Reflections on Transparency

The controversial Compartamos IPO in 2007 provoked Chuck Waterfield into founding the MFTransparency initiative to fight practices that obscure the full costs of loans.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.If MFTransparency helps poor people understand what they are paying for credit, then it is a great thing. In Dhaka, Stuart Rutherford introduced me to a client of his SafeSave microfinance project who lived in the slum around the corner from a SafeSave branch. He took pride in showing me the rules for the woman’s loan and savings accounts: in plain Bengali, on a single sheet of paper folded into her passbook. She could not read it but she and Rutherford took further pride in showing me that her school-age son could. Implicit in SafeSave’s transparency was a criticism of business-as-usual microfinance in Bangladesh.But in writing about transparency today for the book, I found myself scratching my head about a few things:

• What is the link between Compartamos and transparency? The IPO was controversial because it made the founders millionaires on the backs of poor people paying 100%/year interest (including 15% tax; the before-tax rate has since fallen). Did the Mexican borrowers not realize they were paying such high rates? Rich Rosenberg's superb review of issues around the Compartamos IPO thanks Waterfield for comments but makes no mention of transparency. My best guess about the link, if there is one, is that Compartamos quoted rates on a monthly basis. 6%/month sounds cheaper than 100%/year, even though they're the same with compounding.
• But if that is the link, I don't find it compelling. Anyway, the thought leads me to a larger question: do annualized percentage rates (APRs) always increase transparency? MFTransparency.org emphasizes the importance of computing APR equivalents of all charges. When I was researching whether to refinance my home in April, all the lenders listed headline rates as well as APRs. The APRs were always higher because they factored in various fees. I assume a transparency law made them do this. The APRs let me compare apples to apples, so I'm glad for the practice.At the same time, APRs seem overrated in some contexts. In the early 20th century, Morris Plan banks made small loans to working Americans who could muster two cosigners to assume joint liability not unlike in group microcredit today (see chapter 3). If you took a $100 loan, the bank took 8% right off the top and gave you the rest, $92. Then you paid back $100 in small regular installments over the following year. Superficially the interest rate seemed to be 8%. But critics pointed out that the balance on the loan started at $92 and fell to 0 over the year, so it averaged $92/2=$46; and $8 interest on $46 worked out to a much higher 8/46=17% APR. The same point can be made about many microloans today. But in a panel discussion at the annual meeting of the American Economics Association in 1931, surrounded by economists who think this way, one Ralph Pitman, who served as president of the Morris Plan Bankers Association, mounted a passionate defense of Morris lending practices:In other words: "Regular folks don't know from APRs. We make our deal simple and clear, and in a way that fits with how people think about money: you get $92 for a special need, you pay back $2/week out of your regular cash flow. We are transparent."Consider also the example of the vegetable sellers of Chennai, who pay 10%/day for informal credit. Are their moneylenders remiss in not disclosing the effective APR of 128,330,558,031,335,170%/year? I'm reminded of the Steven Wright joke: “One time, the police stopped me for speeding, and they said, ‘Don't you know the speed limit is 55 miles an hour?’ I said, ‘Yeah, I know, but I wasn't gonna be out that long.’”APRs are one good route to transparency in many contexts. But to answer my own question, sometimes APRs are not enlightening or necessary.
• I was surprised to learn that MFTransparency is not really focusing on ensuring that MFIs are transparent with clients. The initiative is doing three things: 1) getting MFIs to endorse a general statement of support; 2) collecting data from some MFIs needed to compute APRs or the like, presumably to publish on its website for the benefit of those who put money into microfinance; and 3) "MFTransparency will develop and disseminate educational materials to enable microfinance stakeholders at a broad range of levels---analysts, donors and investors, MFI managers, microentrepreneurs themselves---to better understand the concept and function of interest rates and product pricing." Clients are just one item in that sentence, and I think Ralph Pitman would say that it is more important for the MFIs to disclose costs to clients in ways compatible with how clients think about money than to teach clients how to think about money the way MFIs do. Stuart Rutherford might too, but he's alive, so I won't speak for him.A new paper by Bruce Carruthers, Timothy Guinnane , and Yoonseok Lee documents how in the Morris Plan era, the Russell Sage Foundation focused precisely on transparency for the client (via APRs, I should mention), in an interesting bargain. It persuaded two-thirds of U.S. states to pass versions of a Universal Small Loan Law, which exempted lenders from usury rules provided the lenders disclosed their charges in a simple interest rate.