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The Microfinance Vig

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People of conscience, the media and social investors are discovering, finally, that poverty-reducing microfinance (small business loans for the self-employed) and profit-maximizing microfinance are not the same thing. At this month's first national conference on domestic microfinance, organized by the well-regarded Opportunity Fund, a featured panel challenged industry leaders "What Is the Fair Price for Good Credit?"

With the average worldwide microloan interest rate for poor people hovering around 37%, the typical response is sticker shock. The implied allegation is that overseas microfinance institutions (basically, mini-banks or credit unions) backed by Western investors are realizing big profits by charging unconscionably high interest rates on microloans.

The most common defense of microloan interest rates is that administrative costs to handle thousands of smaller loans are necessarily high. As the logic goes, it is cheaper to make a single large business loan in Lima, Peru, than a large number of tiny business loans in the Peruvian Andes.

But this argument, which with conviction I have made many times myself, entirely misses the pro-poor point. When I hire any other service, say, a plumber, do I care that back office expenses might be cheaper if the plumber did NOT take my business and, instead, only fixed larger, lower-overhead piping problems?

The most fundamentalist defense of high interest rates is that they will stimulate investment, growth, competition, and, ultimately, better rates for consumers. "As competition and scale increase, charging the destitute of today high interest rates...may give the destitute of tomorrow lower interest rates." (quoting myself, Stanford Social Innovation Review, "Microloan Sharks," Summer, 2008).

Writes Professor Ananya Roy in Poverty Capital, "This is the peculiar logic of subprime credit markets: that they are simultaneously instruments of financial inclusion and instances of exploitative, even predatory, lending. Such also is the logic of microfinance, for it allows the poor access to credit but on terms that are significantly different from those enjoyed by 'prime' consumers."

Moreover, an exceptionally radical, virtually unchallenged, policy idea pushes high interest rates. "...there is now widespread agreement...MFIs ought to pursue financial sustainability by being...efficient...and by charging interest rates and fees high enough to cover the costs of their lending...." ("Are Microcredit Interest Rates Excessive?", CGAP Brief, February, 2009).

This is not standard doctrine for other public goods. Most anti-poverty programs -- from health clinics to environmental clean-up, from water projects to schools - need long-term external subsidies while micro-business development requires the poor to bootstrap themselves into profitability.

Well-respected microfinance leaders are understandably pushing hard to "achieve scale" or, in simple English, reach more poor people. The argument for mobilizing large sums of private sector microfinance capital is one of pragmatic desperation and, indeed, not much different from why the poor use payday lenders. To wit, government funds, foundations and donors are often parsimonious, cumbersome, inaccessible and unreliable while private markets stand at the ready on every neighborhood corner.

On April 12, 2010, a New Yorker cartoon depicted a customer discussing a pending loan with his banker. The customer pleads, "Could you stop referring to the interest rate as 'the vig'?" As every fan of The Sopranos knows, the vig is the interest on a shark's loan.

If the microfinance model truly requires high interest rates, is it an anti-poverty tool for the impoverished or a pro-profit tool for investors? Are some microfinance programs loan sharking? What is a fair price for good credit?

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