THE BLOG
10/02/2013 09:55 am ET | Updated Jan 23, 2014

The Sharks of Microfinance and the Future of Impact Investing

We created microcredit to fight the loan sharks; we didn't create microcredit to encourage new loan sharks... Microcredit should be seen as an opportunity to help people get out of poverty in a business way, but not as an opportunity to make money out of poor people. -- Muhammad Yunus, founder of Microfinance

In the 1990s, people assumed that the altruistic intentions inherent in microfinancing would be enough to prevent exploitation once introduced into mainstream markets. Perhaps impact investing is a similar enough financial innovation that we can learn from some of the growing pains of microfinancing to help prevent history from repeating itself.

Microfinance is a form of financial service for individuals and businesses lacking access to traditional banking and institutional credit. It differs from impact investing in that it focuses on opening capital to typically disadvantaged populations, whereas impact investing is more concerned with results-based outcomes that either improve society or the environment while still garnering economic returns. Also, occasionally impact investing is connected with donations and public dollars to account for various financial risks, or if there is government involvement (e.g., social impact bonds).

Regardless, both impact investing and microfinance are market-based solutions designed to address economic gaps within society. However, the notion of profiting from the poor is still a contentious debate at the cornerstone of these modern financial innovations, and impact investing is no exception with its primary target being emerging markets.

One way of possibly addressing this issue would be to embed third-party oversight into the very infrastructure of governance, such as regulation and accountability structures. This way, if any donations or public dollars are topping off an impact investment, we can be sure those dollars are being used appropriately, or if a company is leveraging an impact investment as a part of their social responsibility envelope, the public will be informed whether the investment is actually making a positive difference in the community.

If proponents for impact investing are serious about the introduction of new social and environmental markets, they need to equip these markets with the necessary tools to stand a fighting chance. Otherwise, once impact investing becomes commonplace, and more and more players enter the market, financial outcomes will again dominate, as witnessed in some cases of microfinancing, only with impact investing, it will be at the expense of social and environmental gains.

The lack of regulation in microfinancing opened the door to exploitation and led to a number of negative consequences with the most egregious being a series of suicides that happened after a number of reckless microloans were made to local farmers in India. According to MFTransparency, the annual percentage rates of some microloans have been over 300 percent in countries like Zambia or Ghana. These high interest rates alone are not necessarily indicative of exploitation (since the smaller the loan, the higher the distribution cost), but they serve as sobering reminders of how market forces dictate costs despite any altruistic intentions. Clearly, the only way to ensure values are being upheld is by providing some type of oversight or monitoring.

Organizations like the IIPCollaborative have been making some notable efforts in this domain, such as their London Principles guidelines, but these recommendations represent drops of water in the ocean; more global institutional support is needed to help establish oversight, financial transparency, credibility and appropriate standardizations (especially for environmental and social metrics).

Since impact investing is searching for the sweet spot between high-net-worth individuals' expectations for responsible investing and effective channels for catalyzing social change, we need to ensure that this financial instrument is not abused. Or else, just as microfinance was defenseless against the sharks, impact investing may find itself in deep waters.