional loans, but the trend is actually down, not up. For the past decade average rates around the world have been falling. They need to continue in that direction to make credit more affordable to more clients. Second, it is not the so-called banking giants that dominate the field. The players making the biggest impact are dedicated microfinance institutions (MFIs) that started out as non-profits with a strong social mission and become regulated financial institutions or banks so they could scale up to carry their mission to more people.

MFIs have to meet the same challenges as any other financial institution. They have to manage risk, control costs and raise funds. These are some of the factors that keep interest rates up, especially when loan sizes are tiny. We differ in our mission, however. Microfinance is reaching people previously ignored by banks and giving them services that assist them to improve their quality of life. Experience in the field has taught us that interest rate caps make it harder for reputable lenders to serve the poor. MFIs need to earn profits to stay solvent so they can continue helping those they serve.

I believe, as do many of my colleagues, that transparency is a key to driving interest rates down. The Smart Campaign (where I serve as a member of the Steering Committee) is asking the industry to endorse a set of six Client Protection Principles, and one them focuses squarely on transparent and responsible pricing. Microfinance industry participants have responded overwhelmingly to the call to uphold these principles in their daily operations. So far, nearly 1,000 key players --from institutions to donors to individuals--have endorsed the principles and are making the commitment to protect their clients.

So what does this really mean for clients? That they won't be subjected to teaser rates or told one thing but then sold another. Transparency goes further than just posting rates up on the wall for everyone to see. As the subprime mortgage crisis taught bankers, it means that clients actually have to understand what their loans are all about. The burden is on MFIs to make loan terms simple and clear and build client education into the process.

MFIs and their partners are striving to make the industry a model of responsible banking. For example, Kiva is asking that its partner MFIs endorse The Smart Campaign's Client Protection Principles. MFIs that don't will jeopardize their continued link to Kiva. Investors in microfinance have started incorporating client protection checks in their due diligence, and through The Smart Campaign website, MFIs have started sharing practical ideas with each other on incorporating the principles into operations.

MFIs will always be faced with the tension between sustaining their business and keeping their products affordable. It is simply a permanent consideration of double bottom line endeavors like microfinance. But there is no fixed definition of what is responsible. Microfinance is a global industry; institutions are faced with variable cultural factors, governance, and regulations, so rates that make sense in one area may not in another. Transparency allows all the participants in an industry to develop norms and identify outliers. The best practice for MFIs is to offer simple products that clients understand, without penalty fees or restrictions that prevent clients from using their full loan amounts.

Lenders in microfinance recognize that enticing clients to over-borrow, offering complicated financial instruments, ignoring client education, and failing to progress on interest rate transparency will have dire consequences. We need look no further than the American mortgage industry for a stunning lesson. The microfinance industry is determined that it will not have to learn this lesson the hard way.