Think of microcredit as you read John Kenneth Galbraith, who wrote that financial euphorias share common denominators:
This is of no slight practical importance; recognizing them, the sensible person or institution is or should be warned. And perhaps some will be. But...the chances are not great, for built into the speculative episode is the euphoria, the mass escape from reality, that excludes any serious contemplation of the true nature of what is taking place.
Uniformly in all such events there is the thought that there is something new in the world. It can, as we shall see, be one of the many things. In the 17th century it was the arrival of tulips in Western Europe...Later it was the seeming wonders of the joint-stock company, now called the corporation...
In all speculative episodes there is always an element of pride in discovering what is seemingly new and greatly rewarding in the way of financial instrument or investment opportunity. The individual or institution that does so is thought to be wonderfully ahead of the mob. This insight is then confirmed as others rush to exploit their own, only slightly later vision...
As to new financial instruments, however, experience establishes a firm rule...that financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design, one that owes its distinctive character to the aforementioned brevity of the financial memory...All financial innovation involves, in one form or another, the creation of debt secured in great or less adequacy by real assets...All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment.
(A separate, viewable excerpt of the book is here.)
I'll leaven the comparison to microcredit with a few caveats:
- Most actors in microcredit are not in it solely for profit. So the positive feedback loop of market manias is not at work in the same way. It is not the case that people are plunging into microfinance institutions (MFI) stocks and bonds because their price is going up and vice versa. Compartamos's stock fell hard after its IPO (though has since mostly recovered).
- Today's microfinance embodies a lot of innovation, and innovation continues. I think the focus on women is a great innovation of our era. Whether these advances are small or large in the sweep of financial history lies in the eye of the beholder.
- To wonder whether microcredit contains bubbles is not to suggest that microcredit is one big bubble any more than noting history's parade of banking crises implies that we ought to dispense with banks.
- More microcredit (from more microcreditors) is a good thing for people who can invest the capital well, or have the wealth to easily repay.
But Galbraith's detached scorn also resonates:
- Most of what people think is new in microfinance isn't. Lending to jointly liable groups of poor people goes way back---remember the credit cooperatives in Bengal 100 years ago.
- So a bit like the promoters of tech stocks and subprime mortgages whose claims of "innovation" obscured the true value of the assets behind their securities, many promoters of microfinance do exaggerate the novelty of their favored financial instrument. This attracts people to microfinance even as it obscures the uncertainties and complexities about the true value---financial and social---of investments in microcredit.
- A dangerous positive feedback loop can occur in microcredit. Enthusiasm for investing in microcredit can fuel the rapid expansion of several MFIs in any given place, making it easy for people to borrow from one MFI in order pay off a debt to another. That maintains appearances on paper, reassures investors, and draws in more investment. You see where that might lead.
To descend from abstractions, the phenomenon just described, "multiple borrowing," has occurred and will occur again. Bolivian microcredit experienced a crisis in 1999 after years of rapid growth and the arrival of purely commercial gung-ho lenders. Here's Beth Rhyne in 2001:
Poaching clients from other institutions through the offer of larger loans has proven to be an extremely successful marketing technique in Bolivia, as elsewhere. And it has been shown repeatedly that clients are not good judges of their own debt capacity. Apparently credit is like good food: when seated at the table in front of a feast, many people eat too much and regret it later...The truly unfortunate dynamic is that if over-lenders are successful at luring clients away from more responsible lenders, the responsible lenders are virtually forced to follow suit. The pressure to lend more to keep good clients is nearly as irresistible as the client's desire to borrow more. Worse, if clients begin using one loan to pay off another, the game becomes..."Who collects first?" In short, the sector as a whole starts to become one big Ponzi scheme...In such a situation only a central body, like the Superintendency of Banks, can stop the spiral, with regulations like those it put in place in 1999.
And as I blogged, Siddhartha Chowdri, Accion's director in India, has pointed to multiple borrowing as a source of the political blow-up in Andhra Pradesh (AP) in 2006 and newer troubles in Karnataka state.
I should note that neither the Bolivia nor the AP crisis proceeded quite the way the financial bubble analogy suggests. In Bolivia, a separate breed of lender, not considered microcredit, sprang onto the scene and then collapsed almost as quickly, but not before infecting MFIs with repayment problems. A political backlash came too. Protesters pelted bank windows with trash, and, in 2001, took the Superintendency of Banks hostage. In India, the "crash" was also as much political as financial, with local politicians responding to complaints from borrowers by shutting down MFI offices. And in both cases, microcredit, though wounded, survived the wiser---unlike, say, Bear Stearns and NASDAQ darling NorthPoint Communications.
The practical question is: How can MFIs detect and prevent (multiple) over-borrowing? How do they implement the first Client Protection Principle developed by CGAP and Accion's Center for Financial Inclusion? A new Microfinance Gateway profile reviews the steps the Nicaraguan MFI Banex took in response to another political backlash:
Gabriel Solorzano, president of Banex, explains, “Our policies have been a reaction to the environment here in Nicaragua. It’s not easy to be on the front page of the newspaper five days in a row. It’s not easy to have the president of the country telling people they don’t have to pay.”
“In a country of only five million people, there are 350 MFIs and just about every donor on this planet. There was a level of market saturation, about to explode,” says Solorzano. In Nicaragua, over-indebtedness has become a serious problem, Solorzano explains, “so we changed our credit policy not only to request credit information from the new credit bureau, but also to tighten the liquidity of the client.”
Banex significantly lowered its threshold for a client’s debt-to-net income ratio. As a result, they now reject 80% of all loan applications (up from a previous rate of 20--25%). Though this more conservative position stopped the MFI’s growth (they had previously enjoyed a 74% compounded annual growth), Banex recognized it as a necessary step.
In general, the prescriptions for preventing over-borrowing center around collecting information about clients---tallying up their income or assets to determine how much debt they can handle, instituting credit bureaus. This all seems sensible and important, even if fraught with difficulties.
But is it practical for group credit? Banex is an individual lender. Group microcredit caters to the poorest by cutting costs to the bone. And that it does by offloading the tasks of selecting and monitoring clients onto clients. Collecting information about how much people owe, own, and earn seems antithetical to the business strategy that has brought group microcredit to millions. It costs too much. Put otherwise, in group credit it is up to borrowers to keep tabs on how many loans their peers have, how much they owe, and whether they can keep up with the payments. The financial health of major group microcreditors, such as in India and Bangladesh, depends on the good judgment of their borrowers. Does that judgment remain reliable as multiple borrowing becomes the norm?
Perhaps Bangladesh's example should soothe my angst: it's had substantial multiple borrowing from group creditors for 10 years and hasn't crashed yet. A 2002 study by BRAC researchers Iftekhar Chaudhury and Imran Matin (hat tip to Christoph Kneiding) found that 90% of BRAC-only borrowers were regular loan repayers, compared to just 50% of those who borrowed from BRAC and at least two other MFIs. Pretty worrisome---though this correlation doesn't prove that multiple borrowing causes lower repayment. (Maybe it's the other way around.) The authors also found---and struggled to explain---that even irregular repayers usually pay off their MFI loans eventually. I don't know whether this is simply good news, or a haphazard pattern of paying off old loans near the end of their one-year cycles in order to quickly get new ones, possibly using bridge financing from moneylenders.
So to return to the question of whether we trust peers monitoring multiple-borrowing peers...Galbraith emphasized what is obvious today: human beings are eminently capable of collective delusion about the value of financial claims. If multiple borrowing becomes common in a society, might an upward bias creep into people's intuitions about how much debt people like them can handle? "Everyone is borrowing from multiple MFIs and nothing bad has happened to them, so it must be OK." Are group microcreditors in competitive markets riding a tiger? Would they know if they were?
I ask these questions not merely to be rhetorical. Do you have answers?
I close with the opening quote from Galbraith's book: