Author: Unnati Singh
Publication Date: 24 Apr 2021
Introduction
Effective microcredit programs aim to serve marginalized communities with low-cost loans used to fund successful micro businesses. They are operated by microfinance institutions (MFIs), which in the conventional narrative, are benevolent by definition. Yet, in many countries where crippling poverty persists, the microfinance sector has been criticized due to the extortionate interest rates that some MFIs charge. Such extortionate interests rates and other exploitative practices were initially practiced by loan sharks. Ironically, MFIs sought to replace these loan sharks, but some MFIs now engage in the same predatory practices that they aimed to eliminate. This article will not focus on criticisms of microfinance as a tool to alleviate poverty and inequality. Instead, it aims to shed light on the ways in which malicious MFIs can and have taken advantage of the regulatory structure of the microfinance sector, and subjected the most vulnerable populations to further harm for their own benefit. It begins with an introduction to the conventional models of lending that allow lenders to ignore the risks that microfinance transactions pose to borrowers. It then explores the crises of Uganda’s microfinance market, before outlining the need for greater monitoring of microfinance lenders.
Section 1: Potential for Exploitation in Conventional Models of Lending
Classical microfinance methodologies reduce the risk of default by disbursing loans to a group of borrowers, and refusing to lend further until all group members have repaid the loan. Such a model enables lenders to outsource screening, monitoring and loan collection activities to borrowers, reducing the cost to the institution. It is clear that existing models have focused on eliminating incompetence and risk to the lender, whilst ignoring the fundamental ways in which lending contracts may make borrowers vulnerable to opportunistic lenders. In fact, an interview with Ms Malin Rosenkvist, the Director of Fundraising and Communications of the Microloan Foundation, revealed that borrowers may face risks stemming from the terms and the conditions of the contract, as explored below.
The conventional models of microfinance lending suggest that only lenders are vulnerable to borrowers, whereas the reverse does not hold true. By strengthening protections for lenders, this model creates an imbalance between the degree of protection afforded to lenders and borrowers. In doing so, this model makes borrowers more vulnerable to lender malfeasance. In fact, according to Catherine S. M. Duggan (2016), many MFIs have begun to accept, and sometimes even require collateral, which they collect themselves extra-judicially in case of default. Collateral in the microfinance market can be of various types, including livestock, furniture, forced savings or the property of guarantors willing to co-sign the loan. Although these developments may allow benevolent lenders to efficiently recoup their money after a default, they can be used by malicious lenders to exploit clients. Although in the past, borrowers would prepare themselves for this type of abuse from informal moneylenders, microfinance’s stellar international reputation creates a halo effect that extends to MFIs. It is, therefore, difficult for borrowers to differentiate between benevolent and malicious MFIs, and in developing countries that lack strong state institutions to mitigate lender malfeasance, exploitation in the microfinance sector emerges.
Section 2: Crises in the Uganda Microfinance Market
Exploitation of borrowers in the microfinance sector was distinctly observable during the 2002-2007 Uganda Crisis. During this period, Uganda operated laissez-faire economic policies to expand the prevalence of microfinance and spur financial inclusion. Granted, their policies worked extremely effectively, with over 800 institutions operating and providing small loans in urban and rural areas (Ministry of Finance 2006). However, their ineffective regulation incited theft and fraud and a large-scale crisis that led to the decline in trust of the entire financial sector as a whole.
Since 2003, Uganda has taken a tiered approach to the regulation and supervision of its financial institutions. The first two tiers are banks and credit institutions, which are highly regulated and supervised by the Bank of Uganda. MFIs fall under its Micro Deposit-taking Institutions (MDI), and this tiered system was created to allow the largest MFIs to submit themselves to full supervision by the government. However, two years after this tiered system was completed, only 4 MFIs had completed this process, as it cost approximately USD $1 million per institution. Consequently, all other forms of lenders, including MFIs who did not complete this process to identify as an MDI, fell into the fourth tier. This system was designed to promote unbridled entry and the growth of the microfinance sector. Here, all lenders exist without formal supervision from the Bank of Uganda and from any effective government regulation. While tier 4 institutions are formally required to register with the government, in practice, it allowed anyone to identify as an MFI. Given the lack of experience and knowledge of the staff of these new MFIs, they faced high delinquency rates. In 2005, tier 4 institutions reported that 77% of the 354,000 loans they disbursed were outstanding (Ibid.). Amidst the high risk that these tier 4 MFIs faced, they sought new ways to protect themselves from default, namely switching from group-based loans to individual loans based on collateral (Ibid.).
This new practice created a number of opportunities for malfeasance, since the forced savings taken as collateral were not regulated by the Bank of Uganda. Forced savings is when the borrower deposits a percentage of the principal borrowed with the institution prior to receiving the loan. The failure to repay allows the institution to reimburse itself from these funds. 80% of borrowers in Uganda reported that they were required to make such a deposit to secure a loan (Angura 2002). In some cases, tier 4 MFIs secured these savings without making any loans to borrowers. One example of this type of exploitation is through an MFI called Caring for Orphans, Widows and the Elderly (COWE), who registered as an NGO with the Ugandan government. Its model required individuals to pay a membership fee and a forced savings deposit into the institution prior to receiving a loan. However, it was accused of failing to provide its promised services and illegally seizing its members’ deposits, embezzling USD $2.7 million from impoverished borrowers (Ibid.). Despite widespread knowledge and proof of fraud, COWE operated with impunity, as there was little authority to supervise or investigate tier 4 lenders. It was the same for the several other tier 4 MFIs who were also accused of embezzling from clients.
The effect of such unethical operations went against the very objectives of microfinance. Malfeasance eroded trust from Ugandans in all types of financial institutions, including commercial banks and MDIs - both of which are well-regulated and well-supervised.
The public perception of the microfinance sector faced a remarkable negative shift. In fact, a 2013 survey revealed that 75% of respondents stated that they did not trust commercial banks (Finscope 2013). Moreover, Ugandans also changed their borrowing behaviour after this crisis. 4 years after the crisis, only 18% of Ugandans borrowed from informal lenders (Ibid.). This reduction stems from the fact that individuals stopped borrowing from any source. Effectively, they were excluded from borrowing - even though microfinance aims to extend the reach of the financial sector’s arm and allow marginalised communities to borrow money. This impedes the potential income growth and poverty alleviation that microfinance intends to offer. Uganda’s microfinance sector crisis of 2002-2007 has resulted in more information about lender-based opportunism, as well as steady changes to the sector. However, it came at the cost of further excluding members of the most marginalized societies.
Section 3: Implications and Potential Solutions
The implications of this opportunistic behavior in unsupervised microfinance markets extends beyond the specific harm caused to borrowers who fell victim to fraud. Such exploitation has tarnished the reputation of the microfinance in these countries, and prevented potential borrowers from realizing the benefit of microloans. Such exploitation has not been limited to Uganda. Marginalized communities in Nigeria, Bangladesh, China and South Africa (to name a few) have suffered from fraud as well. There needs to be a reevaluation of policies facing the legality of unsupervised collection of deposits and the very use of deposits as collateral. According to Ms. Malin Rosenkvist of Microloan Foundation, solid regulation of the MFI sector is essential but regulations can dampen the reach of reputable and efficient MFIs. Thus, further regulation may not be a potential solution to this issue.
Instead, a potential solution to this issue is joint liability and social pressure to help borrowers identify and avoid malicious lenders. By creating incentives to lenders to identify, screen, monitor and punish one another, this type of regulatory innovation may be able to harness the interest of benevolent MFIs to keep con artists out of the sector. At the very least, it gives borrowers a means to distinguish between benevolent lenders and those hiding malicious intentions under the guise of microfinance’s good reputation. On the flip side, it is not too feasible for governments of developing nations to prioritize creating incentives for the microfinance sector, during a global healthcare crisis and recession. Furthermore, given the slow speed at which governments create formal bureaucratic processes through which MFIs can report this information, it will be a long time before borrowers will be able to access this information to make well-informed decisions.
To reiterate, this article does not aim to condemn microfinance. It aims to highlight the dangers of encouraging unregulated, profit-driven lenders and consider institutional and regulatory means of mitigating these dangers. The most vulnerable members of society should no longer be targeted under the banner of the Nobel Prize winning concept of microfinance.
List of References:
Aggrey, R. (2006) “Largest Number of MFIs in Africa,” The Monitor (Uganda), November 30, 2001. 2006 figure calculated from the Ministry of Finance.
Finscope Uganda (2013), FinMark Trust, and Economic Policy Research Centre. Finscope III survey report findings. Kampala: Economic Policy Research Centre.
Angura, J. (2002) “COWE helps orphans, elderly,” The New Vision (Uganda).
Duggan, C. (2016). Doing Bad by Doing Good? Theft and Abuse by Lenders in the Microfinance Markets of Uganda. Studies In Comparative International Development, 51(2), 189-208. https://doi.org/10.1007/s12116-015-9211-5
Ministry of Finance (2006). Planning and economic development and DFID financial sector deepening project Uganda. Kampala: Report of a Census of Financial Institutions in Uganda.
Rosenkvist, M. (2021). Exploitation by Lenders in the Microfinance Market [In person]. Zoom.
The Dark Side of Microfinance: An Industry Where the Poor Play 'Cameo Roles' - Knowledge@Wharton. UPenn Knowledge@Wharton from https://knowledge.wharton.upenn.edu/article/the-dark-side-of-microfinance-an-industry-where-the-poor-play-cameo-roles/.