The Bicycle Tire Theory of Microcredit Market Stability

Last Thursday and Friday I attended a symposium on "Microfinance 3.0" hosted by the German Development Bank (KfW) in Berlin. KfW was created under the Marshall Plan to finance the reconstruction of West Germany and to this day lends primarily within the borders of Germany. I was told its portfolio is worth €500 billion. The modest percentage of that which is lent to developing countries, however, is sizable enough in absolute terms to make KfW, I believe, the largest (official?) investor in microfinance.I really enjoyed the meeting, because the organizers brought together so many interesting people. Present were Vijay Mahajan of India's BASIX; the heads of MI-BOSPO and MIKROFIN, Bosnian microfinance institutions (MFIs) that have been through tough times; Harry Schmidt, who is one the sources of Germany's involvement in microfinance; Bob Christen, formerly of CGAP and the Gates Foundation, and not one to shy from provocative words; Gerhard Coetzee of South Africa, who understands clients better than most in the room; the always-interesting Rupert Scofield, who probably has been involved with loans to the poor longer than anyone else there; and Beth Rhyne, one of my most important influences.Frau Professor Dr. Eva Terberger did a great job of interviewing me in the opening session, drawing me out while keeping me to time.The majority of those there were from investing institutions, public and private. And what struck me most was a contrast between those investors and the investees. The investors generally agreed that the industry had hits some bumps in the road (bubbles in Bosnia and beyond and the Andhra Pradesh Armageddon), from which all must learn. Generally, though they seemed settled, ready to forge ahead. The people who work in microfinance organizations, however, seemed unsettled, if not shell-shocked---though they too were carrying on. (I am avoiding attribution because I think verbal comments were off the record.)By the same token, I noticed that the most-cited lesson from the recent difficulties tends to put the onus of reform on those beleaguered MFI directors: the need to assure that lending is done in a way that protects clients. The Smart Campaign has done an excellent job of defining and promoting a notion of responsible lending that includes such good things as being transparent about interest rates and not causing overindebtedness. This focus on responsible lending implies a certain division of labor. Microfinance institutions need to improve how they lend. Investors should support them in this effort, such as by funding training; but most of all investors need to be smart shoppers, making sure to assess, even certify, responsible lending, and only entrust their money to institutions that have attained the standard or that can be reasonably expected to in the fullness of time.The principles of client protection are, as principles, inarguable, so I am glad that groups such as the Center for Financial Inclusion (at Accion) and CGAP are promoting them. Still, it's my (self-appointed) job to think critically about such things, and I have a critical think about all this.The big worry these days is that more microcredit markets will blow up...not that such episodes are generally fatal to an industry, but they do hurt institutions and clients, arguably unnecessarily. I would suggest that the question of whether a microcredit market will blow up is like that of whether a bicycle tire will blow up. It depends on the amount of air in the tire and the strength of the tire. If the tire goes, you can with equal logic blame excess pumping or the frailty of the fibers in the tire wall. Thus a debate about causes can run in circles forever. The practical, context-specific question is what you can do to prevent blow-outs going forward. If you are unable to influence tire quality, your best hope lies in limiting the pressure; and vice versa.Just so with financial crises. Why did Canada come through the global crisis so much better than the U.S.? A conference and report from the Atlantic Council cite both kinds of factors in the tire metaphor. In the U.S., Greenspan's Fed kept rates low for much of the 2000's, making for easy money: too much air. And whereas teasers rates became an ignominious household term in the U.S. after the crisis broke, Canada regulated its retail lenders---its banks---more tightly: tougher rubber in those tires.So to reduce the risk of a microcredit explosion, we can strengthen the tires---regulate lending to prevent profligacy---or bleed out some air, providing less finance for microfinance. It's not that useful to argue about which is more important---and, implicitly, whether overeager microfinance investors or overeager MFIs are more to blame for past troubles. What matters is what "we" can do going forward to influence either factor, which depends on who "we" is. Notably, one of these factors is primarily the responsibility of the investors while the other is primarily the job of microlenders (and their regulators). Presumably the best strategy is to work on both aspects since each party's influence on either is limited.What bothered me at the symposium was that the dominant rhetoric from the dominant group put the onus of reform on someone else. Nothing wrong with that in itself, except that it was convenient for most present, and that should inspire some healthy skepticism. Now, the U.S.-Canada contrast demonstrates that the retail lending interface really does matter. So many loans were made in the U.S. in ways that preyed on the predictably poor judgement of ordinary people that it damaged entire U.S. economy. Thus it is right that the Smart Campaign focuses on this interface.But worth scrutinizing is how well microfinance investors, as distinct from microfinance regulators (regulators being key in Canada), can influence what happens there. The challenges are twofold. First is the principal-agent problem: it is much harder for investors than MFIs to observe the quality of those millions contacts with borrowers each year. Are they coercive? Transparent? Second is the institution bias of most investing entities toward disbursement. As Paul Collier put it in 1999, "People do not build careers in financial institutions on default and a lack of loan disbursement." The general desire to invest can make investors weak negotiators, limiting their influence over how their money is used. Thus while it is entirely legitimate for investors to seek to define and enforce responsible lending, it is less certain how effective this top-down pressure, to whatever extent applied, will be. Collier's sour ruminations arose as he contemplated the experience of the World Bank and the IMF with structural adjustment in 1980s and 1990s. The idea had been lend to developing countries not to fund specific projects, but to leverage policy reforms through conditions attached to the loans. At the time the hot controversy was over whether these conditions were imposing the policies of Reagan and Thatcher on the rest of the world, thereby immiserating the poor. In retrospect the academic consensus (e.g., Killick, Easterly) is that the conditions "imposed" by these imperious institutions had surprisingly little effect, for both reasons I listed above. Here's a table from my 2001 monograph, Still Waiting for the JubileeReasons IMF and World Bank Pressure for Structural Adjustment Is Weaker Than It Seems

Reason	Examples
Debt trouble	In Bolivia, debt crisis in the early 1980s led the government to print money, sparking hyperinflation and chaos. In 1985–86, a new administration adopted a harsh stabilization program that raised taxes, laid off state workers, and stopped hyperinflation. IMF and the World Bank adjustment loans came later and so contributed little to the policy shift.
Domestic politics	In Zambia, in 1986–87, strikes by government workers and riots over a 120 percent price increase for staple foods forced the government to restore food subsidies and abandon its agreed adjustment program.
Disasters	In Malawi, in 1986, drought and an influx of 700,000 refugees from civil war in Mozambique necessitated large corn imports and contributed to the government’s decision to reverse commitments to end fertilizer and crop subsidies.
Finance	Adjustment lending to Argentina continued through most of the 1980s with little effect except to bolster forces for the status quo with additional funds. Withdrawal after 1988 deepened the economic crisis that soon forced reform.
Geopolitics	In the Philippines, the U.S. government, which viewed the country as an important ally, apparently pressed the IMF and World Bank to keep lending despite low compliance until the final years (1984–86) of the Ferdinand Marcos regime.
Pressure to lend and appear successful	In 1990, the World Bank promised a $100-million loan to support Kenya in ending its rationing of foreign exchange for purchasing imports. The government then resumed rationing. But local Bank officials did not alert the Bank’s board for fear that it would not approve the loan.
Multiple conditions	Among a sample of 13 sub-Saharan African nations, adjustment agreements in 1999–2000 had an average of 114 policy reform conditions each. It is unrealistic for lenders to demand complete compliance with so many conditions. Other surveys have found that countries technically comply with a typical 50–60 percent of conditions.
Ease of undermining commitments	Starting in 1984, the government of Turkey levied special taxes on imports to support extra-budgetary funds that in turn financed housing and other popular programs. This undermined but did not technically violate loan agreements

Yet there is a mysterious and hopeful coda to this analysis. While in most individual cases, specific conditionalities appear not to have led to much real change, many norms embodied in structural adjustment programs nevertheless won the day. Worldwide, for example, hyperinflation is much rarer than it was in the 1980s. Fewer governments wildly distort their exchange rates. By the same token, it is reasonable to hope that the Smart Campaign and similar initiatives will promote a global shift in how governments regulate microfinance. In post-bubble Bosnia, I learned at the conference, the government has imposed tough new rules meant to prevent another epidemic of overlending. And it sounds like the rules have administrative teeth. The regulators, needless to say, do not experience pressure to disburse.It seems to me that the best strategy for donors and investors wanting advance the cause of stable microfinance is twofold. Work to strengthen the tires, by propagating responsible lending norms and providing training to regulators (and handing out copies of the new edition of CGAP's Guide to Regulation and Supervision of Microfinance). And work to realistically assess the durability of those tires when and where they might invest, and, based on such assessments, sometimes invest less rather than more. What I fear is that all the talk about social performance and responsible lending and seals of excellence will lead investors overestimating their ability to assure that the tires are fortified---even as they add more air. What I fear, in other words, is that they conclude that they need merely tweak the decision making processes of the past.