Agree or Disagree: Profit Margins in Microfinance Should be Limited
by Jordan Filko
The Microfinance Club of New York (MFCNY) and ACCION USA recently co-hosted the first event in a series of debates on current issues in the microfinance industry. This debate addressed the question of whether profit margins in microfinance should be limited. MFTransparency CEO & President Chuck Waterfield and Grameen Foundation Vice President for Microfinance Camilla Nestor argued on the side in favor of limiting profit. Michael Edberg, Director of Investments for MicroVest, and Brian Cox, CEO of MFX Solutions, argued against limiting profits. Jacob Haar of Minlam Asset Management served as the skillful moderator of this heated debate.
Agree: Profits in microfinance should be limited
The proponents of limiting profit in microfinance took the position that while profits are good and sustainable microfinance institutions are essential to achieving the social mission of microfinance, there should be limits to how much money can be made off of the poor. Mr. Waterfield raised the point that microfinance, such a diverse industry and one created as a better alternative to moneylending, needs to define itself. What is the difference between microfinance and moneylending? Why is microfinance a better alternative and what can we do to make it stay that way?
Profit is an important factor to consider when determining how committed microfinance is to its social mission, but it must be evaluated in combination with several other factors. For example, it is not enough to see “high” interest rates and conclude that institutions are making too much profit. High interest rates can indicate that the institution is working in a difficult country environment, or serving a particularly hard to reach population. Loan size is also a factor here. As loan sizes go up, prices should come down. If prices start high, loan sizes increase and prices stay high, then one can start to suspect that large profits are being made.
The Agree Team also presented several options for implementing a limit on profits. Ms. Nestor outlined the five major options as follows:
- Interest rate caps. There are currently 30 countries with interest rate caps. These can be effective but often come with major drawbacks such as an increase in non-transparent pricing or exclusion of the poorest as the cap makes the smallest loans too expensive for MFIs to offer.
- Margin caps. A limit on the difference between the costs to an MFI of offering a loan and the interest rate charged to the client for that loan. This method can be used in a diverse set of environments, so it can be applied fairly to MFIs serving harder to reach groups as well as those serving more accessible populations.
- Return on Equity caps. This approach focuses on the profits of the institution directly, rather than the price given to the client. A major disadvantage of this approach is that it doesn’t distinguish between different ways of using profits.
- Comparative transparency. This is the approach that MFTransparency has taken, collecting, publishing and standardizing prices in a country to help define what is “responsible” in a given market.
- Competition. In theory, competition should prevent institutions from making excessive profits off of poor clients, but given the many market imperfections in microfinance this approach has been shown to either fail or take a very long time to work.
Mr. Waterfield pointed out that many institutions, such as ProCredit, already maintain internal profit limits, one option that others in the industry should follow. In addition to limits, Ms. Nestor also brought up the topic of the best ways of making profits, namely those that involve clients receiving a portion of these profits.
Although profit limits are not found in many industries, the pro-limits side argued that microfinance is different from other industries. In microfinance clients are poor, uneducated and often financially illiterate. This makes them extremely vulnerable to exploitation on the part of financial service providers. Given the many distortions in the microfinance market, such as the absence of strong regulatory frameworks and the combination of donor and commercial funding, it cannot be assumed that client interests will be protected by fair market forces. We need to therefore draw on the social mission of microfinance to serve our clients better, not solely on the profit motive.
Disagree: Profits in microfinance should not be limited
One of the main points made by the team opposing profit limits in microfinance was that limits could impede the progress of financial inclusion. Mr. Edberg made the point that without a sufficient profit motive, new entrants will have less incentive to serve the poor, resulting in overall decreased access for the poor to financial services. The microfinance industry needs profit-driven funders, as there is not enough donor money available to meet the demand for microloans. Mr. Edberg also cited the example of ProCredit, pointing out that they have reinvested the majority of the profits they’ve made into their core business, leading to tremendous growth in the capacity of their member institutions. This demonstrates that profit need not be a bad thing if it is used well, and in fact it should be encouraged to allow just this type of practice to expand.
In addition to expanding financial inclusion, the profit motive is essential for the improvement of existing microfinance services. Mr. Cox made argued that competition is necessary in order to improve services and drive down prices for clients, and without the ability to profit the drive to compete will be diminished. Profit as an incentive for innovation is especially important for the poorest clients, who are the most expensive and hardest to reach. Competition is necessary and exploitation is unacceptable, so we need to make competition work.
In addition to opposing a profit cap in theory, the “disagree” team found the idea of implementing a cap to be effectively impossible. Without a strong, unified regulatory framework for microfinance internationally how could any sort of limit possibly be put in place, let alone enforced?
The anti-limits side agreed that there are aspects of microfinance that need to be “cleaned up” and ways of measuring dedication to a social mission that need to be better defined. However, these issues can be addressed without implementing a limit on profit, such as by promoting transparent pricing. If we choose profit limits as a way to ensure a dedication to poverty alleviation, commercial capital will be driven away and we will reach fewer poor people with a lower quality of services.
Both sides in this debate were in favor of profit. Where they differed was in the questions of how much, how it is made and what is done with it. Another fundamental difference between the two seemed to be ideas of how to improve microfinance. More microfinance is not better if the quality of the services is low. Do we improve our service of poor clients through competition or through voluntary industry initiatives? I think both sides might agree that a little of both is necessary. In general I think the crucial component in addressing this issue is focusing on common ground. One comment in the Q&A, made by Asad Mahmood of Deutsche Bank, really resonated with me (paraphrased): “Microfinance is both social and financial. These two components are inextricably intertwined, like DNA. You cannot focus on one or the other.” I think this is the approach we have to take as we build the foundation for the future of microfinance. I hope in the next debate we can start from this point and move forward.
A full video of this debate is available here. For further industry discussion on this topic, read the debate between Muhammad Yunus and Vikram Akula on the Forbes blog, the Business Standard opinion piece “Big is beautiful in microfinance,” and another review of this debate also on the Forbes blog.