Unitus today released a rather sudden announcement that it will be releasing its staff and “shift[ing] its resources and activities to areas of maximum socio-economic impact for underserved people throughout the world that have yet to attain either scale or commercial viability.”

I agree with Sean Stannard-Stockton that while the announcement presents the closing as a simple strategic change in direction (due to success, rather than failure), its suddenness is odd and raises many questions.

We have always found Unitus to be an opaque organization. It is one of several large U.S. microfinance organizations whose value-added is unclear.

We urge Unitus to provide more information than is in its press release.

If the “change of direction” is in response to failures and/or disappointments, we urge Unitus to be clear on this point and to share as much information as possible about what has happened so that others can learn from its experience.

If the “change of direction” is, as the press release implies, a big-picture strategic change brought about by less need for its activities, we have the following questions:

• What, specifically, will Unitus be focusing on from here?
  
• Why does its new focus require a complete change in personnel?

• Why has the announcement been made so suddenly? Recent newsletters and press releases seem to imply that there are substantial unexploited opportunities for the work Unitus is doing; did these give the wrong impression? What has changed?

Coming on the heels of the LAPO controversy and our recent post about USAID’s “failure” to target the poorest, we see this event as yet another reason to be wary of the appealing stories associated with microfinance.

USAID’s most recent report on microfinance and microenterprise development tells an interesting story and, in my view, shows just how widely microfinance has been (and continues to be) misunderstood. While many advocate that microfinance institutions focus on people under the global “extreme poverty line”, USAID’s report implies that actually doing so is rare and even unrealistic.

Background: the myth of targeting the poorest

The international “extreme poverty line” is around the equivalent of US$1.25 per day, and around 1.4 billion people worldwide (and over half of those in sub-Saharan Africa) are estimated to live below this line (see the discussion in our international aid report).

Many seem to believe that people in this category are appropriate - even ideal - as clients. For example, see Opportunity International and Grameen Foundation stressing the need to reach the “poorest” and “most vulnerable.” Both Accion and CGAP cite the entire 3-billion-strong set of people under the US$2/day line as potential microfinance clients (upwards of 50% of this set falls below the “extreme poverty line”).

U.S. official aid seems to have taken this idea particularly far. For the past several years, USAID has been required by law to target the “very poor,” defined partly with reference to this “extreme poverty line”:

Both the Microenterprise for Self Reliance Act of 2000 (henceforth, the 2000 Act) and the MRAA mandate that at least half of all USAID funding for microenterprise development directly benefit the very poor. The 2000 Act initially defined the “very poor” as the bottom [poorest] half of those living below each country’s national poverty line … Subsequent amendments to the 2000 Act mandated a second, much more ambitious approach … the amended law created a second definition of the “very poor” — those living on less than the equivalent of $1 per day, calculated using purchasing power parity (PPP) exchange rates. The law made clear that, for any given country, the applicable definition of the very poor would be the more inclusive one.

(Note that “$1/day” may be a reference to the $1.25/day “extreme poverty line” discussed here - see note 6.)

Investigating actual poverty levels of clients

To its credit, USAID put significant effort into tracking whether it was actually meeting this goal, developing poverty assessment tools for assessing clients’ poverty levels and requiring certain grantees to use them. The results:

Among the eight microfinance institutions that applied and reported on the Poverty Assessment Tools, the average share of Funds Benefiting the Very Poor (FVP) is estimated at 28.5 percent, up from 16.3 percent in FY 2007. … For the 14 enterprise development programs that applied and reported on the Poverty Assessment Tools, average FVP is estimated at 26.0 percent, up from 20.5 percent in FY 2007 …

USAID did not come close to its target of 50% “extremely poor” clients. Furthermore, it concluded that continuing to push for this target would be unwise:

As matters stand, USAID sees no promising options for meeting the FVP target. It cannot do so by reallocating funds among its existing partners, because with the exception of one small program, none had more than 50 percent “very poor” clients. It cannot do so by shifting funds to established microenterprise organizations that are not already receiving USAID funding, because few if any such organizations are voluntarily applying the USAID-certified poverty assessment tools, and no such organization has offered solid evidence that it has more than 50 percent “very poor” clients …

Misguided target?

USAID does not conclude that microfinance/microenterprise projects should be de-emphasized (it observes that “the great majority of clients … are very poor, at least in commonly used terms”). Instead, it concludes that the idea of serving the poorest was unrealistic/inappropriate in the first place.

the overall pattern of results lend further weight to the point that USAID raised in last year’s Annual Report - that current law imposes too low a threshold for being “very poor.” This very narrow definition makes it impossible for USAID to allocate its microfinance and microenterprise funding so as to reach the legislative target of directing 50 percent of the benefits of microenterprise funding to the “very poor,” without undermining other goals emphasized in the same legislation, such as sustainability and support for broad-based economic growth.

Unfortunately, this definition of being “very poor” was adopted without any evidence that a 50 percent FVP target based on this definition could be reached. Two years of results using the poverty assessment tools strongly suggest that the target cannot be reached without inflicting undesirable side effects on sustainability and economic development. In short, USAID sees no realistic prospect of reaching the target contained in the law, and urges prompt and serious consideration of changes in the law. (Bold mine; italics in original)

I’m inclined to agree with USAID’s conclusion. I agree that people with incomes well above the “extreme poverty line” can still be very poor, certainly poor enough that I’m interested in donating to help them. So my point is not that microfinance is being carried out inappropriately, or is failing to reach the very poor.

Rather, I’m noting yet another way in which microfinance seems to have been badly misunderstood by its biggest funders and proponents. USAID, and by implication its grantees, seem to have thought that they were serving the world’s poorest - to the point of legislating it - without any data, and wrongly. It’s another debunked myth, and another sign that the funding and the stories have gotten ahead of the facts.

Back in December, we expressed concerns about LAPO, one of Kiva’s largest microfinance partners. Last month, the New York Times ran an article implying criticism of LAPO. Now, Kiva has suspended its partnership with LAPO. A couple of questions this raises:

Which of the several objections to LAPO have led to the suspension?

Several concerns have been raised about LAPO:

• The New York Times article focuses largely on the high interest rates and forced savings (which cause the interest rates to be higher). We have argued that focusing on interest rates in isolation is a mistake.
• The Times article also raised concerns about LAPO’s transparency/accountability, including the question of whether it is collecting savings without the right legal license and the question of whether it is misleadingly presenting its interest rates to the outside world.
• To us, the most compelling concern about LAPO is its 49% dropout rate.

How many more of Kiva’s partners might have similar problems, and what is Kiva doing to address this concern?

As the case of LAPO shows, the interest rates reported to Kiva may not fully capture what clients are paying. More broadly, it appears to me that Kiva’s due diligence on partners is intended to assess the risk of money being lost and/or going to illegitimate organizations, but not the more difficult-to-assess risk encountered with LAPO: that a partner’s activities may be leading to overindebted, misinformed, and/or dissatisfied clients, and thus result in financial success but not positive social impact. The stories posted on Kiva’s website do not, in my view, help to address these risks either.

When the New York Times discovers a problem, makes it very public and causes change, this is a good thing. But I don’t think we can expect this mechanism to reliably address the broader issue. Kiva has had enormous success getting people excited about microfinance and getting capital to MFIs; I would like to see more work go into making sure those MFIs are benefiting the people they serve.

I’m very interested in the recent debate over microfinance interest rates (see our response to the NYT article, as well as Te-Ping Chen’s comments at Change.org).

It seems that realizing how high interest rates can be has been a wake-up call to many that microfinance can easily be doing damage as well as good. If someone is paying 150% interest a year, all it takes is some accounting errors for them to end up losing money and getting stuck in debt rather than helping themselves as intended.

But isn’t this concern equally valid for lower interest rates? The same people complaining about excessive interest rates imply that rates 10-30% above the cost of raising capital can be considered reasonable. 10-30% above the cost of raising capital is still significant - it’s more than most Americans pay on their credit card debt - and small losses could be especially risky and damaging to the very poor.

In my view, there is no substitute for asking tough questions about social impact and no excuse for donating to a microfinance charity that can’t answer them.

Recent coverage of microfinance has had a sharp focus on interest rates, implying some line between “reasonable” interest (associated with “social investment”) and “excessive” interest (associated with “loan sharking”).

In Nicaragua, President Daniel Ortega, outraged that interest rates there were hovering around 35 percent in 2008, announced that he would back a microfinance institution that would charge 8 to 10 percent, using Venezuelan money …

Damian von Stauffenberg, who founded an independent rating agency called Microrate, said that local conditions had to be taken into account, but that any firm charging 20 to 30 percent above the market was “unconscionable” and that profit rates above 30 percent should be considered high.

Mr. Yunus says interest rates should be 10 to 15 percent above the cost of raising the money, with anything beyond a “red zone” of loan sharking. “We need to draw a line between genuine and abuse,” he said. “You will never see the situation of poor people if you look at it through the glasses of profit-making.”

It seems very important that interest rates be transparent, i.e., clearly communicated to and understood by clients. It also is clearly important that there be no coercion, i.e., that clients not be pressured to take loans they don’t want to take. More debatable, but something that we support strongly, are additional measures to assess and improve the client experience, including monitoring overindebtedness, examining dropout rates, etc.

But if/when such things are in place, it is unclear to me on what grounds anyone can complain about interest rates being “too high.” If the terms of loans are clearly communicated, then I see no explanation for why clients would take out loans - unless they feel they have no better alternatives.

What objection can be raised to a 100% interest rate, if the next-best alternative is a 500% interest rate (as I have been told some informal moneylenders charge)? What objection can be raised to a 500% interest rate, if there is no other way for people to get credit? When a loan could result in a sick child’s being treated, or a profitable micro-business, what fee is too high for that benefit?

When MFIs charge more than they need to in order to make a profit, that’s an opportunity for someone else to come in and undercut them. If no one else is coming in, that implies that the costs and difficulty of providing credit in an area may be higher than they appear to an outsider. For an outsider to declare profit margins “too high” strikes me as ungrounded and unproductive, especially when that outsider has not tried to provide credit for less in the same area.

Microfinance exists to improve the lives of the poor. Ideally, then, microfinance institutions would be judged by their effects on people’s lives. Instead, they’re being judged by simplistic financial metrics that crudely attempt to get at the moral uprightness of the organizations. To me that’s a very familiar situation.

I believe the ideal way to evaluate an MFI is to look directly at its impact. When this isn’t possible, proxies for client participation and satisfaction may (debatably) be appropriate. I don’t see any place for universal rules about how much interest can be charged.

One of the more difficult things to understand about the microfinance institutions we’ve investigated is the “true” interest rate they’re charging their borrowers. In July 2009, David Roodman of the Center for Global Development wrote:

It appears that many MFIs impose subtle fees that effectively raise interest rates. Some charge one-time loan origination fees. Some require borrowers to deposit a percentage of each loan amount with the MFI in a savings account that pays interest at a rate lower than that on the loan. Some overcharge for credit-life insurance bundled with the loan. Another criticized practice is to charge interest on the full loan amount even as the outstanding balance declines over the repayment cycle. Such “flat-rate” interest effectively doubles the interest rate compared to “declining-balance” interest since the average balance over the cycle is half the starting amount. Also, MFIs may also prefer to quote their rates on a monthly basis, hoping to exploit borrowers’ ignorance of how a seemingly modest 6 percent per month compounds into 100 percent per year.

Our experience with the microfinance organizations we have investigated to date suggests that these are real issues that donors should be aware of when interpreting interest rate data.

To be clear, we don’t think charging a high interest rate signifies wrongdoing on the part of a microfinance bank. High interest rates may be the best way to minimize losses and serve more people, and client participation at high interest rates may be an indicator that they are getting a service they value. We just want to note how striking the difference is between the initial “cited” interest rate donors often hear about and the “effective” interest rate taking all factors into account.

We recently evaluated a microfinance institution (MFI) in Malawi, the Microloan Foundation, as part of our process for distributing a grant to an economic empowerment charity in Sub-Saharan Africa. Its stated interest rate for its most popular loan type is 20%, but:

• 20% is the rate over the course of the 4-month loan. The “nominal Annual Percentage Rate (APR)” (a common way of stating interest rates in standardized terms and the rate which U.S. lenders are required to provide to borrowers) of this loan, with no other costs, would therefore be 60%.
• Interest is calculated as a flat rate. 20% of the whole loan amount is charged each payment, instead of 20% of the remaining loan balance. This method raises the nominal APR from 60% to 93%. On a $100 loan of this type, a borrower would pay $20 in interest compared with only $12.80 on a loan with declining balance interest.
• Payments are due every two weeks, instead of every month, so that the first payment is due only two weeks after the loan is made. Requiring 8 payments instead of 4 raises the nominal APR from 93% to 102%.
• The Microloan Foundation requires borrowers to hold 20% of the loan amount in a savings account which cannot be accessed until the loan is repaid. On a loan of $100, this requirement reduces the effective size of the loan to $80, while decreasing the effective size of the last payment due by $20 (because savings are then accessible). The savings requirement raises the APR from 102% to 149%.
• Arguably, the APR used above (i.e. the “nominal APR”) understates the interest rate people are paying because it does not take into account the compound value of interest. (Wikipedia’s entry on APR has a discussion of the relevant issues.) At relatively low interest rates, such as the interest rates we’re used to in the U.S., the “nominal APR” (what is usually reported) and the “effective APR” (the “mathematically true” interest rate) are usually very close to each other - but at the much higher interest rates charged by microfinance institutions, the “effective APR” can be considerably higher, raising the question of which one should be quoted to give Americans the best picture of what people are being charged. The Microloan Foundation’s nominal APR of 149% is equivalent to an effective APR of 326%.

Not only are these final “effective” interest rates many times bigger than the initial “20%” figure, they’re also significantly higher than would be implied by looking at MLF’s nominal gross portfolio yield according to MixMarket (93% for 2008; Mix Market defines this as interest and fees divided by the gross average loan portfolio ).

MLF doesn’t charge fees on its loans, but other microfinance institutions do, and these can cause further significant increases in the effective interest rate. (For example, adding a 5% fee to the beginning of a loan that without fees would have a nominal APR of 40% raises its nominal APR to 66%.)

From what we’ve seen, fees, compulsory savings, and the flat interest rate method seem to be fairly common among microfinance institutions. Of the 65 MFIs who had submitted a Social Performance Standards Report to Mix Market as of late 2009, 42% use the flat interest rate exclusively, 29% held compulsory savings accounts, and 72% collected fees on at least some loan products (according to their Mix Market profiles).

Understanding the true cost of credit for a borrower is important for reasons discussed previously:

• High interest rates (combined with high rates of repayment and low drop out rates) show that borrowers are willing to pay a high price for the loan, arguably implying that they value this service.
• If interest rates are low, microfinance institutions may be effectively giving cash transfers, at which point the mere fact of participation becomes less meaningful, and it becomes more important to ask whom the handouts are going to.
• On the other hand, the higher the interest rate, the more we worry about whether borrowing is good for the borrowers (and about anecdotes like this one).

A fairly new initiative (started in 2008), MFTransparency, is working to create a more open discussion about microloan pricing, and has compiled and published interest rate data for two countries, Bosnia and Cambodia. We look forward to following the progress of this initiative and to drawing on its data to inform our investigations of microfinance organizations.