My last two posts described the high risk of a repayment crisis in Chiapas, Mexico, and its potentially devastating consequences to the microfinance sector around the world. But here is the good news: thus far there is no crisis, and one could still be avoided.
I have argued before that DFIs and other funders could leverage Smart Certification to enforce client protection practices and thus avoid the kind of overlending that’s happening in Chiapas. However, that prescription alone would not work in Mexico, mainly because a large number of Mexican MFIs are independent of foreign funding, and there are many other lenders active in the same space, including consumer finance companies and large retailers that provide credit.
The answer to avoiding a repayment crisis in Mexico will thus require government action, most likely new legislation that would bring all lenders under a common set of regulatory standards. Specifically, there are two key areas that must be addressed:
Mandatory credit bureau reporting for all financial institutions. While regulated institutions are already reporting to a credit bureau, according to a recent MicroRate report, many unregulated MFIs do not. Bringing them and other lenders in the space under the same credit bureau umbrella is critical to curbing over-lending.
Mandatory loan limits. On its own, knowing how many loans a client has will not prevent overlending. Thus, once credit reporting becomes mandatory, all new loans should become subject to a ceiling of both total balance and number of loans outstanding, similar to the microfinance regulation currently in place in India. Such cross-borrowing limits may be crude, but with a reliable credit bureau, they are straightforward to implement for both individual and group-lending methodologies. Moreover, such an approach can still allow for flexibility, by giving lenders the option to exceed these limits, but only if they can demonstrate that they have verified the borrower’s repayment capacity within established guidelines.
These two requirements must be applied to all financial institutions. Not doing so would simply push irresponsible lending to the least-regulated parts of the market, thus repeating exactly the experience of the US mortgage market, where the least regulated segment – subprime – was to a large degree responsible for pumping up the housing bubble.
The road to such national legislation will not be easy, but it is up to the global microfinance community to lead the way. In the best case, it will help generate a sense of urgency in Mexico and perhaps lead to action that can actually avoid the crisis. But even if a crisis can’t be avoided, then taking action today can help provide some measure of protection from its worst effects. First and foremost, that means taking a very clear and strong stance with those MFIs in Mexico that are affiliated with the international lenders and donors. All future funding of these MFIs must be made contingent on the standards outlined above and on beginning the process of becoming Smart Certified. In addition, MFIs should also be required to introduce loan repayment flexibility, which will help ease some of the pressure in an overheated market.
The root of the problem: high profits
However, regardless of what else is done, any solution that does not end the huge profits in the sector is doomed to fail. At the end of the day, the problem is too many MFIs have entered the sector and are now competing for the same customers. How did this come about?
In many respects, such overcrowding is a demonstration of the success of Compartamos. For years, it has couched its high-profit strategy in terms of crowding-in commercial investors to the sector. In this, Compartamos has been wildly successful. According to Chuck Waterfield, there are now roughly 2000 MFIs in the country.
Why do I keep harping on Compartamos? Indeed, there’s a reasonable argument to be made that relative to most Mexican MFIs, Compartamos is a fairly responsible lender. On client protection, it received a C+ from the most recent Planet Rating social rating – not good, but also not terrible. Compartamos loan pricing is well below the market average, even after controlling for loan size. And of course, as a regulated institution, it makes full use of the credit bureau. However, even Compartamos cannot escape the market reality that it helped create: 46% of its clients live in areas with 10 or more other MFIs present, and this figure is almost certain to be higher in Chiapas.
The issue of high profits is perhaps best understood via David Roodman’s ingenious Bicycle Tire Theory of Microfinance Market Stability: no matter how thick the tire (i.e. strength of regulations), it cannot withstand ever-increasing air pressure (influx of credit). As high profits continue and ever-more credit flows into the sector, the regulatory regime will develop weak spots that will inevitably fail. Meanwhile, there’s no sign that competition has been pushing profits down at all. That’s part of the problem of bubbles – the highest profits are often seen at their peaks.
The dilemma of doing right
The unfortunate truth is that this most important piece of the puzzle – bringing profits down to sustainable levels – is also the most difficult to accomplish. Any attempt to do so would be hopelessly ineffective without Compartamos leading the way. But even if Compartamos management were to adopt a strategy of lower profits, the result would devastate the company’s stock price, which is valued according to current profit expectations.
In effect, Compartamos is now prisoner to its own profit targets, and setting the prisoner free will be the subject of my next blog. Until then, I invite you to share your thoughts. Do you agree with the premise of my earlier blogs: is the sector at or near the brink of crisis? Would the crisis be as devastating as I suggest? And what will it take to bring the sector back from the brink?
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