The tragedy of microfinance

An article in the New York Times describes the crisis facing microfinance institutions in the state of Andhra Pradesh, India where up to 80% of microfinance clients have stopped repaying their loans. The story compares the situation to the subprime crisis in the US: "Initially the work of nonprofit groups, the tiny loans to the poor known as microcredit once seemed a promising path out of poverty for millions [but now] some Indian officials fear that microfinance could become India’s version of the United States’ subprime mortgage debacle, in which the seemingly noble idea of extending home ownership to low-income households threatened to collapse the global banking system because of a reckless, grow-at-any-cost strategy."

Similarities with subprime

I think there are definite similarities between the subprime crisis and the microfinance crisis as it is described in the Times article. However, I think the article glosses over the underlying cause of both crises. With the exception of some banking laws in the US which prevented banks from 'red-lining' certain (poor) areas where they would not make loans, a lot of non-profit efforts to increase homeownership among low income Americans were community-based efforts that focused on providing education and other non-financial assistance to borrowers to help them qualify for mortgages. In a similar way, most of the early non-profit microfinance institutions were lending, but their lending was accompanied by a lot of other assistance to help the borrowers understand how to run a business and provide other non-financial assistance.

The subprime crisis was fueled both by aggressive sales efforts, which concealed more about the loans they were offering than provided education that is so vital to incorporating previously under-served portions of the population into the mainstream financial services industry. When the volume of loans (and the profits of the originators) became more important than the outcome (increased low-income home ownership) and the regulation of the activities of originators was lacking, it was a set-up for failure. In the subprime area, however, there was another factor: it was "conventional wisdom" that home prices did not fall either at all or to a degree that would be significant enough to put borrowers underwater on their homes.

The microfinance industry shared some characteristic and the role of education was even more important to finance a microbusiness in order to achieve the repayment rates that are now expected in microfinance. However, what appears to have happened in many cases was that the costs of providing that education became an impediment to increasing loan volumes. The NY Times article mostly describes situations of borrowers who were provided with financing for improving their homes or buying consumption items.

Consumer spending

There is certainly a role for microfinance institutions to finance consumer spending (some of the problems of a micro-debt spiral were due to microfinance institutions financing repayment of other debts, whether they were aware of it or now). However, the primary focus of microfinance should be to create a sustainable income for the borrowers. If that limits the industry's size to a level smaller than what has been achieved in areas of high penetration like Andhra Pradesh, that should be accepted as a reality of the market, not an opportunity to become more reckless with the lending process.

Islamic finance and the Indian microfinance crisis

Now, what does this all have to do with Islamic finance? The point of the twin stories of the subprime crisis and the current microfinance crisis in India demonstrate areas where conventional finance has failed, and has failed in a headline grabbing and significant way. In the case of the subprime crisis, the Islamic finance industry did not take the opportunity to highlight the ethical foundations of Islamic finance that should limit the type of abuses that contributed to the subprime crisis. Instead, a lot of the analysis and commentary (embodied in quotes in widely distributed articles) was that Islamic finance was 'immune' to the subprime crisis, despite the nearly universal absence of facts or theories to support that proposition. In fact, the industry had developed its own risks that would become apparent as the subprime crisis led to a deep global recession (for example, the problems of Gulf Finance House, as described by Mohammed Khnifer, Aatef Baig and Frank Winkler [PDF].

If the industry had been more up front about the vulnerabilities of Islamic finance to crisis (i.e. that it is not 'immune'), it could have spent more time discussing some of the features of Islamic finance that differentiate it from conventional finance, particularly in the sense of risk. There were many bad investments made by Islamic financial institutions in the run-up to the crisis, particularly in areas where the real estate boom rose the highest. However, the differentiating factor in most cases was that if one held an investment in a piece of property, it was unlikely to lose its entire value (although it is possible). In a collateralized debt obligation made up of lower tranches of subprime securitizations, it was easily possible that enough damage was done to the underlying securitizations in a recession that the entire value would be wiped out (for example, staff from the NPR show Marketplace bought a piece of a 'toxic asset' and reported extensively on in while they watched it die). However, at that time, the Islamic finance industry didn't take the opportunity to use the crisis to explain itself. Opportunity missed.

It may already be too late for Islamic finance to seize the opportunity to explain itself and explain how Islamic microfinance would be less likely to lead to the situation of microfinance in Andhra Pradesh. That the opportunity may be lost is due more than anything to the lack of attention that Islamic banks have paid to Islamic microfinance. However, should Islamic finance want to use this crisis as a way to demonstrate its differences from conventional finance (and in particular, microfinance), I think there are a few things that it should emphasize. First, it is useful to catalogue the problems in Indian microfinance are driven by several factors: i) large use of consumption loans; ii) rapid growth focused on boosting loan volumes; iii) lack of verification of customer financial situation and means for repayment; iv) lack of education of clients; and, v) focus on reducing interest rates by boosting loan volumes.

What should Islamic finance learn and how can it use this crisis?

The Islamic microfinance industry is still nascent and has not yet gotten to a point where it is common, let alone to the point of rapid growth, so there are a lot of things that can be used as cautionary tales for Islamic microfinance, as well as to highlight as differences between conventional microfinance and Islamic microfinance.

The over-riding lesson that the Islamic microfinance industry should take is that it needs to focus primarily on the development of business financing. That is where microfinance began and that is where it had the greatest impact and the fewest problems. The initial impetus for microfinance was to develop a way to help the poor create sustainable income sources in lieu of (or in addition to) charitable assistance. This should be the focus of Islamic microfinance as well and any move away from that purpose need to be considered very carefully to ensure that it cannot lead to the incentives for microfinance institutions (MFIs) to focus on their growth and profitability over the benefit of their customers.

Along this line of thought, there are plenty of products used in Islamic microfinance that can shift the incentives towards a more sustainable growth path. For example, while murabaha makes up the bulk of financing in Islamic finance (and may also become the case in Islamic microfinance), the use of mudaraba and musharaka rather than murabaha (or ijara/salam or other financing products) may make better systemic sense for the Islamic microfinance industry as a whole. The systemic benefit comes not from the greater stability of relying on these contracts (it will likely be more unstable than if murabaha is used), but it will focus Islamic microfinance on business financing and will also place the burden of failure more onto the microfinance institution, which should limit the incentives towards "growth at all costs". It will also to some degree limit the negative potential impact of reckless financing on the clients (which of course has important implications for the incentives of the client to act in both parties' mutual interest). However, for the Islamic microfinance industry, using mudaraba/musharaka should ensure that Islamic microfinance institutions continue to recognize the value (to them as well as customers) of providing education and technical assistance, along with financing.

There are still ways that non-business (e.g. for the purchase of an asset) microfinance can be effective in an Islamic context and there are even aspects to many of the contracts used that would prevent some of the abuses in Indian microfinance where loans were extended to repay other microfinance loans that led to customers becoming over-leveraged. Unless the Islamic microfinance industry develops and begins offering tawarruq/commodity murabaha-based financing (which it may still do), there will have to be some asset underpinning the financing. This can limit the excessive growth of debt without a corresponding growth in ability to pay.

There remain significant challenges for Islamic microfinance to develop when there are questions raised about the value of microfinance for customers, but also for the institutions funding the MFIs. However, there are specific areas where Islamic microfinance can focus that build in some safeguards (or incentivize Islamic MFIs to develop their own safeguards) to avoid the pitfalls being realized in Andhra Pradesh. It all adds to the issues that Islamic microfinance industry must grapple with as it develops strategies to attain the growth that the rest of the Islamic finance industry has seen in the past decade (even with the effects of the financial crisis).